Commercial cannabis licensing in California kicked off on January 1, 2018. A few days later, former U.S. Attorney General, Jeff Sessions, rescinded all former Department of Justice guidance on federal enforcement of the Controlled Substances Act in states with legal cannabis. The industry reaction in California that day was all over the place, and chaos and uncertainty was in the air.
Interestingly enough, it’s safe to say that the chaos that commenced with initial licensing under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA”) has never really abated. In a given day, I get a good amount of client and would-be client feedback opining that California is still “a mess” or dysfunctional when it comes to cannabis licensing. All state commercial cannabis markets take time to establish and settle out, though. California is no different, it’s just bigger. The imminent maturation (and consolidation) of businesses and more concrete and consistent enforcement from regulators is taking longer.
In any event, certain bad and/or bizarre behavior persists. If you’ve seen any of this activity out in the marketplace, you’re not alone. And hopefully most if not all of these seven deadly cannabis sins will abate as the market goes on.
1. Straight up unlicensed actors.
It’s no secret that California has a large illegal market problem. And maybe it always will given its size. However, we have multiple cities and counties in California that will not get on board with legalization, and these places are hotbeds for real drug dealers and criminal operators. In addition, in a place like the City of Los Angeles, you have a culture of persistence still that is more than happy to set up fly-by-night shops and delivery services only to be shut down and then re-open again and again. Luckily, the state has upped the ante on illegal operators with steep fines, penalties, and even potential jail time, but it’s going to be a hot minute before we eliminate even a small portion of the black market (if ever).
2. The “collective hangover”.
Shockingly enough, our cannabis business attorneys in California still get calls from people who want to set up non-profit “collectives” under the Compassionate Use Act of 1996. Unless you’ve been living under a rock, you know that the “collective model” died on January 9 of this year, and it’s not coming back. Of course there are those folks who would still set up collectives anyway knowing that they’re violating the law, but this is one cannabis sin that should burn away pretty quickly for obvious financial and organizational reasons. And if you’re an investor and someone is still pitching you on investing in their non-profit collective in California or an attorney is telling you to set up a non-profit collective, you can safely flee from that proposition.
3. Screwy M&A.
We have written a lot about California M&A on the blog. It’s not a straightforward situation because of state and local licensing laws and resulting changes of ownership protocol, but a ton of people are breaking state and local laws left and right through M&A in California. It’s only a matter of time before regulators catch on to people’s recklessness here, which will lead to license cancellations and a good amount of lost investment, but until then (because of inconsistent enforcement combined with buyer momentum), many cannabis businesses that have sold ownership interests are likely sitting on significant rule violations.
4. Crappy legal advice.
Cannabis is still an emerging marketplace. And the fact that it’s federal illegal has still mostly kept the large, white-shoe law firms out of the scene (unless they form small practice groups to advise on things like employment and financing, which we see on occasion). This has led to a significant amount of legal hacks and newbies joining the industry holding themselves out as “legal experts” in the field. And don’t get me started on the volume of criminal defense attorneys that now claim to do legitimate business, corporate, and securities work. I’m constantly in receipt and reviewing legal work being produced in California relative to intellectual property licensing, M&A, inventory purchase agreements, distribution contracts, and a number of other transactions between licensees, and some of it is still terrifying coming from attorneys who are not competent in the area (in that they completely ignore applicable regulations) or unethical in their dealings altogether. Again, as the industry matures, the hope is that bad and unqualified actors fall by the wayside.
5. Regulators shuffling the deck (at your expense).
It’s a common annoyance in the state legal cannabis industry where state regulators constantly change the rules or, more accurately, their interpretation of certain rules as time goes on (and you better learn “regulatory language” now to better deal with this issue). California, again, is no different. Our firm has had conversations with each state agency regarding change of ownership laws, distribution rules, testing requirements, the ability to return products, and other lucrative day-to-day licensee tasks where we literally get different answers almost every time we touch base. As industry issue arise and fall and the political powers change, so too will the state’s interpretation of its own rules. It’s not easy being a regulator, but I can promise you that the state agencies will eventually even out and remain fairly consistent with their rule interpretations (eventually).
6. Local authorization headaches.
California is a local control state. This means that before you can get a state license, you have to secure local approval for your cannabis operation from your city or county. And each of the 482 cities and 58 counties in California is doing regulation or prohibition differently. Local authorization is no picnic. It seems that certain cities have really dragged out the process to no end, either flipping their position from allowance to prohibition or significantly changing the entitlement process at the expense of applicants. In some cases, third party litigation has halted commercial cannabis activity in cities that allow it (see El Monte). The City of Los Angeles is another prime example of municipal change in that it has navigated complex issues relative to three phases of local licensing and implementing a social equity program that it’s had to refine for months and months (as opposed to L.A. County, which commissioned a group to study the impacts of legalization and regulation and even has an Office of Cannabis Management, but still has a ban in place).
7. No real banking options.
California’s regulations for its licensees are not super tough. There’s a lot of red tape, but the state as a whole isn’t as strict as it could be (when compared to other states) relative to owner and financier reporting requirements and just general day-to-day compliance issues (for example, we have no residency requirement and you can vertically integrate your licenses). This means that our rules probably aren’t the strongest to satisfy the 2014 FinCEN guidelines that enable cannabis banking, and this is why we don’t have really robust banking options in California. Thus, many cannabis companies still open management companies that secure phantom banking for the actual cannabis operations (which is a terrible idea because of 280E reporting to the IRS and for a number of other reasons). And if folks aren’t using these convoluted structures, they’re dealing in all cash, which is a major pain and public safety hazard.
A few of these hazards cannot be avoided right now in California, but most will go away with time as the market stabilizes. In the interim, compliance is king and that, alone, will help you avoid getting into most of the foregoing trouble.