Photo of Daniel Dersham

Located in Harris Bricken's San Francisco office, Daniel's practice focuses on commercial and real estate disputes. His success in Federal and State trials, arbitrations, and mediations has made him a sought-after legal adviser not only for cannabis corporate clients, but also for individual owners and landlords seeking representation on a variety of real estate issues and disputes, such as leasing, land use, and regulatory compliance.

BCC california cannabis marijuana
We’ve got a lot of questions for the BCC right now.

Last month, California’s regulatory agencies charged with writing commercial cannabis rules released new modifications to the final rules proposed in July. The Bureau of Cannabis Control’s (BCC) proposed modifications contained some of the most dramatic changes, including what would effectively be an outright ban on intellectual property licensing for cannabis products—something we are still trying to wrap our heads around due to the seismic effect it would have throughout the industry. The comment period is now closed on the proposed modifications, so now we must wait and see what the BCC decides to do with its final rules in the next few weeks. (To see at our law firm’s comments to BCC on this, go here.)

The proposed rule banning IP licensing agreements is the result of the BCC’s attempt to redefine what constitutes “commercial cannabis activity.” Existing California statutes—which allow the BCC to create and modify cannabis rules—already require that “all commercial cannabis activity shall be conducted between licensees.” So, if you are conducting “commercial cannabis activity” you must have a license to do so. But what truly is “commercial cannabis activity,” and where should the state draw the line?

Current state law defines “commercial cannabis activity” as “includ[ing] the cultivation, possession, manufacture, distribution, processing, storing, laboratory testing, packaging, labeling, transportation, delivery or sale of cannabis and cannabis products.” That much makes sense—activities that touch the plant or its products fall squarely within a common sense understanding of what activities should require a license from the state. But under the BCC’s new proposed rules, the following would now also constitute commercial cannabis activity:

  • Procuring or purchasing cannabis goods from a licensed cultivator or licensed manufacturer on behalf of, at the request of, or pursuant to a contract with a non-licensed person;
  • Manufacturing cannabis goods according to the specifications of a non-licensee;
  • Packaging and labeling cannabis goods under a non-licensee’s brand or according to the specifications of a non-licensee; and
  • Distributing cannabis goods for a non-licensee.

Distributing cannabis goods for an unlicensed operator seems straightforward. But for the other additions, such a broad reading of the statute would undoubtedly sweep many activities within this prohibition that in fact have little or nothing to do with actual cannabis activity. For example:

  • Some types of cannabis licensees are not prohibited from conducting certain types of non-cannabis activity (e.g. manufacturing, distributing, and selling cannabis accessories). To prohibit any of those non-cannabis contracts from having any interaction with cannabis contracts would add an unnecessary restraint on trade. Perhaps a non-licensee makes vape batteries and as part of its distribution agreement wants to require its licensed retailer partner to only purchase cannabis oil from a certain licensed manufacturer to preserve its brand integrity. Under the new rules, that would be prohibited.
  • Imagine that same battery manufacturer wanted to require that same manufacturer by contract to produce vape oil to certain specifications, to ensure the device functions as designed. Under the new rules, that would be prohibited.
  • The third point is perhaps the most concerning, as we have already discussed previously and written directly to the BCC. It means that anyone with a brand, whether they already associate it with cannabis products or not, would now be prohibited from selling licensees the right to use that brand on packaging or labels for cannabis goods. This would mean that if you want to have a brand you also have to have a license, which means you also have to be a cannabis operator of some kind. And the entity that holds the license to operate must also own the rights to the brand – holding the intellectual property in a separate entity for liability purposes would not be allowed. Such an arbitrary barrier to the use of intellectual property is an unnecessary restraint on trade.

It’s not clear exactly why the BCC believes these rule modifications are necessary or justified; it only states in its notice of modifications that it had been made aware “that licensees may be engaging in such conduct” as would now be prohibited by the new rules. It’s also unclear whether the BCC will stick with these changes or discard them based on feedback received during the comment period—only time will tell.

federal court cannabis marijuana
Federal courts are finding ways to enforce cannabis contracts nationwide.

We’ve written previously about how courts, especially U.S. District Courts charged with applying and interpreting federal law, are wrestling with inconsistencies between state and federal law when it comes to state-legal cannabis. A little over a year ago, the emerging solution when it comes to enforceability of contracts involving cannabis was to apply the legal principle that “even where contracts concern illegal objects, where it is possible for a court to enforce a contract in a way that does not require illegal conduct, the court is not barred from according such relief.” Mann v. Gullickson (N.D. Cal. 2016). Fast forward to today, almost a year after California’s new cannabis regulations have been percolating into the world’s fifth largest economy, and that permissive, mostly hands-off approach to state cannabis contracts seems to have not only solidified, but appears to have been applied in other states that have recently legalized cannabis.

In an Oregon case, the plaintiff sought to recover economic damages in a personal injury case stemming the future earnings of a cannabis company. The defendant argued that because cannabis is federally illegal, the court cannot award future earnings from what amounts to an illegal business. In denying the defendant’s motion for summary judgment, the court found that “Marijuana’s legal status is unique. It is neither fully legal nor illegal. Because [plaintiff’s] family cannabis business is allegedly legal under Washington law, I conclude that . . . Plaintiff may recover economic damages based on projected profits from that business.” Tarr v. USF Reddaway, Inc. (D. Or. 2018). In so doing, the court also favorably cited a 2017 Oregon federal case holding that an employee of a marijuana testing laboratory could bring a claim under the federal Fair Labor Standards Act despite the federal illegality of marijuana. Id., citing Greenwood v. Green Leaf Lab LLC (D. Or. 2017). Key to both decisions was that in order to grant the requested remedies (allowance of future economic damages for personal injury; allowing a claim to proceed for violation of labor standards), the court did not need to order either party to directly violate the federal controlled substances laws that otherwise prohibit cannabis. Rather, the remedies were ancillary to the fact that the parties happened to be engaged in cannabis business activity.

In Nevada, a state that legalized cannabis in 2016, a plaintiff wanted to enforce certain promissory notes against a cannabis cultivation business. Some terms of the notes required defendants to use the loan money to pay off debtors and purchase certain real estate in Nevada—both things the court found to be lawful objects of a contract. Other terms of the notes, however, required the defendants to use some of the funds as operating capital in their cannabis business, and to grant the plaintiff a right of first refusal to purchase part of defendants’ business, both things the court found to be unenforceable because they would require defendants to violate federal law. The court, citing favorably to the Mann principle, found in favor of the plaintiff and denied the motion to dismiss, and noted that Nevada law allows courts to interpret contracts so as to sever unlawful or unenforceable provisions while retaining and enforcing the lawful parts. Bart Street III, Inc. v. ACC Enterprises, LLC, et al. (D. Nev. 2018). The significance of Bart Street is that the court expanded the use of the Mann decision, which merely dealt with nonpayment of promissory notes, and narrowly interpreted cannabis contracts so as to allow plaintiff to proceed in its suit to enforce the lawful terms, even where other terms clearly violated federal law and the contracts as a whole involved a federally illegal business purpose.

Finally, in a Texas case applying the law of Illinois, a state that recently legalized medicinal cannabis, a plaintiff sought payment for certain promissory notes involving cannabis businesses, similar to the situations in Mann and Bart Street. The defendant raised the defense of illegality of the contracts as justification for not performing. The court, collecting cases from all over the country in support, found that the defense of illegality under federal contract law was more equitable than remedial, and more presumptive than absolute, instead requiring a balancing of factors such as “the avoidance of windfalls or forfeitures, deterrence of illegal conduct, and relative moral culpability.” Ginsburg v. ICC Holdings, LLC (N.D. Tex. 2017). The court also noted the importance of “creating stability in contract relations and preserving reasonable expectations” as counterbalances to the “costs in forgoing the additional deterrence of behavior forbidden by the statute” that renders the contract illegal. The court concluded that the defendant had not met the standard for a motion to dismiss if its sole argument was for illegality of purpose in the contracts. Ginsberg is remarkable in that the court continued the whittling down of federal law as an invalidating presence upon state contracts involving state-legal cannabis activity, and did so in a way that frames the decision as a culmination of established principles of contract law.

It remains to be seen what will become of the absolute federal illegality in cannabis, but in the meantime, federal courts continue to find ways around invalidating contracts simply because they happen to involve cannabis, and sometimes even when they include terms that require parties to violate federal law, so long as those provisions are severable.

On Friday, the three California agencies charged with issuing and enforcing rules for cannabis business licensees issued a stack of proposed changes to the final rules it had previously proposed in July. Many of the most dramatic changes came from the BCC and will likely motivate more than a few comments during the rulemaking process (deadline for comments on these proposed changes is Nov. 5, FYI).

The Department of Food and Agriculture, which administers the cannabis cultivation licensing program, issued its own set of proposed rule changes that, while not as jaw-dropping as some of the BCC’s proposed changes, are still noteworthy.

Most importantly, the rules for cultivation plans just got a lot more onerous for licensees that plan to “stack” small licenses for use on one premises. Recall California’s controversial decision last year not to cap the total cultivation acreage per licensee to one acre, and the resulting benefit to mega farms that were then free to “stack” multiple smaller licenses to get a larger total cultivation area that they would otherwise be prohibited from getting due to the one-per-licensee limit of 1-acre outdoor licenses and the prohibition on Type-5 “large” cultivation licenses until 2023. A key element to that loophole’s benefit to large growers was AB 133, which clarified that a licensee could maintain one big “premises” upon which to operate all of its licenses, and was not required to make each license have its own “separate and distinct” premises. This would allow for economies of scale, as it would be arbitrary and inefficient to require every single chunk of canopy on a parcel to have its own fencing, security, etc.

Cue the DFA, which through its new proposed rule modifications, now says there are certain categories of a licensed premises that categorically cannot be shared among licenses owned by a single licensee.  Permissible shared areas must be contiguous, and they are limited to areas designated for pesticide storage, composting, cannabis waste storage, and harvested cannabis storage, in addition to traditional common areas such as hallways, bathroom, and break rooms. However, areas that cannot be shared among multiple licenses held by one licensee include: (i) areas outside of the canopy where only immature plants are grown (i.e. nursery-type areas); (ii) processing or packaging areas (i.e. “drying, curing, grading, trimming, rolling, storing, packaging, and labeling”); and (iii) areas designated for physically segregating cannabis during an administrative hold pending resolution of a notice of violation from the state. While it is not clear exactly how the DFA would interpret this proposed new rule language in practice, a likely result could be that cultivation licensees holding multiple licenses (either of the same type or a variety) for use on a single premises would no longer be able to take advantage of the same economies of scale for processing and packaging or for cultivation of immature plants, and that each separate license would require its own dedicated room for each such activity. We also know that the BCC requires separate walls and sealed doors when it calls for premises to be separate. Time will tell how this rule will look in a few months, but as it stands now it could harm companies with limited access to space and resources for building additional rooms, and would certainly add to costs of compliance.

Other notable small changes that could add to licensing costs include requirements that each license applicant must now agree to put one supervisor and one employee through a standard 30-hour Cal-OSHA course for workplace safety; and beginning in 2020, all cannabis and nonmanufactured cannabis products packaged or labeled by a licensed cultivator must come in child-resistant packaging, which conforms to the requirements of BCC and DPH for packing of other cannabis products.

Finally, one proposed change in the BCC rules that may end up having more of an effect on cultivators is that all structures included as part of the licensed premises must now be permanently affixed to the land for an indefinite period of time. Off-the-grid type operations are notorious for using RVs, mobile homes, lightweight moveable greenhouses, etc., so this rule change might also serve to prevent what would otherwise be a quick fix to the first issue identified above.

RICO cannabis landlord
RICO suits are not just busting up gangs these days.

The Racketeer Influenced and Corrupt Organizations Act (RICO) is a federal Nixon-era law originally intended to combat drug cartels and organized crime. Among other features, it allows average citizens claiming a loss in property value to bring suit for triple damages plus attorney’s fees against any “person” or “enterprise” that has a part in any neighboring “racketeering activity” which includes—you guessed it—“dealing in a controlled substance.” Currently, federal law continues to classify cannabis as a Schedule I controlled substance—meaning it has no medicinal value, and is supposedly more dangerous than methamphetamine, methadone, hydromorphone, and oxycodone, among other things.

RICO has been read broadly enough by its patrons to include operators, as well as landlords, lenders, and even government licensing agencies and customers, as co-conspirators in licensed cannabis operations, meaning angry neighbors have found their deliverance when it comes to trying to shut down state-legal cannabis businesses. The painful irony of all this is that anyone with an aversion to cannabis in a state where voters democratically decided to legalize it has unique power to be an American Gangbuster because of an almost-half-century-old relic of the federal War on Drugs; yet, meanwhile, companies that would be investing in local communities are looking north to do five-billion-dollar Canadian Blockbusters. The bottom line is that as long as federal law remains unchanged, it does not matter how state voters decide to govern themselves, or even how sensibly the federal government decides to enforce federal laws prohibiting cannabis. RICO provides a private right of action for any would-be provocateurs that can plausibly claim they have been damaged by a neighboring cannabis business.

So how can landlords and tenants approach this issue when designing a cannabis tenancy? The short answer is that RICO will continue to be a real issue for as long as federal law allows it to be, but the parties can take some proactive measures in drafting the lease to mitigate that threat:

Build in an early termination option for third-party lawsuits. Just as the lease can include early termination options for a variety of cannabis-specific occurrences, it can provide an opportunity for one or both parties to address an undismissed third-party lawsuit by terminating the tenancy. This can include RICO actions as well as standard nuisance actions, which often have longer legs than RICO lawsuits. It can also include indemnification obligations if, e.g., the tenant causes the problem by failing to comply with the lease terms, or if the landlord misrepresents neighborhood sentiment (more on that below).

Vet the neighbors. Just as a tenant would analyze the zoning laws applicable to a proposed use, a cannabis tenant should take some time to see what the neighborhood is all about. Does the community support the use? How are the neighboring areas zoned? Is there any kind of history of bad actors in this space that’s left a bad taste? The tenant will have to make sure the site isn’t within any prohibited buffer zones of schools or youth centers as part of its state license application anyway, and what better opportunity to get to know your potential neighbors? Even some casual exploring is better than nothing, and can save loads of trouble down the road. Depending on how the parties negotiate the lease, it can include, e.g., landlord warranties of no known neighbor objections after diligent inquiries, or a term that puts the responsibility on the tenant to figure out how the use would go over in the community.

Tighten up those compliance obligations. Compliance with state and local law is the key to avoiding enforcement actions, and is equally important when it comes to neighbor relations. State regulations contain strict requirements about security protocols, waste management, hours of operation, and product transportation. Local rules will typically dictate things like parking requirements, odor management, and noise. The stronger and more specific the lease is with regard to complying with these various rules, the better chance you will have that the tenant (i) knows them, and (ii) follows them. Simply indemnifying yourself in the lease makes little difference if you end up losing an otherwise good tenant because they were uninformed.

Research the local politics and get to know local law enforcement. California’s cannabis regulatory regime is unique in that local jurisdictions are still king when it comes to who gets to operate and where. And we’ve already seen a repeat of what’s happened in other states that have legalized: jurisdictions sometimes change their minds and declare previously allowed cannabis operations to be non-conforming uses. Having your finger on the community pulse and knowing the level of support for your local cannabis ordinance when it passed is going to put you in a better position to know whether your cannabis tenant or your cannabis operation is more likely to be a welcome neighborhood feature or a walking lawsuit.

For more on California cannabis leasing, check out the following:

california marijuana cannabis enforcement
Home of fewer illegal grows.

Federal enforcement of the Controlled Substances Act in states that have legalized cannabis has been a huge question mark for years, but especially so in California since the 2016 passage of Prop 64, which legalized medicinal and adult-use cannabis and laid the framework for a new regulatory regime. Almost two years later, that question remains, but certain trends have emerged, were reinforced, and now seem to be forging full speed ahead. Those trends suggest that (1) the Department of Justice is not engaging in a crackdown against cannabis businesses that are in compliance with state and local law, and (2) the state and the federal government have agreed to coordinate on enforcement actions where it furthers the priorities of both entities. So far, those priorities have been organized crime and illegal cultivation on public lands, and this week the latter priority got a big boost from both sides of the equation.

On the state side of things, a proposed state law extending the statute of limitations from one to three years for state enforcement actions against unlawful “conversion of timberland to nonforestry-related agricultural uses”—a move that targets illegal cannabis cultivation on public lands—has passed the state legislature and is now before Governor Brown for signature. The bill also clarifies that the limitations period does not begin to run until the state discovers the violation.

On the federal side of things, the Department of Justice issued a formal statement about the results of its summer-long collaborative project with the state and local governments to target and eradicate illegal cultivation operations on public lands, aka Operation Forest Watch, which we now know has been underway since at least October 2017 and also included the California National Guard. One important reason behind this effort was an unprecedented level of illegal toxic pesticides being used in unlicensed cannabis cultivation, some so powerful that a “quarter-teaspoon can kill a 300-pound bear.” Because cannabis grown using these dangerous pesticides cannot pass California’s stringent quality standards, it has been mostly shipped illegally to the Midwest and the East Coast, undermining both California and federal laws prohibiting diversion out of state.

The big-picture takeaway from this joint operation is that “federal authorities are concentrating their efforts on hazardous illegal grows on public land instead of targeting California’s new recreational marijuana industry, although marijuana remains illegal under federal law.” Another take on it is that federal and state cooperation on cannabis enforcement as it has been structured to date benefits both entities when priorities are aligned: The federal government furthers its goals of protecting public lands and public safety and targeting organized crime; while the state furthers those same goals in its own interests, and at the same time reinforces the state’s regulatory regime by incentivizing licensing and compliance and cracking down on the state’s illegal markets.

It remains to be seen what effect these joint enforcement actions, as well as California’s continued crackdown on unlicensed operators, will have on the state’s cannabis market writ large, but to date they have unquestionably proven beneficial to both parties, as well as all Californians who enjoy and want to preserve our forests.

california cannabis lease
Entirely avoidable, fortunately.

We’ve written previously about some common issues landlords run into when leasing to cannabis businesses (see links at the bottom of this article). Now that we’ve seen almost a year’s worth of emergency regulations, and the state has released its proposed final regulations, we’ve also seen a variety of cannabis leasing issues crop up. Here are a few of the most common ones.

Insurance

This is a frequent problem. Sometimes it’s an issue with the landlord’s current carrier being no longer willing to provide coverage, or a questions of how to pass the increased cost of premiums on to the tenant if coverage is actually available. Or sometimes it’s about the tenant’s inability to obtain reasonably priced coverage with sufficient policy limits and necessary endorsements. But more often than not, insurance presents a problem for one or both parties. Fortunately, insurance is becoming more available and reasonably priced as more admitted carriers join the market. There are different strategies suitable for different insurance-related problems, but some examples have been building a termination contingency into the lease for landlord’s inability to obtain or maintain coverage on the building, or for tenant’s failure to obtain or maintain its required policies. Generally in cannabis leases, the cost of premiums gets passed directly onto the tenant, and in a multi-tenant building the increase will be allocated directly to the cannabis tenant. We do anticipate that insurance will become less of a problem as the market for providers continues to expand.

Federal and state enforcement actions

As we’ve also written previously, while federal enforcement is a concern both parties need to account for, state enforcement is the more pressing and predictable concern, especially now that both federal and state enforcement priorities are ostensibly aligned. The keys to accommodating enforcement concerns are: building early termination options into the lease; training indemnification obligations to enforcement event-related costs, damages, and claims; and including robust use restrictions in the lease. One solution has been to levy hefty increases in the security deposit to act as an indemnification bond, and to expand its use to act essentially as a landlord legal defense fund in the event the tenant’s noncompliance with the lease triggers an enforcement action.

Licensing

The easily obtainable temporary state cannabis license is a thing of the past: Now applicants must submit the full annual license application, which is far more robust and demanding. Similarly, it can take months for an applicant to obtain a conditional use permit in localities that require one, which is common. Understandably, neither landlord nor tenant will know quite how they feel about the tenancy–and how much they want to invest in tenant improvements–until there is more certainty on licensing. A common solution has been to build into the lease an anticipated licensing timeline with benchmark contingencies that allow the parties to evaluate progress and decide whether to terminate if there is not enough.

Security instruments

If a landlord’s property is financed, the note and deed of trust will often have terms requiring compliance with “all laws” (including federal), or prohibiting nuisances, or maintaining insurance coverage. A landlord’s compliance with those requirements can be jeopardized by a cannabis use on the premises, so the parties need to consider the possibility that landlord could be held in breach by the mortgagee, or would not be able to finance or refinance the property if needed. One solution to this problem has been to build in an early termination option for the landlord, but to also provide the tenant the option of securing or providing alternative financing, or paying the difference in interest rate between the landlord’s traditional loan and a hard-money loan.

Payment

Cannabis tenants are forced to deal mostly in cash because of federal banking regulations, and would love to be able to pay their rent the same way. Landlords should resist the temptation, and prohibit the tenant from paying in cash. Right now there really isn’t a great solution for this problem, except for landlords to make sure it’s not their problem. There are a handful of banks that serve cannabis businesses, and it’s the tenant’s responsibility to find them.

Subletting, multi-tenant buildings, and premises modification

Often, a cannabis tenant will be applying for multiple types of permits and licenses, with the intent of conducting several separate operations on site. For example, indoor cultivation, manufacturing, and distribution businesses all owned by tenant and operated under separate licenses under the same roof. Under current proposed regulations, this is possible, but licensed premises must remain separated by distinct barriers and locked doors. This means that where one or more cannabis tenants are operating on the same site (often a former warehouse) tenant improvements will be needed (often they already are due to a required increase in utilities capacity), and strict protocols must be followed regarding access and security. The parties should anticipate these issues with a through regulatory review during the leasing process and crafting of the tenant work letter, and part of that can also include requiring the tenant to submit its security and access plan to the landlord for approval, as it already will have to be submitted to the state (and often the local government as well).

One thing we have not noticed since this time last year is a cool-down in real estate purchases and leasing. Because of the limited number of jurisdictions allowing cannabis uses, and the even more limited number with accessible permitting regimes and attractive taxation, real estate in suitable locales has stayed expensive and competitive. Now that California is seriously considering the prospect of a public bank for cannabis, it will be interesting to see if real estate prices ease off at all as more jurisdictions open for business.

For more on California cannabis leasing, check out the following:

california cannabis marijuana landlord
…In a good way, for cannabis landlords.

Almost two years after the passage of Proposition 64, the 2016 California voter initiative to legalize and regulate medicinal and adult-use cannabis, California has begun to finalize its regulations that will govern the largest cannabis market in the country, though that effort has not been without some hiccups and bumps in the road. But, things are coming along and we anticipate that, as in other states that legalized cannabis like Washington and Oregon, after an initial period of turbulence, the rules will be solidified, prices will clam down, and there will be at least some measure of market stability going forward, notwithstanding those localities that decide to sit this one out. In the meantime, how are marijuana landlords faring in the midst of these industry growing pains? As it turns out, quite well. Here are a few examples.

Availability of insurance. Landlord insurance is essential in any tenancy. It protects the landlord against liability for injuries and property damage that occurs on the leased premises, and it covers losses to the building such as fire or burglary. Just months ago, California approved the first lessor’s risk policy for cannabis landlords to be written by a traditional state-admitted carrier. That may not sound like a big deal, but it really is: admitted carriers are held to high standards, and for the California Department of Insurance to agree to allow (and therefore essentially underwrite) such policies to be issued despite the subject activities being federally illegal is encouraging for the industry. The state also recently approved a business owners policy for cannabis operators, which is good for tenants.

Mainstream investor acceptance. One does not have to look to Canada to see mainstream investment success for U.S. cannabis companies. Real estate investment trusts (REITs) are highly regulated investment vehicles that can also be subject to federal scrutiny. In the U.S., only a handful of publicly listed REITs include properties leased to cannabis tenants, and now one of the country’s preeminent financial publications is openly recommending investment in a cannabis REIT, on the premise that businesses that lease to cannabis tenants “don’t actually ‘touch the plant’ which makes it a safer bet for long-term investors.” With the proviso that the CSA doesn’t necessarily agree with that assessment, this is one of many watershed moments in the normalization of commercial cannabis, with due respect to the republican former Speaker of the House becoming a board member of a cannabis investment fund.

Emergence of renewed federal enforcement priorities. Since the rescinding of the Cole Memo at the beginning of 2018, it has slowly emerged that federal cannabis enforcement priorities in California will be aimed at aligning with the state’s own enforcement priorities, as well as traditional federal prerogatives such as protecting federal lands and preventing organized crime. Notably, these articulated enforcement priorities have not included any mention of pursuing landlords of commercial cannabis tenants that are in compliance with state laws.

Advancement of tenancy-friendly state legislation. Recently, the state legislature has advanced a proposed law encouraging shared tenancy resources and tenant cost savings, e.g. bathrooms, break rooms, locker rooms, hallways, or loading docks. This is obviously an encouraging development for tenants, especially in places like the Bay Area where commercial space is at a premium. But it is also good news for landlords, who can market their properties to multiple tenants, rather than try to lease larger multi-unit spaces to a single tenant because of the inability to share common areas.

As long as cannabis remains federally illegal there will always be a measure of uncertainty and risk involved in commercial cannabis leasing for both landlord and tenant. But the trend lines do seem to be pointing towards normalization, which in turn points to decreased risk. Only time will tell.

For more on California cannabis leasing, check out the following:

cannabis lawCannabis has remained federally illegal at the same time states continue to legalize cannabis in one form or another. As a result of legalization, private parties enter and perform contracts, loan and borrow money, and convey leasehold property rights in ways that involve cannabis. These contracts affect and depend upon millions of dollars in assets, including real estate, thereby interweaving the cannabis industry into the economic systems that allow our free market economy to function. Courts, and especially federal district courts and courts of appeal, often must wrestle with whether and how to enforce such contracts where one body of law says they are void as illegal and another says they are perfectly valid.

Courts have generally been willing to enforce these contracts and have come up with some pretty creative arguments for doing so, perhaps because of the economic disruption that would occur if parties were suddenly permitted to walk away from contractual obligations and the consequences to city and county governments that have issued property entitlements and licenses to cannabis businesses. However, a recent appellate court decision illustrates how there are still limits on the ability to indulge, even when done in compliance with state law.

In U.S. v. Schostag, a defendant had pleaded guilty to felony possession of a firearm and attempted possession of methamphetamine and was sentenced to 120 months in prison and 5 years of supervised release. One of the conditions of his release set by a federal district court in Minnesota was that he not possess or use any controlled substance “except as prescribed by a physician.” Minnesota law allows physicians to prescribe certain forms of medical marijuana and the defendant notified his probation officer that his doctor had prescribed medical marijuana for chronic pain. The probation officer advised the defendant that, cannabis prescription or not, defendant’s consuming cannabis would violate the terms of his release because it was prohibited by federal law.

The defendant tested positive for marijuana and his probation officer reported the violation. Defendant argued he was simply following the terms of his release conditions, which allowed for him to use prescribed controlled substances. The district court, apparently acknowledging the awkwardness of the language, modified his release conditions to explicitly forbid defendant from using or even possessing marijuana with a medical marijuana prescription and gave defendant two weeks to find a legal form of pain management. Defendant appealed this decision, arguing that the court should have exercised its discretion in setting his release conditions and should have allowed him to use medical marijuana under Minnesota law.

The Eighth Circuit Court of Appeals rejected defendant’s argument, noting that under federal sentencing law, federal courts can modify release conditions but cannot do so in a way that violates federal law, including the CSA, which outlaws marijuana in all forms. The court also declined to engage in any nuanced discussion of the interplay between federal and state laws on cannabis, instead simply declaring, “the state’s law conflicts with federal law.” Though this decision seems harsh, consider the alternative: if the court had allowed the defendant to use marijuana while on federally supervised release — the conditions of which a federal court is itself responsible for setting — this would have amounted to a federal entity (the court) directly allowing for a violation of federal law. This wasn’t a contract between private parties; it was the federal government deciding whether to allow a releasee under its supervision to use a substance that is unquestionably prohibited by federal law.

Though the court in Schostag found Minnesota’s medical marijuana law to conflict with federal law, there is a colorable argument that this case is an outlier from the general trend of federal courts being unwilling to get in the way of state-legal cannabis. The federal government and its court system cannot be expected to ignore federal controlled substances law when applying federal sentencing law to those under federal custody or supervision simply because the court happens to be located in a state with contrary laws on cannabis.

An example of a similar approach occurred in Forest City Residential Management, Inc. v. Beasley where a federal district court in Michigan held that tenants in a federally subsidized housing project were not entitled to a reasonable accommodation under the federal Fair Housing Act to use medical marijuana at their rental units. Though closer to a private contract than federal sentencing guidelines, allowing marijuana use in federally subsidized housing as a legal accommodation is akin to the federal government sanctioning a clear violation of federal law within the confines of its own program.

Though the general trend is that federal courts are reluctant to interfere with state legal cannabis activity, that tolerance typically stops at the doorstep of federal programs operating under federal law. This is something Congress can and should change, not the judiciary. Unless and until cannabis becomes federally legal, we will continue to see courtroom manifestations of the cannabis federalism fight.

california cannabis remediation nuisance lease
Don’t get left with a mess on your land!

For California landlords leasing to cannabis businesses, we’ve previously discussed how compliance with state and local law, perhaps even more so than the specter of federal enforcement, should be a top concern when structuring the tenancy and drafting the lease. As the state ramps up its efforts to transition the industry to a robust regulatory regime, one result of those efforts that is playing out across the state is that cultivator tenants, particularly outdoor grows, are abandoning their cultivation operations rather than paying for cleanup or dealing with state or local enforcement actions.

Sometimes this is due to a lack of wherewithal to become a licensed operation and pay the costs of compliance. Other times it’s due to a change in local law that renders the operation a nonconforming use. And still other times it’s the result of a private or government-initiated nuisance action (although these actions can sometimes create other problems). But the result is often the same: The property is left abandoned and trashed, cannabis growing material such as dangerous fertilizers are left spread across the site, and, often, illegal stream diversions or alterations have been illegally constructed, posing a threat to wildlife, water quality, and natural water drainage systems. The result is an environmental disaster and a landlord left holding the bag, often with a hefty administrative fine or nuisance abatement assessment to boot. Below are some of the many considerations that should go into structuring a cannabis lease when it comes to preventing these types of situations from happening in the first place.

  1. Reviewing tenant SOPs as part of the vetting process. Before even putting pen to paper on a lease, landlords should consider requiring potential tenants to produce their standard operating procedures (SOPs) and other relevant cultivation planning documents to demonstrate what materials they will be using to cultivate, where they will be obtaining their water, how they will be disposing of waste, and how the site layout will be organized. Much of this information will have to be provided to local and state agencies anyways in order for the tenant to obtain its cultivation licenses and permits. The lease can also include tenant obligations to list all hazardous materials it intends to use at the site and to provide material safety data sheets (MSDS) for each. If the tenant doesn’t have a proper site use plan in place before they sign a lease, then chances are things will not end well for the landlord.
  2. Maintaining strict control over tenant improvements in the lease and allowing for discretionary inspection. Commercial cannabis is a strictly regulated industry (for good reason), and the lease should afford similar control for the landlord over how a tenant uses the leased premises. Indoor cultivation leases may require discretionary landlord approval at multiple stages for any alterations to the building, and outdoor cultivation leases may also require the same level of approval for changes to the land, however insignificant. The lease can give teeth to these restrictions by allowing for landlord and government inspections, and affording the landlord early termination options for a tenant’s failure to comply.
  3. Including strong tenant indemnifications for remediation. Indemnity clauses provide a guaranty that a tenant will hold the landlord harmless and defend it against certain types of claims. A common such clause pertains to remediation of hazardous substances on site, where the tenant promises to pay for any costs associated with spills or contamination. Cannabis cultivation leases can add to that by including cleanup costs for any damages caused or messes left behind by cultivation operations, and defense costs for any governmental remediation actions or private nuisance actions requiring abatement.
  4. Including early termination options for government enforcement actions and third-party lawsuits. If the government or a private actor sues the landlord or the tenant because the tenant is causing a nuisance by creating a mess (and not just by conducting the permitted use—another example of a carve-out that tenants will want to include), the landlord will want to be able to abate the problem quickly by terminating the tenancy and enforcing the tenant’s indemnity obligations. To that end, the lease can include a landlord early termination option to end the tenancy and evict the tenant on short notice, should the landlord opt not to deal with convincing the tenant to comply.
  5. Adjusting the security deposit to the size of the cultivation operation. While commercial security deposits are normally one or two months’ rent, there’s nothing requiring them to be. Because the stakes for noncompliance are so high in this industry, landlords may consider upping the deposit to an amount sufficient to properly deal with a cleanup of the tenant’s operation, should tenant fail to comply and abandon the premises. The lease can also be written so that the security deposit essentially acts as a bond for performance of the indemnification obligations, though in California there are necessary statutory waivers to be included in the lease.

California is serious about dragging its cannabis industry into regulatory compliance, and that includes a lot of cultivation site cleanup and forward-looking maintenance. California is also extremely serious about compliance with its environmental laws, as the world already knows, and we are fortunate for that. Landlords should be aware of the consequences of the leased premises turning into a nuisance or environmental violation, and consider how to build the tenancy to protect against such problems from the get-go by drafting a proper lease agreement. When everyone’s on the same page about strict compliance and good environmental stewardship, everybody wins.

california cannabis lease
…with your California cannabis lease.

The current state of enforcement in California tends to be dominated by headlines about the Department of Justice, Jeff Sessions, the DEA, and the Controlled Substances Act. And for good reason—under the constitution, federal law is the law of the land, and commercial landlords and tenant alike should study federal enforcement guidelines closely. Lease agreements should account for those guidelines by mandating clear tenant compliance obligations as well as providing for appropriate remedial measures in the event those obligations are not followed.

But California’s commercial cannabis legal regime does not exist under or because of federal law—rather, it is a creature wholly of state and local law. California statutes, state agency regulations, and city and county ordinances, zoning plans, and land use restrictions are what form the flesh and bones of California cannabis law. As a result, most risks affecting commercial tenancies materialize not from threatened federal action, but from issues surrounding compliance with state and local law, and related enforcement actions. Commercial cannabis leases in California should therefore primarily account for and address these risks. Following are examples of some specific issues that should be addressed in the marijuana business leasing process.

     1.     State and local enforcement actions. 

After twenty years of a mostly hands-off approach to the medicinal cannabis industry, it has proven difficult for the state to properly incentivize cannabis businesses to apply for licenses and comply with California’s new cannabis regulatory regime. And the ones that have done so are currently at a relative disadvantage in that they cannot deduct business expenses for tax purposes, must pay the costs of acquiring permits and licenses, and must maintain compliance with all applicable laws (which continue to change not infrequently). With the exception of a legislative budget dispute on how to fund it, the state is set to ramp up enforcement efforts against unlicensed entities. What this means for cannabis tenancies is that leases should include, among other things: strict compliance obligations that track the status of local and state regulation; a clear licensing and permitting timeline with built-in contingencies for failure to acquire, maintain, or comply with any relevant government approvals; and early termination contingencies for enforcement actions brought by local or state agencies. While these are similar to federal enforcement contingencies, they can go further by tailoring to locality-specific requirements, and referencing specific provisions of tenant permits when available. Whereas the industry is rife with speculation about federal enforcement priorities, there is a voluminous amount of information about state and local laws applicable to the cannabis industry in California, and tenancies should take advantage of that knowledge to minimize risk of adverse enforcement actions.

     2.     Change in local law rendering tenant’s operation a nonconforming use.

Interestingly, this is often something that I have had to convince clients is actually a real risk to consider: a locality passing a commercial cannabis ordinance, and then following it with a ban, but not before issuing cannabis permits and happily accepting the fees. This first became an issue in states such as Washington where legalization occurred early on, and it’s now becoming an issue in California, inevitably leading to enforcement of those post-hoc bans and ensuing criminal charges and civil litigation. Whether or not a ban is ultimately upheld in court, it creates uncertainty and immediate enforcement concerns for landlords and tenants. Leases should account for this risk by building in early termination contingencies for changes in local law, or, depending on what the parties negotiate, indemnification and attorney’s fees provisions in the event one of the parties decides to challenge the change in law.

     3.     Zoning, land use, and water rights.

No matter what the federal government might say or do in the future, every locality will always have laws that govern how land within its borders may be used, and how water may be used on that land. While such laws are not unique to commercial cannabis, laws that apply to cannabis in California are, and they vary between every city and county. Of course, there are also private land use restrictions such as CC&Rs and easements that may affect a cannabis use. In every commercial tenancy there are risks that such laws and restrictions would prevent the tenant from performing the permitted use, perhaps due to an overlooked setback requirement, or a property that’s zoned for one cannabis use but not another, or a conservation easement on farmland whose terms require compliance with “all laws” (including federal), or an inability for the tenant to divert enough water or property discharge waste. These issues should be part of a tenant’s due diligence process prior to singing the lease, and responsibility should be allocated accordingly in the lease. But it doesn’t hurt for the landlord to conduct its own analysis during the tenancy vetting process, and the lease can also be structured to allow for early termination if any such unanticipated issues arise, including in the event that any such laws or restrictions change during the tenancy.

What is unique about state and local laws is that they will likely remain active concerns for commercial cannabis leasing no matter what the federal government does in the future. More so than typical commercial tenancies, cannabis landlord and tenants alike will have to continue to account for state and local issues that present risks to the tenancy, and all parties will have to stay abreast of laws and regulations as they continue to change.

For more on California cannabis leasing, check out the following: