Cannabis Development Agreements
Development agreements should be in your real estate tool kit.

We’ve seen this movie before: a city gets excited about commercial cannabis opportunities and passes an ordinance allowing indoor medical cannabis cultivation. After the law goes into effect, neighbors complain about odors or aesthetic issues or just because they don’t want anything to do with cannabis in their neighborhood. Sooner or later, the right neighbor complains to the right city council member and cannabis suffers a major setback with a restrictive ordinance or even a moratorium. The city declares the “offending” cannabis business use to be nonconforming and issues a notice and order to abate. The cannabis business finds itself hundreds of thousand dollars in debt on its construction/build-out project without a path forward for being able to operate and a permit it can’t take elsewhere because it runs with the land.

How then should a would-be cannabis tenant or purchaser avoid this risk, or at least mitigate against it, before jumping into a huge investment for improving the land? A development agreement is one solution.

A development agreement is essentially a contract between a property owner/developer and a municipality that specifies how a given parcel will be improved and used for a certain finite period of time, and specifying how the planning and zoning laws for that parcel will change or not change during that time. Municipalities benefit from development agreements because by reducing risk they encourage development and increase property tax revenues. The property owner/developer benefits by having much greater certainty regarding the uses to which the property may be put.

The added certainty of stable zoning makes developers and their investors and lenders more willing to invest their time, effort, and financial resources into improving the land. Without a development agreement, developers typically must risk paying architects, engineers, and contractors before they can obtain a building permit from the municipality. Developers and municipalities often end up litigating over vested rights and the permitting process. Under California’s vested rights doctrine, only after developers obtain the building permit can they be certain their parcel will remain unaffected by future zoning law changes — and even this isn’t always a total certainty, as California courts have found exceptions that allow zoning changes, depending on the circumstances.

Given its unpredictability and its huge potential, California’s commercial cannabis industry is a prime candidate for development agreements, yet they are still rarely used for cannabis business land development. I see this as due to a combination of things, ranging from local government reluctance to tie land within city limits to uses the federal government still deems unlawful, to cannabis lawyers (especially those who only recently switched from representing cannabis criminal defendants) simply not knowing about development agreements. See How To Choose Your Cannabis Business Lawyer.

Whatever the reason, less certainty in already uncertain times is bad for all parties involved.

Cities want to attract responsible, experienced developers to improve land and public infrastructure and increase property values and tax revenues. Developers and their associates seek certainty that the improvements they pay to add to their land may be legally utilized. Cities that pass ordinances to allow cannabis business activities, as well as would-be purchasers and developers, should be considering development agreements as part of their commercial cannabis development plans.

California cannabis commercial leaseA contract isn’t worth much without your being able to enforce it, and the same goes for commercial leases. We’ve written about unique problems in cannabis contracts due to the state-vs-federal illegality problem (see here, here, here) and of how courts have navigated that inconsistency in the context of contract enforcement. But when it comes to commercial cannabis leases in California, landlords and cannabis companies alike want to know how likely it is a court will enforce their lease. The short answer: it’s much likelier now than five years ago.

The main challenge with California commercial cannabis leases, as with all cannabis contracts, goes back to the problem of federal illegality. Because cannabis is still federally prohibited under the Federal Controlled Substances Act, it is federally illegal to cultivate, manufacture, or sell cannabis for any purpose. This means cannabis contracts trigger the doctrine of illegality in contract law, which holds that contracts without a lawful object are void and unenforceable as against public policy. Though enforcement of contracts is generally governed by state law, state law includes federal law under the U.S. Constitution’s Supremacy Clause.

Courts have struggled with how to reconcile the different laws, but a consistent theme emerges in California court decisions: commercial cannabis lease agreements will generally be enforced so long as the dispute before the court is purely contractual and so long as the landlord and tenant are in an arms-length transaction for payment of rent. One infamous example of this is the Harborside case, where a U.S. District Court declined to void a commercial lease for a cannabis dispensary on grounds of illegality, where the dispensary was in compliance with California law.

Another more recent example is Mann v. Gullickson, a November 2016 Northern District of California decision involving a dispute between a creditor plaintiff who sold shares in two cannabis businesses to the defendant in exchange for a promissory note. When the creditor sued for nonpayment under the promissory note, the defendant argued federal illegality rendered the contract (the promissory note) unenforceable. Though the court acknowledged it could void a contract if it required a party to violate the CSA by, for example, requiring it to cultivate or sell cannabis, for several reasons, the court declined to do so in this case.

First, the fact that the court could order payment on the note without requiring any cannabis-related actions meant that enforcing the contract would not necessarily further an illegal purpose. Second, even if an illegal purpose were to be furthered, the court found it would be inequitable for the defendant to be unjustly enriched by not having to pay on the promissory note. Third, the court noted that many states, including California, had recently changed their laws to encourage state-legal cannabis business activities, thereby undercutting the defendant’s public policy argument. Fourth, and most interestingly, the court called out the observed effect of changing state laws on federal enforcement: “The federal government’s concern over the CSA’s medical marijuana prohibition has waned in recent years, and the underlying policy purporting to support this prohibition has been undermined.” The court also noted that under the McIntosh case, the Rohrabacher-Farr amendment prohibits CSA enforcement against medical marijuana in the Ninth Circuit (the federal appellate circuit that encompasses California).

The lesson to be drawn from these cases for California commercial cannabis leases is that cannabis leases should be written to keep the landlord-tenant relationship as an arms-length transaction. This means no profit-sharing arrangements, no payments in cannabis product, and no equity shares changing hands; just payment of rent. Ultimately, the best way to avoid enforcement problems for your California commercial cannabis lease may be to include a well-drafted arbitration clause that specifies choice of California state law, among other things, as that can to a large extent side-step the issue of court enforcement, at least until you need to get your arbitration award enforced by a court.

To help you better understand what is going on with California cannabis and what MAUCRSA means for your cannabis business, three of our California attorneys will be hosting a free webinar on Tuesday August 8, 2017, from 12 pm to 1 pm PT. Hilary Bricken from our Los Angeles office will moderate two of our San Francisco-based attorneys (Alison Malsbury and Habib Bentelab) in a discussion on the major changes between the MCRSA and MAUCRSA, including on vertical integration and ownership of multiple licenses, revised distributorship standards, and what California cannabis license applicants can expect more generally from California’s Bureau of Cannabis Control as rule-making continues through the remainder of the year. They will also address questions from the audience both during and at the end of the webinar.

To register for this free webinar, please click here. We look forward to your joining us.

California cannabis leaseCommercial leases for cannabis businesses are unique and require special considerations for risk management during the tenancy. Commercial cannabis leases in California are prone to the following pitfalls inherent in a landlord doing business with a cannabis tenant, and these risks should be considered when deciding how to structure your landlord-tenant relationship:

  1. Accepting ownership in the cannabis tenant company. Buying and selling shares in privately held cannabis companies can trigger state and federal securities laws and create regulatory problems under California’s cannabis licensing program. A landlord’s acceptance of an ownership share from a tenant in lieu of or in addition to rent can jeopardize the cannabis tenant’s California state cannabis license status. California’s proposed cannabis rules define an “owner” as a person with 20% or more ownership in the licensed cannabis company, a CEO or board member with 5% or more ownership in an entity with 20% or more ownership in the licensed entity, or any individual that exercises “direction, control, or management” of the licensed business. All such “owners” are subject to thorough background checks as part of the company’s ability to acquire and maintain its cannabis business license. A change in ownership or control puts the tenant’s license at risk of being revoked, harming both landlord and tenant.
  2. Receiving cannabis product as rent payment. Though cash-poor cannabis tenants may have trouble finding financing, they usually have plenty of valuable cannabis product. But for the same reasons landlords should avoid accepting ownership in their cannabis tenants business entities, they should also avoid accepting cannabis product as well. Not only does a tenant providing its landlord with cannabis jeopardize the tenant’s license (and thus the landlord’s source of rent revenue), it also exposes the landlord to liability for operating as an unlicensed cannabis merchant. California’s proposed cannabis rules strictly control who can and cannot handle or accept cannabis product as part of a licensed operation, and circumventing those strictures exposes both landlord and tenant to liability.
  3. Profit/revenue sharing. Commercial leases for garden-variety business tenants sometimes include terms requiring the cannabis tenant pay a certain percentage of its profits or revenue to its landlord in addition to or as part of rent. Though this sort of arrangement can be advantageous in other situations, it raises problems for cannabis tenancies since receipt of profits or revenue specifically tied to cannabis sales can expose the landlord to liability for unlicensed cannabis activity as a de facto owner. 
  4. Liens for build-outs. Indoor agricultural grows require unique environmental control systems and this in turn often means cannabis tenants must engage in expensive build-outs. Landlords may want to seek lease provisions ensuring all alterations be authorized in writing beforehand, that the landlord acquires no ownership or benefit from any alterations, and that all alterations must be removed when the tenancy ends unless the landlord elects otherwise, in addition to serving notices of non-responsibility where appropriate. Essentially, landlords will want to avoid allowing build-outs that might result in liens filed against their real property. On the other hand, the landlord may want to be involved in the build-out to outfit the facility to its own preferences. In other words, landlords should seek to avoid unintended entanglements while structuring their leases to reflect their intent.
  5. Access and security. Though landlords typically want commercial cannabis leases to allow them access at any time with reasonable notice for things like maintenance, inspections, and showings, the situation is different for cannabis business tenants. California’s proposed cannabis rules under the Medical and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) require cannabis tenants to set up and maintain a rigorous security protocol that only allows product to be handled by authorized individuals, and that only allows authorized individuals to access the premises. Unfettered access by a landlord will likely raise problems with California’s cannabis regulators, and with good reason. Part of the rationale for complying with strict state-mandated security requirements is to further federal enforcement goals, such as preventing diversion of product to minors or to states where cannabis has not been legalized. By failing to sufficiently regulate access in the lease, the landlord can unintentionally entangle itself with the operations of the licensed cannabis entity and thereby place its tenant’s cannabis license in jeopardy.

Bottom Line: California commercial cannabis tenancies benefit from being kept as arms-length transactions so as to protect against problematic entanglements, both intended and unintended and any proposed tenancy should be analyzed with this goal in mind.

California cannabis leaseWe’ve written previously on arbitration and why it so often makes sense for cannabis business contracts, primarily because of enforceability issues stemming from cannabis being illegal under federal law. But in the realm of commercial real estate leasing, cannabis uses can present other unique challenges that require thoughtful solutions to disputes, and, more importantly, thoughtful planning to prepare for potential disputes down the road.

Below are some of the issues our California cannabis lawyers typically consider when anticipating how to draft dispute resolution clauses for commercial cannabis leases.

  1. Enforceability of the lease and the arbitration award. Federal illegality of cannabis impacts all cannabis business transactions. Though the Federal Department of Justice has issued cannabis enforcement guidelines in the Cole Memo (and every cannabis-touching lease agreement should include language mandating compliance with these guidelines), this does not guarantee against federal civil asset forfeiture or other federal enforcement actions. Another consequence of federal illegality is that cannabis companies must consider what recourse they will have in enforcing their contracts and account for federal district courts being unwilling to enforce any such contract. For this reason alone, it will nearly almost always be better for you to have your disputes resolved in a California state court that will be far more likely to apply and enforce California state cannabis laws. California state courts can also apply federal law, but because there is often a risk of your case being removed to federal court you should always consider putting an arbitration clause in your cannabis commercial leases, specifying the arbitral body, limiting how the lease and the arbitration award can be enforced (confining it to state courts, perhaps) and limiting potential appeals.
  2. Choice of law. We’ve written about how California commercial cannabis landlords (and tenants) should consider beefing up their lease’s indemnity provisions, allowing for early termination in the event of enforcement actions, disallowing federal illegality as a grounds for invalidating the lease, and generally requiring strict compliance with California state law for the specific proposed cannabis use. For similar reasons, arbitration clauses can include a mandate that the arbitral body apply state law and the California Arbitration Act, and not, for example, the Federal Arbitration Act, which allows an award to be vacated where the arbitrator “manifestly disregards the law.” It is not difficult to imagine a scenario where a federal court vacates an arbitral award for an arbitrators having failed to apply the Controlled Substances Act or void the cannabis lease ab initio. California arbitration clauses should, at minimum, specifically outline 1) the method for choosing the arbitrator, 2)  the laws the arbitrator must apply in resolving the dispute, and 3) the standard of review any reviewing court must apply. For many California real estate transactions, the arbitration clause should also include specific statutory notice language.
  3. Carve-outs for Unlawful Detainer, Nonpayment, and other Early Termination Causes. Though arbitration can be a highly useful tool, landlords will also want to maintain their ability to seek remedies for nonpayment of rent and unlawful detainer (eviction) without having to go through the arbitration process. Similarly, if a tenant faces a state or federal enforcement action, the landlord (and even the tenant for that matter) will likely want to maintain its ability to terminate the lease quickly and without arbitration. The parties to a California commercial cannabis lease should always consider carving out exceptions to arbitration to keep options open and to encourage timely performance of the lease.
  4. Arbitrator’s industry expertise. California arbitrators tend to be retired California state court judges and the changes of this sort of arbitrator having deep knowledge about the cannabis industry or cannabis laws are not good. But spelling out the arbitrator selection process in your commercial lease agreement (or even naming the specific arbitrator or arbitrators) can allow you to make certain your arbitrator has sufficient cannabis industry knowledge to understand any eventual dispute.
  5. Consider making mediation the first step. Arbitrations can be expensive and their outcomes uncertain. So instead of drafting a commercial lease agreement that requires you to jump right into that process whenever a dispute arises, consider making private mediation a mandatory first step before a demand for arbitration can be made.

Though every commercial lease dispute is unique (even more so for cannabis commercial leases), there are common themes and one is that private dispute resolution tends to work best for disputes between cannabis businesses.

Cannabis real estateHaving a bank loan on your cannabis property is usually not the greatest business plan. If you already own a property encumbered by a bank loan, commencing cannabis operations is a risky proposition. If you don’t own property but apply for a bank loan on a parcel to grow, process or sell marijuana, the banker will likely send you away in ten seconds or less. In our experience, even equipment loan offerings by small credit unions to cannabis businesses are vanishingly rare.

Because it’s so hard to get institutional financing for cannabis properties, we have facilitated many seller-carried property transactions over the past few years. Those transactions are a breeze when the seller owns the land free and clear. When the seller does not, however, things can get interesting– especially so when the transaction happens anyway. The vehicle for many of these unusual transactions is a wrap-around mortgage.

A wrap-around mortgage (a “piggy-back” or “wrap”) is a junior mortgage where a seller has one or more existing trust deeds on his or her property– typically, with a bank as beneficiary. Together, the seller and pot farmer or processor, or what-have-you, enter into a land sale contract or a promissory note and trust deed. These documents cover the full purchase price, minus whatever earnest money is agreed upon, and minus any down payment. Every month, the buyer pays the seller, and the seller pays the bank. In a classic wrap, the parties agree not to notify the bank of the transfer, although sometimes a memorandum is recorded in the public record. The laws surrounding wraps differ state by state.

Why do sellers like wraps? Because they can be lucrative, especially in the cannabis industry, where land has premium pricing. If the bank loan is at 5%, and the seller is getting 10% or 12% on a junior note, for example, a wrap can be highly profitable. Why do buyers like wraps? Sometimes, it’s the only way for a cannabis business to get a foothold on a property. The big risk here for both buyer and seller is that the bank will cite the trust deed’s “due on sale” clause, wiping out the buyer’s interest, and resulting in foreclosure for seller. With a cannabis wrap, there may be several contractual levers a bank can pull to trigger this clause: the senior mortgagor is permitting “illegal activity” on the property; the senior mortgagor has given a deed to its junior mortgagee; etc.

Wrap mortgages were prevalent in traditional, non-cannabis property loans five to seven years back, especially in residential real estate. This was due to the slowdown in real estate generally and to the scarcity of bank financing at that time. With cannabis—where bank financing is nearly impossible, still—wraps are one of several creative real estate options for entrepreneurs looking to make an industry play.

It is critical for all parties, including attorneys and realtors, to be aware that a wrap mortgage in the cannabis context often involves a seller triggering the due on sale clause in the first lender’s deed of trust. For that reason alone, we generally steer our buyer and seller clients away from wraps. Do our clients always listen? No. Many cannabis businesses and landlords are already taking on mortgage risk, or are determined to do so, by facilitating weed activity on a mortgaged property. And many take heart in the reality that banks are loathe to call loans: banks love getting paid, hate owning property and often ignore the “due on sale” remedy for convenience.

Given the above, we expect to see a continuing stream of wrap-around mortgages on cannabis properties. After all, when your core business activity involves violating federal law, a little extra business risk may not seem so bad.

For more on the unique issues involved with cannabis real estate, check out the following:

California Cannabis Cultivation in old greenhouses. It's complicated
California Cannabis Cultivation. It’s complicated.

There has been surge of interest in converting old flower-growing greenhouses in Monterey County to cannabis cultivation. Though this has brought a welcome increase in real estate values and, in some cases, a lifeline for family-owned greenhouses hit hard by the growing international flower trade, prospective buyers or commercial tenants looking to convert these properties to cannabis grows should take a hard look at the legal landscape and the suitability to the locality before jumping in.

In many ways, dilapidated greenhouses and cannabis cultivation would seem to be a perfect fit. Greenhouse owners see increased property values and a seller’s market. Cannabis cultivators see rural or semi-rural commercial space prebuilt for optimal plant cultivation conditions. And local governments see increased tax revenue and a welcome improvement of rundown properties.

However, such deals are far from turnkey transactions, as there remain important existing controls at the municipal, county, state, and federal level that must be considered and accounted for before putting pen to paper. Here are a few of the many things to consider as part of your real estate business plan:

  1. Local Regulations. This remains by far the most important factor for determining the viability of real property for medical cannabis business use. Under California’s Medical Cannabis Regulation Safety Act (MCRSA), local governments retain control over whether, how, and when cannabis businesses can operate and this is in addition to traditional local controls over zoning, land use, building safety, and occupancy. Monterey County (which has had an interesting history with cannabis regulation), has decided to allow old greenhouses to be converted to medical cannabis indoor cultivation operations, but under a strict set of requirements. Applicants must obtain a commercial medical cannabis permit and a use permit, which is allowed only for greenhouses within certain specific zoning districts and only under certain conditions related to on-site renewable energy generation, water conservation, offsite plant visibility, and security measures, among others.
  2. State Regulations. As we’ve been writing about for a while now, California is in the process of enacting a massive new regulatory regime for all types of medical cannabis businesses, including cultivation. If you intend to operate in California as a state-licensed cannabis cultivator and you haven’t yet formulated a business strategy for making that happen (e.g. corporate form, financing, local code compliance, environmental review, etc.) you are already behind the curve. Under MCRSA, California will not issue you a state cannabis license unless you can demonstrate local approval.
  3. Land Financing. Though some California banks, savings and loans and credit unions are dipping their toes into providing cannabis businesses with banking services, your chances of getting a traditional mortgage on a property that will be used for cannabis are slim to none. Consequently, most land deals end up being either all-cash deals or supported by secured notes. If a purchaser with a standard mortgage later leases the property to a cannabis business, because of federal cannabis illegality and anti-money laundering laws, the bank can call the loan, putting both the landlord and the tenant at risk. Bottom line: do not expect standard financing options if your greenhouse will be used for any kind of commercial cannabis activity.
  4. Commercial Lease Considerations. Commercial leases in the cannabis industry are not only unique in their requirements, they are now part and parcel of both the local and state licensing schemes because to get a state license as a tenant you need to show that your lease allows you to use the space for cannabis. It is essential for both landlords and tenants to have a properly drafted commercial lease that is tailored specifically to the proposed cannabis use and to the locale.
  5. Federal Enforcement. Cannabis remains federally illegal in all forms and uses. The recently renewed Rohrabacher-Farr amendment and current controlling case law prevent the federal government from enforcing the Controlled Substances Act against medical cannabis businesses in compliance with state law, but this is hardly a guarantee against federal civil asset forfeiture. One interesting effect of this federal-state legal purgatory is the protectionist benefits given to cannabis businesses. Whereas a Monterey greenhouse flower business would find it hard to compete with imported flowers, a cannabis cultivator in that same greenhouse benefits from the prohibition on interstate commerce in cannabis. In other words, because cannabis cannot legally be transported across the border (or even across state lines), cannabis businesses in California are NAFTA-proof.

Bottom Line: The cannabis industry, real property, and California state and local regulations are a complicated mix of legal issues, and whether you’re buying or renting, you need to invest real time and effort into sorting these things beforehand to prevent worlds of trouble down the road.

California cannabis leaseCalifornia is in the middle of building a massive regulatory structure for licensing medical cannabis businesses. Though we already knew that the state will be giving priority review to existing collectives “in operation and in good standing with the local jurisdiction by January 1, 2016,” last week, we learned from the state’s chief cannabis regulator that California will be issuing temporary licenses this fall to applicants with prior local approval. This is ahead of the state’s January 1, 2018 deadline to generally begin accepting license applications, and it highlights the importance of gearing up as soon as possible. The first steps for that involve securing property to lease.

We have written about some nuances in lease provisions for commercial cannabis tenants in California, but the state’s rapid timeline for licensing creates some unique problems. Here then are a few things you should consider including in your California commercial cannabis lease to address uncertainty in licensing and to help streamline the licensure process:

  1. Clearly and narrowly define the permitted use and the controlling law. It’s important to restrict the use of the property and to establish boundaries for indemnification purposes, and particularly important for laying out the basis for complying with applicable local law as a precursor to applying for a state license. The proposed regulations under the Medical Cannabis Regulation and Safety Act (“MCRSA”) require tenant applicants to demonstrate they have the right to conduct their specific proposed business activity on the premises, as demonstrated by a lease agreement. MCRSA also requires proof of approval from the local government. Lease language should include obligations to use the premises only in conformance with the specific regulations applicable to the tenant’s proposed use and in accordance with the terms of the local permit or other approval, as well as with all local laws.
  2. Mandate local approval from the get-go. Though a state-issued cannabis license is more of a forward-looking proposition at this point, local approval can and should be sought before the parties put pen to paper on their lease agreement. A common mistake is for a tenant to invest in a cannabis facility build-out or start buying equipment and supplies before getting all necessary local inspections and permits, or before confirming compliance with zoning and land use laws. The lack of building permits is a classic basis for a municipality’s after-the-fact decision to label a tenant’s cannabis business a nonconforming use (for more on recent California land use disputes, see here). The bottom line is that the parties need to know ahead of time whether the locality will allow the use, and if so, exactly which existing and proposed local laws the tenant will be expected to follow. The lease should prohibit the tenant from engaging in any cannabis activity without express written approval from the locality, preferably through a permit.
  3. Lay out a state license application timeline. California has said that it will begin accepting license applications as of January 1, 2018, but it has also confirmed that it will accept applications for temporary licenses as early as this coming fall. The lease should therefore contain an obligation for the tenant to begin the state application process for the specific type of license sought, upon its execution. Proposed regulations for some types of licenses allow the applicant to continue operating if it was operating in compliance with local law prior to January 1, 2018 and has submitted its application to the state before July 2, 2018. The parties may carve out an allowance for such a scenario, but they should also include an obligation to secure a state license by a certain date or the lease may be null and voice.
  4. Assign responsibility for application costs. Tenant applicants can expect to incur standard license application fees and costs, but under the proposed regulations, certain applicants will need to demonstrate compliance with California environmental laws, either through certification by the local permitting entity, or if no local permitting system exists, then through an environmental impact report (EIR) commissioned by the tenant. The lease should set out a timeline for an anticipated EIR, if one is necessary, and should clarify that all such costs shall be borne by the tenant.
  5. Include an out for failure to obtain a license. In line with number 4 above, if the tenant ultimately fails to acquire a state license under the timeline in the lease, then, regardless of the reason for the failure, both parties will want to be relieved of their lease obligations. The tenant will be unable to collect revenue for rent, and the landlord will not want to be stuck with a non-paying tenant. The lease should include failure to obtain a license within a certain period of time as an event of default.

California is still in unchartered territory as it seeks to create and implement a complex regulatory structure over the country’s oldest and largest cannabis business ecosystem, and it remains to be seen what the final rules for medical will look like, and how they will reconcile with the yet-to-be-released rules for adult use cannabis. But in the meantime, cannabis entities seeking to be the first participants in the regulated marketplace (and their landlords) need to carefully consider how their lease relationship is going to be affected by the licensing process.

Cannabis attorneysCommercial leases for cannabis businesses are a major concern for many of our clients largely because cannabis businesses operate in an industry prohibited under federal law. Generally, contracts that are illegal are unenforceable and there is an argument to be made that any and all cannabis contracts are illegal, at least at the federal level. But a recent Arizona state court shows that state courts are not always receptive to that argument and that a contract that violates federal law is not necessarily unenforceable.

Green Cross Medical, Inc. v. Gally (April 18, 2017) addressed whether a commercial lease with a medical marijuana grow operation in Arizona was enforceable. John Gally owned commercial property in Winslow, Arizona that he leased to Green Cross Medical to operate a medical marijuana dispensary. Two weeks later, Gally sent a letter to Green Cross revoking the lease. At the time Gally terminated the lease, Green Cross had not received the necessary license to operate a dispensary. However, the lease permitted Green Cross to sublease the property and nothing in the lease stated the lease would be terminated if Green Cross did not receive a license to run a dispensary.

Green Cross sued Gally for breach of contract and attempted to obtain a temporary restraining order to prevent Gally from revoking the lease. Gally argued that the lease was illegal and therefore unenforceable because it involved cannabis distribution. The trial court was persuaded by Gally’s argument and ruled that the lease agreement was indeed unenforceable because violated both federal and state law. Based on this, the trial court did not grant Green Cross the restraining order and it denied Green Cross damages for Gally’s having revoked the lease.

Green Cross appealed the trial court’s decision.  First, the appeals court determined that Green Cross could seek damages against Gally even though Green Cross did not receive a license to operate a dispensary on the leased property because the right to sublease was a valuable property right. As a result, Green Cross was permitted to seek damages for the loss of the lease.

The appeals court also held that the lease was not illegal on under Arizona law. The court stated that the Arizona Medical Marijuana Act (AMMA) protects rights of dispensaries to enter into commercial leases and that dispensaries have a contractual right to enter into lease agreements with landlords. The appeals court concluded that “[g]iven the language of the AMMA, a court may not void or refuse to enforce a dispensary’s lease with a landlord simply because the dispensary would be supplying marijuana in compliance with the AMMA.”

The appeals court also rejected Gally’s arguments that he as the landlord could face criminal liability under state law because he was facilitating marijuana distribution by leasing property to a cannabis dispensary. The appeals court pointed to the fact that Gally agreed to execute the lease understanding that Green Cross intended to operate in Arizona’s medical market:

We emphasize that nothing in the AMMA requires a landlord to rent a property to a proposed dispensary. Gally was free not to enter into the lease if he was uncomfortable with the proposed use of the Property. But once he chose to do so, he was not free to rescind his contractual commitments without facing potential monetary liability. Accordingly, leasing property to a medical marijuana dispensary that is in compliance with the AMMA is not illegal under Arizona law. Thus, the superior court erred when it found the lease was void and dismissed the complaint seeking damages for the breach.

The appeals court then acknowledged that federal law prohibits distribution of marijuana under the Controlled Substances Act (CSA) and that it is, therefore, illegal under federal law for an Arizona landlord to lease property to a marijuana business. However, the appeals court went on to state this federal illegality “does not render the contract in this case unenforceable under all circumstances.” The court cited to several cases where contracts involving medical marijuana businesses were upheld by courts despite being prohibited under federal law, showing that courts balance the federal government’s interest in enforcing the CSA with states’ interest in permitting the medical use of marijuana.

The appeals court weighed the interests of the federal government and the state of Arizona and held that the lease was not unenforceable simply because it violated the federal CSA. The appeals court explained that federal government enforcement of the CSA against state-compliant marijuana operators had been in flux for years and that the Department of Justice (DOJ) had instructed US Attorneys not to prosecute individuals acting in compliance with the Cole Memo. The court also noted that Congress has prohibited the DOJ from using funds to prosecute people distributing marijuana in compliance with state law. As a side note, that spending provision was recently extended.

The Arizona Appeals Court sent the case back to the trial court to reconsider the facts of the case in light of the appeals court having held that the lease was not unenforceable and that Green Cross may recover damages for Gally’s terminating the lease.

You can find more on cannabis leases here:

 

 

California cannabis leaseWe’ve written before on how commercial leasing for cannabis business is a uniquely different animal that requires special attention beyond a boilerplate commercial lease agreement. The new multi-agency rollout of California’s proposed medical cannabis regulations under the Medical Cannabis Regulation and Safety Act (“MCRSA“), as well as Governor Brown’s recent budget trailer bill to harmonize the MCRSA and Proposition 64 (California’s adult use cannabis initiative), highlight just how complex things could become as part of California’s new licensing regime, and why it’s important you have a commercial lease agreement that protects your interests, particularly if you are the landlord.

Here are a few things you should consider when drafting a medical or adult use cannabis lease in the new frontier of regulated cannabis in California:

  1. Defining the Permitted Use. Since California will have at least 20 different types of cannabis business licenses under the MCRSA and Proposition 64 and since unlicensed activity can lead to revocation or denial of a tenant’s license, your lease should specifically define the business activity the tenant contemplates engaging in on the property and set out an anticipated timeline for the tenant’s license application and eventual licensure. Any deviation from the tenant’s permitted use defined in the lease or any failure to acquire a license should be cause for terminating the lease agreement. Clearly defining the permitted use is also necessary for the tenant as the new MCRSA cannabis regulations require licensee applicants to demonstrate property owner approval for the proposed license type if the license applicant is leasing the space.
  2. Compliance with Local Laws. Though Proposition 64 does not require proof of local approval to qualify for a license, the MCRSA does. And though Governor Brown’s reconciliation bill would require the State work with local governments to determine compliance for both medical and recreational cannabis licensees at some point in the licensing process, if there is no local permitting structure, the cannabis tenant must conduct an Environmental Impact Report (EIR). If the local government does not approve the EIR and/or the EIR determination disallows the tenant’s proposed use, but the tenant has already signed a lease, that’s a problem for both the tenant and the landlord. For these reasons, landlords and tenants need to know any applicable local laws (which change constantly), and their lease for a medical or adult use cannabis tenant should include a provision requiring compliance with specific local laws and setting out what will happen to the lease in the event of a bad EIR.
  3. Compliance with State Laws and Regulations. The MCRSA (in AB 266) mandates that “a person or entity that holds a state license is prohibited from licensure for any other activity … and is prohibited from holding an ownership interest in real property, personal property, or other assets associated with or used in any other license category.” This means individuals with a state license cannot have an ownership interest in any real property held by any other licensee not within their same license category or license combination allowed by the State. Proposition 64 does not have this real property prohibition. And though the State has yet to come out with its Proposition 64 regulations, other existing state regulations must be addressed in a lease for an MCRSA tenant. For example, there are certain security practices and ID badge requirements to which everyone accessing an MCRSA premises must adhere, including the landlord. There can only be one license per location and the licensee in that location cannot sublet to other licensees. MCRSA retailers are only allowed to operate from 6 a.m. to 9 p.m. and their products must be sight-obscured from the public. The premises of MCRSA licensees must have certain security and surveillance and MCRSA licensees must have a general commercial liability insurance policy of at least $1 million. Your MCRSA lease should include provisions addressing all of these state law requirements.
  4. Compliance with Federal Enforcement Priorities. Your cannabis lease should also have provisions requiring compliance with relevant current and future state and federal laws, except to the extent federal law is inconsistent with California cannabis laws. The 2013 Cole Memo is still the most important federal guidance on state-regulated cannabis operators and Attorney General Jeff Sessions has indicated at least some continuing support for it.  Landlords should ensure their tenants comply with the Cole Memo in addition to state and local laws as this best ensures against federal law enforcement action.
  5. Asset Forfeiture and Indemnity. No one can predict how the federal government will approach cannabis enforcement, but one thing is clear: landlords need to do whatever they can to avoid getting caught up in any kind of civil asset forfeiture stemming from a tenant’s federally illegal cannabis activity, even if the activity is otherwise allowed by California law. A prime example of how this can go wrong for landlords is the Harborside case where the landlord was unable to evict her medical cannabis dispensary tenant because it was not violating the lease agreement, which was drafted to be upheld according to California, not federal law. Your cannabis lease should include language requiring that the tenant indemnify the landlord for any enforcement action and making any such action constitute a default under the lease.
  6. Signage and Advertising. Proposition 64 has specific requirements on where, what, and how a cannabis business can advertise and market to the public and a proposed bill would extend these restrictions to medical cannabis businesses under the MCRSA.  Adult use cannabis businesses cannot advertise or market within a 1,000-foot radius of any school, day care center, or playground, nor can they advertise or market “on a billboard or similar advertising device located on an Interstate Highway or State Highway which crosses the border of any other state.” At minimum adult use retail business leases should mandate compliance with Proposition 64’s advertising and marketing restrictions.

Federal cannabis prohibition, coupled with the fluidity of California’s new cannabis laws, makes standard commercial lease agreements dangerous for leases involving cannabis businesses. Your cannabis commercial lease needs to address the realities and multiple legal issues involved with operating a cannabis business and managing a cannabis business tenant.

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.