The California Distribution Solution

distribution

By Luke K. Stanton
Jeffrey D. Welsh
and Lukian Kobzeff
Frontera Law Group

A discussion of the benefits of a closed loop distribution model for the Golden State.

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Distribution remains one of the most daunting obstacles on California’s medical marijuana landscape. Most cannabis distribution activity occurring in California currently is illegal, and while in some ways this seems impossible, it is the inescapable truth. A number of recent, high-profile incidents have brought this issue to the forefront of the industry’s collective consciousness, and we believe it is time to bring the discussion of the distribution issue out of the dark and into the light.

The problem
California cannabis businesses must meet the following basic compliance requirements: 1) they must be groups of patients who work together using a collective model, 2) that collective must operate without generating a profit, 3) the collective must be licensed or permitted by its local jurisdiction, and 4) all of the collective’s activities must occur within a closed loop. Typically, California cannabis businesses can satisfy some number of these requirements. They are often groups of patients, organized as nonprofit mutual benefit corporations (NPMBs) and operating with local a license (or at least without being prosecuted by their local jurisdiction).

But what about operating in a closed loop system? If you are a product company selling your goods in multiple dispensaries throughout the state, or worse, a company claiming to offer sales and distribution services to multiple product companies, how do you comply with the closed-loop requirement? Most of the time, when we ask that question, we get a shrug and a smile. Uh-oh. Warning: Prosecutors and law enforcement typically do not respond well to shrugs and smiles to explain illegal cannabis activity.

Let’s begin by breaking down a couple of these categories.

  1. Group of patients
    We will not belabor the point here, but if you are engaged in cannabis business activity in California and you are not associated with a group of patients, consult a local cannabis attorney immediately.
  2. Non-profit mutual benefit corporations (NPMBs)
    Most cannabis businesses in California are organized as NPMBs. However, this choice of corporate form makes little sense for anything other than the most basic compliance purposes, and in many instances, it is quite limiting. Non-profit corporations typically are structured for favorable tax treatment, a benefit you don’t receive in the cannabis industry. Additionally, the NPMB structure prohibits your cannabis business from making a profit even when the market opens up down the road to allow for profit-making models. Finally—and most importantly as it relates to distribution—while the NPMB has members, the NPMB does not provide for those members to be other businesses, an incredibly important distinction. This combination of the NPMB’s limitations leaves you with all of the disadvantages of being structured as a non-profit corporation, and ironically enough, none of the benefits.
  3. Local permit or license
    While it is still relatively rare for cities and counties in California to license and permit cannabis businesses, over the course of the next several years California cities and counties will regulate cannabis more effectively and collectives increasingly will be able to satisfy the requirement of possessing a local license to operate. Under the Medical Marijuana Regulation and Safety Act, cannabis businesses also will need to be licensed or permitted by their local government prior to applying to the state in 2018. But remember: a local license only protects you locally. Having a license or permit in one city or county does not mean you can conduct business elsewhere with that same license. This is an exceptionally simple point, yet it is widely misunderstood. A license to cultivate, retail, manufacture, produce, or distribute cannabis in one city or county does not allow you to engage in those activities with impunity everywhere in California.
  4. Closed-loop operation
    The closed loop requirement is the biggest problem for cannabis businesses that want to distribute their products. Distribution, in its most basic form, is the antithesis of a closed-loop system. Product manufacturers and distributors seek a maximum number of retail outlets in order to reach the greatest number of customers. This makes it very easy for law enforcement and prosecutors’ offices to arrest and prosecute sales representatives and transporters working for cannabis businesses when they encounter what they consider to be questionable cannabis distribution and sales activity.

The solution
The Central Organization Cooperative is the solution for cannabis businesses.

The starting point for cracking the code of California distribution actually was recommended by the state itself in 2008 and has existed in the California Corporations Code since long before the advent of medical marijuana. In 2008, then-Attorney-General Jerry Brown’s office published the Attorney General Guidelines for the Security and Non-Diversion of Marijuana Grown for Medical Use to assist collectives, patients, and counsel in the process of properly forming medical marijuana businesses. The AG Guidelines recommend one, and only one, corporate structure for collectives—the California Cooperative Corporation. Despite these specific instructions as to the recommended collective corporate structure, many collectives continue to utilize the NPMB structure.

The Cooperative corporate model also contains an answer to the seemingly inherent contradiction of distribution within a closed-loop system. California law grants Cooperatives the ability to act as central organizations. These central-organization Cooperatives have the ability to manage and coordinate the resources of their members who, importantly, are not limited to being individuals. These members may be collectives themselves, each of which has many individual members, all of whom are meant to take advantage of the resources, services, and products provided by the Cooperative at large. Members, whether individual or corporate, make contributions of goods, services, and other resources to the central organization, and the central organization manages the member contributions. This facilitates the distribution of the products and services to all of the Cooperative’s corporate and company members, who in turn provide those benefits to their individual members.

This form of distribution maintains the closed-loop requirement by making sure all member collectives are members of the central organization and that no distribution occurs to any non-member collectives or individuals. This structure also achieves the state’s goals of tracking marijuana activity in advance of implementing state-level regulation, as all activities are monitored by the central organization Cooperative. This Cooperative structure is utilized in many industries nationwide, including farming and agriculture, retail, and professional services, and should be embraced by a California cannabis industry desperate for a distribution solution.

Possible concerns with the model
Before you run out and start managing your own central organization Cooperative, some words of caution. The central organization model has not been tested at the appellate level yet. This is a double-edged sword. On one hand, there is no bright line saying the Cooperative model is a truly bulletproof solution. On the other hand, the Cooperative model has been used to defend cannabis business interests very successfully at the trial level and no district attorney’s office has attempted to challenge the model on appeal, likely because it would be an uphill battle against a model with statutory backing.

We also foresee a size limitation to the central organization model. At some point, the number of collectives a central organization allows as members could make it unmanageable and likely vulnerable to challenge. Maintaining a well-balanced and reasonably sized Cooperative is one of the keys to staying within the confines of this edict. Should a business utilizing the central organization structure become too greedy or expansive, this could carry it out of compliance and break the closed-loop requirement.

We are not claiming the alpha and omega to distribution in California, but we do want to start the conversation. No one should be arrested for legitimate and careful cannabis business activity, so make sure your organization is run the right way, particularly if you are distributing.


Frontera Law Group (FronteraLawGroup.com) focuses on cannabis legal services, corporate formation, cannabis business development, and helping cannabis companies of all kinds succeed in capitalizing on the positive changes we see occurring in the U.S.

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