Since moving to Los Angeles, I have non-stop been reviewing the work of other “cannabis attorneys” from all over California that were working for their clients under Proposition 215, and I have to say that far too much of what I’ve seen has disturbed me when it comes to corporate formation, financing, and entity structures. What seems to have occurred under Prop. 215 (which is a terrible piece of law if you’re looking to be a real cannabis business) is that many self-proclaimed industry attorneys in and out of California abandoned any semblance of helping their clients comply with the corporations code, federal and state tax laws, and various basic transactional laws and standards. All of this is coming to light now because many Prop. 215 “collectives” want to start for-profit companies to pursue licensure under the Medicinal and Adult Use Cannabis Regulation and Safety Act (“MAUCRSA“) and/or merge their collective into a for-profit entity for the same reason. Unfortunately, this kind of transition is going to be legally impossible because of how these collectives were originally structured (combined with their failure to comply with corporate laws) or it will be rife with liabilities because of straight-up bad legal advice.
In defense of California, I have to say that this sort of off-the-cuff lawyering is always par for the course in states where cannabis businesses had to operate in the grey. In those situations, few successful corporate lawyers are willing to risk their law license and so what happens instead is that criminal lawyers (whose business is on the decline due to decreased arrests) and new lawyers step in to fill the void. From this the problems arise. Now might be a good time for you to check out Seven Keys to Choosing Your Cannabis Business Law Firm.
Below then is my top five list of the worst legal advice our California lawyers have seen given to Prop. 215 collectives here in the Golden State.
- Your bylaws aren’t that big of a deal. The majority of operators in California are non-profit mutual benefit corporations (“NPMBC”) because a 2008 California State Attorney General memo interpreted Proposition 215 to permit only non-profit entities to “collectively or cooperatively” produce and distribute cannabis medicine by and among qualified patients. Many lawyers (apparently unfamiliar with California’s corporate laws) failed to draft corporate bylaws or provided only boilerplate bylaws for the directors and members to control the entity. A very specific portion of the California corporations code deals with NPMBCs and if your NPMBC does not have proper bylaws in place, its operations will be controlled by statute and you may be legally prohibited from acting on behalf of the entity. What’s even worse though than having no bylaws are boilerplate bylaws that are not followed by the corporation’s directors. I’ve seen bylaws that focus on essentially made-up compliance with Prop. 215. and that ignore every other facet of actually running the NPMBC and I’ve heard multiple times of lawyers who claim that the only reason to have these bylaws at all is to show to the police in an event of a raid. This is obviously a problem when it comes to what happens on wind-up and dissolution, where assets go upon dissolution, how the entity is managed, and who has authority to do what, and these corporations are having to learn this now, in their hour of need.
- Membership voting doesn’t matter. This ties in to having poorly written or no bylaws. Member voting absolutely matters. Most NPMBCs were never told that they vested corporate voting rights in their entire patient membership, which means they cannot do anything without putting it to a vote of their entire collective. We have also seen many NPMBCs set up where their directors vote on day-to-day decisions but all members get to vote about dissolution, dissemination of assets, etc., which is not what you want to see if you want to do a for-profit merger. To make matters even worse, many of these NPMBCs require a vote of their entire membership to amend the bylaws to address these sorts of situations. Some even require this vote be unanimous for anything to happen. Just imagine for a minute finding and getting hundreds of people to vote your way; not going to happen.
- The IRS won’t care about relationships between collectives and their management companies. Some lawyers told collective operators to start a parallel management company along with their NPMBC so that they could get bank accounts, run payroll, and provide various “management services” to the NPMBC. Their real plan though was to strip out cash from the NPMBC (which can’t otherwise make a profit). Unfortunately, astoundingly few of these lawyers gave a thought to how the IRS would view all this for income tax purposes. Fast forward just a bit and we now have the IRS applying Section 280e to these management companies that are managed or controlled by the same people who sit on the board of the NPMBC. In many instances, the IRS sees these as “designed to hide” relationships set up as a front set up to allow those who control the NPMBC to get paid large amounts. And no surprise, the IRS is not liking what it is seeing.
- Don’t document anything. Is cannabis still illegal at the federal level? Yes. Is there criminal liability for doing pretty much anything related to cannabis? Yes. But if you are going to run a cannabis operation that complies with state law you need to document what you are doing, especially your compliance efforts. And if you ever want legitimate relationships with future financiers, handshake deals and fly-by-night dealings are not going to cut it, especially now that MAUCRSA has passed. The number of collectives that have told me that they can’t now operate properly under local law requirements or that they’re getting hung up on negotiations with a financier because of a lack of documented operating history or a lack of vendor or other contracts is staggering.
- Merger is a collective’s best option under MAUCRSA. Definitely not true for most collectives, and don’t even get me started on the stupidity of selling your collective. In California, many collective operators want to merge with for-profit entities using the same management, name, and assets as the non-profit entity. But mergers, even those done purely as a reorganization, can be complicated beasts. For many collective operators, their relationships with amorphous management companies, their outstanding tax liabilities, their lack of any written operating history or contracts, and their prior general corporate incompetence would make merging a poor choice. The corporate, tax, tort, contract, and debt liabilities of the nonprofit would transfer to the surviving entity — and those liabilities can be countless for businesses that have worked outside the bounds of the law for years. Unless your collective has followed California’s corporations code, reported its income to the IRS and paid its taxes to the Board of Equalization, documented its arm’s length transactions with third parties, and has transferable assets of real value, a merger will probably not be the way for you to go unless you want to carry all of your Prop. 215 baggage with you.