The Regulatory Twilight Zone: California Cannabis Transactions
For years now, I’ve seen and analyzed many different cannabis business relationships across the industry spectrum. Specifically, many proposed and draft agreements have come across my desk detailing the contractual relationships between a variety of parties in the cannabis industry for various purposes–from investors, ancillary services providers, and licensees to intellectual property holding companies, equipment lessors, and lenders (and more). Altogether, I’ve seen lots of different contractual and corporate set ups within a variety of cannabis-friendly states. California, though. takes the cake on the most bizarre and legally questionable cannabis business relationships and contract structures; and that makes sense as California cannabis continues to emerge (sort of slowly) from a gray medical market.
Ultimately, when you think of California’s cannabis marketplace at this point, you can harken back to Rod Serling saying:
You’re moving into a land of both shadow and substance, of things and ideas. You’ve just crossed over into … the Twilight Zone.”
I recently wrote about all the bad behavior that still occurs in California (even with licensing in play) and also about the top 5 most dangerous cannabis contracts in this state, but this post is dedicated to those contractual and corporate relationships and structures I’ve seen most recently in the Golden State that keep coming up again and again. These arrangements either skirt the cannabis rules completely, or make zero sense from a contract and/or corporate governance standpoint. So, if you’re seeing these agreements and structures in the marketplace and scratching your head, you’re not alone.
1. Unlicensed companies operating under another company’s license.
The number of times I’ve seen a licensee allow an unlicensed business to operate within its premises is increasing rapidly in California. In most other states, the regulations make abundantly clear that any company engaged in commercial cannabis activity, no matter what, would require a cannabis license and that you cannot operate an unlicensed cannabis business within the licensed premises of another company. Not so here in California.
Whether it meant to do so or not, the Bureau of Cannabis Control (BCC) created a fairly confusing situation with the adoption of Rule 5032 where it mandates that all commercial cannabis activity can only occur between licensees but at the same time. In its Final Statement of Reasons, the BCC also states that unlicensed parties can have white label and/or intellectual property (IP) licensing relationships with licensees so long as those unlicensed parties are disclosed to the BCC as a financial interest holder. Some parties have taken this a step further to interpret this rule to mean that an unlicensed company, so long as it’s disclosed to the BCC in some capacity, can literally operate its own business within/under/through a licensed company, conducting commercial cannabis activity as if the unlicensed company owns the license. (And things become very confusing from a performance obligation perspective when one of these unlicensed companies is an equity owner in the licensed business, but is also acting as, let’s say, a management company of that licensed business at the same time).
These arrangements, of course, aggressively push boundaries and are untested with the BCC (let alone with local governments). Still, I’m seeing these proposed agreements between licensed and unlicensed parties more and more: unlicensed parties simply do not want to or cannot secure their own licenses, despite conducting all the regulated commercial cannabis activity. I have no doubt that once the BCC finally flips into enforcement mode that it will start really analyzing these relationships to determine who is actually conducting commercial cannabis activity in violation of the rules (probably lots of folks).
2. Licensee contracts with unlicensed parties that operate at a licensed facility.
These kinds of contracts become increasingly tricky because of number 1 above. If you’re a licensee and you’re being presented with a contract from an unlicensed party that’s operating within another company’s licensed premises, you need to proceed with extreme caution. Even if an unlicensed company is disclosed under another licensee as an “owner” or a “financial interest holder,” that doesn’t mean that that company can start undertaking its own commercial cannabis activity carte blanche.
Recall, commercial cannabis activity can only be conducted between licensees. That’s not to say that an unlicensed company cannot assist a licensee with its commercial cannabis activity, but if that unlicensed company is inking its own contracts without any mention of the actual licensee under which it operates, you’re going to have significant regulatory issues in the future (not to mention murky issues around representations and warranties around compliance with the rules, fitness of product, recalls, etc.).
The common relationship I’m now seeing most often is where an unlicensed company is utilizing a cultivation or manufacturing facility and trying to directly contract with licensed distributors or retailers to get their own product to market (where that product, at the same time, will contain the cultivator’s or manufacturer’s information to satisfy the packaging and labeling rules, but will be co-branded with the unlicensed company’s information and intellectual property). Without more guidance from the BCC, it’s not difficult to determine that such a contract violates Rule 5032.
3. IP licensing and white labeling.
Thanks again to the BCC, IP licensing with cannabis licensees in California is not at all straightforward. While unlicensed companies can license their IP to cannabis licensees as long as those unlicensed companies are disclosed as financial interest holders, if they exercise too much direction, control, and/or management over the licensee relative to the IP, the unlicensed company may be considered an “owner” under BCC regulations; and that means disclosure of the unlicensed party and maximum scrutiny from the state.
Anyone who’s done an IP licensing agreement knows that the licensor typically gets substantial control over the use of the IP relative to the licensee, so already we potentially have a problem in California where preserving the integrity of the mark “too much” may make the licensor an “owner” of the cannabis licensee. The same issue may occur with white labeling, where too much control over formulations and product compilation could amount to unlawful “ownership” over the cannabis licensee.
I am positive that there are IP licensing and white label and supply agreements in California that have created secret owners all over the place because of the level of control in those agreements given to unlicensed parties. The BCC has very little guidance out about these relationships, so its scrutiny of these agreements will probably be on a case-by-case basis if and when such relationships are discovered.
4. Disclosure issues.
Near as I can tell when talking to folks, most people still don’t understand or know the extent of owner and financial interest holder disclosures required by the State of California. What’s for sure, though, is that certain investors and financiers want to avoid these issues altogether if they can help it (which is easier said than done). In particular with the BCC, if you’re an owner that’s an entity, you are disclosing every single owner in that entity, even if they own under 20% of the entity. This means you will disclose not only your equity owners at 20% or more AND all individuals in a control, direction, or management positions, but you’ll also disclose all of your financial interest holders (with very few exceptions) that are at 19% or less in equity. (And, yes, this includes disclosure of any investment funds or limited partners in a general partnership, and every person or entity within those structures, too, if you ask the BCC).
All of this is obviously extremely problematic for fundraising and M&A and many licensees do not realize that they’ll violate the rules if they fail to timely make these disclosures. Despite that fact, I see lots of transactions and cap tables from licensees where they realize only when it’s too late that they must make these robust owner and financial interest holder disclosures or face major rule violations. And many of those investment agreements and/or M&A transactions don’t even mention any kind of default or obligation around these disclosures — which is a massive drafting mistake.
5. Operating without a provisional license.
For some reason, some stakeholders are under the impression that they can continue to operate if they have local authorization but no state license. This is just dead wrong. And even if you have local authorization and have applied for an annual license in order to get a provisional license, you still cannot operate. Just standing in line for a provisional does not make you a legal operator. You have to have both local authorization and either a provisional or annual license. In doing diligence on certain operators, I’m continuing to see expired temporary licensees that don’t yet have provisional or annual licenses. To buyers and/or investors of cannabis companies in California, make sure that your target has both local authorization and a state license before pulling the trigger.
California cannabis has certain pitfalls that are unlike any other state due to the nascent nature of the licensed industry and ambiguities created by the regulators. Unfortunately, these pitfalls and ambiguities aren’t being addressed with additional guidance or even consistent BCC enforcement. In any event, proceed with caution out there and be sure to read the fine print in your proposed agreements and in the rules.