Now, there is growing concern among cannabis PPP loan recipients of potential audits related to the Small Business Administration (SBA) Office of Inspector General’s estimate that up to one-third of PPP loans were fraudulently secured (and forgiven). Notably, as part of the PPP, the SBA issued specific guidance in 2019 that both cannabis and cannabis-related companies were not eligible for PPP loans (though it’s likely that hundreds if not thousands of these companies applied for and received these funds anyway). And while “plant touching” businesses likely have no leg to stand on if they’re audited by the SBA, cannabis ancillary businesses potentially have a shot at surviving these audits.

CARES Act and PPP Loans

In March of 2020, during the height of the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). The CARES Act created the PPP, which is overseen and enforced by the SBA. Funds administered to eligible small businesses under the PPP were to be utilized to assist with financial hardships during the pandemic.

Cannabis PPP Loan Policy from the SBA

In most states during the COVID-19 pandemic, cannabis businesses were deemed essential services and allowed to remain open, but the SBA didn’t see it that way regarding any financial support.

In 2019, the SBA issued general guidance for lenders seeking to participate in SBA lending programs, and that guidance addressed SBA loans to cannabis businesses as follows:

Because federal law prohibits the distribution and sale of marijuana, financial transactions involving a marijuana-related business would generally involve funds derived from illegal activity. Therefore, businesses that derive revenue from marijuana-related activities or that support the end-use of marijuana may be ineligible for SBA financial assistance.  Whether a business is eligible is determined by the nature of the business’s specific operations. The following businesses are ineligible:

“Direct Marijuana Business” — a business that grows, produces, processes, distributes, or sells marijuana or marijuana products, edibles, or derivatives, regardless of the amount of such activity. This applies to personal use and medical use even if the business is legal under local or state law where the applicant business is or will be located.

“Indirect Marijuana Business” — a business that derived any of its gross revenue for the previous year (or, if a start-up, projects to derive any of its gross revenue for the next year) from sales to Direct Marijuana Businesses of products or services that could reasonably be determined to support the use, growth, enhancement or other development of marijuana. Examples include businesses that provide testing services, or sell grow lights or hydroponic equipment, to one or more Direct Marijuana Businesses. In addition, businesses that sell smoking devices, pipes, bongs, inhalants, or other products that may be used in connection with marijuana are ineligible if the products are primarily intended or designed for such use or if the business markets the products for such use.

The SBA essentially updated the foregoing guidance later in 2019 to address the 2018 Farm Bill and certain hemp-derived activities, but it also expanded on the examples of “Indirect Marijuana Businesses” to include “firms” that:

• Provide marijuana product testing services (strength, purity, etc.);
• Sell or install grow lights or hydroponic or other specialized growing equipment to Direct Marijuana Businesses;
• Sell smoking devices, pipes, bongs, inhalants, or other products primarily designed, intended, or marketed to facilitate marijuana consumption; and
• Advise or counsel Direct Marijuana Businesses on the specific legal, financial/accounting, policy, regulatory or other operational issues specifically associated with establishing, promoting, or operating a Direct Marijuana Business.

Cannabis PPP Loan Audits and “Indirect Marijuana Businesses”

The SBA is authorized to audit all PPP loan borrowers’ compliance with the eligibility and other requirements established at the time of a borrower’s application or related to the terms of a borrower’s application. These audits entail, among other things, an investigation into whether a borrower was eligible for the loan, or for loan forgiveness, based on the information provided in the borrower’s initial loan application and/or application for forgiveness.

Based on recent conversations with clients and potential clients, the SBA is on the PPP audit trail for both “direct marijuana businesses” and “indirect marijuana businesses”. Given that “plant-touching” companies operate in direct violation of federal law (and certainly still were during the COVID-19 pandemic), there is likely no defense for these companies when it comes to an SBA audit of a PPP loan.

However, regarding “indirect marijuana businesses” that do not fall squarely into the examples set forth in the SBA’s guidance, there could be defensible positions taken in an audit depending upon the nature of the business. These audits are factually intensive, and while it may seem like all cannabis ancillary companies were ineligible to receive PPP loans, the actual standard the SBA should utilize in an audit is whether these ancillary companies’ goods and services could “reasonably be determined to support the use, growth, enhancement or other development of marijuana” at the time of application/forgiveness for the PPP loan. In its own guidance, the SBA opine that “[w]hether a business is eligible is determined by the nature of the business’s specific operations.” In turn, there will undoubtedly be room to argue with the SBA over eligibility for cannabis ancillary companies depending on “the nature” of business operations and factual proof of “support” for the “use, growth, enhancement or other development of marijuana” at the time of application/forgiveness for the PPP loan.

How a Cannabis PPP Loan Audit Works

If the SBA decides to conduct an audit, it will send written notice to the PPP lender of record, who must then provide notice to the borrower within five business days of receipt. Upon receipt of one of these notices, cannabis companies should work with legal counsel to compile the key documentation likely to be requested during the audit process, which will include borrower’s records from the date of receipt of the PPP loan, all PPP loan documentation (including the application(s)), all internal documents and correspondence related to the PPP loan, various financial records detailing the borrower’s need for the loan, and all correspondence with the PPP lender.

Cannabis companies should not ignore these SBA audit inquiries—failure to respond could result in the SBA’s automatic determination that the company was ineligible to receive the loan or to receive loan forgiveness. If the SBA determines ineligibility, the SBA is free to seek repayment of the PPP loan or to pursue any other available remedy. And if the SBA makes a determination of ineligibility, the borrower only has 30 calendar days to file an appeal with the Office of Hearings and Appeals.

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