Photo of Robert McVay

Robert is a partner at Harris Bricken focusing on corporate, finance, and transactional matters for clients both inside and outside the cannabis industry.

cannabis business marijuana
If only it were so easy.

There is a direct correlation between the complexity of a state marijuana business licensing system and the complexity of financial deals that industry participants undertake. Washington, Oregon and most of all, California, provide fertile grounds for increasingly complex deals. Outside of cannabis, my firm sees similarly complex transactions proposed in our international business practice, especially in our China law practice which is another body of law requiring specialized knowledge. Regardless of circumstance, though, it is vitally important that parties to a deal firmly understand how the deal shifts and manages risk.

Complex transactions can feel like a game of hot potato. Here is a relatively simple example that demonstrates some of the complexity I’m talking about: Sally signs a supply contract with a large processor to provide bulk raw material. Sally realizes that she can’t service this herself, so she asks Henry, who has a background in servicing large orders like this, to use his experience in coordinating and managing production to service the contract. Henry realizes that he needs significant capital to expand capacity and turns to outside investors. Those outside investors want security before they invest, so they ask for, among other things, a pledge from Sally of her contract rights to receive payment from the processor as collateral.

In a perfect world, Henry gets the investment and uses it to provide the raw material. Sally and Henry provide them to the processor and split the contract fees they receive, some of which go to pay back the investors. Everybody wins.

Sometimes deals like this do work for everyone. But there are so many different ways that they can go wrong. None of the parties should enter into the deal without understanding what the consequences would be of various potential failure risks. In the example deal, there are plenty of potential failure points:

  • Can Sally coordinate production to service the contract?
  • Can Henry actually produce?
  • If Sally and Henry can produce, can the processor actually pay?
  • What if state regulations change and disallow contracts like this midway through the production cycle after money has been spent?

All of the parties in the deal need to understand their exposure at each stage of the deal from beginning to end, in order to negotiate the arrangement but also to perform under the contracts. We have seen deals like this look like they are on a good path until, at the last possible moment, the processor decides that they can’t pay for the product.

But that’s the crux of almost any business arrangement. There is a moment where a party spends money with the anticipation of receiving that back with a return. Whether or not the return comes is a function of risk. Businesses that do best are those that can understand and quantify risks and that understand how best to shift risk and hedge against downside. Whether the hedging/shifting mechanism is through security agreements, outside insurance, or reliance on lawsuits, parties need to understand the costs and benefits of each in order to properly manage their risk position.

Risk isn’t necessarily bad. But if a party is taking on a significant portion of the risk in a deal and that risk isn’t properly hedged, that party should receive the lion’s share of the potential upside.

cannabis administrative lawAnyone that does business in a highly regulated environment like cannabis or alcohol needs to have a basic understanding of administrative law. The majority of government interaction as a cannabis business–and the primary sources of headaches–involve state agencies. In Washington, for example, our Liquor and Cannabis Board is the primary regulatory agency, but the Department of Labor and Industries, the Employment Security Department, the Department of Revenue, the Department of Agriculture, and others all play a role in the lives of marijuana businesses. Sometimes agencies feel all-powerful, as if they can govern by fiat. Other times, they seem extremely limited in their abilities to act in certain ways. Cannabis businesses interact with administrative agencies when they are applying for licenses, advocating for regulatory change, and when they are held liable for violations of regulations. Smart cannabis businesses know the ins and outs of authority that their governing agencies wield.

Some background on how these agencies are structured and why they exist is probably in order. We’ll use the federal government as our example because every state is a little bit different, but most are structured similarly to the federal structure. The power to write law is vested in the legislative branch – the U.S. Congress. The power to enforce those laws is vested in the executive branch — the President and federal agencies. And the power to interpret those laws is held in the judicial branch — the court system. Administrative law blends all of those authorities together somewhat and places them, in a limited way, in the hands of a regulatory agency.

Congress is not good at dealing with rapidly changing legal landscapes. Its statutes are written broadly, and meant to stand the test of time. As such, Congress almost always drafts statutes that delegate some portion of its authority to write further laws to the executive branch, via administrative agencies. This Congressional enacting statute provides the general boundaries in which the executive branch, through a named agency or department, can create rules and regulations. That same executive branch agency is also tasked with enforcing those rules, and adjudicating initial disputes of whether those rules are broken (often, with the involvement of administrative law judges).

In the cannabis context, the enacting statute hasn’t tended to come from legislatures — it tends to come from the people in the form of a citizen’s initiative. In that context, the citizens are playing the same role as the legislative branch — writing law for the executive to enforce. Sometimes, the state’s Constitution will allow the legislature to amend an initiative statute, even before it takes effect. Unless the legislature makes a broad alteration, though, the only authority granted to the regulatory body is whatever is included in that initiative. If a regulatory agency like the Liquor and Cannabis Board does something that either oversteps the authority granted in the initiative or acts directly contrary to the initiative, it is acting unlawfully.

But agencies have significant leverage here. First, there is a federal interpretation rule that many states also follow called “Chevron Deference.” Under this rule, if there is vague or ambiguous wording in a statute that grants administrative authority to an agency, courts will defer to that agency’s reasonable interpretation of that language. Agencies get to decide any question about the extent of their power in a way that maximizes that power, so long as it is at least a reasonable reading of that enacting statute. If you are suing an agency, this can be a difficult standard to overcome.

Additionally, you generally can’t challenge an agency action until you have “exhausted administrative remedies.” This means that if you want to take an agency to court because you think it is doing something wrong, you first have to go through the agency’s internal dispute process. This can take time and money, and it often feels like the deck is stacked against you when the writer of the regulation, the enforcer of the regulation, and the judge for that regulatory enforcement are all the same people.

We’ll write more in the coming weeks about agency authority generally, and interacting with regulators specifically. Sometimes, it is good to defer to regulatory decisions and go with the flow, but other times it’s vital that regulated parties push back hard to make sure that their regulators are following the law themselves.

marijuana cannabis business
Want to show you own that canna business? Write it down.

Of all the core legal concepts that first-year law students study, property law is the most esoteric. The concept of property boils down to relative rights. Do I have more or less of a right than you do to possess, manipulate, lease, or sell this thing that I am claiming ownership of? Things get harder when we deal with intangible property. While simple possession of real property or equipment doesn’t prove ownership, it at least provides some indication of ownership. But regarding intellectual property like trademarks and copyrights, or other intangible property like interest in a partnership or a limited liability company, there often isn’t anything to possess. This has led to major problems for inexperienced cannabis business owners.

Regarding ownership interests in corporations and LLCs, it is important to make some distinctions. I’ll use Washington as an example, but most states adhere basically to the same principles. The Secretary of State’s office is in charge of forming business entities, and it maintains a database of governing persons. If I look up a company on that website, it is going to list the names of one or more people that are reported to the state as governing persons of that company. However, that listing is not proof of or even evidence of ownership. The people listed are supposed to be managers of LLCs or directors and officers of corporations. They are not shareholders (owners) of corporations, and they are not necessarily members (owners) of LLCs. Frankly, it isn’t even proof that they are governing persons. I could go in and file a new annual report for any company I wanted to and change the listing of governing persons. It is just a courtesy database made public by the state.

That notice distinction is also true of the state’s licensing agency, the Liquor and Cannabis Board. When a company goes through cannabis licensing, renewal, change of location, etc., it self-reports its governing persons and owners to the state. The state, in turn, subjects those people to criminal and financial background checks, and maintains them in a database as “true parties of interest” of the licensed business. But just being reported to the Liquor and Cannabis Board is not itself proof of ownership. The law requires a company to accurately report its owners, but that is still just a notice and reporting requirement. If a business reports its true parties of interest incorrectly, it doesn’t change who those owners are and what they actually own. If a company went through receivership or other administered liquidation, the ownership listing maintained by the Liquor and Cannabis Board wouldn’t be the ultimate authority on ownership.

How, then, is ownership of business entities actually determined? It isn’t through any type of public reporting. The United States, unlike many other jurisdictions, doesn’t tend to have any type of broad public registration of company owners. Instead, companies and individuals maintain those records privately. In our experience, most small businesses do a poor job of that.

With LLCs, the record keeping requirement is easier. Upon initial formation, the members/owners execute a limited liability company operating agreement that defines for each of them the scope of their ownership. A third party should be able to read that operating agreement and understand what right each individual has to profit distributions, liquidation distributions, profit allocations, loss allocations, etc. The agreement should also define transferability of membership and what steps need to be taken to accomplish that transfer. Someone who is buying part of an LLC would need to read that agreement to make sure that they were actually able to acquire it, lest the transfer be found inoperable. The LLC operating agreement should also contain an updated schedule or exhibit that lists the relative percentage ownership interest of each member. That schedule should be updated regularly — at least every time there is any change in membership interest.

Corporations have more paperwork, but they are also more standardized than LLCs. A corporation is initially formed by an “incorporator,” a generally meaningless title that doesn’t grant any inherent ownership rights. That incorporator appoints an initial board of directors, who take over governance of the corporation. The board of directors than adopt bylaws. Finally, they are ready to issue shares of stock. Until they do that, nobody owns the corporation. The stock is issued to individuals for some buy-in price, which could be real money or could be entirely nominal. But only upon signing a resolution approving of the issuance of stock does ownership exist. That stock is generally evidenced by a printed stock certificate that is possessed by its owner, and a ledger is kept at corporate headquarters noting the certificates that are issued. The bylaws may allow for uncertificated stock. In that case, the same information kept in the normal stock ledger is maintained at the corporate headquarters, and shareholders are given notice of what they own.

If you own an LLC or corporation and have failed to do any of this, it’s not like you have zero claim to ownership. It just means that it’s harder for you to prove it. And with intangible property, the ability to prove ownership to third parties is what it’s all about. That’s how you make money on it by accomplishing a sale, or using it to secure a loan. That’s how you convince a judge in a business dispute or dissolution claim or a receivership case that you have an actual right to business assets. So, make sure you write it down.

marijuana cannabis bank
For now, banks are still taking that cash.

On January 22, the National Association of Cannabis Businesses (NACB) hosted a symposium on cannabis banking and finance in Washington, D.C. The NACB is an interesting group. It isn’t quite a lobbying organization like the NCIA. Instead, it views itself more as a standard-setting organization that wants to make sure that its members follow certain standards. The thinking is that by setting up industry self-regulation, members are seen in a generally positive light, and states and federal regulators are less inclined to promulgate the most draconian regulations possible. The symposium brought together lawyers from large and small firms, accountants, Canadian attorneys, and a few practitioners. In the wake of Jeff Sessions’s withdrawal of the Department of Justice’s prior guidance statements on marijuana enforcement, confusion continues to reign regarding whether financial institutions and institutional investors are going to view the cannabis industry different now than they did last year.

Attorneys from large law firms like Jones Day, Cadwalader, and Davis Polk all gave financial presentations. While they all don’t take cannabis business clients, the fact that those firms would even participate at an event hosted by a cannabis-focused group confirms that they, along with other large conservative organizations, are prepared to jump into cannabis as soon as federal legalization happens. More and more banks, after all, are already going there.

One of the most interesting tidbits coming out of the event, which confirmed what we had been hearing, was that FinCEN had not been given advance notice that Sessions was going to withdraw the prior guidance. For financial institutions that bank cannabis businesses, the FInCEN guidance is the primary factor determining whether or not certain banks or credit unions are willing to serve the cannabis industry. Certain institutions can get their heads around the criminal end. Yes, the federal government would have an argument that a bank accepting deposits from marijuana customers is violating the money laundering statutes and is potentially aiding and abetting in cannabis activity. But all the Sessions memorandum did was to move that discretion from the Department of Justice as a whole to the individual U.S. Attorneys. It doesn’t make any more sense that a U.S. Attorney would bring charges like that against a financial institution, pulling resources away from opioid enforcement and from other crimes that actually involve some type of societal harm.

FinCEN’s guidance to institutions that bank marijuana businesses, however, is absolutely necessary. If FinCEN were to withdraw it, you would see a massive pullout from the cannabis marketplace by those banks that currently offer services. It just isn’t possible to be a working institution and be purposefully out of compliance with FinCEN regulations. Additionally, the FDIC and the NCUA are explicit that deposit insurance for financial institutions that bank marijuana businesses is contingent upon the FinCEN guidance remaining in place. Without it, they would potentially pull insurance away from those institutions that continued to serve marijuana businesses anyway.

And if the federal government had actually coordinated (like they did when the DOJ and FinCEN first jointly announced the Cole Memo financial guidance in February 2014), we may have had a massive problem. But the DOJ didn’t give FinCEN any advance notice that it was withdrawing the prior marijuana prosecution memos. And in wake of the Sessions decision, FinCEN, the FDIC, and the NCUA have told banks and credit unions that the FinCEN marijuana guidance will continue in place. Though it makes several references to the now withdrawn Cole Memo in its introduction, the operative provisions of the FinCEN guidance don’t actually depend on the Cole Memo staying in effect.

So while new institutions are going to be less likely to enter the cannabis industry because of Jeff Sessions, most existing financial institutions seem likely to stay in the market for now, unless and until something concrete changes with enforcement or with regulatory guidance from FinCEN.

Properly managing marijuana supply is the single most challenging aspect of state-level marijuana regulation. In an op-ed published January 12th in the Oregonian, Billy Williams, U.S. Attorney for the federal district that encompasses Oregon wrote about what he calls Oregon’s “massive overproduction problem.” According to Williams, postal agents in Oregon seized 2,644 pounds of marijuana in outbound parcels in 2017 alone. Decreasing wholesale prices in Washington and Colorado indicate oversupply as well based on the inverse correlation between supply and price. We hear anecdotes in Washington all the time from marijuana producers that are finding it more and more challenging to survive with the current market prices.

If this were any other market, data points indicating falling prices and oversupply would be wholly unremarkable. Free markets tend to find an equilibrium point between supply and demand that support relatively stable wholesale and retail prices. Free markets also tend to self-correct, if given the opportunity to do so. If businesses in a market are all extremely profitable, new firms are induced to enter the market. The entry of those new firms tends to increase competition and decrease profits across the board, signaling to other would-be market participants not to enter. Similarly, if things are not going well and competitors exit the market, surviving businesses are given a little bit more room to maneuver and succeed.

cannabis marijuana supply
Managing cannabis supply is a tightrope for state regulators.

But standard markets differ from cannabis markets. They have a longer history from which to draw conclusions and base expectations. The legal cannabis markets in Washington and Colorado didn’t really start until 2014. It is challenging to determine what effects outside forces have on those markets when there isn’t historical data to draw on. How elastic are cannabis markets– meaning, how price-sensitive are they? We are learning a lot now, but the cannabis data we have pales in comparison to, for example, the alcohol market with data going back to prohibition.

The cannabis market’s short life span can also explain why market participants often act differently than one might expect. People investing in the cannabis market see it as a once-in-a-lifetime opportunity to get in on the ground floor of something. Whether it’s the original dotcom bubble, bitcoin, or marijuana, new markets create hope of potentially boundless returns. Because of that hope, firms tend to stick around longer than one might expect — you don’t want to be the person that exited the industry right before it took off and made everyone in it a billion dollars.

And that hope is part of the reason that oversupply issues exist in legal marijuana states. Oversupply by itself wouldn’t be a problem if not for cannabis’s federal illegality. Because even in the cannabis market, forces will eventually correct oversupply and get us to equilibrium. Companies aren’t going to stay in business losing money year after year into eternity. But whereas other markets get the benefit of time to find that equilibrium, cannabis oversupply issues bring threats of federal enforcement. If there is too much supply in the legal market, the incentives remain for certain unscrupulous and desperate cannabis businesses to cut their losses and sell their overage in the black market.

Which brings us back to state regulations. If we could have had Eric Holder as attorney general for ten more years, the Department of Justice may have understood that legal cannabis markets need time to adjust, and that the adjustment period would be occasionally rocky. But under Jeff Sessions and the U.S. Attorneys that share his views, these periods of market adjustment provide ample opportunity to criticize state cannabis programs and claim that federal law enforcement is necessary due to black market leakage.

Ending the cannabis black market is the one shared goal that prohibitionists and legalization proponents have in common. No one thinks that empowering an underground illegal cannabis market is a good idea. But if states move too far in controlling supply because they are worried about black market leakage inviting in federal law enforcement, legal cannabis prices will rise too high within those states. And those high prices will incentivize black markets to continue selling outside the eye of any state regulatory system.

This tightrope is why managing supply is such a tough nut to crack for state regulators. If U.S. Attorneys and the Department of Justice really want to see the end of cannabis sales in black markets, though, they will provide room for the legal markets to stabilize and find their natural supply, demand, and price points on their own.

marijuana cannabis
What will the future bring for marijuana markets?

The end of one year and the beginning of another presents a good opportunity to look ahead at the long-term goals of the marijuana legalization movement. In the near term (next year or two), nationwide legalization or even decriminalization of marijuana is unthinkable. The current Congress and President Trump have not shown any inclination toward effecting that type of change. At some point though, sooner or later, the United States will legalize marijuana nationwide — not just move it to Schedule 2 or 3 of the Controlled Substances Act, but fully deschedule it. It’s not too early to think about what nationwide legalization would look like and how it would affect cannabis businesses that are open today.

There are three main routes that legalization could take. First, there is total unregulated legalization — treat marijuana like apples. That option is so unrealistic that it’s not worth discussing. Next, there is the alcohol model, with a mixture of federal and state regulations. Products can be distributed and sold across state lines, and states can regulate however they choose, but they can’t show preference to local actors. Finally, we could build on the current cannabis legalization model. Every state creates its own market with its own licensing system and regulatory scheme. Product cannot move across state lines, and many states limit or ban ownership stakes in marijuana businesses by out of state individuals.

If the U.S. ultimately takes the last route, continuing the current trend, market change would be gradual. Banking would certainly be easier, and marijuana businesses wouldn’t pay as much in taxes. States would likely ease some of their regulations that they have in place solely because of the Cole Memo. But on the whole, the state markets would continue on much the same trend as today. Note that very few commodities cannot be transported interstate. Health insurance is one, but state insurance markets are more about individual states being able to regulate the types of policies that can be sold in the state. There isn’t a physical product that is being barred from crossing state lines.

Continuing with individual state cannabis markets doesn’t seem likely, either. If cannabis is legalized, it doesn’t make sense that Congress would bar states from opening their doors to out of state product. They don’t do that with any other similar products. The Dormant Commerce Clause would also present a major legal challenge for a state that wanted to only allow in-state actors to sell products to its residents.

The most likely outcome, then, is the alcohol/tobacco model, with interstate commerce allowed, and a mixture of federal and state licenses and regulations. Though this transition will undoubtedly be an exciting moment for many, it will also be a scary time for the cultivators and processors across the country that are already doing business. Two different kinds of consolidation would start happening at the same time. First, there is corporate consolidation. In 2015, 90% of the beer sold in the United States was owned by 11 multinational corporations. Constellation, owner of Corona and other beer brands, has already made a large investment in a Canadian marijuana company. Big business will certainly look at marijuana. But the other type of consolidation that isn’t talked about as much is geographic consolidation. In a free interstate market, it doesn’t make a lot of sense to grow marijuana in Nevada, Massachusetts, Washington D.C., and a number of other states that have current licensed marijuana cultivators. In the same way that Virginia and North Carolina dominate in tobacco cultivation, California, Oregon, and a few other places will likely dominate marijuana cultivation. That could leave producers getting licensed in other locations in a tough spot, when federal legalization finally happens.

washington cannabis marijuana
Is Washington doing enough for the little guy?

Lester Black has a good article up at FiveThirtyEight about the Washington marijuana market. Washington’s mandatory data transparency presents a fantastic opportunity for the kind of market analysis that is challenging in other industries that don’t have access to that type of data. In this context, the data reflects what a lot of Washington marijuana producers already know: The market out there is incredibly tough. Even though Washington’s window for marijuana licensing was only open for a month in late 2013, there is still enough product cultivated and sold in Washington that wholesale prices continue to drop, over four years later. This makes it hard for small businesses to compete.

Washington’s legislative and regulatory systems try to prop up small, local businesses a few different ways. The mandate that all business owners reside in Washington is a big one, of course. But we also have consolidation limits. An individual cannot have in ownership interest in more than three licensed producers and/or three licensed processors. On the retail side, no one is allowed to own more than five retail stores.

Those anti-trust pot market provisions have worked to some extent in providing initial market entry to a lot of different people. Entering a market and surviving a market, however, are very different. When the Washington market was first coming online, wholesale prices of more than $5.00 per gram were common. The average wholesale price in September was half that, at $2.53. Some amount of price decline was always expected, but small businesses that based their cost structure on that higher price point are struggling to make things work.

In any market with unexpected decreases in profits based decreased demand, increased competition, cost spikes, etc., well-financed business actors will be better able to survive than businesses that don’t have access to capital. Of course, if a business has so little money that it can’t pay its bills, it won’t survive. But access to capital provides additional advantages. You can get better financial planning advice from the outset so you know how best to plan for 280e. You are less likely to be swindled by consultants or other vendors with backloaded payment contracts. You have better access to credit. The list goes on.

The most eye-opening aspect of Black’s article may be the section on nationwide cannabis demand. According to Jonathan Caulkins of the Drug Policy Research Center at RAND, you can grow all of the THC consumed in the United States on 10,000 acres of farmland. That isn’t really that much, and it helps clarify why Washington producers continue to struggle. Even with its fixed number of production licensees, Washington likely has too much licensed production capacity for its in-state demand.

Where does that leave small Washington producers? They have a few different routes to success. One is to become large Washington producers, winning a race that so many others are losing. Another is to hope that marijuana demand trends upward — something that state regulators wary of DEA intervention hope does not happen. There is also the chance that marijuana goes legal nationally, opening up a much larger market without established players. Otherwise, no matter how much the state fights it, the industry will continue to trend toward consolidation with larger, better financed businesses surviving longer than small companies can hang in there.

Jeff Sessions wants U.S. Attorneys to “Just Say No” to Marijuana Legal Reform.

Yesterday proved to be a wild day, featuring Jeff Sessions single-handedly demolishing the federal government’s former cannabis enforcement framework. Now that 24 hours have passed since the news came out, we have had a chance to refine our analysis of the Department of Justice’s move.

Reactions in the media have ranged from treating the Sessions announcement as nothing more than an attempt to frighten the cannabis industry to claiming that it was the first step in an organized crackdown of the marijuana industry that could affect cannabis businesses and users. For now, we must treat both of those possibilities as plausible futures. Trump and Sessions may be gearing up for a wave of arrests, prosecutions, and asset forfeitures related to marijuana businesses —or Sessions may just be trying to put a fright into marijuana business owners and investors. Only time will tell.

The “Sessions Memo” was short on specifics. It didn’t contain an outright directive ordering U.S. Attorneys to go after marijuana businesses. Instead, it simply withdrew the earlier marijuana-specific guidance memoranda and directed U.S. attorneys to treat marijuana sales like any other federal crime. The withdrawn memos include, among others, the August 2013 Cole Memo that has underpinned federal marijuana policy for the past four and a half years; the February 2014 Cole Memo that extended low enforcement priority status to apply to banking activities; and the 2014 Wilkinson Memo that was a sort of Cole Memo for tribal lands.

So now, U.S. attorneys have full discretion to determine to what extent they can/should enforce federal law in the context of marijuana crimes in states with legalization and medicalization. Sessions referred to the principles of enforcement in the U.S. Attorneys’ Manual, but that document reinforces the level of discretion and authority that each U.S. attorney has already. The Cole Memo was useful in providing a consistent nationwide federal policy. Under the new Sessions Memo, we are back to the days of having potentially 93 different enforcement policies — one for each U.S. Attorney. Here’s what we know already about a selection of the U.S. Attorneys that will be making these decisions:

Robert Troyer, District of Colorado: Bob Troyer issued a statement yesterday saying that his office “has already been guided by [the U.S. Attorneys’ Manual’s] principles in marijuana prosecutions.” This statement implies that Troyer doesn’t see any difference in Colorado between prior policy and today’s policy.

Annette Hayes, Western District of Washington: Annette Hayes, who has served as either the Acting U.S. Attorney or an interim U.S. Attorney since October 1, 2014, also put out at statement, but it was significantly denser than Troyer’s statement. It wasn’t overtly negative, but it also wasn’t as direct as Troyer’s regarding enforcement policies remaining the same.

Joseph Harrington, Eastern District of Washington: Joseph Harrington is another Acting U.S. Attorney that is a holdover from the Obama administration. Harrington did not issue any specific statement in response to the Sessions Memo. When media outlets asked Harrington about his position, he responded by referring media requests to the Department of Justice in Washington D.C. Harrington, for now, is something of a black box on this.

Billy Williams, District of Oregon: Billy Williams was also appointed during the Obama administration, but Trump did nominate him to stay on as U.S. Attorney in December. Williams prosecuted two Oregonians for federal cannabis crimes in 2016, but there were Cole Memo priorities implicated, including sales to minors. More recently, Williams invited Sessions to visit Oregon to discuss Oregon’s cannabis market in September 2017. In response to the Sessions Memo, Williams issued a press release saying: “We will continue working with our federal, state, local and tribal law enforcement partners to pursue shared public safety objectives, with an emphasis on stemming the overproduction of marijuana and the diversion of marijuana out of state, dismantling criminal organizations and thwarting violent crime in our communities.” Again, this statement doesn’t read too poorly, but it is sufficiently vague enough to still be worrisome.

California: California is a bit of a mess in all of this. Oregon and Colorado only have one U.S. Attorney each. Washington has two, but they are neatly separated into eastern Washington and western Washington, which often feel like two different states anyway. California, on the other hand, has four U.S. Districts.  And none of those four has or will have a U.S. Attorney with more than two months on the job.

  • Northern District: The U.S. Attorney for the Northern District of California, Brian Stretch, resigned yesterday to join a private firm. No replacement has been named.
  • Central District: The Central District is a populous jurisdiction that includes Los Angeles, Riverside, San Bernadino, Ventura, Santa Barbara, and San Luis Obispo. Two days ago, Sessions appointed a new U.S. Attorney for the Central District, Nicola Hanna. Hanna doesn’t seem to have much written history regarding his views on marijuana, but the fact that Sessions picked him and specifically called him out for “taking on drug traffickers” isn’t the most positive sign.
  • Eastern District: McGregor Scott, also a recently-named U.S. Attorney, has actually been a U.S. Attorney in the past, having prior experience in the Northern District of California. He did not earn positive marks from the cannabis community, as he did pursue aggressive marijuana prosecutions in the mid-2000s.
  • Southern District: Finally, Adam Braverman was named U.S. Attorney for the Southern District of California a couple of months ago in November. He is most well-known for international cartel work as well as other types of organized crime. Braverman made a statement in support of the Sessions Memo, saying: “The Attorney General’s memorandum today returns trust and local control to federal prosecutors in each district when it comes to enforcing the Controlled Substances Act.”

If we are reading the tea leaves to see what is going to happen next (and they are indeed tea leaves), Colorado appears to be in the safest position, but California could turn into a real mess with different enforcement standards in different counties depending on which judicial district a business is in. Banking will be a major unknown for some time as well. FinCEN’s 2014 Guidance heavily referenced the Cole Memo, which is now rescinded. If FinCEN withdraws that guidance, what kind of ripple effect will it have on other bank regulators?

It also remains unclear how all of this policy will work out. Cory Gardner, a republican senator from Colorado, appeared furious when he responded to the initial announcement of the Sessions Memo (video below). He went so far as to threaten to hold up DOJ nominations, which would include those newly appointed California U.S. Attorneys. Sessions’s actions, as well as those of the U.S. Attorneys, are not yet set in stone. Ultimately, political pressure from Congress may still have an effect on the final outcome.

Will Washington finally tear down the walls?

When Colorado and Washington kicked off recreational marijuana legalization and business licensing, both states limited ownership of licensed marijuana businesses to their own state residents. Oregon’s ballot measure, passed two years later, followed suit. But Oregon’s legislature almost immediately removed that restriction. Colorado’s legislature similarly lifted the restriction in 2016, allowing U.S. citizens to qualify for ownership of licensed cannabis businesses. California, Nevada, and the clear majority of legal cannabis states allow at least some level of out of state ownership of licensed businesses. Washington, however, continues to maintain its strict residency requirement for ownership of marijuana businesses.

Washington’s residency requirement does not have any de minimis baseline — a 0.01% business owner is subject to the same restrictions as a 100% business owner. And the residency requirement doesn’t only apply to owners: any person that can exert control over a business (such as a director, officer, or contract manager), anyone that has the right to receive business profits, and the spouses of all those people are all required to live in Washington. The restrictions even rope in things that may not be apparent on first read. For example, the state Liquor and Cannabis Board still considers royalties on branded products (e.g. a trademark license for 2% gross sales on products carrying the mark) to invoke the residency restriction.

As with all regulated industries, businesses push as much as they can at the bounds of these rules to accomplish their objectives. Out of state residents enter into business deals that include providing capital loans for a fixed interest return, which was itself restricted for the first few years of legalization. They lease or sublease real property, purchase and lease capital equipment, enter into consulting contracts, and enter into branding deals with fixed payments. The closest that they can come to a profit share or revenue share is an agreement to sell inputs at a markup to licensed cannabis businesses – be they branded packages or ingredients for edibles. The various restrictions and promises in these agreements test the boundaries of whether or not the out of state businesses exert “control” over cannabis businesses.

Some state lawmakers and many licensed businesses cite these out of state business deals as reason to partially lift the residency restrictions. If these types of deals are being entered into anyway, why not allow them to encourage transparency, the logic goes. It’s a similar argument to the one made about legalization in the first place.

But there are voices in Washington that support maintaining the residency restriction. Retailers, craft and cottage industry advocates, and established businesses think that the negative ramifications of more out of state money flowing into the state would outweigh any potential benefits. And for now, Washington agrees. While the August 2013 Cole Memorandum put out by the Department of Justice did not have any language touching on state residency of cannabis business owners, the follow-up financial guidance from FinCEN did include payments to non-state residents as a red flag event for marijuana businesses.

A quirk about marijuana businesses is that the states really don’t want them to fail. If this were any other new industry getting a lot of press buzz, you would expect to see lots of business failure in the early days. Businesses that are not adequately capitalized would have a tough time going up against competitors with large bankrolls that can afford to sell at a loss in the early days of the market. In a regular market, that trend would course correct in a reasonable amount of time, and the market would stabilize. But with cannabis, business failure can be a scary thing for the state. A dying marijuana business is a risky candidate for black market and out of state diversion of product. And that type of diversion is precisely the type of activity that could trigger direct involvement from the DEA and DOJ, agencies that would love nothing more than to have a good reason to bust up state-legal cannabis businesses. Many business owners and legislators in Washington think that maintaining the state residency requirement contributes to current industry stability, and they prefer the status quo to the unknown possibilities of a large influx of out of state capital.

The Washington legislature goes back into session in January, now under unified Democratic Party rule. After taking on cannabis issues every year since 2014, the legislature seems ready to move on to other things, but don’t be surprised to see the state residency restriction rear its head in proposed legislation.

Cannabis franchising
Who will be the McDonald’s of Marijuana?

We often work with cannabis businesses that want to license their brands to third parties. Licensing is a great way to expand the reach of a brand and make some revenue without the capital expense of funding and owning a new location outright. For states that restrict ownership of marijuana businesses to state residents, licensing can be one of the primary ways non-state residents get into the market.

But any time a business enters into a licensing deal where the licensee is in the same line of work as the licensor, challenges arise. Specifically, that licensing agreement can be interpreted by state and federal regulators to create a quasi-franchise. As we’ve written before, this can cause problems because franchises must comply with a bevy of state and federal rules with which non-franchises do not have to contend.

Just because franchises are regulated, however, does not mean they are to be avoided forever. The first cannabis company to execute on a well-planned franchise model is going to make an absolute fortune. To date, there hasn’t been a lot of movement of would-be marijuana franchisors. Part of the reason is that would-be franchisees want to see established brand and operations value before entering into a franchise agreement. To demonstrate that value, a franchisor company’s best bet is to show positive performance at multiple locations. A single cannabis retail store may do great business, but from the outside, it is hard to tell whether that store is benefitting more from its location or its local team or its marketing or its branding. But when multiple locations carrying the same branding and using the same business practices consistently put up big numbers, they become very enticing to potential franchisees.

Market consolidation is already happening — a first step in creating the types of chains that can be precursors to franchises. In Colorado, data shows that more and more retail stores are becoming part of corporate retail chains. Washington recently increased its cap on direct ownership of marijuana businesses, allowing an individual to own up to five retail licensed businesses, and has seen similar movement toward consolidation.

In looking for potential franchise locations, California’s new demand-rich market is a logical target. California also boasts some of the nation’s most restrictive franchise laws, providing significant protections for franchisees. Franchises must be registered with the state of California. California also requires the Franchise Disclosure Document, a large comprehensive document defining the ins and outs of the franchise relationship, to be registered with the state. Franchisors are prohibited from terminating franchise agreements early without good cause, and a franchisor cannot stop a franchisee from selling or transferring the franchise to a different person that meets all of the franchisor’s current standards for new or renewal franchisees. If a franchisor wrongfully terminates a franchise, the franchisee is entitled to the fair market value of the franchised business and assets as damages.

And though California has the strongest protections for franchisees, most other states offer similar protections. A franchise isn’t a relationship a franchisor can enter into on a whim; it is a significant long-term commitment of time and money.

All that said, it’s only a matter of time until we see big movement in cannabis franchises. They represent part of the natural progression of a growing industry.