Cannabis business ownership lawsMany marijuana businesses include one or more people in their ownership group that contributed “sweat equity” to their business, rather than cash or other valuable assets. Because of the level of state regulations, even small cannabis businesses typically require a lot of capital to start. Many experienced entrepreneurs have had to team up with investors to get their cannabis businesses off the ground. Many other people looking to start cannabis businesses have had to entice experienced growers to help set up their facilities by offering equity in lieu of or in addition to salary.

But working relationships don’t always last. Whether it be for poor performance or for more serious issues (violating state regulations, stealing from the company, etc.), cannabis companies often find themselves wanting to part ways with senior employees that also have an ownership interest in the company.

For large publicly traded companies, this is no big deal because they can easily terminate employees that have received stock — even a large amount of stock. All the company must do is finalize the termination, stop paying salary, and determine whether there are any stock options or grants subject to a vesting schedule that need to be finalized. Then, the company and the employee simply go their separate ways. There is no reason for a large publicly traded company to worry about the stock already issued, as it is likely only a minute fraction of the company’s overall capitalization.

For small, closely held companies, however, stock grants and LLC membership interests held by employees can be far more complicated. The employment relationship and the ownership relationship tend to intermingle, especially if the owner/employee was also one of the company’s founders. Depending on the size of the ownership group, even a 10% share of the voting ownership interest can be significant and can handcuff owners trying to bring on more capital in the future while also trying to retain a voting majority.

First, it is important to decouple the ownership interest from the employment relationship. For businesses that are taxed as corporations (subchapter C or S), owner/employees likely receive a significant part of their compensation as standard W-2 employees. For businesses taxed as partnerships (how most multi-member LLCs are taxed), the employment portion of income is likely categorized as a guaranteed payment. Regardless, this is the issue that should be dealt with first. Company owners with work obligations should be treated like employees for purposes of those obligations. The company should set expectations for employment, and best practice is to have a written employment agreement specifically drafted for the owner/employee scenario. That employment agreement, or the LLC operating agreement or shareholder’s agreement, should determine who can decide to terminate an owner/employee. The decision will need to be made by a majority of either the company’s managers, members, directors, or stockholders. There is no cookie-cutter answer on how to do this as every situation is different.

Once the employment situation is handled, the next issue is what to do with the lingering ownership interest in the cannabis business. Inexperienced business owners that gave away equity as compensation too often treat it as something more temporary than it is. There are mechanisms to provide a worker with profit-sharing so long as that person is working, only for that profit-share to disappear when the person is no longer working for the company. But that is something different than standard ownership of stock or membership interests, which we see far more often. There is a property right in the stock or the LLC membership interest, and it isn’t just going to disappear.

One option is to let the departed employee keep the stock or membership interest. If there is no pressing need, there is nothing inherently wrong with having a former employee continue to have an ownership interest in your cannabis company. They are still entitled to their vote and to their distribution of profits, but that does not mean they need to play a day to day role in company business.

But for cannabis companies looking for a clean break, their easiest option is to have an agreement, either in the LLC operating agreement or in the corporation’s shareholders agreement, providing the company with a buyout option for owners that no longer work for the company. Making it optional helps the company if it does not want to be forced to make a significant cash payment, but the employee would likely want the buyout to be mandatory. The value can either be set by a mathematical formula or the agreement can refer to a third party appraiser. The payment terms are set, and the company is able to buy out the owner/employee.

The important thing is that this is something that needs to be laid out ahead of time. If there is no buyout mechanism in an LLC operating agreement, there is no automatic right under most states’ LLC laws to remove individual LLC members. It is to both the company’s and the owner/employee’s benefit to figure this out up front when negotiating the original hiring. Once termination has started, it can be really hard for the cannabis company and the owner/employee being terminated to cooperate. If you set up from the outset what a break-up will look like both parties will have an easier time dealing with the change and moving on.

Buying and selling cannabis businesses We like to blog about buying and selling pot businesses. It’s a rich topic and the transactions can be memorable for both entrepreneurs and attorneys. In our recent posts, we have canvassed subjects from diligence items for buyers to checklist items for sellers. We also have covered important transactional topics such as how much your cannabis business may be worth and what you can actually sell. Today’s entry covers a structural part of many business sale agreements: the earn-out.

An earn-out is a contractual provision that entitles a seller to additional compensation in the future, if the business achieves stated financial goals. Earn-outs are used when the asking price for a business is more than a buyer is willing or able to pay up front. A well drawn earn-out can bridge the valuation gap between an optimistic seller (pretty much all of them) and a skeptical, cash-strapped, buyer (just some of them). It can also provide a buyer with additional financing. In an industry where hard money is the rule and bank loans are not available, that can be compelling.

The primary objective in an earn-out is to allow the buyer to make payments over time. The earn-out may also require the seller to step into a consulting role post-sale, and actually “earn” the post-transaction payments. In those cases, it is important to clearly outline the parties’ expectations. This scenario makes for a less clean break, but sometimes a seller has invaluable expertise and experience—particularly in a local marijuana market—that can be passed along with the sale.

In addition to seller support, there are many factors to consider in negotiating an earn-out agreement. Five important ones include: (1) the earn-out period; (2) payment structure; (3) payment schedule; (4) performance matrices; and (5) accounting standards. Earn-out payments may also be capped or uncapped, and the parties can stipulate that future events (like federal enforcement action, for example) will offset earn-out payments. Depending on the type and size of the deal, and the parties’ personalities, an earn-out can be simple or extremely complex.

If the goal is to keep things simple from both a payment and audit perspective, the parties will choose an easy-to-peg accounting and payment metric. For example, sellers often suggest an earn-out based on sales, because this line item is never disputed and the calculation is simple. A buyer, on the other hand, may push for an earn-out based on net income, as this metric accounts for all nuances of a business’ operations. A middle road would peg the earn-out at a multiple of EBITDA, usually over a certain number and in each relevant year. Ultimately, simpler calculations mean fewer disputes.

Given the nature of federal law, the earn-out metric for a pot business must also consider factors mainline businesses needn’t entertain. One of these is the oppressive effect of IRC 280E, the tax code provision that cuts into marijuana business profits. Another is licensing implications at play in the relevant state: readers of this blog know that states have strict rules on who can hold a financial interest in a pot business, and how that interest may be postured.

At the end of the day, many deals in the cannabis industry are structured to account for a lack of institutional financing. Like the marijuana sale-and-leaseback or the ubiquitous seller carry, an earn-out may be a way for a cash-light market entrant to gain a toehold in state-legal cannabis. We expect that earn-outs will remain an attractive option for the industry until things change at the federal level. Given the current shape of things, that could be a while.

Happy 4/20.

China counterfeit lawyers
There are a lot of fakes out there, in the cannabis industry too.

As we’ve previously written, my law firm, which does considerable international trade and China law work in addition to our regulated substances practice, has on all fronts been getting an influx of clients complaining about counterfeit cannabis goods and seeking our help in dealing with the problem. The problem of counterfeit goods in the cannabis industry has only continued to grow over the last year.

I was interviewed earlier this year about the lawsuits brought by Roor pipes against nearly 200 smoke shops and convenience stores, alleging those stores are selling counterfeit Roor bongs in violation of Roor’s U.S. federal trademark registration. Though those lawsuits may be on uncertain ground from a federal trademark law perspective, Grenco Science, maker of the G-Pen brand vaporizer, recently found success in federal court against counterfeiters.

Earlier this year, Grenco sued more than 65 different online retailers for selling counterfeit G-Pen products. Most of the offending companies were based in China, which is consistent with the majority of the counterfeit cases my firm handles. Some of the lawsuits settled out of court, but many of the Chinese companies failed to respond to Grenco’s complaints filed in court – also a common occurrence when trying to pin down a Chinese company in U.S. court. In light of this, a federal judge in Illinois granted Grenco $47 million in damages, which equates to $1 million from each of the 47 companies found to have infringed Grenco’s federal trademarks, as well as injunctions against each of the companies ordering them to cease sales of the counterfeit goods.

Of course, getting a judgment against a Chinese company for trademark infringement is only half the battle – Collecting on these judgments is another matter. Oftentimes, U.S. judgments against Chinese companies are worth very little. A U.S. judgment against a Chinese company can lead to collection, but for that to occur, one must know about the operations of the Chinese company and one must be prepared to be legally creative in figuring out how and where to act in using the U.S. judgment to go after the Chinese company’s assets.  We’ve written extensively about this process on our firm’s China Law Blog, and you can read more about it here and here.

Given the difficulty in enforcing these judgments it is critical that you as a business owner take preventative steps to ward off counterfeiters, and to know what to do in the unfortunate event someone does counterfeit one of your goods. And as we tell all our clients: investing in these preventative steps now is always way less expensive than fighting a legal battle (and trying to enforce a judgment) in court down the road.

So what preventative steps should cannabis businesses take to address counterfeiting? Prevention hinges on first identifying your intellectual property (IP), determining what categories it falls into, and then protecting it accordingly in the relevant jurisdictions. The design of a novel device like a water pipe, for example, could be subject to patent protection. Though we’ve blogged extensively about the difficulty in obtaining federal cannabis trademarks, federal patent law does not contain the same “legal use in commerce” requirement, or a prohibition on “immoral or scandalous” matter. A patent is the grant of a property right to the inventor, issued by the United States Patent and Trademark Office (USPTO), and this property right gives the inventor “the right to exclude others from making, using, offering for sale, or selling the invention in the United States or importing the invention into the United States.” Patents are often the most powerful tool in fighting counterfeit goods.

Patent infringement is not the only way counterfeiters can rip off products. Oftentimes, when talking about counterfeits, we’re talking about trademark infringement (as in the G-Pen and Roor cases) rather than patent infringement. A counterfeiter could, for example, slap your logo on its vape pen, exploiting the goodwill and notoriety you’ve established through your brand. Of course, the best way to prevent trademark infringement is to register your trademark with the USPTO. Though it is not possible to obtain a federal trademark for use on goods that violate the Controlled Substances Act (CSA), it is often possible to obtain trademark protection for goods that do not violate the CSA, like many smokers’ accessories. A trademark gives the owner the exclusive right to use their mark on the specified goods in commerce, and it gives the owner a right to seek remedy in federal court in the event of infringement.

If you are having your products manufactured in China (or anywhere else overseas), as is the case these days with so many of our clients, you need to protect your IP there as well. Because if you don’t register your trademark or your design patent in China, someone else almost certainly will and then that someone else will be able to stop your products from leaving China because those products violate their intellectual property! For more on this, check out China: Do Just ONE Thing: Register Your Trademarks AND Your Design Patents, Part 1 and China: Do Just ONE Thing: Register Your Trademarks AND Your Design Patents, Part 2. You should also check out Your China Factory as your Toughest Competitor for the contractual steps you need to take to prevent your own manufacturer in China from selling your product worldwide, and likely at prices far lower than you can ever match.

But logistically, how does enforcing your IP rights against counterfeiters play out? Typically, it doesn’t make sense to take the alleged infringer straight to court. Litigation is expensive, and there is often room to negotiate. When you know who the infringing party is, your attorney can contact them with a cease and desist letter directly. But when the party is, for example, a third party seller on a larger platform like Amazon or Alibaba, tracking down the infringer is much more difficult. See also China Counterfeiting: 8 Common Myths and Alibaba and Small Business Owners.

The protocol for dealing with online retail platforms in taking down counterfeit goods will vary depending on the company. With every online retail platform with which our lawyers have worked (be they in the United States or in China), the process is expedited greatly when our client alleging a counterfeit is able to offer up proof of its own IP rights. This is particularly true with trademarks, where infringement is often apparent, and the retail platform can quickly decide to suspend a counterfeiter’s account. Without verifiable IP rights, the retail platform is put in a difficult position of having to figure out who has the right to sell what. This involves complicated legal analysis, and takes substantial time and resources, as well as back-and-forth with both parties. In the meantime, you’re likely losing business. See How To Remove Counterfeits From Alibaba.

So the lesson here is two-fold. First, make sure you’ve identified your intellectual property and that you’ve taken every step possible to register and protect it. Second, if you suspect a company is selling a counterfeit of your product, contact your attorney immediately and develop a strategy for blocking the counterfeit sales, whether through direct communication with the counterfeiter, or by working with the relevant online retail platform. There is often much that can be done to stop a counterfeiter before resorting to filing a lawsuit, and ending up with potentially un-collectable judgment.

Cannabis credit cards

Because of federal prohibition, marijuana businesses have limited access to financial services. Distributing cannabis is a federal crime and proceeds from cannabis sales trigger anti-money laundering laws. The Bank Secrecy Act requires banks combat fraud and money laundering and protect against criminal activity. This Act mandates banks investigate their customers for criminal activity and it prohibits banks from doing business with bad actors. Additional banking laws also require national banks file Suspicious Activity Reports (SARs) with the federal government when they know or suspect an account holder is engaged in or trying to cover up illegal activity.

Yesterday, I participated on an educational panel entitled, “The Marijuana Industry & Financial Services: What’s Happening? What’s in Store?” at the American Bar Associations’ Business Law Section Meeting in New Orleans. This panel was co-sponsored by the ABA’s Credit Card Committee, highlighting how important the banking and financial services issues are to both the cannabis industry and to the financial services industry. Federal cannabis prohibition has been hugely costly to the cannabis industry and its customers and to the financial services industry as well, not to mention the massive public safety issues engendered by having to work in an all-cash business.

Federal banking laws kept most banks and credit unions from knowingly working with marijuana businesses until February 2014, when the Financial Crimes Enforcement Network (FinCEN) and the Department of Treasury issued guidelines for financial institutions that want to bank cannabis businesses. These guidelines require banks and credit unions vet their marijuana business customers and regularly report their marijuana customers’ activities to the federal government to ensure compliance with the 2013 Cole Memo.

Though the FinCEN guidelines address getting a bank account (and thoughseveral U.S. Senators have asked for increased guidance from FinCEN regarding banking marijuana ancillary businesses), there are no federal guidelines regarding credit card usage in the cannabis industry, and so none of the big credit card networks (Visa, MasterCard, American Express, Discover) allow their cards to be used for buying or selling of cannabis. This means that even if a marijuana retailer manages to open and maintain a bank account, it likely has no way to accept credit card payments and cannabis customers still typically pay in cash to purchase marijuana products. Even the FinCEN guidelines don’t completely alleviate the cash issue as a result.

These cash payment issues have forced marijuana retailers to employ alternative payment processing methods, such as cashless ATMs, third party payment programs, and bitcoin. These non-bank financial services address many of the problems that arise from running a cash-only business, but they also come with their own set of challenges. Just by way of one example, my law firm’s cannabis business lawyers have handled many cases where banks stopped paying third party payment processors,  resulting in our clients (the cannabis businesses, themselves) not getting paid. No alternative payment service matches traditional credit cards on safety, costs or ease of use. Unless and until cannabis becomes federally legal, cannabis businesses and their customers will still need to employ credit card workarounds (for better or worse).

For more on cannabis and the banking industry, check out our following posts on this topic:

 

Cannabis business lawyersIn a multitude of marijuana-regulated states, certain individuals and companies cannot own or even finance a marijuana business due to state regulations on residency and criminal and financial background checks. This means the cannabis business lawyers at my firm often get clients interested in getting involved with an ancillary cannabis business so as to avoid these heavy regulations.

Whether it is technology, real property development, or consulting,  how you structure your services or licensing agreement can control whether the ancillary company violates applicable state marijuana regulations. And marijuana equipment leases are no different. Done right, leasing expensive equipment to marijuana producers and processors is a great way to service state licensed marijuana businesses without violating state rules. However, just like real property lease agreements, garden variety off the shelf boilerplate marijuana equipment lease agreements will not cut it in the cannabis space. So here’s what you need to know when leasing equipment to a licensed or permitted marijuana business in a heavily regulated marijuana state:

  1. Marijuana Regulations: How the Lessor Gets Paid. Every equipment lease agreement must be structured so as not to violate applicable marijuana rules in a given state. This usually means the lease agreement must clearly address how the lessor will get paid and that payment plan cannot violate state law. In a number of states, if the lessor takes an equity interest in the marijuana company in exchange for lease payments, or if the lessor is entitled to receive net or gross profit from the marijuana business, or if the lessor’s equipment lease payments hinge on the marijuana business’s financial performance or harvest or manufacturing yield, the lessor must be disclosed to and vetted by the relevant government agency. Most states require a fixed fee for rental payments and anything different will likely lead the state to believe the lessor is really a hidden profit sharer. The higher the lease payments, the more likely regulators are to think there’s some unlawful profit sharing taking place. Be sure you can defend your above-market-rate charges.
  2. Marijuana Regulations: Lessor Control Over the Marijuana Company. In addition to lease equipment payments, state regulators also want to know and approve of any person or company exercising any control over the marijuana company. States don’t usually fully define what constitutes an impermissible level of control, but you can assume the definition will be fairly broad and will be analyzed on a case by case basis. In the context of an equipment lease, an impermissible control provision would be the lessor restricting the marijuana business from renting equipment from another equipment lessor. And if the lessor wants to throw in some consulting services as a supplement to leasing the equipment, the lessor’s control over the staff of the marijuana business regarding the use of the equipment may also create a control violation if lessor oversight goes too far.
  3. Marijuana Regulations: Contract Rules. As an equipment lessor, you have to make sure your lease doesn’t violate any applicable state law contract rules. For example, in Washington State, the term of the contract cannot be indefinite — it needs a termination date. This stems from state regulations prohibiting third parties from locking marijuana businesses in too long to term contracts that could create “undue influence” over the licensee. We constantly see equipment leases that violate this simple rule.
  4. Security Interests. Make sure your security interest in your equipment is valid. In most states, state regulators should have no issue with a lessor’s security intern est in its equipment. However, if the lessor tries to maintain a security interest in marijuana inventory or ithe licensed business itself, it is going to have a control problem. State receivership proceedings may be another collection option, but you need to make sure that’s a realistic scenario in your state and that your equipment lease carefully details how that will happen.
  5. Defaults. The rules governing cannabis businesses are unpredictable and ever-changing and this means you as the lessor must stay on top of the rules and make sure you remain in compliance with them. This also means your equipment lease needs to account for very specific events of default that should include the marijuana business having to maintain good standing with regulators and any permissible appeal/cure period if the marijuana business is hit with a marijuana regulation violation that carries shutdown or crippling fines as penalties.
  6. Access to the Equipment. You can’t just come and check up on your equipment whenever you want. All states control physical access to the marijuana business itself, so be sure your equipment lease takes that into account. Most times, you’re going to have to consent to applicable security procedures, including scheduled visits, the donning of ID badges, and being escorted at all times by an employee of the marijuana business.
  7. Disputes and Repossession of Equipment. Because many marijuana businesses fail in their first year, you need to be ready for the eventuality of a default on your equipment lease. Your contract should include the right laws and the right venue for your dispute. Since marijuana is still federally illegal, you should consider private mediation and/or arbitration of your disputes and you should ensure that any court filings go through state court, which is more likely to recognize and honor your equipment lease than would a federal court. We sometimes use provisions mandating state court and prohibiting removal to federal court. You’ll also want to give yourself an easy route to repossess the equipment, so don’t ignore the benefit of providing for self-help repossession methods in your equipment lease agreement, so long as they don’t violate applicable marijuana rules.

Just as is true of cannabis commercial property leases, your cannabis equipment leases need to account for all sorts of cannabis-specific situations.

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.