Regulated industries like the cannabis industry require careful planning when drafting corporate governance documents. Boilerplate agreements fail to address many of the most important and specific issues for cannabis businesses. Whether it is a limited liability company operating agreement for an LLC or a shareholders’ agreement and bylaws for a corporation, it is a good idea to make sure your cannabis business’s governance documents address the following marijuana-specific points.
1. Licensing Cooperation. Most states that have legalized cannabis require massive amounts of paperwork to secure a cannabis industry license. In addition to mandating the company seeking the license execute documents discussing its floor-plan, its product offerings, its security policy, and overall operational plan, most states also require all of the members of the LLC and all of the corporate shareholders go through criminal and financial background checks. For example, in Washington State any financier, LLC member, or corporate shareholder must submit a personal history form detailing their criminal, residence, and employment history. There is also a financial background questionnaire requiring disclosure of virtually all assets and liabilities. This is in addition to providing bank statements for any accounts that are financing the business and going to an electronic fingerprint facility to provide fingerprints to the Washington State Liquor and Cannabis Board.
Though tedious, these things are vital to the cannabis company’s well-being. The governance documents, therefore, should usually include a clause requiring all LLC members or corporate shareholders, and all corporate officers, cooperate with all licensing and regulatory requirements the cannabis business needs for licensing approval and to continue operating legally. This may not seem like an issue at the outset, where everyone’s goal is to receive the cannabis license, but more than once our cannabis business lawyers (and yes, sometimes our cannabis litigators) have had to deal with cannabis companies that are falling apart because one of its key players becomes recalcitrant about producing all state-required information. A single member, shareholder or officer can hold up or even scuttle the licensing process by refusing to execute mandatory regulatory forms. It is easier for everyone to bind themselves at the outset to meet the regulatory burdens on individuals.
2. Regulatory Violations. Many state marijuana laws require good behavior of LLC members and corporate shareholders after the business has been licensed and is operational. The clearest requirement is that ownership of even a single share of a marijuana business is precluded for felons. If a shareholder is charged and convicted with a felony while the marijuana business license is active, that can place the business in a predicament, where it is violating regulations because a felon owns it. But there is no automatic mechanism to force a felon to exit a marijuana business. Corporate governance documents can address this in two ways: expulsion or buyout. This is slightly easier in an LLC, where more leeway is given to what the company can agree to in its operating agreement. Expulsion strips away any membership interest and dissociates the member from the cannabis business without any type of payment, whereas a buyout right gives the business the right to buy the member out at an agreed upon price or an agreed upon price formula.
3. Confidential Arbitration. As we have written before, arbitration is attractive in cannabis business contracts for many reasons, the most important of which is that it reduces the risk that the contract will be tossed out by a court as being for an illegal purpose. An added bonus of arbitration for an already licensed cannabis business is that the agreement to arbitrate can (and should) include an additional clause binding the parties to confidentiality regarding the dispute, both during and after the arbitration itself. Court cases are very public, and regulatory bodies that catch wind of your protracted legal battle may not know who is actually in charge of your regulated business, which can cause you and your business all sorts of trouble. Aggrieved shareholders and members sometimes try to use their ability to create regulatory turmoil for the cannabis business as a bargaining chip in any dispute. Avoiding that type of extortion is easier when you can point to binding requirements of confidentiality and confidential dispute resolution.
4. Calculating distributable profits under IRC 280e. Sub-chapter S corporations, as well as LLCs that elect sub-chapter S status or default to partnership status, don’t pay federal income taxes. The profits are instead allocated proportionally among the shareholders or members, and those individuals pay extra personal tax on the money. This can be a problem in marijuana businesses, where effective tax rates under IRC 280e tend to be much higher than for other businesses. All of this liability is passed on to the individual partners, regardless of the size of cash distributions over the course of the tax year.
Many companies deal with this by including mandatory tax distributions to shareholders, but those are only valuable if there is cash to distribute. Marijuana businesses are often best-served if their operating agreements require their managers to set aside sufficient capital to fund tax distributions while taking IRC 280e into account.
5. Distribution of cannabis inventory upon dissolution. When a business dissolves, its non-cash assets are usually distributed to its members or shareholders in equal proportions (though this simplifies matters greatly). Most of the time, the business is able to liquidate assets and distribute cash, but that’s not always possible, especially if it is in a hurry to dissolve for some reason. In non-marijuana businesses, the shareholders generally can take possession of the assets, including inventory. For cannabis businesses, though, it is illegal for individuals to possess the quantities of cannabis inventory that a business can possess, and it is also illegal for a cannabis business to transfer marijuana inventory outside of the licensed system. For these reasons, your cannabis business’s operating agreement or shareholders’ agreement should address what will happen to your business’s cannabis inventory that hasn’t been liquidated prior to company dissolution, as there can be some clever ways to deal with it legally. It also usually (but not always) makes sense for the shareholders or members to agree in writing that all distributions when the cannabis company dissolves should assume that any non-liquidated inventory is valueless.