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Learning from the First Wave Part 2: California’s Cannabis Supply Chain and Vertical Integration, with a Grain of Salt

By Todd Feldman
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Part One of this series took a look at how the regulated cannabis market can only be understood in relation to the previous medical market as well as the ongoing “traditional” market. Part Two of the series describes how regulation defines vertical integration in California cannabis, and conversely, how vertical integration can address some of the problems that the regulations create. But first:

A Grain of Salt

Take the conventional wisdom about vertical integration with a grain of salt. Expected benefits may not materialize under the current circumstances:

  • Overall, the business environment is highly challenging due to extensive regulation, over taxation, insufficient retail capacity and competition from the “traditional” market. As a result, integrating businesses upstream or downstream may mean capturing losses, not profits.
  • The three major types of cannabis activity span three major industrial sectors: raw materials (i.e., cultivation), manufacturing and service (distribution, testing and retail). As a result, a vertically integrated company needs to carry out very different types of activity, which require very different types of core competencies, equipment and facilities.
    • Developing core competencies is especially challenging because each of the major cannabis sectors is still evolving.
    • Realizing the benefits of vertical integration requires an additional core competency in cross-sector operations.

 Regulations Define the Supply Chain

California’s regulations define the cannabis supply chain by defining both the individual links (licensees) and the relationships between those links. Therefore, an understanding of vertical integration must be grounded in an understanding of the underlying regulatory definitions.

The regulatory definition of each link is extensive. For example, each licensee is tied to a specific facility, and must have its own procedures for production, inventory control, security, etc. When the links are strung together, this definition tends to preserve operational redundancies, and impede operational integration.

Overall, the relationships between the links are primarily defined in terms of preserving the chain of cannabis custody. On top of that, regulations define very specific (and very consequential) links between certain licenses, as discussed below.

A Taxonomy of Links

There are currently 26 types of cannabis license in California, 25 of which can be vertically integrated:

  • Cultivation – 14 licenses, including 4 sizes each for Indoor (up to 22,0000 sf), Mixed Light (up to 22,000 sf) and Outdoor (up to 1 acre), as well as Nursery and Processor (drying, trimming and packaging/labeling). Note that cultivation licenses are the only licenses that restrict the scale of activities.
  • Manufacturing – 5 licenses, including volatile extraction, non-volatile extraction, everything but extraction (i.e., infusion) and packaging/labeling.
  • Testing (Type 8), for testing cannabis according to state standards prior to sale. The owner of a testing license cannot own any other type of license.
  • Distribution (Type 11), acts as the gateway between cultivation and manufacturing on the one hand, and retail on the other. The distributor’s gateway status is entirely an artifact of regulation – cannabis must be officially tested before it is sold to a consumer, and only a distributor can order the official test. All products must stay in a “quarantine” area at the distributor until they pass testing. Products that fail testing must be destroyed if they cannot be remediated.
  • Transport (Type 13), which can move cannabis between licensees (with a narrow exception). This license does not allow for official testing.
  • Storefront Retail (Type 9), which is the best license to have, and the hardest one to get.
  • Delivery Retail (Type 10), for delivery services that are subject to the vagaries of software platforms and the intransigence of local authorities.
  • Microbusiness (Type 12), which allows the licensee to carry out cultivation (up to 10,000 square feet), non-volatile manufacturing, distribution and retail.
  • Event Organizer

Self-Distribution – A Case of Useful Integration

You may gather from the previous section that shoving a gratuitous and mandatory distributor into the middle of the supply chain creates problems for cultivators and manufacturers. Savvy operators solve this problem by getting a distribution license. This allows the cultivator or manufacturer to:

  • Pick the time and place for the testing of its cannabis products.
  • Avoid paying someone else for the storage of cannabis products as they await test results or purchase.
  • Reduce transport costs (particularly if the distributor is near the other operations).
  • Sell directly to retailers.

The bottom line is that vertical integration in California cannabis is useful as a means to an end, as opposed to an end in itself. Therefore, cannabis operators should carefully consider how vertical integration will benefit their core business before incurring the risks and expenses associated with an additional license.

This article is an opinion only and is not intended to be legal advice.

California Suspends Almost 400 Licenses

By Cannabis Industry Journal Staff
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On November 1st, the Bureau of Cannabis Control (BCC) sent notices to 394 businesses in California that their licenses will be suspended until they comply with certain traceability system requirements. This story was first reported by John Schroyer at Marijuana Business Daily.

On Wednesday, November 6th, the number of licenses suspended dropped to a total of 385, including 63 retailers, 61 delivery services, 47 microbusinesses, 185 distributors and 29 transportation licenses. That’s almost 5% of all the cannabis business licenses in California.

According to Alex Traverso, spokesman for the BCC, licensees were given plenty of opportunities to fix their errors. Businesses were given notice that they needed to enroll in Metrc within five days following their provisional licensing. The BCC gave those businesses a reminder roughly three months ago and sent an additional warning in late October regarding the deadline.

It’s a relatively easy fix for those trying to get back in compliance. The rationale behind suspending the licenses is that those businesses need to undergo a mandatory traceability system training so they know how to use Metrc and get credentialed. Enroll in the Metrc system, get credentialed and your license should be restored.

“It’s relatively simple to get your license out of suspension,” Traverso told KPBS News. “These are growing pains. I think we knew it was going to be a process and it was going to take some time, and that it was going to be an adjustment period for a lot of people who have been doing things one way for some time now.”

Traverso added that about 80 businesses enrolled in the Metrc system as soon as they received the notice that their license is suspended. Those licenses should be restored to active shortly, Traverso said.

Sequoia Analytical Labs Caught Falsifying Results

By Aaron G. Biros
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Last month, Sequoia Analytical Labs admitted that they falsified hundreds of pesticide tests for batches of cannabis products. The Sacramento-based laboratory faked data on 22 different pesticide tests for more than 700 batches over a period of four months.

According to a notice posted on Sequoia’s website, the skewed results were originally found due to a “faulty instrument” but “it was further discovered” that the lab director knew about it and was fraudulently posting the results in order to hand out certificates of analysis. The lab director in question has since been fired and Sequoia voluntarily relinquished their state license.

Joe Devlin, Sacramento’s chief of cannabis enforcement, told KCRA3 News “We’re going to be taking a look at suspending or possibly revoking their permit.” He followed that up with saying that California needs more testing labs. “The shortage of labs has really created a bottleneck in the supply chain across the state,” says Devlin. There are only 43 licensed laboratories in the state of California as of this time, and just three of those are in Sacramento.

The Bureau of Cannabis Control (BCC), the regulatory authority overseeing the cannabis testing market in California, has not commented on this story, but they did reach out to distributors who had sent batches to Sequoia for testing. “Any cannabis goods from these batches, returned by consumers to the retailer, must be destroyed,” reads the BCC letter. “Any cannabis goods returned from a retailer’s inventory or remaining in your inventory may be destroyed, or may be re-sampled and re-tested after obtaining approval from the Bureau. Any cannabis goods from these batches may not be released to a retailer without re-sampling and re-testing.”

Sequoia Analytical Labs posted two notices on their homepage, one was a letter to their clients informing them of the fraud and the other is that BCC letter to distributors doing the same. “Management and ownership were horrified to learn about this severe breach of a very important safety regulation,” reads the notice. “We have voluntarily surrendered our license to do COA testing to the BCC while we make the required corrections. We are already hard at work making the needed changes to the instrument and revamping procedures so that we may get our license reinstated January 1.”

As of today, the lab’s license has not been reinstated.

Growing Pains a Month Into California’s Market Launch

By Aaron G. Biros
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For about a month now, California’s adult use market has been open for business and the market is booming. About thirty days into the world’s largest adult use market launch, we are beginning to see side effects of the growing pains that come with adjusting the massive industry.

Consumers are also feeling sticker shock as the new taxes add up to a 40% increase in price.While the regulatory and licensing roll out has been relatively smooth, some municipalities are slower than others in welcoming the adult use cannabis industry. It took Los Angeles weeks longer than other counties to begin licensing dispensaries. Meanwhile, retailers in San Diego say the first month brought a huge influx of customers, challenging their abilities to meet higher-than-expected demand.

Businesses are struggling to deal with large amounts of cash, but California State Treasurer John Chiang may have a solution in store. Yesterday, his department announced they are planning to create a taxpayer-backed bank for cannabis businesses.

Reports of possible supply shortages are irking some businesses, fearing that the state hasn’t licensed enough growers and distributors to handle the high demand. Consumers are also feeling sticker shock as the new taxes add up to a 40% increase in price.

CA cannabis testing chart
California’s plan for phasing in testing requirements.

In the regulatory realm, some are concerned that a loophole in the rules allows bigger cultivation operations to squeeze out the competition from smaller businesses. The California Growers Association filed a lawsuit against the California Department of Food and Agriculture to try and close this loophole, hoping to give smaller cultivators a leg up before bigger companies can dominate the market.

The Bureau of Cannabis Control (known as just “The Bureau”) began holding meetings and workshops to help cannabis businesses get acquainted with the new rules. Public licensing workshops in Irvine and San Diego held last week were designed to focus on information required for licensing and resources for planning. The Bureau also held their first cannabis advisory committee meeting, as well as announcing new subcommittees and an input survey to help the Bureau better meet business needs.

On the lab-testing front, the state has phased in cannabinoids, moisture content, residual solvent, pesticide, microbial impurities and homogeneity testing. On July 1, the state will phase in additional residual solvent and pesticide testing in addition to foreign material testing. At the end of 2018, they plan on requiring terpenoids, mycotoxins, heavy metals and water activity testing as well.

California Releases Proposed Emergency Regulations

By Aaron G. Biros
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Last week, the California Bureau of Cannabis Control released their proposed emergency regulations for the industry. The Bureau, the government agency tasked with regulating California’s cannabis industry, announced the proposed emergency regulations ahead of the highly anticipated January 2018 start date.

The Bureau also published helpful fact sheets and overview documents, providing a good snapshot of the major requirements for different types of licenses. Here are some of the key takeaways:

Temporary licenses will allow businesses to operate for 120 days while their annual license application is being processed. Not surprisingly, local jurisdictions have considerable autonomy. Getting a license seems to be contingent on first getting local approval to operate. According to Josh Drayton, communications and outreach director at the California Cannabis Industry Association (CCIA), working with local governments will be crucial to making progress. “Now that the Brown Administration has created the framework for medical and adult use cannabis, the main challenge we face as an industry is getting local municipalities to move forward with regulations,” says Drayton. “California has a dual licensing process which means that cannabis operators must receive a local permit/license/authorization before being able to apply for a state license. A majority of California cities and counties have yet to finalize their regulations which will delay state licensing.”

The initial reactions to these proposed regulations seem positive, given that this is a culmination of efforts over several years. “The California Cannabis Industry Association welcomes the release of the emergency regulations,” says Drayton. “These regulations represent years of hard work and collaboration between the administration, the regulating departments, and the cannabis industry.”

License Distinctions

A-type licenses are for businesses in the adult-use market, while M-type licenses are for the medical market. Laboratory licenses don’t have this distinction, as they can test both medical and adult-use products.

The record keeping and security requirements seem relatively straightforward, requiring normal surveillance measures like 24-hour video, commercial-grade locks and alarm systems. The rules also lay out guidelines for disposing of waste, including securing it on the premises and not selling it.

Distributors

Distributor licenses appear to have a number of compliance documentation requirements, such as arranging for all product testing, quality assurance and packaging and label accuracy. “Cannabis and cannabis products must pass through a distributor prior to being sold to customers at a retail establishment,” reads the overview the Bureau published. There is also a transport-only distributor license option. Those regulations appear to be more comprehensive than others, with a number of regulations pertaining to appropriate transportation and security measures.

Everything has to be packaged before it gets to retail; Retailers are not allowed to package or label cannabis products on premises. Microbusiness licenses will be available, which should be an exciting new development to follow as the market matures.

Labs

The state will require ISO 17025 accreditation for testing labs. A provisional license is required for a lab to operate in the short term, expiring after 12 months. Laboratory personnel are required to go in the field and do the sampling. Documentation requirements, sample sizes, sampling procedures and storage and transportation rules are also laid out.

Testing labs are required to test for cannabinoids, foreign material, heavy metals, microbial impurities, mycotoxins, moisture content and water activity, residual pesticides, residual solvents and processing chemicals and terpenoids (terpenes). Infused and edible products are required to be tested for homogeneity in THC and CBD concentrations as well. Drayton and the CCIA welcome these new testing regulations, hoping it might improve overall public safety. “We believe that these regulations will address public health issues by mandating the testing of all cannabis products,” says Drayton. “The evolution of the cannabis industry will continue, and we will continue to advocate for good policy that creates solutions for the problems that arise. I believe that we will be visiting and revisiting cannabis regulations for many years to come.”

Certificates of analysis (COA) will be required, showing whether a batch passes or fails testing requirements. Harvest batches that fail testing can be processed for remediation. “Testing laboratories are required to develop and implement a quality assurance program that is sufficient to ensure the reliability and validity of the analytical data produced by the laboratory,” reads the statement on QA and QC.

The Bureau, at the end of their regulatory overview document, lays out some possible enforcement actions, disciplinary actions and citations that could come from noncompliance. “These emergency regulations create a framework for both medical and adult use consumers,” says Drayton.  “January 1, 2018 will be the first date that adults 21 years and older will be able to purchase cannabis without a medical card.”

In the coming weeks, we’ll be breaking down and analyzing the other proposed emergency regulations that the state released. Stay tuned for a breakdown of the California Department of Food & Agriculture (CDFA) regulations on cannabis cultivation, as well as The California Department of Public Health (CDPH) cannabis manufacturing regulations.