Tag Archives: court

August 18, 2020

CBD You in Court: Consumer Class Actions Involving Hemp-Derived CBD Products

By David J. Apfel, Nilda M. Isidro, Brendan Radke, Emily Notini, Zoe Bellars

Consumer demand for products containing cannabidiol (CBD) is on the rise across the country, with industry experts estimating that the market for CBD products will reach $20 billion by 2024. This boom in consumer demand has outpaced the regulatory framework surrounding these products. While the 2018 Farm Bill decriminalized hemp, it left much up to individual states and preserved the FDA’s jurisdiction over dietary supplements, foods and cosmetics. The FDA has not yet issued any specific rulemaking for CBD products.

The structure of cannabidiol (CBD), one of 400 active compounds found in cannabis.

Against this background, it is not surprising that consumer class actions regarding hemp-derived CBD products are flourishing. Over the past year alone, the plaintiffs’ bar has filed approximately twenty putative class action lawsuits against manufacturers of hemp-derived CBD products. The cases are primarily in federal court in California and Florida, with additional cases in Illinois and Massachusetts. Plaintiffs challenge the marketing and advertising of a variety of CBD products, including oils, gummies, capsules, creams, pet products and more.

The cases so far follow a familiar pattern seen in prior consumer class actions, especially in the food and beverage industry. Read on to learn what plaintiffs have claimed in the CBD lawsuits, how companies are defending their products, and how best to position your hemp-derived CBD products in light of lessons learned from past litigation.

What These Lawsuits Are Claiming, and How Companies Are Defending Their Products

In most of the recent CBD lawsuits, plaintiffs claim either that: 1) product labels over- or understate the amount of CBD in the products; and/or 2) the sale of CBD products is inherently misleading to consumers because the products are purportedly illegal under federal law. Regardless of which theory underlies the claims, plaintiffs typically frame their claims as consumer fraud, false advertising, breach of warranty, unjust enrichment, and/or deceptive trade practices.

In most cases, defendants have filed motions to dismiss seeking to have the cases thrown out. In these motions, defendants argue that plaintiffs’ claims are “preempted” by the Federal Food Drug and Cosmetic Act (FDCA), and that only the federal government can enforce the FDCA. Some defendants have additionally argued that if the court is not prepared to dismiss the claims as preempted, the doctrine of “primary jurisdiction” applies. This means that the issues raised regarding CBD are for the FDA to decide, and the cases should be stayed until the FDA finalizes and issues rules on products containing hemp-derived CBD. Many defendants have also advanced dismissal arguments for lack of standing, claiming that the individuals bringing the lawsuits are trying to sue for conduct that never harmed them personally (e.g., because they never purchased a particular product), or will not harm them in the future (e.g., because plaintiffs have stated they will not buy the product again). The standing arguments often apply to particular claims or products within the lawsuit, rather than to the lawsuit as a whole.

Current Status of the Cases

Of the approximately twenty consumer class actions filed over the last year, about half remain pending:

Five have been stayed pursuant to motions filed by defendants;
Two have motions to dismiss pending;
One has a pending motion to vacate a default judgment against defendants;
One was filed earlier this month, and defendant’s deadline to respond has not yet elapsed.

To date, none of the cases (currently pending or otherwise) has proceeded to discovery, and no class has yet been certified. That means that no court has yet determined that these cases are appropriate to bring as class action lawsuits, rather than as separate claims on behalf of each individual member of the putative class. This is significant, because plaintiffs’ ability to achieve class certification will likely influence whether these CBD lawsuits will continue to be filed. Consumer fraud cases like these typically do not claim any physical injury, and the monetary damages per individual plaintiff are relatively low. As such, the cases often are not worth pursuing if they cannot proceed as class actions.

Of the cases that are no longer pending, all but two were voluntarily dismissed by plaintiffs. While the motivation behind these dismissals is not always announced, approximately half of the voluntary dismissals came after defendants filed a motion to dismiss, but before the court had ruled on it. One Florida case was mediated and settled after the court denied defendant’s motion to dismiss.¹ A California court spontaneously dismissed one matter (without the defendant having filed any motion) due to a procedural defect in the complaint, which plaintiffs failed to correct by the court-imposed deadline.²

Early Outcomes on Motions to Dismiss

Of the thirteen motions to dismiss filed to date, only five have been decided. So far:

No court has dismissed a case based on federal preemption grounds. Courts have either deferred ruling on preemption, or denied it without prejudice to re-raising it at a later time.
Four courts have stayed cases based on primary jurisdiction.³
Only one court has denied the primary jurisdiction argument.⁴
Standing arguments have been successful in three cases,⁵ and deferred or denied without prejudice to later re-raising in the other two cases.⁶ However, the standing arguments applied only to certain products/claims, and were not dispositive of all claims in any case.

These rulings show a clear trend towards staying the cases pursuant to primary jurisdiction. In granting these stays, courts have noted that regulatory oversight of CBD ingestible products, including labeling, is currently the subject of FDA rulemaking, and that FDA is “under considerable pressure from Congress” to expedite the publication of regulations and guidance.⁷

Any label claims need to meet FDCA regulations and applicable FDA guidance.

Plaintiffs may be recognizing the trend towards primary jurisdiction as well, since there is now at least one case where plaintiffs agreed to a stay after defendant filed a motion to dismiss asserting, among other things, primary jurisdiction.⁸ But some plaintiffs are still resisting. For example, in the first case to have been stayed plaintiffs have since filed a motion to lift the stay. The motion—which was filed after the case was reassigned to a different judge—argues that primary jurisdiction does not apply, and that the FDA’s recent report to Congress suggests no CBD-specific rulemaking is forthcoming.⁹ The motion is pending.

Lessons Learned From Food Industry Consumer Class Actions

The motions to dismiss that have been filed to date in CBD-related class actions follow a tried and true playbook that has been developed by defense counsel in other food and beverage industry class actions. For example, the primary jurisdiction arguments that have been gaining traction in the CBD consumer class actions are very similar to primary jurisdiction arguments that were successful years earlier in cases involving the term “natural” and other food labeling matters.¹⁰

Similarly, the standing arguments that have succeeded in the early motions to dismiss CBD consumer class actions followed similar standing arguments made years earlier in food and beverage class actions.¹¹

Work with reputable labs to ensure the potency stated on the label is accurate

The preemption arguments that have largely been deferred in CBD consumer class actions to date could become a powerful argument if and when the FDA completes its CBD rulemaking. The preemption defense has been particularly effective when the preemption arguments focus on state law claims that require defendants to omit or add language to their federally approved or mandated product labeling, or where plaintiffs otherwise seek to require something different from what federal standards mandate.¹² These arguments could be particularly compelling once the FDA issues its long-anticipated rulemaking with respect to CBD products.

Until then, primary jurisdiction will likely continue to gain traction. The FDA’s comprehensive regulatory scheme over food, dietary supplement, drug, and cosmetic products, combined with the FDA’s frequently-expressed intention to issue rulemaking with respect to CBD-products, and a need for national uniformity in how such rulemaking will interface with state requirements, converge to make primary jurisdiction especially appropriate for CBD-related class actions.¹³

How to Best Position Your Products

Until the FDA issues its long-awaited rulemaking regarding CBD products, companies can take the following steps to best position their products to avoid litigation and/or succeed in the event litigation arises:

Work with reputable labs to ensure the amount of CBD stated on product labeling and advertising is accurate;
Ensure that the product is manufactured according to appropriate current Good Manufacturing Processes (cGMPs);
Ensure that any claims made on product labeling and/or in advertising are consistent with FDCA requirements and applicable FDA guidance to date – for example, if the product is a dietary supplement, avoid making express or implied claims that it can cure or prevent disease;
Maintain a file with appropriate substantiation to support any claims stated in product labeling and advertising;
Work with legal counsel to stay abreast of developments in federal and state laws applicable to hemp-derived CBD products, and how any changes might impact potential class action defenses; and
If a lawsuit arises, work with legal counsel to develop a strategy that not only resolves the current litigation as efficiently as possible, but also positions the company strategically for any future consumer claims that may arise.

References

Final Mediation Report, Potter v. Potnetwork Holdings, Inc., 1:19-cv-24017-RNS, (S.D. Fla. July 30, 2020).
Court Order, Davis v. Redwood Wellness, LLC, 2:20-cv-03273-PA-JEM (C.D. Cal. Apr. 10, 2020).
Electronic Order, Ahumada v. Global Widget LLC, 1:19-cv-12005-ADB (D. Mass. Aug, 11, 2020); Memorandum and Order, Glass v. Global Widget, LLC, 2:19-cv-01906-MCE-KJN (E.D. Cal. June 15, 2020); Order Granting in Part Defendant’s Motion to Dismiss and Staying Remaining Causes of Action, Colette et al. v. CV Sciences Inc., 2:19-cv-10227-VAP-JEM (C.D. Cal. May 22, 2020); Order on Motion to Dismiss, Snyder v. Green Roads of Florida LLC, 0:19-cv-62342-AHS (S.D. Fla. Jan. 3, 2020).
Order on Motion to Dismiss, Potter v. Potnetwork Holdings, Inc., 1:19-cv-24017-RNS, (S.D. Fla. Mar. 30, 2020).
Order Granting in Part Defendant’s Motion to Dismiss and Staying Remaining Causes of Action, Colette et al. v. CV Sciences Inc., 2:19-cv-10227-VAP-JEM (C.D. Cal. May 22, 2020); Order on Motion to Dismiss, Potter v. Potnetwork Holdings, Inc., 1:19-cv-24017-RNS, (S.D. Fla. Mar. 30, 2020); Order on Motion to Dismiss, Snyder v. Green Roads of Florida LLC, 0:19-cv-62342-AHS (S.D. Fla. Jan. 3, 2020).
Electronic Order, Ahumada v. Global Widget LLC, 1:19-cv-12005-ADB (D. Mass. Aug, 11, 2020); Memorandum and Order, Glass v. Global Widget, LLC, 2:19-cv-01906-MCE-KJN (E.D. Cal. June 15, 2020).
Order on Motion to Dismiss at 12, Snyder v. Green Roads of Florida LLC, 0:19-cv-62342-AHS (S.D. Fla. Jan. 3, 2020).
Minute Entry, Pfister v. Charlotte’s Web Holdings, Inc., 1:20-cv-00418 (N.D. Ill. Aug. 11, 2020).
Plaintiff’s Motion to Lift Stay, Snyder v. Green Roads of Florida LLC, 0:19-cv-62342-AHS (S.D. Fla. July 13, 2020).
See, e.g., Astiana v. Hain Celestial Grp., Inc., 905 F. Supp. 2d 1013 (N.D. Cal. 2012), rev’d on other grounds, 783 F.3d 753 (9th Cir. 2015); Taradejna v. Gen. Mills, Inc., 909 F. Supp. 2d 1128 (D. Minn. 2012).
See Miller v. Ghirardelli, 912 F. Supp. 2d 861, 869 (N.D. Cal. 2012) (holding that the named plaintiff lacked standing where the products purchased by the putative class members were not “substantially similar” enough to those purchased by the named plaintiff); Colucci v. ZonePerfect Nutrition Co., No. 12-2907-SC, 2012 WL 6737800 (N.D. Cal. Dec. 28, 2012) (finding one of two named plaintiffs lacked standing because, even though the other named plaintiff (his fiancée) purchased the nutrition bars for him, he himself did not purchase any of the bars); Veal v. Citrus World, Inc., No. 2:12-CV-801-IPJ, 2013 WL 120761 (N.D. Ala. Jan. 8, 2013); Robinson v. Hornell Brewing Co., No. 11-2183 (JBS-JS), 2012 WL 6213777 (D.N.J. Dec. 13, 2012) (holding that there was no Article III standing because the named plaintiff had testified and stated in written discovery that he would not purchase the product in the future).
See, e.g., Turek v. Gen. Mills, Inc., 662 F.3d 423 (7th Cir. 2011); Lam v. Gen. Mills, Inc., 859 F. Supp. 2d 1097 (N.D. Cal. 2012); Veal v. Citrus World, Inc., No. 2:12-CV-801-IPJ, 2013 WL 120761, at *9-10 (N.D. Ala. Jan. 8, 2013).
See, e.g., Astiana v. Hain Celestial Grp., Inc., 905 F. Supp. 2d 1013 (N.D. Cal. 2012), rev’d on other grounds, 783 F.3d 753 (9th Cir. 2015); Taradejna v. Gen. Mills, Inc., 909 F. Supp. 2d 1128 (D. Minn. 2012).

June 19, 2020

Cannabis Contracting: The Potential Invalidity Defense Created By Federal Prohibition

By Brett Schuman, Barzin Pakandam, Jennifer Fisher, Nicholas Costanza

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The overwhelming majority of Americans now live in a state where cannabis is legal at the state level for at least some purposes.¹ However, cannabis (excluding hemp) remains criminal under federal law for all purposes. This conflict between state and federal law presents challenges for participants in the state legal cannabis industry, including enforcing their contractual agreements. This is because a number of federal court rulings have called into question whether contracts involving cannabis are enforceable in federal court.

In this article, we explore how federal courts and state legislatures have addressed the enforceability of contracts relating to cannabis and provide some practical tips for cannabis companies to protect their contractual rights.

The “Illegality Defense” in Federal Courts

“No principle of law is better settled than that a party to an illegal contract cannot come into a court of law and ask to have his illegal objects carried out . . . .” Mann v. Gullickson, 2016 WL 6473215 at *6 (N.D. Cal. Nov. 2, 2016) (quoting Wong v. Tenneco, Inc., 39 Cal. 3d 126, 135 (1985)).

Bart St. III v. ACC EnterprisesApplying this principle, a number of federal courts have refused to enforce contracts relating to state-legal cannabis. For instance, in Bart St. III v. ACC Enterprises, LLC, No. 217CV00083GMNVCF, 2020 WL 1638329 (D. Nev. Apr. 1, 2020), the parties entered into a loan agreement wherein the plaintiff-lender, Bart Street III, loaned the defendant cannabis cultivators in Nevada approximately $4.7 million to fund operating costs, pay down debts and purchase land for a cannabis cultivation facility in Nevada. Id. at *1-2. The loan agreement specified that it was governed by Nevada law. The cannabis cultivators defaulted on the loan, and Bart Street III sued for breach of contract and unjust enrichment. The cannabis cultivators argued that they could not be liable for breach of a contract that is illegal under the Controlled Substances Act of 1970, as amended (the CSA). Id. A federal judge in Nevada ruled that certain provisions of the loan agreement (i.e., a right of first refusal provision and another provision concerning disbursement of operating costs) were illegal under federal law and could not be enforced. The judge was unable to decide on summary judgment whether the illegal provisions could be severed from the other parts of the agreement, so on that basis the cannabis cultivators’ summary judgment motion was denied as to the breach of contract claim. However, the judge granted the cannabis cultivators’ motion as to the unjust enrichment claim based on the following reasoning: “Plaintiff cannot prevail for unjust enrichment because the parties’ contract involves moral turpitude. If the Contract is unenforceable, it is because Plaintiff invested in Defendants’ marijuana cultivation business primarily to obtain a pathway to an equity investment therein . . . . Providing funds in exchange for equity violates the CSA because it would allow the investor to profit from the cultivation, possession, and sale of marijuana . . . . Conspiracy to cultivate marijuana is a crime of moral turpitude.”

Polk v. GontmakherThe illegality defense was also raised in Polk v. Gontmakher, No. 2:18-CV-01434-RAJ, 2020 WL 2572536 (W.D. Wash. May 21, 2020), which involved two business partners—Polk and Gontmakher— who owned a licensed cannabis processing facility and retail store through an entity called NWCS. When Polk decided to leave the business, Gontmakher refused to acknowledge Polk’s ownership interest because Polk had a prior criminal record, which violated ownership requirements for cannabis businesses under Washington cannabis regulations. Polk sued Gontmakher for breach of a verbal partnership agreement and sought to recover past and future profits of the cannabis business. Gontmakher moved to dismiss, and the district judge granted the motion: “Mr. Polk’s claim that his requested relief would not require a violation of the CSA defies logic. He is demanding the future profits of a business that produces and processes marijuana in violation of federal law. How does Mr. Polk anticipate NWCS will generate these future profits? The Court cannot fathom how ordering [Gontmakher] to turn over the future profits of a marijuana business would not require them to violate the CSA. And as this Court has previously explained to Mr. Polk, it cannot award him an equitable interest in NWCS because to do so would directly contravene federal law.” Polk, WL 2572536 at *2.

J. Lilly, LLC v. Clearspan Fabric Structures Int’l, Inc.Certain federal district court judges have addressed the illegality defense directly, even when it has not been asserted by the parties. In J. Lilly, LLC v. Clearspan Fabric Structures Int’l, Inc., No. 3:18-CV-01104-HZ, 2020 WL 1855190 (D. Or. Apr. 13, 2020), a licensed cannabis cultivator in Oregon contracted with Clearspan, a lessor of commercial greenhouse equipment located in Connecticut, to lease greenhouse equipment for the facility and also have the facility constructed. After construction began, the cultivator notified Clearspan (and the sub-contractor) of numerous defects in the facility that were impeding cultivation efforts, and after Clearspan allegedly fixed only one defect, the cultivator sued for breach of the agreements and claimed lost profits due to the inability to cultivate cannabis, in the amount of $5.4 million. While Clearspan moved to dismiss the claims on the basis that the cultivator waived any contractual right to consequential damages, the District Court raised the issue of the illegality of the contracts under federal law sua sponte at oral argument. After supplemental briefing on the issue, the Court held that “awarding Plaintiff damages for lost profits [for the sale of cannabis] would require the Court to compel Defendants to violate the [CSA…and] provides an independent basis to dismiss Plaintiff’s lost profits claim in addition to” the issue of waiver, and other merits issues. Id. at *11-12.

And in Ricatto v. M3 Innovations Unlimited, Inc., No. 18 CIV. 8404 (KPF), 2019 WL 6681558 (S.D.N.Y. Dec. 6, 2019), Ricato (an investor) and M3 (the intended cannabis operator and licensee) entered into an agreement to purchase a plot of land in California for M3 to develop as a cannabis processing facility. The investor sued to enforce the investment instrument, and M3 moved to dismiss. The court granted M3’s motion to dismiss on other grounds but noted that “it is not readily apparent to the Court that it could [even] enforce such a contract [as] ‘[m]arijuana remains illegal under federal law, even in those states in which medical marijuana has been legalized,’” such as California. Id. at *5, n.4.

Ricatto v. M3 Innovations Unlimited, Inc.However, under some circumstances a federal court may enforce a cannabis contract. In Mann v. Gullickson, Mann loaned Gullickson money to be used in a cannabis-related business. The agreement was governed by California law. When Gullickson defaulted on the promissory note, Mann sued for breach of contract. Gullickson asserted that the contract was illegal under federal law and moved for summary judgment. In an order denying Gullickson’s motion, the court said that “even where contracts concern illegal objects, where it is possible for a court to enforce a contract in a way that does not require illegal conduct, the court is not barred from according such relief.” 2016 WL 6473215, at *7.

Federal courts are wary of parties seeking the enforcement of cannabis contracts. If there is any possibility that the issuance of a court order enforcing the contract would result in a party violating the CSA, federal courts are likely to deny relief.

State Laws Protecting the Enforceability of Cannabis Contracts

At the state level, legislatures in some states that have legalized cannabis for adult use have enacted laws to protect the enforceability of cannabis contracts. These statutes specifically exempt commercial cannabis activities from general laws voiding contracts that are in furtherance of illegal activities. Examples of these state laws include:

Massachusetts: In December 2016, Massachusetts enacted a statute providing that “[c]ontracts pertaining to marijuana enforceable” and providing that contracts entered into by cannabis licensees or their agents, or by landlords of cannabis licensees, “shall not be unenforceable or void exclusively because the actions or conduct permitted pursuant to the license is prohibited by federal law.” (Mass. Gen. Laws ch. 94G, § 10)

California: In January 2019, California enacted a statute providing that “commercial activity relating to medicinal cannabis or adult-use cannabis conducted in compliance with California law and any applicable local standards, requirements, and regulations” shall be deemed the lawful object of a contract and not contrary to law or against public policy, notwithstanding any law that requires all contracts have a “lawful object” under state or federal law. (Cal. Civil Code § 1550.5)

Nevada: In 2016, a ballot initiative was passed in Nevada, which was then codified under state law, declaring “[i]t is the public policy of the People of the State of Nevada that contracts related to the operation of marijuana establishments under this chapter should be enforceable,” and that such contracts “shall not be deemed unenforceable on the basis that the actions or conduct permitted pursuant to the license are prohibited by federal law.” (N.R.S. § 678B.610).

Similar statutes have been enacted in other states, including in Oregon (January 2018), Michigan (December 2018), Illinois (June 2019) and Colorado (January 2020). See Or. Rev. Stat. § 475B.535 (In Oregon, “[a] contract is not unenforceable on the basis that” commercial cannabis activity legal in Oregon is illegal under federal law); Colo. Rev. Stat. § 13-22-601 (similar to Oregon); Mich. Comp. Laws § 333.27960 (Public policy in Michigan is that “…contracts related to the operation of marihuana establishments [are] enforceable.”); 410 Ill. Comp. Stat. § 705/55-75 (similar to Michigan).

However, many states that have legalized cannabis do not have statutes exempting contracts relating to cannabis activities from the illegality defense.

Contracting Tips for Cannabis Companies

Notwithstanding the uncertainty and inherent risks caused by the conflict between federal and state law, there are certain steps parties entering into commercial cannabis agreements can take to protect their contractual rights, including:

Always include a forum selection clause specifying resolution of disputes in state court and waiving any right to remove the dispute to federal court.
If entering into an agreement in a state that has enacted a statutory provision exempting cannabis contracts from the illegality defense, consider selecting that state’s law (as opposed to New York or Delaware law, which are often the jurisdictions of choice for transactional lawyers who don’t know better) in a choice of law provision.
If neither the parties nor the performance of the agreement have any nexus to a state that has enacted a statutory provision protecting the enforceability of cannabis contracts, consider incorporating the contracting entity in one of those states. In the same way that Delaware is the jurisdiction of choice for incorporating most companies, a state like California may on balance be the better choice for cannabis industry participants due to the legal recognition of commercial cannabis activity.
Consider using an arbitration clause in commercial cannabis agreements. These clauses require parties to arbitrate disputes that may arise in connection with the agreement. As a general rule, arbitration is both more efficient and less expensive than litigation, and arbitrators are less likely than federal judges to refuse to enforce an agreement because it relates to federally illegal cannabis activity.

Conclusion

Notwithstanding expanding legalization at the state level, and general federal tolerance of the state-legal cannabis industry, federal courts remain a dangerous place for cannabis companies. If possible, cannabis companies should specify state court (or arbitration) for resolution of disputes in their contracts, and they should choose a state law that expressly excludes cannabis contracts from the illegality doctrine.

References

Cannabis is legal for medical purposes in 33 states plus the District of Columbia; cannabis is legal for adults over 21 in 11 states plus the District of Columbia. Approximately 76.5% of the population of the United States lives in a state with some form of legal cannabis. See https://www.census.gov/data/tables/time-series/demo/popest/2010s-state-total.html#par_textimage_1574439295. This figure excludes Texas, which has a limited medical cannabis program as of this writing. However, if Texas is included, then over 85% of the population lives in a state with some form of legal cannabis.

May 16, 2020

Solutions & Alternatives to Bankruptcy for Cannabis Businesses

By Richard Ormond

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A Cannabis Related Business (or CRB), whether a plant-touching operation or a provider of goods and services to plant-touching operations cannot seek protection from the bankruptcy court as it is a federal court and cannabis remains illegal at the federal level. As such, a CRB does not have the benefit of a court approved restructuring as provided by Chapter 11 of the Bankruptcy Code and does not receive the benefit of an orderly liquidation as provided by Chapter 7 of the Bankruptcy Code. However, alternatives to bankruptcy do exist and are available to a CRB.

Historical Considerations

Before the emergence of the Bankruptcy Code, businesses and their creditors had very few options available to undertake a court-supervised restructuring or liquidation other than seeking the appointment of a court neutral, typically called a receiver or special master. That “neutral” would take the business or its assets into “legal custody” or custodia legis and begin the process of dissolving the entities, selling the assets or otherwise sell the business as a going-concern. In the 1880s and 1890s with the Gilded Age coming to an abrupt halt, this process was successfully used to restructure and recapitalize the failing network of over-extended railways and rail lines, leading to the consolidation in the market that remains to this day.

Cannabis businesses can be legal and now an “essential” business but, still cannot receive the benefits of bankruptcy court.During the Great Depression, the federal judiciary established “reference” courts to deal specifically with bankrupt businesses and individuals laying the foundations for the modern bankruptcy code which is still in effect today. Many of those first precedents used to establish the bankruptcy code and rules were drawn directly from the receivership case law and receivership statutes ever-present in the historical record of common law cases and common law countries, reaching all the way back to the Courts of Chancery in Britain established soon after the Norman invasion of the British Isles in 1066.

In the United States, the equitable power of courts to initiate receiverships or other insolvency proceedings and crafting orders and decrees based on equity, as opposed as based on law or statute, is codified clearly in Article III of the United States Constitution. Today, receiverships and special masters are still utilized by state and federal courts to remedy unique circumstances where a simple bankruptcy cannot address the inequities presented in that case.

State Court Powers & Financing of Receivership Estates

State courts in particular, and California especially, have a wide body of case law supporting the equitable powers of the court, the quasi-judicial immunity of the receiver and the many equitable tools available to receivers. These powers include the negotiation and transfer of liens, with liens attaching to proceeds of sales of assets, the dissolution of a business and the establishment of a claims process akin to a bankruptcy or assignment for benefit of creditors.

One of the many overlooked powers of a receiver is their ability to bring in outside financing or capital to fund the receivership estate to maintain a business as an ongoing concern or to provide short term leverage so that assets can be properly maintained, “dusted off” and sold.

This process of bringing in new capital is typically done by the issuance of receivership certificates. These certificates are approved, ahead of time, by the court and courts can authorize that such certificates prime all other claims (including sometimes administrative claims) and that these certificates can be reduced to a security interest recorded against real or personal property.

The Mechanics of a Receivership

However, because cannabis is approved at the state level, state courts retain their equitable powers and the power to appoint a receiver over a business in need of restructuring or liquidation. There are many avenues to get to court for this benefit, but the primary path to a receivership is either through a creditor (or group of creditors) filing a lawsuit and seeking the appointment of a receiver. This scenario can be done through cooperation and stipulation but can be hostile as well. The receiver option is available and open to address the needs of insolvency for this rapidly expanding industry.Or, a legal entity, can seek dissolution protection from the state court and seek a neutral dissolution officer (a receiver) to manage that process which may include the infusion of new capital through receivership certificates, the sale of assets to third parties, the negotiation and payment of liens and claims through a claims process and the final restructure of dissolution of the legal entity in a manner similar to a bankruptcy or assignment for benefit of creditors. This voluntary petition is permitted by statute and case law and is a mechanism available to a business that is unable to file for bankruptcy protection but is in dire need of court supervision and authority to work through its insolvency problems. Further, by court order, a receiver is able to establish banking relations where a CRB may be unable.

Typically, it is recommended that any receivership filing whether by creditors, claimants or the business itself, be guided by a well-written, explicit order that outlines the parameters of the receivership, the funding requirements and limits, the rights of claimants and some sort of stay of claims against the receivership estate to give the receiver the time needed to work through all of the issues in that receivership estate. Further, outside funding can be pre-approved by the court and the priority of that funding can be established through the open process that the court provides, much akin to a debtor in possession (DIP) financing motion in bankruptcy court.

Because of the unique circumstance that CRBs find themselves in here in California, where they are a legal and now an “essential” business but still cannot receive the benefits of bankruptcy court, the receiver option is available and open to address the needs of insolvency for this rapidly expanding industry.

February 17, 2020

Dank Until Gone Dark: The State of Corporate Insolvency for Cannabis Businesses

By Aaron L. Hammer, David S. Ruskin, Nathan E. Delman

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Two thirds of all states and the District of Columbia have, to varying degrees, legalized cannabis. With the recent addition of Illinois, eleven states now allow adult recreational use. But cannabis entrepreneurs’ rush of excitement and dreams of cashing in is met with fierce competition and economic risks that makes the dreams, which look so dank at first, end up going dark, or in other words, out of business.

This article discusses the available options for a cannabis business that finds itself on hard times and in need of reorganizing its debts or liquidating altogether. With the federal status of cannabis remaining illegal, cannabis businesses must clear significant hurdles to achieve success. Among the many other pitfalls traditional business owners experience, a cannabis business must navigate limited access to financial institutions and its related security concerns of keeping large amounts of cash on location. Also, they cannot deduct ordinary and necessary business expenses for federal income tax purposes. Turning a profit in legal cannabis can be a big challenge.

The first thought for a business facing insolvency is bankruptcy. However, bankruptcy courts have not been welcoming to cannabis businesses. Bankruptcy courts are courts of federal jurisdiction, and the federal government is represented by the United States Trustee Program (UST), which is the division of the Department of Justice responsible for oversight of Bankruptcy Courts. Since cannabis remains illegal under the Controlled Substances Act of 1970 (CSA) as a Schedule I controlled substance, it is unsurprising that the UST creates roadblocks for those seeking relief. In fact, the UST currently and steadfastly seeks dismissal of cases against cannabis businesses, cannabis employees and landlords of cannabis businesses.

But all hope is not lost. First, a change at the head of the DOJ could have a significant effect on how these cases are handled, even without a reclassification of cannabis. Second, recent caselaw shows a willingness by the courts to forge a path allowing cannabis cases to survive. Finally, if federal bankruptcy protection is not an option, other state remedies may be available to unsuccessful cannabis ventures.

The UST’s prosecutorial discretion has a strong influence in how a bankruptcy case can develop. While still very difficult to predict, a compelling analogy for cannabis cases can be seen in how the UST dealt with same-sex marriages in 2011. Nine years ago, the Defense of Marriage Act (DOMA) governed, and Section 3 of DOMA¹ defined marriage as “a legal union between one man and one woman as husband and wife.” In In re Gene Douglas Balas and Carlos A. Morales, a same sex couple filed a Chapter 13 petition in California, and the UST filed a motion to have the case dismissed. The UST sought dismissal of the joint bankruptcy case, arguing the couple did not qualify for a joint petition under 11 USC § 302(a) because they were in a same-sex marriage. The bankruptcy court denied the UST’s motion. The bankruptcy court in Balas based its opinion partially on a letter from then United States Attorney General Eric Holder, with President Obama’s support, reasoning that Section 3 was unconstitutional as it applied to legally married same-sex couples. The UST appealed the case to the Ninth Circuit Court of Appeals, however, the UST did an abrupt about-face and dismissed its appeal. In fact, the UST took a further step by publicly stating it would not seek dismissal of any joint bankruptcy filed by a legally married same-sex couple. Similarly, if today’s executive branch decides not to enforce the CSA in bankruptcy court, cannabis businesses in compliance with state law would have access to bankruptcy courts.

Many businesses have pushed the bankruptcy courts to use a similar public policy approach to allowing cannabis businesses to seek debt relief, but it is proving to be a far stickier issue. Bankruptcy Courts have routinely dismissed cases with both direct and indirect relationships to the cannabis industry. The UST has taken a stance firmly against affording relief with any type of connection to cannabis. In an April 2017 letter to Chapter 7 and Chapter 13 trustees, the Director of the UST put it bluntly: “[i]t is the policy of the United States Trustee Program that United States Trustees shall move to dismiss or object in all cases involving marijuana assets on grounds that such assets may not be administered under the Bankruptcy Code even if trustees or other parties object on the same or different grounds.”

Indeed, one can fairly point out a significant difference between allowing a same-sex couple to file a joint bankruptcy. The practical significance of allowing same-sex couples to file jointly is the loss of a filing fee to the bankruptcy court, whereas a cannabis company’s liquidation creates a situation where a Chapter 7 trustee would have a fiduciary duty to liquidate a controlled substance, effectively violating federal law.

However, the UST shows equal hostility to cases involving downstream cannabis businesses such as landlords and even certain gardening suppliers, where there is no risk of cannabis itself becoming property of a bankruptcy estate. A Colorado District Court affirmed a bankruptcy court’s dismissal of a holding company for purported CSA violations.² The Court reasoned that since the company owned stock for a large hydroponic gardening company, it willfully aided and abetted criminal activities.

While the federal executive branch is decidedly opposed to the cannabis debtor, one hope for reform lies with the judicial branch. To this end, the Ninth Circuit handed the biggest victory to date to a downstream cannabis business in Garvin v. Cook. Based on a microscopically close reading of the Bankruptcy Code, the Ninth Circuit held that a reorganization plan which relies partially on money from cannabis does not equate to a plan being “proposed by means forbidden by law” because the statutory text of one section cannot mean “all applicable law” or else the language in a closely related section that “the plan complies with the applicable provisions of this title” would be surplusage.

But this victory has not created much daylight for cannabis ventures seeking to utilize bankruptcy courts. Notably, Garvin could have gone a different direction if the UST had revived a motion to dismiss for gross mismanagement of the estate, which is how most Chapter 11 cannabis cases are dismissed. Indeed, in the weeks following the Garvin decision, two lower courts declined to blaze a new trail, and instead distinguished its cases from Garvin, dismissing debtors with equally indirect ties to cannabis.

Bankruptcy courts have shown significantly more latitude for legal hemp companies. In a promising decision, In re Royalty Properties, LLC, a Northern District of Illinois Bankruptcy Court took no issue with the legality of a debtor growing hemp seeds. The court took pains to distinguish hemp from its psychoactive relative marijuana and based its ruling on the 2018 Farm Bill which effectively legalized hemp. The court even denied as unnecessary an order to approve contracts to grow hemp, stating its approval was not necessary. Ultimately, the reorganization failed for reasons unrelated to growing hemp. Nevertheless, the case does show a step toward tolerance. Now that CBD giant GenCanna Global has filed a Chapter 11 in Kentucky, the UST’s tolerance will be put on full display.

The United States Trustee Program is a part of the United States Department of Justice

Also, it is worth noting that the unwillingness of bankruptcy courts to take on cannabis cases cuts both ways. Creditors of cannabis businesses, already taking on a certain amount of risk for dealing with borrowers who cannot use depository institutions in a traditional way, also have been prevented from banding together and filing an involuntary bankruptcy against cannabis businesses.

Fortunately, legal cannabis businesses facing insolvency have options aside from federal bankruptcy to deal with debt issues.

An assignment for the benefit of creditors proceeding (ABC) presents one very workable option. In an ABC, a distressed company selects an “assignee” to liquidate the debtor’s assets via state law and distribute the proceeds to the creditor’s benefit. Depending on whether the assets include cannabis, the assignee will likely have to comply with applicable state law to be able to legally liquidate the asset. Nevertheless, an ABC might be the best solution currently available for cannabis companies seeking debt relief.

Another option is a corporate receivership where a disinterested third party, typically an attorney, is appointed to take control of an ailing business. The receiver takes over management of the company and can liquidate the company’s assets. Receiverships present certain advantages over bankruptcy proceedings. They allow for greater flexibility in decision making because the receiver is not bound by the confines of the Bankruptcy Code. Receiverships can be more cost effective, due to less court involvement and administrative expenses. For creditors, there is the advantage of potentially deciding on the receiver. Also, the receiver, unlike a Chapter 7 trustee, does not bear the imprimatur of any government, and is not a public officer within the meaning of a constitutional or statutory provision relating to public officers. Oregon and Washington have both amended their receivership statutes to ensure that cannabis businesses can effectively manage debt without receivers running the risk of violating the law. Ideally, other legal states will follow suit to ensure this remedy is available to cannabis businesses.

Finally, another bankruptcy alternative would be a friendly foreclosure under Article 9 of the Uniform Commercial Code (UCC). Unlike the Bankruptcy Code, the UCC is not federal law, but is adopted individually by each state. Again, considering the secured lender is required to comply with state law, this is another instance where amending state statutes could provide great assistance to a struggling cannabis business and its secured creditors.

Legal options for insolvent cannabis businesses is a new challenge. Society is trending in the direction of a more permissive attitude toward cannabis, so it should follow that the legislatures and courts accept this shift and afford distressed cannabis businesses the same opportunities to reorganize or orderly liquidate just like other legal business entities.

References

DOMA was ruled unconstitutional in 2013 US v. Windsor, 133 S. Ct. 2675 (2013).
See In re Way to Grow, Civil Action No. 18-cv-3245-WJM, 2019 U.S. Dist. LEXIS 207846 (D. Colo. Sep. 18, 2019)

July 30, 2019

Sweden Joins Italy In Path To Defining CBD Oil Regulations

By Marguerite Arnold

2 Comments

The highest court in Sweden has weighed in on the novel food, and the darling of the Swiss marketplace, CBD conversation. Further, it has done so in a move that seems predetermined to push the so-far escalating novel food debate EU-wide. Along, of course, with what constitutes “narcotic” cannabis.

Namely, Sweden’s highest court ruled in June that CBD oil with any concentration of THC falls under the narcotic jurisdiction.

Sound confusing? Welcome to the world of every CBD producer and purveyor on the “right” side of the Atlantic.

Beyond The Lingo and Legal Mumbo Jumbo

When one follows the logic, there is one, hidden in the Swedish meatball of careful legal wording. Here is a translation, more or less of what the court intended.

The first is that the Swedes, along with the Italians (and expect this attitude to be reflected all over Europe) accept that cannabidiol when it comes from hemp, if not CBD oil derived from the same, generally, is excluded from the definition of cannabis (as a narcotic). Therefore it is not a narcotic drug.

However, according to the court, the loose definitions of what “CBD oil” is both legally and in the marketplace, no longer applies if the plant has been converted into a preparation containing THC. This is a clear shot across the bow of the “Cannabis Lite” movement that has been so popular across the continent for the last year or so and has absolutely electrified certain regions (see not only Switzerland but the UK and Spain).

This has added to the sky-high evaluations of the cannabis industry (or even the CBD part of it) in certain industry predictions, rosy scenarios and forward-looking statements.

However, in a nod to reality, the court also recognized that there is an exemption for trace amounts of CBD in the current frameworks, although it is indeterminate. In other words, this is a move to force regulators to determine what trace levels of THC are permitted. And further, to force regulation and licencing of the so-far, fairly free-wheeling industry that hoped, much like Holland, to establish itself in the grey spaces between the regulatory schematic of Europe.

No dice. See Holland of late. But also see Italy, Austria and Germany.

For those who still held out a vague dream of hope that this whole issue was going to go away, or get swept under the carpet of anti-regulatory Brexit mania (in the British case), think again.

In the Swedish situation, much like the Italian CBD caper, the individual at the heart of the court case was a man who escaped a minor drug charge for possession of CBD oil. However, the message is clear: Large scale distribution of CBD oil with “undeterminable” levels of THC (essentially all of it in the market until the rules are set), is courting a criminal drugs charge.

Look for licensing definitions soon.

What Does This Say About The CBD Future In Europe?

Much of this debate is also caught up in larger issues, namely labelling. The British, for example, have just seen recalls at some of the largest supermarkets in the country because of the same. It is a hot topic in several places.

Europeans, in general, and this includes the British, are generally also horrified at how Americans in particular, consume food and other products exposed to chemicals they know are toxic. However common chlorinated chicken is in the U.S., for example, this is a discussion as toxic to all Europeans, including the British, as well, chemically treated anything.

This is also a reflection of the much “greener” lifestyle Europeans aspire to lead (even with bizarre gross-outs like “fatbergs” in the Victorian recesses of London sewers). Even if they have not managed it yet, here. Climate change denial, especially in mostly air-conditioner free Europe, and especially this summer, is a rare concept indeed.

The novel food issue where it crosses with cannabis, in other words, has just popped up again, in Sweden. And given its proximity to not only recent legal decisions on the same, especially by their neighbors, if not on the calendar, the industry and all those who hope to chart its projections if not successfully surf its market vagaries, need to take note if not adjust accordingly.

June 10, 2019

The Sale Of Cannabis Sativa Derived CBD Becomes A Crime In Italy

By Marguerite Arnold

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For all the excitement about the “CBD” or “Cannabis-Lite” possibilities in Europe thanks to Switzerland over the last few years, the reality as of 2019 is proving to be a little different.

As of the end of May, Italy’s top court, the Court of Cessation, ruled that selling derivatives of cannabis sativa (from the buds and leaves to oils and resins) is illegal. Hemp of course, is excluded from this decree. And in fact, this decision was intended to close a loophole that was created in 2016 for so-called “Cannabis-Lite.” In other words low THC, CBD products and extracts that are showing up in the market as is or as an ingredient in something else (from food to makeup).

While this development is certainly a blow to those who were not in the know already, it is hardly surprising– especially given current events next door. German authorities just declared that they could find no use for “CBD”. This of course confuses the issue even further (since CBD is obviously found in both hemp and cannabis sativa.) Austria did the same thing late last year- and further did so on a level unseen anywhere else in Europe (namely putting cosmetics on the list too).Novel food regulation, at its heart, is all about the source of the plant and how it is processed.

In fact, and certainly in comparison, far from being nebulous, Italy appears to have taken, surprisingly, a rather scientific, if not clear-headed, approach to the issue in general. Not to mention a step that is absolutely in line with current EU policy on the same.

Novel food regulation, at its heart, is all about the source of the plant and how it is processed. This entire discussion about CBD falls squarely within that- although of course, hardly limited to just this one cannabinoid or in fact, plant genus.

What Should Investors Be Aware Of?

There is, as always, a hype around CBD. That is true in almost every legalizing market, but Europe, with a much stricter regional regulatory regime and at least a four-year path to recreational, has seen an odd twist in all of this for the last two years.

There is the potential for a CBD play in Europe, but it is niche, and country-by-countryIn the EU, the distinction between hemp and cannabis-derived cannabinoids (including but not limited to THC), is a well-known fact for those with any stripes in either the cannabis, or beyond that, mainstream food and drug industry. The largest confusion, in other words, is strictly at the lower rungs of the biz. Not to mention all foreigners.

Proof of the same? Purvey the contents of even the most wide-ranging Dutch Seed shop catalogue, and you will be hard-pressed to find non-hemp products. And even though such entities know how to get around loopholes themselves (starting with the online sale across Europe of cannabis seeds from all over the world), novel food is not a regulation even these cannabis entrepreneurs want to cross.

In other words, there is the potential for a CBD play in Europe, but it is niche, and country-by-country in an environment where both local and regional rules are shifting. And further are likely to do so for some time to come.

And in the meantime, those who make the grade, are certainly freed from one pressing if not looming question. The market in Italy is, in fact, not only far from “illegal,” but opening up both in terms of import and export to cannabis products from all over the world. Including of course, Canada and the United States.

April 30, 2019

Soapbox

Insurers Must Play Catch-Up to Meet Cannabis Industry Needs

By Matt Engle

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As the cannabis industry continues to grow, demand for insurance products is also increasing. While insurers have been cautious about entering a market that carries the stigma of a Schedule I drug, the cannabis industry is clamoring for insurance coverage options tailored to meet the needs of key players— distributors, growers, processors and retail dispensaries.

The escalating need for insurance products tailored to these cannabis business sectors has not expedited an increase in coverage offerings. The slow entry of insurance carriers into the cannabis sector can be tied to a reluctance to insure an industry with emerging and often unknown risks. This will begin to change as more information becomes available on what loss ratio trends look like in the cannabis industry.

For now, there is a wait-and-see stance held by insurance carriers. This presents a major concern for cannabis-related businesses that are subject to risk at every stage of the supply chain, with particular exposure for theft, general liability, crop loss, and product liability.some degree of crime and theft coverage is needed for these enterprises to help manage the risks associated with a cash-based business

Theft

For cannabis companies, the use of paper currency is a huge part of their risk exposure. Federal banking regulations have limited these businesses to dealing mostly in cash, which makes them a prime target for crime and fraud. Currently, only one carrier will insure coverage for cash and theft risk, and the policy is limited to $1 million for most risks. This is inadequate coverage since many operators have more than that amount on-site.

In states with legislation legalizing cannabis, the cannabis sector will be able to move away from operating in cash if Congress passes the Secure and Fair Enforcement (SAFE) Banking Act, which would protect financial institutions from liability for federal prosecution that could arise from servicing cannabis-related businesses authorized under state law. Until banking regulations give the cannabis industry the ability to operate as legitimate businesses with the stability and safety that would deter criminal activity, some degree of crime and theft coverage is needed for these enterprises to help manage the risks associated with a cash-based business.

General Liability

Cannabis-related businesses need the same general liability coverage as other businesses to protect their premises and operations from lawsuits involving public contact. However, standard general liability policies—which exclude Schedule I substances from coverage—were not created with cannabis businesses in mind. It is still difficult for these businesses to obtain adequate general liability as a result of the legal uncertainty associated with the industry.

Product Liability

Product liability exposures for cannabis businesses encompass a wide range of areas, including edibles, vaporizers, pesticides, mold/fungus, misrepresentation, label claims, breach of warranty, deceptive practices, and failure to warn.

A major area of exposure concerns accidents resulting from impairment. A cannabis cultivator, processor, distributor, or retailer potentially may be considered liable in the event a product defect results in injury after reasonable use or when label defects fail to warn users that a product may have psychoactive effects.

Another area of risk exposure involves products that contain THC, the psychoactive compound that gives cannabis users a high. As the number of THC-containing products such as edibles and tinctures increases, so does the potential exposure to product liability claims for manufacturers and retailers.

The California Cannabis Track-and-Trace (CCTT) system also has implications for product liability. The CCTT is a statewide system used to record the inventory and movement of cannabis and related products through the commercial supply chain. All state cannabis licensees, including those with licenses for cultivation, manufacturing, retail, distribution, testing labs and microbusinesses, are required to use this system. The product liability impact lies in its capacity to determine responsibility along the supply chain from seed to sale.

For example, if a plastic vape pen explodes, a product liability lawsuit could have repercussions for many touch points across the supply chain beyond the manufacturer of the pen–all of which can be identified through CCTT. Entities that touch cannabis products such as soil suppliers or delivery persons also have product liability risk exposure. Personal injury attorneys can find incident-related parties easily and determine liability. This makes it particularly important to add these parties to the policy as additional insureds to help reduce claims exposure.

Crop Loss

Another area of concern for risk exposure is crop loss. Crop insurance is generally hard to obtain due to the significantly different nature of cannabis crops compared to traditional crops like corn or soybeans.

Fires in Sonoma County devastated cannabis crops in Northern California back in 2017.

An indoor crop insurance policy covers cultivators when there is loss resulting from threats such as fire, theft, and sprinkler leakage. However, crop insurance policies generally do not cover losses resulting from mold, rot, disease, changes in climate, or fertilization issues. Many growers forgo this coverage and instead elect to absorb losses and regrow their crops.

Outdoor crop coverage is generally unavailable, or the cost is prohibitive. Any potential for writing outdoor crop insurance for the cannabis industry essentially disappeared as a result of the recent wildfires in California. These devastating fires highlighted the pressing need for property damage and business interruption coverage for growers and dispensaries and other downstream businesses whose supply was disrupted. This lack of available outdoor crop insurance is one of the more notable gaps in available cannabis business insurance coverage.

While cannabis businesses operating in states that have legalized medical and/or recreational cannabis use have challenges getting adequate insurance coverage, there is some good news on the insurance front for those in California. Last year, California’s insurance commissioner announced approval for carriers to offer insurance coverage specifically to cannabis businesses. The state also approved a cannabis business-owners policy (CannaBOP) program that provides a package policy containing both property and liability coverage for qualifying dispensaries, distributors, manufacturers, processors and storage facilities. Colorado is on the verge of being the second state to approve its version of a CannaBOP program.

While more insurance carriers are beginning to write cannabis coverage, the limited insurance options and policies with restrictive plans currently offered todaydo not meet the needs of the cannabis industry. Insurers must catch up to the coverage requirements of this sector by offering more options tailored to growers, retail dispensaries, processors and distributors with better terms and better pricing.

April 22, 2019

Soapbox

Interstate Hemp Transportation: A Cautionary Tale

By Robert M. Kline

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Two bags are sitting on the table in front of you. The first bag contains legal hemp. The second one contains illegal marijuana. Can you tell which is which? Neither can state troopers at a traffic stop.

On January 24, 2019, Dennis Palamarchu, an interstate truck driver, had 6,700 pounds of hemp in his rig. Mr. Palamarchu had picked up the load at Boones Ferry Berry Farms in Hubbard, Oregon. Before he reached his destination at Big Sky Scientific, LLC (“Big Sky”) in Aurora, Colorado, the Idaho State Police stopped him on I-84, outside of Boise. Mr. Palamarchu indicated that he was hauling hemp. He did not try to run or escape, and he never tried to dispose of the load. The bill of lading showed that the shipment consisted of approximately 7,000 pounds of hemp. The Idaho State Police arrested Mr. Palamarchu for felony trafficking in marijuana.

Around the same time, Pawhuska police in Oklahoma seized over 17,000 pounds of hemp on its way from Kentucky to Colorado. The cargo was valued at about $850,000. A spokesman for the Oklahoma Bureau of Narcotics and Dangerous Drugs Control said, “We don’t know if it is marijuana. We don’t know if it is hemp.”

The recent events in Idaho and Oklahoma are inevitable consequences of the passage of the Agriculture Improvement Act of 2018, Pub. L. 115-334 (“2018 Farm Bill”). The 2018 Farm Bill provides that no state shall be allowed to prohibit the transportation of hemp through the state. However, a product that contains more than 0.3% THC – in the eyes of federal law – is marijuana, not hemp. Unlike hemp, marijuana still is subject to state statutes and the federal Controlled Substances Act. The legal distinction between hemp and marijuana is too subtle for the human eye, or a trained K-9’s impressive nose, and it has created a quandary for interstate hemp shippers like Mr. Palamarchu and Big Sky.

When Idaho State Police seized Big Sky’s hemp, Big Sky went to federal court¹. On February 19, 2019, the United States District Court for the District of Idaho recognized that in the 2018 Farm Bill, Congress legalized the interstate transportation of hemp grown in the United States so long as the hemp was “produced in accordance with subtitle G” of the Agricultural Marketing Act of 1946. However, the federal plan is undeveloped and Oregon does not have a federally-approved plan, so no one knows what it means to be “produced in accordance with subtitle G.” The federal court therefore concluded that Big Sky’s hemp could not possibly have been “produced in accordance with subtitle G.”

The court recognized, “[a]t some future date, industrial hemp that has been ‘produced in accordance with subtitle G’ will undoubtedly be transported in interstate commerce across states like Idaho that have not legalized industrial hemp.” In the meantime, however, the court found that Idaho could keep Big Sky’s cash crop, which sits deteriorating in the possession of law enforcement. Big Sky has appealed to the United States Court of Appeals for the Ninth Circuit.

The hemp market is projected to approach $2 billion by 2020. By then, hopefully, federal law will clarify what it means for hemp to be “produced in accordance with subtitle G.” In the meantime, Idaho’s House of Representatives recently passed a bill that would allow hemp producers from the 41 states that have legalized hemp to transport their crops and products through Idaho, so long as they get a permit from the state and do not unload any of their cargo there. Idaho Senators then added a section to that bill, announcing their intent for Idaho to legalize hemp in time for the 2020 growing season. The House, however, never signed off on the Senate amendments, effectively killing the bill. Until such a bill becomes law, transporters of interstate hemp should consider taking the long way home.

References

Big Sky Scientific, LLC v. Idaho State Police, et al., No. 19-cv-00040-REB, Dkt No. 32 (D. Id. Feb. 19, 2019)

April 15, 2019

Taxes & Cannabis: 280E, R&D Credits, 199A & Qualified Opportunity Funds: Part 2

By Zachary Gordon, Jason Hoffman

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Editor’s Note: This is the second piece in a two-part series delving into tax issues. Part one discussed tax code 280E as it pertains to cannabis businesses. Part two will go into research and development credits, 199A and a discussion of risk as it relates to Qualified Opportunity Zones.

While 280E is the most influential code section for the cannabis industry, structuring never happens in a vacuum. There are many open questions that each business must answer for themselves without court adjudication. We believe that among the riskiest of questions is whether a cannabis business can claim research and development credits.

There is no clear legal authority that either allows these credits or disallows them but certainly utilizing such credits comes at great risk. At the beginning of this article we talked about Congress and the purpose of 280E. Congress’s intention was to make sure that only the minimum required tax deductions were available to Schedule 1 and 2 sellers. A cannabis business receiving a research and development credit would not be with the intension of Congress. While the credits would be computed based on COGS expenditures, at this time we do not believe that a cannabis business should take this credit. Disallowance of COGS would create a constitutional challenge which is why Congress allowed the COGS deduction. Disallowance of Research and Development Credits does not open up the same constitutional issue since the credit is not part of COGS although calculated based on COGS expenditures. 280E states very clearly that credits arising from other code sections are disallowed in the entirety.

More recently the Tax Cut and Jobs Act (TCJA) opened up new issues for cannabis companies that are still unfolding. Two of the most publicized are Qualified Opportunity Funds and Section 199A, the 20% deduction (Qualified Business Deduction).

The 199A deduction allows eligible pass-through entities to claim an additional deduction of 20% of the income (subject to certain limitations) at the individual level potentially lowering the tax rate from 37% to 29.6%. While the American Institute of Certified Public Accountants (AICPA) and others have asked the IRS to clarify if 280E would make a cannabis business ineligible, the final regulations on the subject did not address this issue. There are other significant limitations and hurdles in 199A regulations that any business would have to first pass to be considered for the rate deduction. If a cannabis business meets all other eligibility and limitation criteria, should the pass-through income to their investors be qualified income under 199A? The answer will depend on whether the courts will treat this “deduction” as falling under the general prohibition of 280E.

We believe that there is a reasonable chance that the courts will allow the 199A deduction for cannabis companies. That does not mean, however, that we advise cannabis companies to claim this on their pass-through returns as Qualified Business Income. Much like everything else, it depends on the particular business and the risk profile that management is willing to tolerate. This is one area of tax law that is sure to be challenged in court. The more risk-averse business should pass on claiming this deduction on their returns, but monitor development with an eye to amending at a later date if favorable precedent emerges. If the amounts are large enough, consideration should be given to applying for a Private Letter Ruling, but that also has its own tax risks.

Another new tax incentive that was in the TCJA was Section 1400Z or Qualified Opportunity Zones (QOZ). The incentive allows for the deferral of capital gains until December of 2026. The use of 1400Z also results in up to a 15% decrease in capital gains tax- and tax-free appreciation if all requirements are met. While the IRS has only released proposed regulations and we anticipate significant changes to them when they are released as final, there was nothing in the proposed regulations limiting cannabis businesses from using Qualified Opportunity Funds (QOF) in their structure. It is interesting to note that the TCJA and proposed regulations did list other types of businesses that could not make investments under 1400Z along with all its benefits. Liquor stores, golf courses and sun tan parlors were among those listed but cannabis growers and dispensaries were not.

As the industry continues to mature, new issues and precedents will require CPAs and attorneys to find new solutions to best serve the industry.Using Opportunity Zones to entice investors sounds like a great opportunity, but there are significant risks. The first risk is that the proposed regulations, while currently proposed, may not be final. There is always a chance that the IRS will take a different position when the final regulations are released and add cannabis to the type of businesses that do not qualify. Another risk, and one that was previously mentioned as part of 199A and other areas of structuring, is that the IRS and the courts can always disagree with the taxpayer’s position. This is a new area of tax law and will eventually be litigated. The loss of the Opportunity Zone benefits can significantly change the return to the investors and lead to other issues.

All of these issues come into play when structuring businesses in this industry. These issues must be evaluated as they pertain to the business needs. This can be very complex and requires a great deal of research for each business opportunity. We have found that professionals operating in this industry like to know about all of their options. The most important thing we can do for the industry is to continue to educate the professionals working in it.

Accountants should be available to assist their clients and their clients’ attorneys with structuring techniques aimed at asset protection and minimizing 280E disallowances. Accountants should also be ready to speak to the questions outlined above and be prepared to explain the risks associated with each choice. As the industry continues to mature, new issues and precedents will require CPAs and attorneys to find new solutions to best serve the industry.

April 9, 2019

Taxes & Cannabis: 280E, R&D Credits, 199A & Qualified Opportunity Funds: Part 1

By Zachary Gordon, Jason Hoffman

3 Comments

Editor’s Note: This is the first piece in a two-part series delving into tax issues. Part one discusses tax code 280E as it pertains to cannabis businesses. Part two will go into research and development credits, 199A and a discussion of risk as it relates to Qualified Opportunity Zones. Stay tuned for Part two coming next week!

When building a knowledge base in the cannabis industry as a CPA, one’s tax research typically starts with Internal Revenue Code (IRC) Section 280E. For those that are unfamiliar, 280E is only three lines long. With this in mind, we at Janover realized that we needed to understand the context for this highly influential tax section.

The genesis of 280E dates back to 1981 with a Tax Court case: Jeffrey Edmonson v. Commissioner. The decision in this case was that a seller of cocaine, amphetamines and cannabis could deduct most business expenses, cost of goods sold, packaging, home, phone and automobile expenses relating to the seller’s illegal business.

In 1982, 280E was enacted to reverse the Edmonson decision and deny sellers of Schedule 1 or 2 controlled substances the right to deduct business expenses. Under the Controlled Substances Act, the federal government defined Schedule 1 drugs as drugs that have no currently acceptable medical use and a high potential for abuse. Since cannabis is classified as a Schedule 1 drug, cannabis businesses were unable to deduct most business expenses.

To get a better understanding of what the legislators were trying to accomplish, House and Senate reports provided insight into what their goals might have been. Under the Explanation of Provision, the Senate Report reads:

All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.

As the Senate Report explanation provides, 280E specifically excluded cost of goods sold (COGS) from the disallowance of deductions. This treatment was affirmed by the Tax Court in 2012 in Olive v. Commissioner (139 T.C. 19 2012).

To date, there are not many cases that have dealt with the tax issues of 280E. In a 2007 decision involving Californians Helping to Alleviate Medical Problems (CHAMP), the Tax Court ruled that a taxpayer may deduct expenses allocable to an affiliated business that was separate from the entity “trafficking in a controlled substance.” In CHAMP, the legal caregiving business, which was a separate business, was able to deduct the allocated portion of shared expenses. This set a legal precedent that allowed a taxpayer engaged in the selling of a Schedule 1 or 2 controlled substance to distinguish expenses incurred on behalf of other non-prohibited business lines and deduct these expenses.

In addition to these court cases, tax professionals can rely on IRS Chief Counsel Memorandum CCA 201504011. The IRS Chief Counsel released this memorandum in January 2015 in order to respond to questions the IRS was receiving from practitioners.

Although Chief Counsel Memoranda, in general, may not be cited by taxpayers as precedent, this memorandum is the current and best authority outlining the IRS’s position with respect to the extent to which a cannabis business may deduct business expenses. The memorandum also refers to IRC Section 162, ordinary and necessary business expenses that would be disallowed, as well as separately identifying certain direct and indirect business expenses that would be allowed. Citing methods in Treas. Reg. 1.471, the memorandum states that a cannabis producer may allocate to inventory and COGS direct production costs, including direct material costs (Cannabis seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting, etc.), and transportation or other costs to acquire of the cannabis. It also indicates certain indirect costs that may be taken as COGS.

As the industry continues to mature, more cases are finding their way to the Tax Court. On June 13, 2018, the Tax Court issued a ruling in Alterman v. Commissioner that specifically disallowed the use of 263A under 280E and applied only Section 471 to determine COGS. While we need to follow the facts and circumstances of each case, the broad language used might very well disallow capitalizing of inventoriable costs for companies subject to 280E.

IRC Section 471 is the general rule for inventory accounting for tax. IRC Section 263A is the uniform capitalization rules for tax. Most businesses need to utilize both 471 and 263A when accounting for inventory and to properly capitalize costs into COGS.This opinion may have lasting effects on the part of the industry trying to create brands associated with their cannabis products.

Many resellers and retailers of cannabis thought they could use 263A to capitalize more costs into inventory decreasing their tax burden. The Chief Counsel Memorandum disagreed and more recently the Tax Court in Patients Mutual Assistance Collective Corp v Commissioner sided with the IRS and upheld some of the precedents set in Alterman v. Commissioner. In siding with the IRS, the judge concluded that a taxpayer who is subject to 280E can only deduct costs of goods sold under 471 as the IRC existed when 280E was enacted (in 1982). The taxpayer in the case used two arguments that were not new to the cannabis industry, but to no avail. The first argument was that the business was not trafficking in a controlled substance because the government had abandoned a civil forfeiture action. The second argument that was rejected was that a portion of the business involved branding, marketing and the sales of other non-illegal products. The claimant tried to convince the court that deductions related to these operations should not be subject to the same disallowance of deduction as outlined in 280E.

This second argument is very important for structuring purposes. The court used a significant portion of its opinion to address why the entire business is integrated and completely subjected to 280E. This opinion may have lasting effects on the part of the industry trying to create brands associated with their cannabis products.

This case has even more implications given part of the ruling in which the courts stated that being state licensed in no way effected the Schedule 1 determination at the federal level and, therefore, subjected them to 280E. The judge went so far as to separate the Department of Justice, which enforces the Schedule 1 status of cannabis, and the Department of the Treasury, which has full authority and enforcement rights to treat cannabis as a Schedule 1 drug subject to 280E for income tax purposes. This ruling made it clear that even if the Department of Justice is not pursing criminal charges against state-licensed cannabis businesses the IRS is not precluded from fully enforcing the Internal Revenue Code.