By Luke E. Stanton & Jeffrey D. Welsh
Frontera Advisors
As the legal cannabis industry grows at fever pace, many entrepreneurs are eyeing expansion into medical and recreational markets in other states. To avoid violating federal law, it is vital to understand the legal mechanisms that prohibit state-to-state commerce in cannabis, as well as the relevant memoranda and directives issued by various federal agencies. Equally important is paying attention to specific emerging-market considerations and cannabis business concerns.
Federal regulations
Prohibitions against interstate commerce
The Commerce Clause of the U.S. Constitution states that Congress may “regulate commerce with foreign Nations, and among the several States, and with the Indian Tribes.” Given that cannabis remains a Schedule I controlled substance under the federal Controlled Substances Act, and the Commerce Clause grants federal jurisdiction to commerce between the states, movement of cannabis interstate is prohibited
The Cole memo
In August 2013, U.S. Deputy Attorney General James M. Cole issued a memorandum to all U.S. Attorneys providing guidance on the proper prioritization of cannabis enforcement. Specifically, the Cole memo lists eight federal law enforcement priorities: 1) preventing distribution to minors; 2) preventing revenue from reaching organized criminals, gangs, and cartels; 3) diverting cannabis from legal state markets to markets where cannabis is still prohibited; 4) using legal activity as a pretext for illegal activity; 5) averting violence and firearms in the cannabis industry; 6) preventing drugged driving and adverse public health consequences; 7) stopping cultivation on public lands; and 8) preventing use or possession of cannabis on federal property. The memo, in concert with the Rohrbacher-Farr amendment to the federal appropriations bill, is the strongest support states have for their ability to implement state cannabis programs despite continued federal prohibition.
Treasury Department FinCEN regulations
In February 2014, the Department of Treasury Financial Crimes Enforcement Network (FinCEN) provided banks with instructions about accepting cannabis-business dollars while continuing to comply with FinCEN regulations. The instructions outline compliance guidelines requiring banks to file reports called Suspicious Activity Reports (SARs) for cannabis customers. Still, few banks have opened their doors to cannabis businesses. For many, the rates of return do not justify the risk. As the industry evolves, so will banking, but for the moment keeping your money safe remains a significant challenges in the cannabis space.
Business concerns in state-to-state expansion
Once you understand the various federal legal issues and policy considerations that allow the cannabis industry to exist in individual states, you will need to look at each individual state market and decide where your enterprise should operate.
Where should you do business?
Identifying appealing markets for cannabis business can be more difficult than in many other industries. At minimum, analysis of viability should include the type of business you plan to conduct, your available resources, identifiable opportunities, the strength of potential partnerships, and the life cycle of state licensing schemes and regulatory environments, factors that will help you evaluate market dynamics and make decisions that are ultimately right for you.
Type of business: primary vs. ancillary
Most businesses in the cannabis space can be divided into two basic categories: primary and ancillary. Primary businesses include cultivation, processing, manufacturing, and retail, among others. Typically these businesses require specific, state-issued cannabis business licenses. In contrast, businesses in the ancillary sector handle aspects of the industry that do not deal directly with the life cycle of the plant, and generally do not require cannabis-specific state licensing. However, they do often require other professional licenses issued by the state. Because hurdles in the ancillary sector are consistent with other industries, this article deals mainly with businesses operating in the primary category.
Operating in each state vs. licensing to local partners
Within the primary category, we subdivide cannabis business models into two main approaches: operators and licensors. Operators are on the ground in the state of their choosing, managing and performing the day-to-day duties of their business. The role of an operator comes with inherent requirements, including industry expertise, operational capital, and the ability to meet all of the state’s regulatory requirements, including residency restrictions, criminal background checks, extensive corporate and financial disclosures, and continuing reporting requirements. Because these can be onerous, one way to avoid the headache of navigating multiple state regulatory regimes is to enter into licensing agreements with qualified local operators.
Licensing agreements
Federal law may restrict cannabis businesses in the primary sector from participating in interstate commerce, but there is tremendous value in the intellectual property, operational methodology, and other proprietary assets a business possesses that can travel interstate. Licensing agreements allow businesses to expand into other states in ways that do not result in any cannabis products crossing state lines or subjecting business owners to violations of federal law.
Licensing agreements commonly seen in other industries operate similarly in the legal cannabis space. A cannabis business (licensor) may license the use of the intellectual property associated with its brand, along with any other proprietary assets, to a local, state-compliant operating partner (licensee) who may then produce the licensor’s products within that state’s intrastate stream of commerce. A business that can successfully execute licensing agreements in multiple states will have a well-functioning, legal, multi-state cannabis enterprise.
Protecting your business and your brand
One of the challenges with utilizing state-specific operating partners is the licensor’s ability to maintain the quality of the brand. Concerns related to product quality and brand dilution can be addressed through the use of specific licensing provisions, a few of which are:
Quality control rights: Brand dilution can be fatal. In order to ensure your cannabis business continues to grow and become the national brand you want it to be, it is essential your products maintain consistency and quality as you expand into new markets. Strong quality control provisions address these concerns through the establishment of operational, production, and testing standards, which can be tailored precisely to reflect the high standards you demand.
Minimum guarantees: While the licensee typically is responsible for local compliance and operations, the licensor’s intention is to minimize risk and secure future revenue. Minimum guarantees are a form of performance insurance under which an initial sum is paid to the licensor regardless how the licensee performs. Minimums are often important to fix the long-term commitment of the licensor, but also constitute a financial risk for the licensee, who cannot be certain of achieving sales levels necessary to cover the guarantee. Licensors should be mindful of setting realistic, fair minimums that will encourage long-term success for both parties.
Milestones: In contrast to minimum guarantees, performance milestones provide expectations for the licensee over time. This can add two elements to an agreement: 1) an incentive for the licensee to perform well, and 2) an escape hatch for the licensor should the licensee fail to perform, particularly in the case of exclusive license agreements.
