cannabis subordination loan
Best if landlord, tenant and lender talk out that cannabis loan ahead of time.

Commercial cannabis leases are different than other commercial leases in many important ways. In other respects, however, they can be quite similar. One item that tends to fall into the latter category is the creation of a landlord’s lien on the tenant’s personal property in the event of an uncured tenant default. For example, if a marijuana producer fails to pay rent, the landlord acquires an ownership interest in that producer’s lights, fans, security equipment, and even the cannabis itself. If the lease is drawn up correctly, the landlord would then be able to seize these assets and liquidate them, in accordance with state law.

When representing landlords, this type of provision makes it into every type of cannabis lease we draft. When representing tenants, we often try to narrow this right, especially in situations where the tenant may be taking on debt. Why? Because lenders often insist on priority rights in the event that a pot business cannot repay a loan. In many cases, the lender will come prepared with a “Waiver and Consent Agreement” or a “Subordination and Consent Agreement.” The tenant is tasked with acquiring its landlord’s signature on this contract, so that if there is a default under the lease, the landlord does not preempt the lender’s rights in the tenant’s property (which serves as collateral for the loan).

From the landlord’s perspective, subordinating its lien on the tenant’s personal property is preferred to a total waiver of the lien. The lender won’t care either way, so long as it receives a primary security interest in the cannabis and everything else. For that reason, most of the time the parties will end up with the landlord agreeing that its lien is subordinate to the lender’s right, but not totally extinguished (“waived”). That way, the landlord is assured that its tenant will receive the cash needed to operate, and will retain the right to hop in line behind the lender and lien on any assets, as needed.

Landlords should be aware that the waiver or subordination agreement will typically allow the lender to enter the leased premises and remove the trade fixtures and even the marijuana itself, subject to state rules. On this point, the landlord will want to require that the lender minimize disturbance with respect to any other tenants on site, and require that removal occur prior to the end of the lease term. Once the lender is in the space, the landlord will want to ensure that the lender is required to comply with state marijuana rules, provide evidence of insurance, and keep the premises open for inspection, among other items.

There are a host of other concerns that a boilerplate consent or subordination document will create in the context of a cannabis loan to a tenant operator. These range from specific items, like the landlord’s obligation to notify the lender of a tenant’s default, to general items, like restrictions on the ability of a landlord and tenant to amend the lease agreement. Depending on which chair you are in—landlord, tenant or lender—these items will have different repercussions and should be negotiated with that in mind.

Each party’s goal, as always, will be to minimize risk and to maximize the ability to make and receive payments, in accordance with state and local rules. If you understand the basics of cannabis leases, lender subordination agreements, and your state’s disclosure requirements for cannabis lenders, you should be able to propose a contract solution that works for everyone. That way, in the event of a default under a loan or lease, the parties won’t have to fight over what happens next.

california cannabis
Pro environment? Or just anti-cannabis?

As we’ve discussed time and time again, California’s voter-passed cannabis legalization initiative, as well as all subsequent statutory and regulatory additions to that law, maintains local governments as the ultimate arbiters of whether and how commercial cannabis operations can take place within any given county or municipality in the state. The most prominent exercise of that authority exists through local permits and licenses (which are now a prerequisite for any state license), and land use laws, such as zoning ordinances. The starting point for any property owner considering a cannabis use on the property is the applicable zoning law and the local ordinance on cannabis, if any. Recently, property values in appropriately zoned places have appreciated accordingly.

But as the new laws are implemented, we are seeing the limits of local authority when it comes to zoning for cannabis operations. In one recent example, a group advocating for a moratorium on marijuana in San Mateo sued the County of San Mateo for opting to issue a “negative declaration” stating that its new cannabis ordinance would not have any significant impact on the environment, rather than engaging in the more rigorous option of preparing a full environmental impact report to study the effects of the proposed activity. The ordinance generally prohibits all cannabis activity except cultivation in greenhouses and transportation.

The plaintiffs in San Mateo brought the lawsuit pursuant to the California Environmental Quality Act (“CEQA”), alleging that “the county prejudicially thwarted CEQA’s statutory goals, including environmental protection, informed decision-making and informed public participation.” According to NORML, the plaintiffs are an anti-cannabis group.

CEQA requires environmental review of discretionary projects to inform the public and government decision makers of the environmental consequences of their decisions and must be interpreted in such manner to afford the fullest possible protection to the environment within the reasonable scope of the statutory language. Unless exempted, all discretionary projects must receive environmental review pursuant to CEQA.

Under CEQA, the “lead agency”—the public agency principally responsible for approving a proposed project, in this case the County of San Mateo—is responsible for preparing the environmental documents for a project, including any negative declaration or environmental impact report (EIR). If a project is not exempt from CEQA, the lead agency must prepare an initial study to determine whether the project will have a significant impact on the environment, or skip the initial study and conduct an EIR if it is obvious that an EIR is required.

A negative declaration, as opposed to an EIR, is appropriate in two situations: (1) when there is no substantial evidence that shows that the project may have a significant impact on the environment, or (2) the initial study identifies potentially significant impacts, but revisions made to the project before public review of the negative declaration reduce impacts to a level of insignificance. Before approval of a negative declaration, the lead agency must find that there is no substantial evidence that the project may have a significant effect on the environment.

An EIR must be prepared if a project is not exempt from CEQA and does not qualify for a negative declaration. Generally, an EIR is required whenever it can be fairly argued that substantial evidence indicates that the project may have a significant impact on the environment. CEQA allows plaintiffs to sue public agencies for failure to comply. Plaintiffs can challenge a public agency’s decision to prepare a negative declaration instead of an EIR (like the San Mateo case), or a public agency’s determination that a project is exempt from CEQA, among other things.

CEQA litigation is rampant, and public agencies and developers alike are critical of its abuse by NIMBY groups and others who may bring an action for an improper purpose. For example, a competitor may file a CEQA lawsuit to delay or derail a competing project, or a labor union might file a CEQA lawsuit to secure an agreement that gives that union control over which project jobs will be allocated among which unions.

While public agencies, rather than private businesses, are ultimately responsible for determining how to proceed under CEQA, operators and developers should be mindful of the potential delays to their projects that could result from challenges brought by CEQA plaintiffs, and to pay close attention to any objections raised against the draft environmental document during the government approval process, which is a requirement for standing to bring a lawsuit under CEQA and could signal future legal challenges to the project. By the same token, cities and counties should be mindful of the high bar they will have to meet for any decisions involving potential environmental impact, and to plan accordingly by doing a thorough environmental review as part of the approval process for any cannabis-related proposals.

In some ways, CEQA challenges can be seen as part of the California cannabis regulatory regime’s rite of passage into public life, just as any other California industry has to contend with. But this is also an opportunity for California’s state regulators and local agencies to get it right and set an example for other states, and to show how the environmental damage caused by prohibition-era operations can be successfully mitigated with robust regulation and implementation of environmental standards. Until then, we expect to see more lawsuits brought by anti-cannabis and NIMBY groups using CEQA as a tool to challenge cannabis projects throughout California.

marijuana lease california
Leave yourself some room to maneuver with that cannabis lease.

The year 2018 began with a mixed bag. California, the nation’s most populous state and its most powerful economic engine, finally began issuing licenses to medicinal and adult use commercial cannabis businesses under the state’s new regulatory regime. Days later, the Attorney General issued a memorandum rescinding the 2013 Cole Memo enforcement guidelines, despite indicating to the contrary several months prior. There has since been bipartisan backlash against Mr. Sessions’ decision, and there are now numerous legislative proposals in congress as to how the federal government will move forward with respect to cannabis.

In the meantime, property owners still have to plan for the future, whether that means deciding how to use their property, or whom to rent commercial space to and under what terms. Operators and landlords alike are uncertain what to expect: on the one hand, state governments are issuing cannabis licenses freely; on the other, the federal government is telling its prosecutors to pursue any and all of them as they see fit–  regardless of any state’s laws. One strategy for approaching all this uncertainty is by building early termination contingencies into the lease. Below are a few of many contingencies that commercial cannabis landlords and tenants alike should consider including as part of a potential tenancy.

  1. Federal enforcement actions. This is what keeps state-legal operators up at night and what many legislators are currently trying to protect against. As long as cannabis remains federally illegal in all forms, however, this will remain a risk. One way to potentially mitigate that risk is by allowing for mutual early termination options in the event of any actual or specifically threatened enforcement actions, such as civil asset forfeiture. If the federal government’s goal is for cannabis operations on the premises to cease, then allowing each party an opportunity to force termination of the lease should be helpful.
  2. Changes in federal law and/or enforcement priorities. Similar to federal enforcement actions, the parties may want to include options to terminate the lease early if something changes at the federal level to an extent that both parties no longer feel comfortable with state law compliance alone. How significant that change would need to be is up to the parties’ negotiations and levels of risk tolerance. For example, while the Cole Memo has been rescinded, the Rohrabacher-Blumenauer amendment protecting state-compliant medicinal operations is still in effect (if only barely), so the recent federal action may not necessarily be cause for parties to end a tenancy.
  3. Cole Memo priorities as affirmative lease obligations. Just because the Cole Memo has been withdrawn does not make it irrelevant. The Cole Memo is essentially a well-thought-out list of the federal government’s highest priorities for enforcement against cannabis operators, such as preventing sale to minors, diversion to non-cannabis-legal states, and revenue to criminal organizations. Keeping these priorities in the lease as affirmative obligations that the tenant must comply with, and giving the landlord an early termination option if any one is violated, adds an extra layer of protection for both parties and helps further the state’s goal of elevating good actors and sorting out the bad. Also, we’ve already seen some federal prosecutors issue statements to the effect that existing enforcement priorities (i.e. the Cole Memo) will guide future enforcement decisions.
  4. Change in local laws/nonconforming use designation. Federal enforcement and changes in federal law are not the only things to pay attention to. California law gives cities and counties final say in whether and to what extent cannabis operations will be allowed in their jurisdictions. If something changes in local law, such as a zoning ordinance, and the proposed use becomes nonconforming and unlawful, then whether or not operations have commenced, the parties may want an option to exit the tenancy rather than fight the local government.
  5. Secured interests. Just as with residential mortgages, contracts supporting secured interests on commercial property often contain “compliance with all laws” provisions. In light of the recent federal action, lenders may be less comfortable with cannabis uses on the property securing their investment, and may be more prone to call the loan due in full, creating a problem for both landlord and tenant. In such event, the landlord may want an option to terminate the lease early without penalty.

We don’t know where the state-vs-federal conflict will go from here, and for now the cannabis industry will have to continue dealing with uncertainty. So far it seems the market is betting on the states to come out ahead. In the meantime, there are some meaningful items to include in a commercial cannabis lease that may mitigate some uncertainty and risk.

Oregon cannabis marijuana lease
Same advice for pot leases.

For any marijuana business not fortunate enough to own its land outright, there are few documents more important than the lease. Not only is the lease the only transactional document reviewed by the Oregon Liquor Control Commission (OLCC) prior to licensure, but it sets fundamental operating parameters than can determine the success –and even life cycle — of the business. Problematic lease arrangements can sink a ship fast.

In Oregon, there are four main varieties of leasehold: the residential lease, the commercial lease, the ground lease and the agricultural lease. We steer most of our pot industry clients toward commercial and agricultural leases, depending on the circumstance. That said, we have had people walk in with just about everything.

Below is a brief summary on each type of lease, what to look for, and when to use them.

Residential Lease

Do not use a residential lease for a commercial cannabis operation under any circumstances. Even if you think you can revise the lease form to suit your purposes, do not be tempted; and if your landlord insists on this form of lease, say no. We are currently aware of two pieces of landlord-tenant litigation in which the parties used a residential lease for a commercial cannabis grow: those leases were upside down on everything, including the eviction process. One goes to trial next week after thirteen months of litigation.

The only time a residential lease should involve cannabis is in the residential landlord-tenant context, discussing the right of an Oregon tenant to grow up to four plants for home use (not OLCC; not re-sale) in accordance with state law.

Commercial Lease

We have written on commercial leasing a fair bit on this blog, and we have adapted a handful of excellent lease forms for various buildings and circumstances. Generally speaking, commercial leases are broken into three categories: office, industrial and retail. The latter two are used extensively by cannabis businesses.

Prior to entering into a commercial lease, the parties will commonly run some due diligence on each other. From the landlord’s perspective, that usually means looking at a business’ operating history (if any) and financials; from the tenant perspective it’s more about local zoning laws and the space. This last piece is especially important: the lease almost always disclaims any liability for premises defects with “AS IS” language.

Prior to signing a lease, the parties will often start with a letter of intent (LOI) that nails down the high-level terms: e.g. duration, rights of renewal, rental amount, occupancy commencement, rent commencement, landlord and tenant improvements, taxes, insurance, common area maintenance, etc. Once the parties agree on these deal points, the next step is to get busy drafting. Here are some cannabis-centric things to watch for at that point.

Ground Lease

Ground leases are long-term leases (think, 20 years or more) where the parties intend for the tenant to construct a building and other improvements (think, a row of cannabis greenhouses) which ultimately become the property of the landlord. These are almost always “net rent” leases, where the tenant pays all taxes associated with the property, including taxes, insurance premiums, utilities and maintenance.

Recently, we’ve seen an uptick in multi-acre property owners choosing ground leases. In some cases, a master ground lease with a series of subleases for different OLCC licensees is used to create a complex of sorts, assuming compliance with local zoning law and the availability of water rights.

Agricultural Lease

Agricultural leases are a specialized subset of commercial and ground leases, and they are used commonly in rural cannabis grows. These agreements tend to be laced with various provisions not present in other commercial leases, like irrigation, water rights, sharing of farming costs, maintenance of equipment, etc. These leases may also be tailored specifically to the nature of the land. This means that in addition to describing the property at issue, the lease will describe buildings, structures, fixtures and other appurtenances included in (or excluded from) the leasehold.

It is important to note that although commercial and agricultural leases are related in many ways, use of a commercial lease on certain types of rural property, like Exclusive Farm Use (“EFU”) land could theoretically have disastrous effects. In Oregon, “commercial activity” is banned on EFU land. More than one attorney has speculated that use of a commercial lease on EFU land could lead to that parcel’s tax benefits being removed.

Sometimes, an agricultural lease is the only way to go.

california cannabis marijuana lease
Put your lease on the list!

With the New Year upon us and California cannabis legalization in full swing, now is the time for industry players to make sure they are poised to thrive in the world’s biggest legalized cannabis market. A critical element of that strategy for commercial tenants, as well as landlords, is making sure the real property chosen for operation is properly tailored to the intended use, and is flexible enough to anticipate various adverse scenarios that can and will arise in a dynamic and rapidly changing legal landscape.

A smart and practical New Year’s resolution would be to make sure your lease is buttoned up and ready to go for commercial cannabis in 2018. Here are some points to consider towards that end:

  1. Stop using form leases. Yes, they’re easy and convenient, and checking boxes is certainly cheaper in the short term than writing a lease, but experience says one of two things will likely happen: either you will (1) end up spending just as much time writing addenda that cancel out, expand upon, or replace terms of the form lease, making it read more like a choose-your-own-adventure book that flips across chapters, or (2) you won’t, but you’ll be far more likely to run into costly problems down the road when you discover the lease is missing crucial pieces that would have helped you avoid a mess. Save yourself the trouble and plan ahead by working with an experienced real estate attorney who understands the proposed use and the industry in California, and can write a proper lease to fit the tenancy.
  2. Specifically describe the permitted use and define applicable law. There are important legal consequences under state and federal law for adult use cannabis operations vs. medical operations, and the state’s regulations require specific authorization from the landlord for whatever license the tenant will obtain. And of course, there remains the issue of federal illegality overhanging everything. To save everyone time and headaches down the road, make sure the parties are in clear agreement on exactly what categories of licensed activity will be allowed under the tenancy, specify that in the lease, and restrict it to that use. Simply writing “cannabis” or the evasive “any use not in violation of law” will not suffice. When it comes to applicable law, local law and state regulations should be front and center, and there should be a carve-out for inconsistent federal law, lest a tenant be in violation of the lease from day one.
  3. Keep it arm’s-length, or know the risks. Entanglement issues such as profit-sharing arrangements and equity-as-rent may be lucrative, but they require a higher risk tolerance. If a federal (or state) enforcement action occurs, the chances that the landlord will be considered part of the offending business may be higher than if the lease had been a traditional arm’s-length tenancy. Also, you might run into problems trying to enforce the lease if it amounts to asking the court to wade into cannabis business operations as opposed to enforcing an arm’s-length rent relationship.
  4. Clarify insurance obligations and anticipate increased operating expenses. Regardless of whether the landlord or the tenancy will be responsible for maintaining and paying for building and property insurance, the parties should realize that: (1) cannabis tenants will have a hard time finding quality property insurance policies right now, and (2) any new or existing policy will likely be much more expensive when a cannabis use is added to the property. In practice, this means that the parties need to decide who will be required to obtain and maintain which kinds of coverages, what the policy limits will be, what happens if that doesn’t happen, and who will bear the increased cost if it does. If it’s a multi-tenant building where common operating expenses will increase disproportionately due to the new tenant’s cannabis use, the lease should account for that and adjust accordingly.
  5. Do due diligence on the property first. Doing things like zoning and title analysis would more typically be associated with a new purchase than a lease. But with cannabis uses there are unique considerations that come into play, such as easements or CC&Rs that prohibit violation of “any laws”, water use rights (which will be a critical part of a state application, particularly for cultivators), and zoning restrictions. On that last item, it’s imperative that the proposed site not run afoul of local restrictions, and it behooves both the landlord and the tenant to have that issue ironed out before pen touches paper. The parties should consider including a due diligence period in the letter of intent, as well as including an early termination option for a variety of land use restrictions that could be triggered by cannabis use, including changes in zoning laws.
  6. Consider the neighbors. We’ve discussed at length how RICO lawsuits have found their way into cannabis land use disputes, as well as nuisance claims, and how NIMBYism will likely play a role in the California cannabis saga just as it has in other states. But similar to a zoning and title analysis, parties looking to start a commercial cannabis tenancy can and should factor the neighbors into the equation before deciding to commit to a lease. This is particularly relevant for business parks or multi-tenant buildings with non-cannabis tenants that might complain about the effect of cannabis (odors or otherwise) on their business operations. Better to know now than 3 years into a 10-year lease term. The parties can also consider including an early termination option in the event that neighbors bring a civil action.
  7. Consider the federal government. One of the most obvious reasons that form leases are wrong for cannabis tenancies is the failure to properly account for the fact that cannabis is still federally illegal, and the government can and does pursue civil asset forfeiture, putting the landlord at risk of losing the property over the tenant’s use. While there is no getting around the fact of federal illegality, one strategy is including early termination options for changes in federal law and/or enforcement guidelines, and for any forfeiture actions.
  8. Anticipate the license timeline. California has just started issuing temporary licenses to applicants who already have local approval. While those have had a relatively quick turnaround, full annual license application review could take longer, and in any event, there is the possibility that the tenant will be denied a state license and/or local approval. This uncertainty can be built into the lease in terms of rent abatement and an early termination option, depending how confident the parties are that approval will be successful.
  9. Make sure the occupancy plan stays legal. California’s new regulations dispensed with SB 94’s requirement that a licensee maintain “separate and distinct” premises for multiple licensed activities. However, licensed premises must still have a designated area dedicated to only one licensed activity at a time, with the exception of adult-use and medicinal operations being allowed to operate in the same place under certain circumstances. The new rules also contain a blanket prohibition on subletting of any licensed premises. This means that the parties should spell out in the lease exactly which activities will be conducted in which areas of the property. Whereas typical commercial tenants would have more or less free reign to use the leased premises however they choose as long as it’s within the permitted use, California’s new rules make this a more nuanced issue.
  10. Choose the right law, venue, and dispute resolution process. Limiting interpretation and enforcement of the lease to California law, restricting venue to state courts, and including a well-drafted arbitration clause are all important aspects of a cannabis tenancy that are typically missing from a form lease.

As we watch California’s regulatory and licensing process play out, landlords and tenants with properly tailored leases and well-researched land use analyses will be more likely to succeed and thrive. Many of the potential problems with the leasehold interest will have been considered and averted.

In 2018, resolve to make your leases better.

California cannabis real estate lawsCalifornia just released nearly 300 pages of new regulations for medicinal and adult-use commercial cannabis businesses. These long-awaited rules follow months of public comment, a substantial environmental impact report on cultivation, and a report from the state Water Resources Control Board on diversion and discharge relating to cannabis cultivation. Though the new regulations do not include wholly unanticipated changes, they do include the following that will impact cannabis businesses when it comes to real estate and land use:

  1. Cultivation aggregate size limits. Though there remains a 5-year prohibition on large (type 5) cultivation licenses for grows of more than 1 acre, and a 5-year limit of one medium grow license (10,001-22,000 sq ft) per person, there is no 1-acre aggregate limit on cultivation, which had been recommended in the environmental report. In other words, there is effectively no limit, other than a company’s monetary resources for license fees, that would prevent a large cultivator from converting an existing mega-farm into a cannabis farm by simply aggregating an unlimited amount of specialty (0-5,000 sq ft) and/or small grow (5,001-10,000 sq ft) licenses. This is a troubling development for small and medium-sized operators, as they had lobbied hard for an aggregate grow limit of one acre.
  2. Subletting and Storage. Though we already knew from MAURCSA that California would require each “premises” to be contiguous and occupied by only one licensee, the new rules go slightly further by forbidding a licensee from subletting any portion of its licensed premises and by requiring each location where cannabis goods are stored be separately licensed. This means any licensee subletting a portion of their space must plan out a proper demarcation of their premises and think carefully about using that old garage next door to store product without an additional license.
  3. Concurrent adult-use and medicinal operations. Under the new rules, one licensee can concurrently operate under both an “M” license and an “A” license on the same premises, if certain conditions are met—mainly that there is one licensee that conducts a single type of operation on the premises but keeps labeling and records separate for medicinal and adult-use. Though this seems like a common-sense regulation (why would someone need two licenses to make the same product in the same place?), it was not clear until issuance of the new rules how adult-use and medicinal licenses would interact, and whether they would be treated as truly separate licenses requiring separate premises.
  4. Renewable energy requirements. The prior proposed MCRSA (medicinal) regulations had required 42% of the energy used by indoor or mixed-light grow licensees come from renewable sources. The new cultivation rules require only that the licensee meet the “average electricity greenhouse gas emissions intensity required of their local utility provider” under California’s existing Renewables Portfolio Standard Program. This means that rather than having indoor grows become leaders in renewable energy standards, licensees now only need to fit in with existing requirements, and even if they don’t, they can purchase allowances and offsets under California’s cap-and-trade programs. There had even been talk of increasing the percentage requirement for renewable energy, but that seems to have fizzled out.

Though the new cannabis rules contain some business-friendly updates, some disfavor small operators. It remains to be seen what effect the licensing process and the state’s enforcement of the new rules will have on the market for cannabis and cannabis real estate. We will be discussing these new regulations a bit at our Southern California Cannabis Investment Forum on November 30 in Los Angeles and it would also behoove you to stay tuned for an announcement setting the date for our next webinar, which will delve into the new regulations in detail.

California cannabis real estate laws
Careful buying real estate for your California cannabis business

Last month, in California Commercial Cannabis: Beware the Residential Farm Purchase, I discussed some of the risks inherent in buying a residential farm for commercial cannabis operations. In this post, I expand on that a bit by addressing some broadly applicable pitfalls for anyone looking to buy land on which to conduct a licensed commercial cannabis activity in California (or just about anywhere else). This post focuses on some land use pitfalls unique to cannabis that our real estate lawyers often encounter during the due diligence phase of land purchase deals involving cannabis.

  1.      Easements. An easement is generally a right to access or travel across real property that belongs to someone else. Cannabis businesses need to look out for easements that benefit the purchasing owner’s dominant estate by allowing access to a neighboring property but are subject to express conditions such as “compliance with all laws” (which would include federal law). If the purchased parcel includes an express easement for parking on a neighboring property subject to “compliance with all laws,” the neighbor could seek to prevent access to the easement as long as the cannabis use remains federally illegal, which could jeopardize the business’s operations. A title analysis during the buyer’s due diligence phase should include not just the usual searches for recorded and non-recorded easements, but it also should also account for the implications on these property rights that a cannabis use might present, which would not necessarily present with a routine property due diligence.
  2.      CC&Rs. Though covenants, conditions, and restrictions are normally associated with residential property (think homeowner associations), they are also common in the commercial real estate industry. CC&Rs typically are binding on future purchasers. Restrictions that might not normally be thorny or even applicable to typical business uses can present unique problems when it comes to cannabis. Common examples of this are restrictions on odor and waste emissions, use/manufacture/trafficking of “illegal drugs,” and the pervasive “compliance with all laws” mandate. Because cannabis is still illegal under federal law (notwithstanding its legal status in California and other states), a beneficiary of a “compliance with all laws” restriction could seek to enforce the CC&Rs against a cannabis operator. Consequently, due diligence for cannabis land purchases should include both a thorough review of CC&Rs and creative thinking on how those restrictions could potentially be interpreted against a cannabis use.
  3.      Zoning and local cannabis ordinances. A buyer looking for land for commercial cannabis operations has usually narrowed the search to jurisdictions with some form of commercial cannabis ordinance (See our California Cannabis Countdown series, which tracks updates in cannabis legalization by locality). Though many California cities and counties have passed legislation to accommodate new zoning requirements for cannabis uses, the burden is on the buyer to confirm that the parcel it seeks to buy will be suitable for its intended use, and, ideally, that it will stay that way. This means conducting due diligence on the local cannabis ordinance and on other related zoning laws and local land use restrictions. This also often means working with the locality to put in place a development agreement (sometimes required by the local ordinance anyway) to make sure the zoning laws won’t change.
  4.      Geographical vicinity and state regulatory requirements. In addition to local zoning requirements, cannabis operators must consider state laws when deciding where to locate. California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) requires cannabis businesses maintain at least a 600-foot distance from schools and other youth gathering places. Local cannabis ordinances commonly include geographical buffer requirements that mirror current state requirements, but they can (and they sometimes are) be stricter than MAUCRSA’s. This means that your search for land suitable for your cannabis operation should include an analysis of local and state geographical buffers and any other local restrictions.
  5.      Neighbors. The importance of maintaining good neighbor relations cannot be overstated in the commercial cannabis industry. You should assume any neighboring landowner who opposes your business operation would have no trouble finding a legal basis to challenge it. They can (and often do) seek to enforce land use restrictions or lobby to change local zoning laws to the detriment of cannabis businesses. Or they might just bring an old-fashioned nuisance lawsuit against you, claiming the smell from your property or the number of people who visit it are damaging them. Your due diligence should, therefore, include gauging the potential risks coming from your future neighbors, particularly if the land you are considering is close to residential zoning or urban areas, where NIMBYism is likely to be more acute.

Due diligence on a real estate purchase is always important, but the unique characteristics and legal status of cannabis make it even more important for commercial cannabis businesses.

 

California cannabis farmsWith California’s cannabis real estate market red hot right now, many cannabis businesses are looking at buying rural farms with family farmhouses as sites for their marijuana business. This though can be a risky approach. Businesses hoping to become legitimate licensed operators under California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) should consider the following before signing on the dotted line on this sort of real estate deal:

  1. Government approval contingencies. One of the most important differences between a residential and a commercial Purchase and Sale Agreement is that well-crafted commercial agreements (especially in the cannabis industry) usually contain business-specific contingencies, including a contingency for local and state government approval that the buyer will be able to confirm that it can legally use the property for its intended use. Residential real estate Purchase and Sale Agreements (even those with an agricultural addendum) rarely include these specific contingencies, leaving the buyer to investigate and bear the risk. Because local law is king under MAUCRSA, you need a contingency in your real estate Purchase and Sale Agreement that will allow you to stop the deal if your local government is not going to let you conduct cannabis business on the property.
  2. Zoning. If a seller is using a residential Purchase and Sale Agreement because a house is included with the land purchase, chances are good that the property being bought is zoned residential. This sort of zoning increases the likelihood commercial uses will be disallowed altogether or restricted by local ordinance — many of which will roll out in the months and years to come as MAUCRSA licensing tees up. Even rural properties that look suitable for farming must be closely scrutinized for land use restrictions of all kinds, including zoning. A buyer cannot simply rely on the appearance of the property or on general knowledge about a past use.
  3. Nuisance. California’s Right-to-Farm laws generally work against neighbors seeking to bring nuisance claims against farming uses abutting a residential development. But those laws do not (at least as of yet) make cannabis an explicit agricultural product that landowners have a right to farm. Add that to probably the most common complaint about cannabis — odor — and you can see why that family farm could end up creating a NIMBY problem that would not be there with your typical cornfield. See California Cannabis NIMBYs and Land Use Disputes.
  4. Civil asset forfeiture. Even state-legal cannabis businesses are at risk of federal civil asset forfeiture actions and that sort of action could be even harsher for cannabis operators living in a house on their cannabis farm — the federal government could take their house as well as their land.
  5. Conservation Easements. California’s Williamson Act allows localities to enter contracts with landowners that restrict the use of their property to only agricultural purposes and not build any improvements on the land in return for local tax breaks. Some California localities (even those with medical cannabis licensing ordinances) will often decline to waive prohibitions on federal illegality in agricultural conservation easements to allow cannabis operations on those parcels, because federal funding is directly tied to these conservation programs, and it is much easier for the federal government to turn off a locality’s funding spigot than to pursue a civil asset forfeiture against individuals and their land. This means you should carefully examine all land use restrictions on any parcel you are considering buying.
  6. Water rights. California’s water rights laws are complex and contentious (see, e.g., Chinatown). A California landowner’s right to use a nearby water source can flow from a number of different legal sources, such as riparian rights (land is adjacent to water source), appropriative rights (first in time, first in right), prescriptive rights (akin to adverse possession), overlaying groundwater rights, adjudicated rights, contractual rights, statutory rights, etc., etc., etc. What’s more, these various rights frequently compete with each other in priority for finite water sources, particularly during droughts. A potential buyer of a residential farm will need to look closely not only at the existing water rights associated with the property, but also at the potential for those rights to be augmented, especially if the intended use is cannabis cultivation, which is water-intensive. Commercial properties, especially those with past manufacturing or large scale agricultural uses, usually have greater established water rights than a small family farm. Furthermore, though the California Department of Food and Agriculture has not yet issued its final cannabis cultivation rules (those will come in November), MAUCRSA will require government approval of any water diversion for cultivation purposes (and water board approval by certain fast-approaching dates for some water sources), which is something that can be included in a government approval contingency but that would not typically be included in a residential Purchase and Sale Agreement, so amend accordingly.

The above list highlights just some of the key land use issues you should consider before you do any residential land deal involving cannabis.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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