Marijuana leasing

Everyone who grows cannabis needs real estate. Some growers start with a small piece of land, but others require acreage to accomplish their goals. New growers, in particular, tend to over-reach on the land piece. As business operations proceed, and harvest dates are pushed back for any number of reasons, the grower may wish it had held back some cash for operations, rather than dropped so much on the land. That’s where the sale-and-leaseback comes in.

Leaseback deals are a time-honored way for companies to access capital. In short, a leaseback is just a financial transaction where an entity sells a piece of property and immediately becomes a tenant, leasing that property “back” for a significant term. The selling entity is often cash-strapped but wishes to continue in its line of business, and at its present locale. The seller therefore finds a buyer, and works with that buyer to negotiate a long-term sale and lease. On paper things look different; but on the ground, everything stays the same.

We have worked on a series of leasebacks in cannabis of late, and we expect more of these transactions going forward. The leaseback model is in many ways ideal for an industry where traditional financing is unavailable. For example, if a marijuana business has stretched its budget by buying real estate, making improvements, and preparing the land for its cannabis operations, that parcel may be sucking up cash. That said, it may also have real liquidation value. With limited options for fundraising, companies can look to the land.

Leasebacks are not only attractive to cash-strapped enterprises. We have handled leasebacks for producer clients that are profitable but wish to free up cash to start operations at a second location, with an eye toward increasing their market share. In jurisdictions like Oregon, where a single entity can hold multiple cannabis licenses, aggressive operators see the leaseback as a unique leverage option. In the eyes of these operators, freeing up cash for a second or third site is a crucial head start in a burgeoning industry.

We have also handled leasebacks for companies built for the sole purpose of entering these transactions. Formally, these companies may be structured as partnerships, LLCS, or even real estate investment trusts (REITs). Once a leaseback partner is identified, a typical approach is to structure the transaction as a sale and triple-net lease, which targets investor preferred returns upwards of ten percent based on those rents, and increasing property values. These companies prefer to invest in highly regulated states, like Oregon, Washington, Colorado and, hopefully soon, California.

We predict leasebacks will continue to be more prevalent for grow sites than for retail or other uses, because of the size and value of the properties at issue. We also predict that as industry competition intensifies, operators will increasingly turn to leasebacks as a way to move money from real estate holdings to core business– namely, growing and selling pot.

Cannabis business insuranceA client asked me earlier this week whether I thought his company should purchase insurance for their directors and officers. His accountant had advised them to do so, and he was looking for a second opinion. This issue has come up often over the years, so here’s a quick primer on D&O insurance and whether it makes sense for marijuana businesses.

At its core, D&O insurance is a way to protect a business’s directors and officers from being on the hook personally for their actions in their roles as directors and officers. Sometimes those suits can come from third parties, like creditors if the company is insolvent, or competitors for tortious interference with contracts, or customers for deceptive business practices. A large chunk of claims also can come from that same business’s shareholders.

Directors and officers owe multiple duties to their own companies. The big two are the duty of care and the duty of loyalty. The duty of loyalty mandates that the director or officer act in good faith in the best interests of the company, rather than for their own personal gain. The duty of care requires officers and directors act with reasonable care in exercising their company duties. You can violate the duty of loyalty by funneling company money toward your family members and you can violate the duty of care by making business decisions no reasonable person would make. Over the years, courts have tended to read the duty of care as an extremely limited duty — as long as there is a conceivable way to argue for what you did having been a business decision, it likely won’t violate the duty of care. If a director or officer violates one of these duties, one or more shareholders can sue those directors on behalf of the company, referred to as a “derivative suit.”

Company officers and directors don’t generally go into their jobs planning to violate their fiduciary duties to their companies, but they also don’t like the idea of being sued by shareholders for their management decisions. So companies make sure to sweeten the pot by offering protections against shareholder actions. One of them is indemnification, where the company agrees to indemnify an officer or director when sued in their role as officer or director. But indemnification is often limited by state law, where companies are not allowed to fully indemnify their officers and directors, especially for duty of loyalty violations.

The next layer of protection is D&O insurance. In a standard D&O policy, the individual officers or directors are covered when the company does not indemnify them. If the company does indemnify them, the company is covered for those costs. Finally, the company can be covered for additional claims against it, including potential securities claims.

For cannabis companies, the decision of whether to get D&O insurance is really no different than it is for other companies, except the premiums and coverage limitations may be different. Cannabis business is still pretty young in the actuarial world, and determining the exposure of directors and officers who are running companies that openly violate federal law is an interesting task. Like a lot of other services in the marijuana space, insurance underwriters tend to quote higher than ordinary rates for D&O insurance because of that uncertainty. For small marijuana businesses still run by their founders, D&O insurance plays the role of providing some liability coverage, but it isn’t necessary to attract outside talent.

Other than cost, one additional reason some companies choose to avoid D&O coverage is perception. If a director or officer wants a company to provide her with D&O insurance, that director or officer is saying she doesn’t want any of her personal assets to be on the hook for her company decisions. But if you look at it from the shareholder perspective, they already have significant personal assets on the hook. Many people have their life savings tied up in cannabis businesses, and there’s no such thing as shareholder insurance for bad decisions by management.

The vast majority of large public companies have some type of D&O insurance, and it is rare for really small companies. For those companies in the great middle, D&O insurance can make sense as a way to retain directors and officers, especially if the company is engaged in activities that invite lawsuits against directors and officers in their individual capacities. On the other hand, it is an expense, and shareholders like to see it when their directors and officers also have some skin in the game.

American lawyer in BarcelonaI spent last weekend in Barcelona attending Spannabis. Our Barcelona lawyers constantly get inquiries from serious international businesspeople wanting to start a cannabis social club or some other sort of cannabis business in Spain. And with more than 200 medical marijuana social clubs in Barcelona alone, I wanted to go there to meet with key industry players to learn more about what is going on with marijuana in Catalonia’s capital city and in the rest of Spain.

Barcelona and medical marijuana felt to me like some combination of California, Oregon, and Washington seven years ago. Namely, it feels like an unregulated, quasi-commercial gray market chalk full of “collective” non-profits and rotating patient members, unclear laws and inconsistent enforcement of those laws. For a breakdown on the current medical marijuana laws in Spain and in Barcelona, go here. This unclear and pioneer atmosphere was also in full force at Spannabis, which was in many respects just like pretty much every other marijuana trade show/expo I’ve attended in the United States: light on serious education about marijuana laws and regulations and heavy on promoting marijuana consumption and on seeking to preserve the counter-culture. But with cannabis cups and consuming events dwindling in the U.S. from increasing state marijuana regulations, I would be remiss if I did not mention how the Spannabis fairgrounds managed to maintain a steady cloud of overhanging marijuana smoke from its more than 3,000 attendees who openly and consistently consumed despite the presence of law enforcement.

Spannabis had only a single panel on the legality and rules surrounding Barcelona’s (mostly medical) marijuana social clubs and the panelist gave little detail or explanation about the law that enables cannabis clubs to operate. That panel was made up of one criminal defense attorney telling attendees about the national and local government’s conflicting policy positions on health and law enforcement and the rights of individuals to consume cannabis for medical use. Needless to say, since our cannabis lawyers represent the business side, I didn’t this panel very helpful. More importantly, this panel served as just another indication that Barcelona and Spain as a whole have just not yet really “arrived” yet as destinations for those seeking to form and operate a cannabis business fully compliant with local (in this case Barcelona), provincial (Catalonia) and federal (Spain) laws. Fortunately, our Spain lawyers mostly focus on representing ancillary cannabis businesses and CBD businesses, along with the standard fare of helping foreign companies in all industries seeking to form a business in Spain and make a go of things there.

But as many in the industry there were quick and emphatic about telling me, the cannabis scene in Barcelona and in Spain is slowing maturing and slowing getting “more legal.” As we wrote just last week, the regional Parliament of Catalonia has proposed reforms in line with a 2014 initiative advocated by Regulacion Responsible in advance of the 2014 Spain national elections. The initiative’s aim was to create a framework for the national reform of cannabis laws to permit regions like Catalonia and cities like Barcelona to set their own cannabis policies. Though the 2016 legislative initiative stalled, it has recently reemerged and anticipation is building for a revised version of this bill that would mean increased regulation for legalized marijuana businesses on a regional basis. Given the inconsistent enforcement of current laws (within both Catalonia and Spain) and the lack of meaningful or comprehensive business regulations, such reforms cannot come soon enough to better protect and give more structure to those cultivating and distributing marijuana for and to patients. Patients would also benefit from such regulation as it would increase both transparency around the sourcing of cannabis products and cannabis quality assurance standards.

Even though marijuana social clubs in Spain exist in a risk-laden gray area, it’s clear that manufacturing and distributing CBD is a popular and, more importantly, legal practice in Spain and Barcelona (in contrast to the United States). Indeed, the majority of booths on the exhibitor floor at Spannabis focused on hemp seeds (there was even a company there from Humboldt County) and CBD-based products. Manufacturing and distributing cannabis paraphernalia or equipment used for consuming, cultivating or handling are also legal and ancillary companies are alive and well in Barcelona, just like in most of the U.S. This is why foreign investors looking at Spain are mostly focusing on financing, starting, managing or assisting ancillary companies and not so much on marijuana social clubs, all of which are non-profit because of existing laws prohibiting commercial “trafficking.” The Arcview Group (well-known for angel investments in ancillary marijuana businesses) held an investor meeting in Barcelona for the first time last week.

Barcelona’s medical marijuana marketplace remains immature and risky (these were the words used by many of those with whom I spoke while I was in Spain), but it no doubt has tremendous potential. Once local governments in Spain are given the freedom (and they might soon) to take the reigns on cannabis regulation and to create a better business atmosphere for cultivators, manufacturers, and distributors, Barcelona will no doubt quickly become a major marijuana city in terms of popularity, investment, and access. The lawyers in our Barcelona office can hardly wait.

Cannabis fraud cannabis lawyersDon’t lie to your investors, and don’t be taken in by investments that don’t make sense. That’s the moral of this story, which made the rounds based on an SEC press release on Friday. A few years ago, the founder of a marijuana ancillary services company allegedly pumped up the value of that company with misleading press releases and created illusory revenues by transacting “sales” between the “operating” company and the publicly traded company. The SEC found out, investigated, charged the founder, and settled for a hefty fine. The cannabis industry is full of these stories. Every time a local newspaper touts how high marijuana tax revenues are or any new milestone in local marijuana sales, it invites investors to throw their money at any company they can. Investing in small, local, state-licensed cannabis companies is challenging and time-consuming due to state regulations, and the back-end return is fine, but usually not amazing. Public companies, on the other hand, promise enormous growth by having their hands in and around all aspects of the industry, and investors flock.

For those of us that try to do things the right way in this industry, it’s easy to highlight stories like this as indicative of bad actors and move on, but it’s important to remember a few things. The company described in the story was prominent in the cannabis industry for a while, and a lot of people thought it was making a lot of money and doing really well. It’s not just investors that get taken for a ride in cases like this. Attorneys, accountants, industry lobbying organizations, and others often get taken in the same way investors do, and they can face similar consequences. Public company fraud often relies on complicit actions by people who don’t realize they are a party to the fraud.

Here’s how things can spiral: Fraudco, Inc. puts out a press release touting big money and amazing technology. Small media outlets jump on it because they desperately need content. Attorneys, accountants, and potential business partners across the country that are looking for opportunities see the initial media coverage and rush in to see if they can do business with Fraudco. Fraudco is light on the details but says yes. Larger industry organizations get word that Fraudco is aligning itself with well-known professionals within the industry and give Fraudco a more prominent public and political role (after Fraudco pays to be a gold-level member). Larger media stories follow, and the public sees a company with positive reporting from large and small outlets and business relationships with recognizable and respected businesses and other professionals. Fraudco doles out just enough money to the industry groups and professionals to make it seem like they are doing real business and to avoid too many questions.

It can take months or even years to figure out that much or all of a company’s business can be fictitious. This happens because we fall into the trap of relying too much on trust. A modicum of due diligence can generally unravel most fraudulent schemes. Just last week, in Buying a Cannabis Business: The Top Five Due Diligence Items or Buyer Beware, we stressed the importance of due diligence when buying a cannabis business. The same holds true when investing in one. Despite what most people think, the fraud aspect isn’t usually that complicated. The problem is that even a modicum of due diligence is hard. It’s time-consuming, and short cuts are attractive. One of the most prominent shortcuts you see in small industries is to assume that a company is legitimate because the media and other businesses in your industry act as though they are legitimate. You say to yourself, “Well they can’t all be wrong about Fraudco,” and you let your guard down. Now you’re part of the problem — a self-reinforcing feedback loop that gives power to a company whose only output is a constant churn of press releases. See also Oregon Cannabis Fraud: How to Stay Out of the Newspapers

If you’re a potential investor in the cannabis space, it’s not that hard to protect yourself. Even if you don’t know the first thing about due diligence, you can still follow the tips that FINRA laid out in its stock scam investor alert of a few years ago. You can also make the decision to have your lawyer review all transactions and perform due diligence before you enter anything binding. There’s no reason to go it alone. See The Six Top Marijuana Scams to Avoid and Top Ten Marijuana Industry Red Flags.

But if you’re an attorney or an accountant or an industry organization or other professional to whom people look for guidance, you have a greater responsibility. It isn’t just to make sure that you don’t do anything illegal. Your associations and your reputation matter. They matter for your business and they matter to the outside world. If you haven’t done your homework on a company to be sure it’s legitimate, don’t vouch for it. If you’re an industry organization, make sure that the businesses you promote and put at the forefront are real, compliant, successful businesses. The overwhelming majority of cannabis businesses we see are legitimate, but I also can tell you right now that there are plenty of cannabis businesses in California, Oregon, and Washington that those in the know whisper about and will not touch, and yet plenty of others seem to have no problem just diving in.

As long as marijuana is illegal federally, the cannabis industry is in a somewhat precarious position and every prominent cannabis company that engages in illegal conduct — whether illegal drug trafficking or investor fraud — is a stain on the industry that makes progress that much harder. Industry participants can’t prevent bad acts, but they can do their part to make sure they don’t contribute, mistakenly or not, to those bad acts.

Cannabis due diligence
Know the red flags and find them.

Our marijuana business attorneys handle lots of purchase transactions for marijuana businesses. These deals often involve two sides rushing to complete a transaction handled by a business broker who doesn’t know or care about the applicable marijuana laws. The worst case scenario is when a company asks us to review a purchase agreement drafted by the seller without having done any due diligence on the potential purchase. Buyers of businesses (like investors) take the lion’s share of risk, which is why buyer due diligence is key. Before buying a cannabis business you should know exactly what assets and liabilities you will be taking on.

The below are the top 5 due diligence items you need to protect yourself and your money (for sellers, check out Preparing to Sell Your Marijuana Business):

  1. State and local law compliance. This is by the number one due diligence item for buyers. State and local law compliance varies greatly by state and by county and by city and you have to know what state and local licensing or permitting is required for a given marijuana business before you purchase it. I cannot tell you how many times we have had buyers come to us thinking they are buying a licensed marijuana business only to find out that the license is only pending and has not actually been issued or that the cannabis business is facing license revocation for rule violations, or that the municipal law has changed and the business must re-locate to continue operating. Before buying a cannabis business you should, at minimum, confirm that the company you will be buying is in good standing with the Secretary of State and the regulators and you should review its proof of licensing and permitting and its history of administrative violations, including any written warnings. If you fail to do this, you may find yourself with a cannabis business without a license to legally operate or that is about to lose it.
  2. State law procedures for ownership changes. Marijuana businesses are heavily regulated and there are onerous state law procedures in place for changes in ownership. Generally, the seller must disclose the buyer to the state and the buyer must be successfully vetted by the relevant regulators. Buyers and sellers of cannabis business cannot undertake these sales like any other business. No matter what any seller or broker may tell you as the buyer about the ease of the transaction, you as the buyer should ensure that the sale can comply with applicable state law requirements for changes in ownership and that the purchase and sale agreement accounts for the timing of performance obligations set forth in that purchase and sale agreement. We have had company’s come to us after the fact that have lost their earnest money for not closing quickly enough on deals where the closing date was impossible to meet from day one.
  3. Corporate authority. Ownership disputes are common in the marijuana industry because many marijuana operators still neglect (to their detriment) to put their corporate and contractual relationships in writing. We often see cannabis business buyers who (based on the word of a single seller in a multi-owner entity), believe they are free and clear to purchase all the stock in a corporation or all of the membership units in an LLC when they actually are not. Purchasers must get copies of all bylaws and subscription agreements when contemplating buying a corporation and they must get a copy of the current operating agreement for an LLC to know whether the seller has authority to sell their (or all of the) membership interests in the business. Failing to secure this authority will violate the seller’s corporate obligations and the sale can likely be undone. If all of the existing owners do not agree to the buy-out or transfer or there is a right of first refusal on sales or transfers, the buyer (and the seller) are going to have serious issues enforcing the purchase agreement.
  4. Real property. When you buy a business, you typically buy all of its assets, including any real estate it owns or has an interest in. Buyers therefore need to get a list of all real property owned and leased by the business that is to be sold. Most importantly, you want to know if the company you are seeking to buy is locked into a long-term lease or whether you’ll be able to re-locate it upon buying it. Many buyers have their own property on which they want to run the cannabis business and for these buyers, the ability to move the business can be key. If there is a lease, you want to know its terms and whether you can or want to comply with it. And because boilerplate leases don’t cut it in this industry, you need to make sure that lease sufficiently covers your issues when it comes to state and local law compliance and the federal law conflict.
  5. Financial liabilities. Again, because too many marijuana business owners don’t memorialize their business and corporate relationships in writing, you as the buyer must thoroughly vet the business’s financial liabilities. You want an agreement that requires the seller to have disclosed every handshake deal with every consultant, investor, and service provider so you know what you’re getting and to whom you’re financially obligated and so that if an undisclosed problem arises, it is the seller’s financial problem, not yours. This should include any instrument that grants a security interest from the cannabis business you are buying to a third party.

To mitigate against anything your due diligence investigation might miss, you need comprehensive and solid seller representations and warranties in the purchase and sale documents. But even skillfully crafted representations and warranties may not be enough to capture all of the liabilities that fall through the cracks, especially if your seller lacks the financial wherewithal to pay for them. So, do your due diligence or buyer beware.

Oregon cannabis lawyersOur Oregon office forms three or four cannabis companies per week. Our Washington office has formed hundreds of these businesses in the past four or five years, and our California office has seen a major uptick in company formation work since AUMA passed last fall. Though every state brings unique considerations for entity choice and structuring, most of these businesses (outside California) end up registering as either LLCs or C-corps. And most of them involve owners who bring different things to the table.

The most common example of differing contributions comes when one person brings skill and labor to the table, while another brings cash. The “sweat equity” partner may have expertise and relationships related to production or processing of cannabis, for example, while the traditional equity partner has the ability to immediately fund the marijuana business. In a classic scenario, these two individuals come to one of our cannabis business lawyers and say they would like to own the business “50/50”, or thereabouts. This raises some serious tax implications for the sweat equity partner.

The Internal Revenue Code values capital over labor, especially when that labor constitutes future services a person will contribute to a business in exchange for ownership. From the IRS’ perspective, if Party A contributes $100,000 in cash to an LLC or corporation, and gives a 50% interest to Party B (for a sweat equity contribution), the IRS will also value Party B’s interest at $100,000. Unfortunately, Party B will have to pay tax on that income, which is sometimes referred to as “phantom income.”

The following are a few of the more common ways to deal with phantom income in a situation where one member of a cannabis business provides the capital, and the other provides services:

Vesting. It is possible to have the sweat equity partner’s interest vest over time, through options allocated to that partner under a shareholder or operating agreement. The sweat equity partner will purchase and pay for his or her equity through distributions or dividends earned as an owner of the company. The vesting schedule here is very important. If the schedule is too long, the value of the membership (and the amount payable) may increase. If the schedule is too short, repayment may not be viable.

Company Loan. Often, the partner without cash at the onset will issue a promissory note to the company. Here, the sweat equity partner is acknowledging having received a valuable interest in the company, for which he or she owes a debt. The promissory note can be made with a commercially reasonable repayment period and interest rate, and the member can pay down the note with income received from the company. It is important to remember, though, that the note payments will be made from taxable income. This is simply a way to extend the tax hit over time.

Owner Loan. Sometimes, neither partner will contribute a sizable amount of cash up front. Instead, both partners will contribute a nominal amount, like $1,000, and the partner with cash will make a loan to the LLC. This option should be considered carefully, for a couple of reasons. First, from a tax liability perspective, the IRS may consider a company with a debt to equity ratio over 3:1 or 4:1 to be “thinly capitalized” and subject to scrutiny. From a legal liability perspective, an undercapitalized company may leave its owners open to vicarious liability on a “piercing the corporate veil” theory.

The above are simplified, high-level summaries of common methods lawyers and CPAs use to deal with phantom income in cannabis start-ups. It is important to note that each situation is unique and depends on a variety of factors. It is also important to note that sweat equity is not the only way phantom income is created in cannabis companies. Almost all pot companies have some amount of phantom income due to IRC 280, for example. That rule alone is a crucial business planning consideration for every marijuana entrepreneur.

Legal and tax structuring are critical decisions that can determine whether a marijuana venture succeeds or fails. Learning to look out for phantom income is key part of this analysis. That’s true for both sweat equity and cash investors — especially in this unique and highly dynamic industry.

Cannabis merger risks
           Cannabis business risks. It’s no game.

Cannabis entrepreneurs have been riding an emotional rollercoaster these past few weeks. Just from Politico, we have seen the following headlines:

Running a cannabis business under these circumstances can be challenging. Employees get nervous about possible legal repercussions just for doing their jobs. It seems like all anyone wants to talk about is what the federal government is going to do about marijuana.

The uncertainty has started to affect the transactional market as well. Mergers and acquisitions in the cannabis industry are certainly still happening, but we are seeing the rate of deals actually closing slowing down a bit, at least in California, Oregon, and Washington. Would-be buyers of cannabis businesses are having a hard time deciding whether a licensed business that was worth $1.5 million four months ago is still worth the same price.

This type of short-term slowdown is typical of volatile markets, where parties are uncertain of how to price risk into their transactions. Looking back at the great recession, part of the reason economic recovery took so long was because firms were slow to deploy capital. Toxic debt had infected so much of the market that even companies with nothing to do with mortgage investments were affected by the outward ripple. They didn’t know if their investments would be caught up in the same debt spiral that killed so many other businesses. If enough people sit on their hands and wait for someone else to move, markets slow down.

Cannabis markets have always had their share of uncertainty. Legislatures and regulators continue to spend large amounts of time tweaking existing laws and regulations for marijuana businesses. Many of these changes happen at a moment’s notice and can absolutely sink people’s businesses. Sometimes they can save businesses and make them thrive. It’s not that regulatory and legal changes are inherently negative or positive — it’s that they create uncertainty. Local governments do the same thing. Unpredictable weather patterns can doom cannabis crops — more uncertainty.

When uncertainty, like that created by the back and forth Jeff Sessions drama, leads to short-term stagnation in sales markets. The first movers in that sort of market are either the most confident about their analysis of the situation or the most willing to gamble. Players in uncertain markets must price their perception of risk into what they are willing to spend. If I think there is a 90% chance the federal government will leave marijuana businesses alone and a 10% chance they will shut down marijuana businesses everywhere, there’s no way I should pay more than 90% of the value that would be there if the federal risk did not exist.

Where uncertainty and gambling converge is in judging that 90% chance. Do we think the chances that Jeff Sessions goes nuclear on cannabis are 10%? What if someone else thinks the chance is 20% or 30%? If you aren’t certain how to price that risk into your cannabis investments or acquisitions, you’re going to have a hard time participating in the cannabis market right now, and hence short-term stagnation.

At the same time, if you have a high level of confidence in your ability to perceive and price risk into your cannabis transactions, there is money to be made by playing the risk spread. There are sellers right now who think the federal government is going to destroy cannabis businesses everywhere and these sellers are willing to accept lower prices for their assets because they have a higher perception of the risks to that asset. If a buyer feels strongly that the risk is lower than the seller does, there’s room for a transaction.

The next few years are going to be interesting to watch, especially if the Trump administration remains cryptic about its attitude toward cannabis businesses. The risk-tolerant and the risk-intolerant are going to start showing their colors, and we will all learn a lot about the power that early movers in uncertain markets have when it comes to creating price anchors for business valuations and finding the biggest spreads between buyers’ and sellers’ risk perceptions. All of this is worth keeping an eye on, even if you aren’t in the short-term cannabis M&A or investment markets.

Washington Cannabis LawyerThe Washington State Liquor and Cannabis Board (LCB) enforces a wide range of rules and laws on cannabis. Because of this, our cannabis attorneys constantly stress to our clients the need for them to set up and rigorously maintain comprehensive regulatory compliance protocols to avoid violations of LCB rules and regulations and to mitigate penalties should such violations occur.

When the LCB believes a licensed cannabis business has committed a rule violation, it will issue the licensee an Administrative Violation Notice (AVN), describing the alleged violation and a recommended penalty. The LCB has broad discretion in assessing penalties for cannabis rule violations, based on Washington Administrative Code instructions that it consider mitigating and aggravating factors in making that penalty assessment. Penalties generally increase if the cannabis licensee has had repeat offenses within a two-year window.

The Washington Administrative Code separates cannabis violations into five categories:

  • Group One—Public safety violations. These violations are considered the most serious and they have the harshest penalties. For example, a cannabis licensee caught buying or selling marijuana to or from an unauthorized source faces cancellation of its license with even a first offense.
  • Group Two—Regulatory violations. These violations include failing to keep proper records, failing to submit required monthly reports, and improper advertising.
  • Group Three—License violations. These violations include failing to abide by licensing requirements and license classifications. Some Group Three violations can result in cancellation of the cannabis license even on the first offense. For example, a licensee’s failure to disclose everyone who owns, operates, or loans money to a licensed cannabis business is a violation of Washington’s true party of interest rules and it can lead to a cancellation of the cannabis license. Other Group Three violations can result in monetary penalties and/or a suspension of license.
  • Group Four—Nonretail violations. These violations involve the manufacture, supply, processing, and/or distribution of marijuana by nonretail licensees and prohibited practices between nonretail licensees and retail licensees. Generally, a first offense of a Group Four violation will result in a fine, but the LCB may cancel a license after the third Group Four offense.
  • Group Five—Violations involving the transportation freight of marijuana. These violations can result in cancellation of a license for a first offense if marijuana is transported from or diverted to an unauthorized source. This includes marijuana transported outside the state of Washington.

The LCB generally doesn’t temporarily suspend producer or processor licenses; it instead employs monetary fines, destruction of inventory, and/or license cancellations to penalize non-retail cannabis licensees. On the other hand, Cannabis retail license holders generally see temporary license suspensions, monetary fines, or license cancellation.

A cannabis licensee has 20 days after receiving a Violation Notice to accept the penalty, request a settlement conference, or request an administrative hearing before an administrative law judge. At these settlement conferences, the cannabis licensee and the LCB discuss the circumstances surrounding the LCB allegations, the recommended penalty, and any aggravating or mitigating factors. You are allowed to bring an attorney to these settlement conferences and you should. The hearing officer’s settlement authority is often limited, but the primary goal of the hearing is to explain why the incident occurred, to identify what failures there were in the licensee’s internal compliance program, and for the licensee to detail a plan to prevent future violations. If a licensee successfully explains all of that, the penalty is generally mitigated. In mitigation, fines and suspension periods are generally cut by 40%-50%.

The administrative hearings on LCB rule violations are similar to court proceedings but a bit less formal. For example, these proceedings do not use the strict evidentiary rules of courts. At these hearings, the cannabis licensee and the LCB may question witnesses and submit and challenge documents regarding the alleged violation. The administrative law judge typically reviews the circumstances surrounding the alleged violation, including any mitigating and aggravating factors and determines guilt or innocence and then hands down a penalty pursuant to the penalty guidelines in the Washington Administrative Code. If the cannabis licensee is not satisfied with any aspect of the administrative judges’ decision, it can appeal to the LCB to have the decision overturned.

Bottom Line: Cannabis licensees should have company-wide policies and procedures in place to avoid rule violations and as a mitigation factor should any rule violation occur. They should also know their various options for dealing with any alleged violations.

How to sell a California cannabis businessSince passage of the Medical Cannabis Regulation and Safety Act (“MCRSA“) and Proposition 64, one of the top questions our California marijuana lawyers have been getting from existing medical marijuana operators is “how can I sell my medical marijuana collective?” Of course, many collectives are not hard-pressed to find willing buyers. In the City of Los Angeles, for example, where only 135 Proposition D-compliant dispensary collectives are allowed to exist (which will also receive priority status from the City under the MCRSA and Prop. 64 in the event Measure M passes on March 7th), buyers are lining up to try to buy LA dispensaries that can get them into that market. There is also plenty of buyer interest in other California collectives that can demonstrate continuous operation and good standing with their local jurisdictions to qualify for “priority status” under both the MCRSA and Prop. 64.

But here’s the big issue: neither the MCRSA nor Prop. 64 repealed Proposition 215 and Senate Bill 420, which together make up California’s current and very vague medical marijuana laws. What this means is that all medical marijuana collectives must still operate as non-profit entities unless and until the application period opens for licenses under the MCRSA or Prop. 64. And just to further complicate matters, “collective” is an industry term of art; it is not a specific type of California legal entity and you are not going to find it in the California Corporations Code. One of the main reasons for California’s “collective model” is that the California Attorney General’s office issued a memo in 2008 with its interpretation of the medical marijuana laws that concluded those laws forbid the sale of medical marijuana for profit and, therefore, only “non-profit operation” would be allowed in the event qualified patients were to “collectively or cooperatively” cultivate and distribute medical cannabis to other qualified patients.

As a result of that 2008 memo, most qualified patients form nonprofit entities to handle their “commercial” medical marijuana activity. They typically form nonprofit mutual benefit corporations (“NPMBCs”) that they refer to as “collectives.” In turn, it isn’t possible to “buy” a collective. Why? Because there’s no equity or stock to purchase. Of course, there are other solutions to this non-profit conundrum, but they must be carefully considered and well thought out by both a prospective purchaser and the collective.

In NPMBCs, the articles of incorporation and the bylaws govern the collective’s every move and decision–but the bylaws really govern the day-to-day activity and decision-making authority of the members. For example, NPMBC bylaws will have provisions that dictate, among a slew of other things, admission of new qualified patient members and what they must do to maintain their membership in the collective. In addition, well-drafted bylaws also typically will address the voting rights of the members and directors. Under the California Corporations Code, a prospective purchaser cannot buy the stock of a NPMBC (because none is authorized or issued). The California Corporations Code does however permit membership transfers if the collective’s bylaws allow them, and these transfers are fairly unrestricted unless the bylaws specifically create restrictions around them.

Section 7320 of the Corporations Code governing NPMBC membership transfers states the following regarding the transfer of membership rights:

Subject to [member voting restrictions in the bylaws]:

(a) Unless the articles or bylaws otherwise provide:

(1) No member may transfer a membership or any right arising therefrom; and

(2) Subject to the provisions of subdivision (b), all rights as a member of the corporation cease upon the member’s death or dissolution.

(b) The articles or bylaws may provide for, or may authorize the board to provide for, the transfer of memberships, or of memberships within any class or classes, with or without restriction or limitation, including transfer upon the death, dissolution, merger, or reorganization of a member.

(c) Where transfer rights have been provided, no restriction of them shall be binding with respect to memberships issued prior to the adoption of the restriction, unless the holders of such memberships voted in favor of the restriction.

The ideal situation is usually one where the bylaws create two classes of membership: usually directors who manage the NPMBC and qualified patient members who access the NPMBC for medical marijuana, with the directors being the only ones who vote on management decisions affecting the NPMBC. The bylaws usually also allow for director membership transfers (presumably with a fee), without requiring a vote of every single qualified patient who has ever become a member of the NPMBC. In turn, directors can sell their memberships to prospective buyers who can then take over and operate the NPMBC until MCRSA and Prop. 64 licensing.

Unfortunately, nearly all of the NPMCB bylaws our California cannabis lawyers have seen on the deals on which they have worked are a mess, largely because most of the lawyers in California that do cannabis law are criminal lawyers not corporate transactional lawyers. Much of the time, the NPMCB bylaws do not contain a provision allowing for membership transfers or they require every single member of the collective vote on such a transfer because they lack multiple membership classes or voting exceptions. In these situations, it is sometimes possible to set up a system where the departing directors provide notice to every single qualified patient member that new directors could take over the board of directors and those new directors might vote to pay the departing directors a fee for services to be rendered to the NPMBC after-the-fact. For example, the new directors could vote to hire the departing directors in a consultant capacity and pay them a fee for that work. Though neither ideal nor efficient, this is one of various workarounds that can be done to transition the management of an NPMBC with bad bylaws.

The bottom line is that non-profit collectives cannot be “purchased,” and it takes good bylaws (or convoluted workarounds) to be able to transition from one group of directors to another. So, if you are looking to “sell” or “buy” a California cannabis business, be sure that the relevant bylaws allow for such a change and that your transition documents are in-line with what the bylaws actually allow. If such care isn’t taken, the buyer can be left with nothing but an empty wallet and the collective may find itself in direct violation of California’s Corporations Code and an expensive and painful lawsuit as well.

Marijuana Real EstateTomorrow, I will co-present a national continuing legal education (“CLE”) seminar for the American Law Institute, titled “Cannabis and Commercial Real Estate.” I will present this 90-minute seminar and webcast with Daniel Dersham, a talented real estate attorney with the San Francisco law firm Wiley & Bentaleb LLP. The seminar is designed for lawyers around the country who wish to assist clients in buying, selling and leasing real estate in the cannabis industry. It is also a great opportunity for non-lawyers to gain insight on how cannabis properties are rented, bought and sold, and to understand how attorneys approach these unique transactions.

Over the past few years, our Oregon, Washington and California offices have advised on hundreds of real estate transactions related to state-legal cannabis. In the Oregon office alone, we are continuously working on these deals, which may range from the negotiation of a 1,500 square foot lease for a dispensary, to the purchase of a 150+ acre property for large-scale agriculture across multiple licenses. Each deal is a snowflake, and each brings unique opportunities and challenges.

Because we are always doing real estate deals, we tend to write about them often. For a recent sampling of work related to this field, including topics that will be covered at tomorrow’s CLE, please see the following recent Canna Law Blog articles:

Like many aspects of the cannabis industry, the central issue that makes real property transactions challenging, unique, and even sort of fun (at least for us cannabis business lawyers), is federal illegality. That issue ripples through pretty much every cannabis real estate deal in myriad ways, and a skilled practitioner with knowledge of the following is required: (1) the dynamic interplay of state and federal law; (2) the intricacies of state and local regulatory programs for cannabis– including zoning and land use laws; and (3) industry standards on achievable deal points for a lease or sale transaction.

Over the next year or two, existing state marijuana markets will continue to mature and new markets will come online. We expect to see a continued emphasis on real estate deals during this period. Buyers, sellers, landlords, tenants and service providers who understand the way this game is played will have a considerable advantage. And for many in the cannabis industry, negotiating a real estate transaction will be the largest decision of all.

I hope that you can join us.