After several years of highly limited capacity and hard markets, cannabis D&O coverage is beginning to become more attainable for both private and public companies. Frontier Risk works with existing and emerging capacity providers to structure protective coverage for cannabis companies, and is observing rates become more affordable by the month for its clients.
Frontier also specializes in placements for cannabis companies that are bordering, or already in, financial distress, and may be considering a reorganization or restructuring. With the collapse of three major banks stressing the already challenged economic environment and constant rate hikes (maybe this last one was really the last one?) we’re in a highly challenging environment for cannabis businesses to navigate.
With the amount of activity in the market, D&O is the single most important policy a cannabis business can have—it protects executives, board members, personal assets, balance sheets and reputations. Companies must understand current D&O market challenges and implement necessary risk management safeguards.
Benefits of D&O Coverage for the Cannabis Industry
D&O policies are a must for those operating within the cannabis industry, offering critical protection and supporting strategic business initiatives, including:
D&O coverage protects the personal assets of board members and management in the event they are sued for their management or mismanagement of the company. This is especially valuable when the company is either unwilling or unable to indemnify managers. Without a D&O policy in place, business leaders would have to fund their own defense and settlement costs, which could be substantial. This is of notable concern within the cannabis industry due to federal regulations around cannabis, which heighten legal risk. Some carriers write D&O policies with regulatory exclusions, but not all.
As a precursor to derivative action claim, cannabis companies will often be presented with a books and records demand, which requires the business to put forth the records of all the board member meetings. This can be an incredibly time-consuming and expensive process. D&O policies recently expanded coverage to supplement books and records demands costs that businesses would historically have to fund on their own.
If a cannabis company is sued, especially in securities class action suit, it will need to perform significant damage control or risk reputational harm. Many D&O policies provide sub-limits that cover the hiring of a public relations firm and other expenses associated with mitigating reputational damage.
Bankruptcy risk mitigation
If a cannabis company goes into bankruptcy and is presented with a derivative lawsuit, which is a non-indemnifiable loss, D&O coverage can mitigate the loss by offsetting defense costs.
Management and board member attraction
As cannabis companies grow in size, scale and sophistication, they require a much higher level of expertise and experience from board members. To attract and retain high-value board members and management, companies must have D&O policies in place. Many executive officer candidates won't join companies without adequate D&O policies, and almost no real independent directors (IDs) – a growing need in the industry – will join without proper coverage. True independence on a cannabis board is hard enough to come by given how many high net worth (HNW) individuals have funded these companies and have cap table positions worthy of a board seat. Why make it harder to prove true independence at the top by forgoing D&O coverage for IDs?
Mergers and acquisitions support
Not having D&O coverage could also prevent an acquisition from going through. It is one of the first things buyers look for before entering into a deal – and dealmaking is poised to pick up again as cannabis equity values remain at historic lows. Have we seen the bottom yet? Fortune favors those with cash when the market is distressed.
Current Challenges Within the Cannabis D&O Market
D&O insurance has been in a hard market for the past few years, becoming more expensive across all industry sectors, not just cannabis. Within the cannabis industry specifically, angry investors litigated against business leaders personally for failing to deliver on growth and profitability promises, driving cannabis D&O coverage costs up further.Carriers are still nervous about federal illegality. But many have dipped their toes in with solid programs nonetheless.
Carriers that are actively offering D&O policies in the cannabis space are writing coverage conservatively, with regulatory exclusions that deny coverage if the federal government flags illegal behavior; and financial condition exclusions, which deny coverage in case of bankruptcy or financial impairment. Frontier Risk helps clients navigate these critical exclusions, because as we all know, the devil is in the details.
If a cannabis company is not in a strong financial position and does not have access to capital, the risk is greater for the insurer. Cannabis companies also are not permitted to go public on traditional markets—they have to go through the OTC exchange or trade in Canada—creating additional insurance headaches.
Softening Market Ahead?
After years of a hard market environment, the D&O and management liability space is beginning to transition. Many new carriers have entered the management liability space for cannabis and non-cannabis business (a combination of new insurance companies, existing insurance companies expanding their product offerings and managing general agents), bringing lots of new capacity into the market. At the moment, Lloyd's and Bermuda cannot legally cover cannabis. If that shifts, and Lloyd's and Bermuda carriers are able to write companies in the cannabis space, the market will open up and carriers could change their tune and begin to insure cannabis more openly. Be wary of Bermuda-based insurance companies, even those with emerging license categories, that are selling cannabis insurance policies.
ConsiderationsTo secure and retain D&O insurance in the current market, cannabis companies must take extensive measures to present themselves as a high-quality risk. Businesses in the industry must be as transparent as possible about:
- Financials (forecasted revenue, cash on hand, earning history)
- How the product is created and protected
- How they are complying with state and federal laws and regulations (including the RICO Act)
Underwriters and brokers are also increasingly looking at investor decks when assessing a company's risk level. Surprise, surprise: they are more likely to offer coverage to cannabis businesses with proven track records and heavily experienced C-suite leadership.
As the cannabis and D&O markets continue to evolve, businesses should work closely with industry experts to navigate challenging conditions and lock in the coverage they need to alleviate risks and continue to prosper.
Given the aforementioned macroeconomic tumult, companies are left wondering how to prepare for worst-case scenarios like bankruptcy. We're also seeing cannabis restructuring advisory boutiques (financial and operational advisors) pop up left and right – a symptom of worsening conditions for cannabis companies. Some are better than others. Fortunately, there are a number of insurance optimization strategies available for cannabis businesses and their leaders to secure their personal and corporate assets in the case of a bankruptcy or distressed sale. We use the term bankruptcy as a general descriptor, as typically, federal Chapter 11 and 7 bankruptcy protection (and associated processes) are not available to cannabis companies, putting the risk back on lenders. The following pre- and post-distress risk transfer ideas can be used to the address the impact of personal and corporate liabilities in a bankruptcy scenario, and can help increase the value of those considering a sale of corporate assets.
Protect Key Stakeholders with Directors and Officers Insurance
The most common allegation against a company filing bankruptcy is that leadership mismanaged corporate assets and breached a fiduciary duty owed to the company. What is often overlooked by directors and officers is that, in the event of insolvency, many jurisdictions will hold that your fiduciary duty extends beyond just the interest of shareholders and includes creditors as well. This is a critical difference, and cannabis companies, given how many are debt-backed, should operate in good times as though their duties extend to all stakeholders, not just who's in the cap table. Being a fiduciary to creditors also raises the pool of potential claimants for a lawsuit, and increases the potential severity of a settlement—and associated defense costs. Because company funds are unlikely to be available to meet claims and indemnify individuals, directors and officers liability insurance (D&O) can be a source of protection for both the company and—critically—the individual insured's personal assets, but only if properly structured policies are in place. Policy details matter here, and base policy forms in today's marketplace will need to be addressed and amended to make sure that coverage is afforded in these special situations.
First and foremost, it is critical to amend the D&O policy to affirmatively state that individuals will be reimbursed before the company for defense costs and settlements they are liable. Other key policy enhancements include:
- Ensuring the policy is not captured by any kind of automatic stay and remains available to pay individual insureds during the bankruptcy process
- Incorporating affirmative language stating that bankruptcy, particularly an out-of-court process for cannabis companies, does not relieve the insurer of its obligations
- Amending the insured versus insured or entity versus insured exclusion to carve back coverage for claims brought by creditors or receivers who try to act in the capacity of a debtor-in-possession (again this term is typically reserved for real, federal bankruptcy processes that are not available to cannabis companies, but creditors will still try to reserve similar rights to play the part)
- Adding affirmative language that the policy is non-cancellable by any trustee or receiver
These amendments typically need to be requested and negotiated prior to the placement or renewal of your D&O program. However, in some circumstances, coverage enhancements can be made mid-term. Right now, organizations should be having proactive conversations with Frontier Risk to determine whether or not these provisions are included to head off issues in the future.
Restructure Inefficient Insurance Programs to Claw Back Trapped Cash
D&O liability is not the only insurance policy that should be examined in the event of a bankruptcy or distressed sale. Many cannabis operators have historically chosen to purchase large deductible casualty insurance programs, including general liability, workers' compensation and commercial auto. This results in the insurer requiring the company to post collateral, typically in the form of an evergreen letter of credit.
If an issue with solvency is on the horizon or a process resembling a bankruptcy has started, this "trapped cash" could help the company satisfy its current and ongoing obligations. By focusing on the right financial levers and restructuring historically overcollateralized or inefficiently collateralized programs, meaningful amounts of this trapped cash can be returned to the company and provide liquidity for other uses.
To achieve these objectives, cannabis operators should consider the following:
- An independent and objective claims and actuarial analysis to identify over-securitized bands and frame negotiating positions with current and legacy counterparties to release excess collateral held by insurers
- Program cross-collateralization to improve capital efficiency
- Establishing contact with insurance company decision-makers to drive rational responses on the release of collateral
- Employing proven alternative risk strategies such as captives or risk retention groups to reduce or eliminate future collateral obligations (Frontier Risk can help you set up a captive or risk retention group)
- Post-restructuring, assess ways to reduce insurance program expenses, including third party administration (TPA) agreements, claims mitigation strategies, ROI-based safety and loss control directives, retention optimization, and alternative captive and risk retention group implementation.
Utilize Reps & Warranties Insurance to Protect Deal Value
In the event that a cannabis company in distress is being sold, either in the form of an asset sale purchase from a bankruptcy or pre-petition asset sale, the issue that arises is sellers being able to provide potential buyers with a form of indemnity to backstop the representations and warranties made within any purchase and sale agreement.
This is why representations and warranties insurance (R&W) is crucial. The coverage increases efficiency (and potentially value) by creating a pool of indemnity—assumed by insurers—that a debtor or distressed cannabis seller would not be able to provide either at all or with sufficient credit quality to protect buyers.
Additionally, fraudulent conveyance and successor liability insurance policies can be utilized to protect distressed asset buyers against claims by upset creditors and from court-imposed liability despite contractual limitations.
Don't Forget Post-Restructuring Planning
Post-restructuring, to help ensure prior solvency issues are not reencountered, it is important to optimize all go-forward insurance program costs based on facts and deep technical analysis to account for reduced business revenues, employee count, or market cap (if the cannabis company is public).
Organizations should consider various carrier management strategies, including establishing relationships with the insurance company's executive team and chief credit officer; streamlining or eliminating TPA, external risk management, and other insurance service provider costs; and implementing new risk management strategies to include more cost-efficient retention structures. Frontier Risk typically allows a cannabis company's finance team to outsource risk management so the already-strapped team can focus on other forms of cost engineering.
Other Lines of Coverage Getting Better, Too
The wider availability of coverage and lower pricing is a relief for cannabis operators that have buckled under high rates and constrained supply (capacity) as recently as 2022.
Limits are increasing as well. Some programs historically offering property limits up to $30 million have, in the past year, started to offer limits on some risks for close to $100 million per location. This is key as creditors, who now seem to be dominating cannabis capital markets, have very little true collateral they can actually claim, so they tend to focus on protecting valuable property assets (as opposed to inventory assets, for example, which they are not state-licensed to receive in the event of a liquidation).
Reinsurance capacity for cannabis risks has also expanded, though hurdles remain.
There are now about ten reinsurers in the market, up from just one or two a few years ago. Interest in the sector is highest among smaller reinsurers looking for a competitive edge among their larger peers.
One growing challenge for cannabis may come from an increase in product liability suits, with many centering on labeling. We're seeing an increase in litigation premised on under or over reporting of cannabinoid content on labels, and similar claims of consumer fraud and false advertising around labeling and testing. Vape hardware is a big one – batteries potentially overheating and causing injury, and metal coils in cartridges super-heating and leeching heavy metals into distillate, which is then inhaled.
While the number of lawsuits has been limited so far, they're sure to increase as cannabis operators have certain internal control failures in their rush to growth. So they should consider product liability risk when evaluating their insurance needs.
Sources: Frontier Risk Group, Business Insurance Magazine, Risk Management Magazine