IRS & Business Taxation of the Cannabis Industry

The Association for Corporate Growth of Los Angeles hosted a panel on Trends & Transactions in Cannabis Middle Market M&A.

The panel addressed appropriate valuation methods for cannabis companies, with one speaker suggesting that a valuation based on a multiple of EBITDA alone would likely not be sufficient if that were the only method, given the outsized effect that the current tax laws have on cannabis companies.  That speaker suggested that a DCF using a five-year projection could be more helpful, where the cash flows are projected on an after-tax basis.  Of course, as we’ve posted before, a valuation of any cannabis asset is a highly fact-specific exercise that is not subject to any one-size-fits-all formula and depends on the facts and circumstances presented in each case.

As a practical matter, the panel also cautioned M&A buyers to go beyond the written financial statements and do a walk though of the facilities, a critical step for cannabis companies to ensure that half the plants aren’t dead, for instance.

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Cannabis valuation issues will continue to grow in importance as the macro industry grows and as market participants continue to engage in transactions that refine the inputs for any valuation analysis.

This piece by Bloomberg BNA [sub] highlights the 34 states that have now legalized cannabis for medicinal use (along with the 19 states allowing recreational usage); the projections put US market growth at 21% annually, reaching $41.5 billion by 2025, with the worldwide legal market for cannabis forecast to reach $91.5 billion by 2028.  These estimates have room to the upside, as further legalization pushes may increase the addressable legal market, while reduced criminal penalties and diminishing stigma may also spur additional innovation.

First Department of New York Loosens the Standard for “Piercing the Corporate Veil”

Delaware law generally respects corporate separateness, but in rare cases will disregard the corporate form to prevent fraud or injustice.  Earlier this year, in Manichaean Capital, LLC v. Exela Technologies, Inc., 2021 WL 2104857 (Del. Ch. May 25, 2021), Vice Chancellor Slights issued the first Delaware decision recognizing reverse veil-piercing, in which liability is imposed on an entity for the liabilities of its owners, in allowing the claim of plaintiffs attempting to collect an appraisal judgment from the subsidiaries of the recalcitrant entity.  This decision provides investors and creditors another tool in their arsenal to prevent potential abuse of the corporate form.

Background.  Plaintiffs were equity holders in SourceHOV Holdings (“SourceHOV”) prior to its acquisition by Exela.  Plaintiffs dissented from the merger and brought an appraisal action, obtaining a $57.6 million judgment against SourceHOV, which did not pay the judgment.  Plaintiffs brought suit asking the court to pierce SourceHOV’s corporate veil downward, so that plaintiffs could enforce the judgment against the company’s solvent subsidiaries.

Decision.  The court denied defendants’ motion to dismiss and permitted plaintiffs to proceed on their reverse veil-piercing theory.  The court explained that “[a]t its most basic level, reverse veil-piercing involves the imposition of liability on a business organization for the liabilities of its owners.”  Opinion at *9.

(Reverse veil-piercing can be invoked by an insider—where the request to disregard the corporate form comes from the entity owner itself—or an outsider—where the request comes from a third party.  The court’s decision addresses only outsider reverse veil-piercing.)

The court began by holding that the “[r]isks that reverse veil-piercing may be used a blunt instrument to harm innocent parties, and to disrupt the expectations of arms-length bargaining,” “while real” do not “justify the rejection of reverse veil-piercing outright.”  Id. at *11.  Given that Delaware law, while respecting corporate separateness, will not permit “the use of the corporate form as a means to facilitate fraud or injustice,” the court found that “there is a place for a carefully circumscribed reverse veil-piercing rule within Delaware law.”  Id. at *12.

The starting point for reverse veil-piercing is the same as traditional veil-piercing:  the alter ego factors of “insolvency, undercapitalization, commingling of corporate and personal funds, the absence of corporate formalities, and whether the subsidiary is simply a facade for the owner.”  Id. at *13.  The court should then ask whether the owner is using the corporate form “to perpetuate a fraud or injustice.”  Id.  The court provided eight illustrative factors in this inquiry, including impairment of shareholder expectations, public policy, harm to innocent third-party creditors, and the extent and severity of the wrongdoing.  Id.  In sum, reverse veil-piercing, “like traditional veil-piercing, is rooted in equity, and the court must consider all relevant factors . . . to reach an equitable result.”  Id.

The court first addressed the alter ego factors, finding that the complaint adequately alleged that SourceHOV was insolvent and undercapitalized and did not follow corporate formalities.  The court then concluded that it was “evident” that certain of SourceHOV’s subsidiaries were actively diverting assets away from SourceHOV to other Exela entities to shield those proceeds from the appraisal judgment.  Finally, the court briefly addressed the other fraud/injustice factors, including that there was no basis to find that reverse veil-piercing would harm innocent creditors of SourceHOV’s subsidiaries.  Notably, the court explained that reverse veil-piercing here would serve public policy by allowing plaintiffs to receive the compensation awarded to them in the appraisal action.

Takeaways.  The decision recognizes reverse veil-piercing for the first time under Delaware law and provides a road map for its use.  Where appropriate, investors and creditors should thus consider a reverse veil-piercing claim if an entity (or owner) is improperly using subsidiaries to, for example, evade liability or frustrate a judgment.

CoinDesk: Bitcoin, Ethereum, Crypto News and Price Data

In a federal court ruling from earlier this year, Vogel v. Boris, the New York federal court refused to toss out a claim by an LLC member, Vogel, against his two other business partners, alleging that they violated a restrictive covenant in the LLC’s operating agreement prohibiting any member from forming a new SPAC aside from the existing SPAC they had explicitly agreed to be working for: their violation consisted of forming a sponsor for a second SPAC and closing a $250 million IPO, all while squeezing Vogel out of the new SPAC.  The court ruled that the allegations sufficiently stated a legal claim to allow the case to proceed further, without deciding the substance of those claims.

First off, in the course of its analysis the court provided a succinct summary of the SPAC process:

The first step of the typical SPAC process, according to Vogel, is for those managing the SPAC to create a company to control it, usually a limited liability company, referred to as the “sponsor.” The sponsor receives a percentage of the shares raised in the IPO as a fee and puts the shares aside in escrow or trust pending consummation of a potential merger. Once a successful merger has occurred, the sponsor will distribute the shares to the SPAC’s managers and/or members based on certain contractual triggers such as, for example, termination of a lockout period or the reaching of a particular share price.

Second, however unusual this set of facts may be, it makes the point that some of the background activity underlying a SPAC transaction is often a creature of contract.  Here in Vogel, that contract was an LLC operating agreement, while in other situations, the operative contract may be a subscription agreement underlying a PIPE transaction relating to the SPAC deal.  In all events, investors considering their rights in connection with a SPAC transaction should be sure to consider any contractual remedies in addition to any federal securities fraud or state fiduciary duty and common law claims.

As reported here in Law360 [$$], Sustainable Opportunities Acquisition Corp. — a SPAC planning to mine the seafloor for metals to be used in electric vehicle batteries — has sued two potential investors for failing to fulfill their purported obligation to provide funding under a PIPE deal.  The investors had signed subscription agreements committing them to fund $200 million to the SPAC but ultimately refused to do so by the stated funding deadline.  The SPAC is seeking specific performance, asking the court for a judgment requiring the investors to fund their PIPE commitment.  The newly filed complaint does not indicate what the investors’ reasons were for refusing to fund.

Delaware Supreme Court Adopts Limited Practice Privilege For 2020 Bar Applicants – First State Update

When can an investor bring an action against corporate directors and officers directly – i.e., on behalf of the investor herself, rather than derivatively, i.e., on behalf of the company?  In a September 20, 2021, decision, the Delaware Supreme Court clarified a split in authority over whether corporate overpayment claims are direct or derivative by overruling a prior precedent – Gentile v. Rosette.  While the impact of Gentile (and thus, its overruling) is limited, the result is a caution to minority shareholders that when faced with oppressive tactics by a controlling shareholder, you must consider the full suite of potential claims and tactics available.  The fact that a transaction is unfair on its face will not necessarily be enough for a harmed investor to recover directly.

To summarize the recent decision overruling Gentile:

Under Delaware law, stockholder claims can be derivative (i.e., on behalf of the corporation) or direct (i.e., a personal claim of the stockholder).  Whether a claim is direct or derivative determines, among other things, whether the claim survives a merger (derivative claims do not).

In 2004, in Tooley v. Donaldson, Lufkin & Jenrette, Inc., the Delaware Supreme Court held that whether a claim is direct or derivative “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” 845 A.2d 1031, 1033 (Del. 2004).

Under Tooley, claims of corporate overpayment are usually derivative.  But two years after Tooley, in Gentile v. Rossette, the Delaware Supreme Court held that there was one type of corporate overpayment claim that is both derivative and direct:  a claim challenging the corporation’s overpayment in company stock for assets of its controlling shareholder, thereby diluting minority shareholders and increasing the controller’s stake.  906 A.2d 91, 100 (Del. 2006).

In the years since it was decided, Gentile faced criticism.  Indeed, in his concurrence in El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016), Justice Strine urged overruling Gentile.  On September 20, the Delaware Supreme Court did just that in Brookfield Asset Management, Inc. v. Rosson, No. 406, 2020, slip op. (Del. Sept. 20, 2021).

Decision Below

Defendants conceded that the facts fit the Gentile rule, but urged Vice Chancellor Glasscock to overrule Gentile.  He declined to do so.  On interlocutory appeal, Defendants asked the Delaware Supreme Court to scrap the Gentile exception.

Supreme Court Decision

 The Delaware Supreme Court agreed with Defendants and overruled Gentile.  The Court discussed the following factors:

  • Gentile Conflicts with Tooley. Although Gentile was decided after Tooley, the Court concluded that “certain aspects of Gentile are in tension with Tooley,” including whether and how stockholders were injured independent of the corporation, Gentile’s reliance on the “special injury” test contained in a prior case, In re Tri-Star Pictures, Inc. Litigation, 634 A.2d 319 (Del. 1993) (a test whichTooley rejected) , and Gentile’s focus on the alleged wrongdoer—the controller—rather than who was injured and who would receive recovery.  Slip op. at 27-43.
  • Gentile Not Needed. The Court gave minority shareholders a roadmap for non-Gentile claims.  Finding that there was “no practical need” for the Gentile doctrine, the Court highlighted that “[o]ther legal theories” gave stockholders a basis to address fiduciary duty violations in a change of control context,” and that stockholders have “the right to challenge [a] merger itself as a breach of the duties they are owed” by arguing that “the seller’s board failed to obtain sufficient value for the derivative claims.”  Slip op. at 43-44.  Shareholders facing a harmful merger can look to this discussion in future cases.
  • Stare Decisis Does Not Save Gentile. Finally, the Court held that stare decisis concerns did not compel upholding Gentile.  The Court explained that Gentile was decided fifteen years ago and that time has proven that the decision “is more of a departure from the then-recent Tooley than the continuation we perceived it to be at the time” and that El Paso “further muted” any reliance on Gentile.  Slip op. at 49.


 Given Justice Strine’s decision in El Paso urging that Gentile be overruled, the Delaware Supreme Court’s decision doing just that was not surprising.  The death of Gentile means that minority shareholders must consider alternative routes to challenge a controlling shareholders’ extractive transaction.  As the Supreme Court discussed, minority shareholders may have other non-Gentile claims, and thus should explore all of their legal options if faced with a controller who has effectively expropriated both economic and voting power via a related-party stock transaction.

IPO News | Seeking Alpha

In this timely academic piece by Maria Lucia Passador, “In Vogue Again: The Re-Rise of SPACs in the IPO Market,”  the case is made that SPACs in the US will continue their growth in the capital markets and should “update and evolve for good” despite the recent increase in litigation and resultant increase in D&O insurance costs.  The article also examines the use of PIPEs as guarantors of SPAC transactions.  In other words, as Passador wryly suggests, SPACs are more than a simple fad utilized during the pandemic ­–  as if they were “Charon ferrying markets through the darkest of waters” (you know, the ferryman of Hades who transported the souls of the dead across the river Styx) – but based on pre-pandemic trendlines they are here to stay.

As reported here in Bloomberg, after launching a record-size $4 billion SPAC last summer, Bill Ackman’s Pershing Square Tontine Holdings is unwinding and returning its invested funds back to shareholders.

In June, Pershing Square announced it was buying a 10% stake in Universal Music Group, surprising investors who had been expecting a classic SPAC merger.  After litigation was filed alleging that the SPAC was acting (improperly) as an investment company instead of an operating company, Ackman denied the merits of the lawsuit but also reversed course and aborted pursuit of the Universal Music stake.

In response to this controversy, Ackman has also announced that he is pursuing SEC approval for a new type of blank-check company, one that may have been better suited to take on the Universal Music investment: Ackman is contemplating the creation of a SPARC – a special purpose acquisition rights company – that would only take investor money after finding a deal.  If approved, existing Pershing Square shareholders may be given the option to participate in a SPARC down the road, in a vehicle under less pressure to identify an acquisition within the customary two-year period facing SPACs.

As Alison Frankel at Reuters observed, of the 60+ lawsuits filed in New York state court in the first half of this year against SPAC directors for inadequate disclosures, most of them typically settled after the initial complaint was filed, without advancing their claims that the SPAC boards violated their duty of disclosure by withholding key information from their public filings relating to the SPAC transactions.  What is motivating the quick settlement?  The chance for those defending these claims to pay the lawyers a fee – known as a mootness fee after the accusation of insufficient disclosures becomes “mooted” by the SPAC supplementing its initial disclosures with new, curative information that overcomes the deficiency – and buy litigation peace in return.  Frankel noted that these lawsuits ostensibly sought to stop shareholders from voting on the SPAC’s proposed acquisition (consistent with the rationale that such shareholder vote would not be fully informed given the disclosure deficiencies), and yet those lawsuits did not include separate motion papers formally requesting the necessary injunction to halt that vote.

Frankel notes that this spike in SPAC disclosure suits smacks of the “deal tax” litigation that previously populated the Delaware Chancery Court after most public M&A deals were announced, with nearly 95% of all such deals facing disclosure-only lawsuits that typically settled after a therapeutic disclosure cured the alleged deficiency (Delaware had clamped down on such suits in Trulia and its progeny, sending that type of litigation to federal court after being repackaged as Section 14(a) disclosure violations.  While this piece appears to inject a strong dose of skepticism into the merits of this particular species of litigation, it should be noted that SPAC litigation has taken on many forms, in many courts, including claims going well beyond the Delaware disclosure-only strike suits of old.

Given the unprecedented surge in SPAC activity in the first half of 2021,  SEC Acting Director John Coates has expressed concerned about risks ranging from fees, conflicts and sponsor compensation, to the sheer amount of capital pouring into the SPAC market.  Naturally, with this surge has come “unprecedented scrutiny,” and the SEC has been focusing on clearer disclosures and transparency for shareholders.

Among the interesting data point Director Coates identified, only about 10% of SPACs have liquidated between 2009 and now, with most SPACs having proceeding to identify acquisition candidates.  To put that point in context, SPAC transactions are essentially two-step process, with the first step being as follows:

The basics of a typical SPAC are complex, but can be simplified as follows. A SPAC is a shell company with no operations. It proceeds in two stages. In the first stage, it registers the offer and sale of redeemable securities for cash through a conventional underwriting, sells them primarily to hedge funds and other institutions, and places the proceeds in a trust for a future acquisition of a private operating company. Initial investors also commonly obtain warrants to buy additional stock as at a fixed price, and sponsors of the SPAC obtain a “promote” – greater equity than their cash contribution or commitment would otherwise imply – and their promote is at risk. If the SPAC fails to find and acquire a target within a period of two years, the promote is forfeited and the SPAC liquidates. About ten percent of SPACs have liquidated between 2009 and now.

[citations omitted].  Next, once the SPAC spots its target, it effectuates a reverse merger by which a private company becomes public:

In their second stage, SPACs complete a business combination transaction, in which the SPAC, the target (i.e., the private company to be acquired), or a new shell “holdco” issues equity to target owners, and sometimes to other investors. SPAC shareholders typically have a vote on the so-called “de-SPAC” transaction, and many investors who purchased securities in the first stage SPAC either sell on the secondary market or have their shares redeemed before or shortly after the de-SPAC. After the de-SPAC, the entity carries on its operations as a public company. In this way, SPACs offer private companies an alternative pathway to “go public” and obtain a stock exchange listing, a broader shareholder base, status as a public company with Exchange Act registered securities, and a liquid market for its shares.

Director Coates is careful to note that the safe harbor for forward-looking statements under the Private Securities Litigation Reform Act (PSLRA) does not necessarily insulate projections and other valuation material from liability; while the SPAC market may superficially appear to provide an “out” for sponsors and targets that is not available in conventional IPOs, Director Coates has warned: not so fast.  Indeed, the PSLAR’s safe harbor expressly excludes from safe harbor protection those statements made by a “blank check company” as well as IPOs, appearing to carve out SPACs from its protection.  As he puts it: “Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst,” cautioning that any material misrepresentation in a registration statement that is part of a de-SPAC transaction is subject to Section 11 liability under the Securities Act, just as any material misstatement in a proxy statement is subjection to Section 14(a) liability.  And beyond just federal securities law claims, Delaware fiduciary duty law applies more strictly where a conflict of interest appears, as is often inherent in SPAC deals.

As Director Coates apply summed it up: no one gets a “free pass” from material misstatements in a de-SPAC transaction.