California’s New Cannabis Rules: The End of the Beginning?

California’s New Cannabis Rules: The End of the Beginning?

Flickr / oswaldo / CC BY 2.0

By Lawrence W. Horwitz and Christopher Faille

All three of the California agencies charged with implementation of the Medical Cannabis Regulation and Safety Act released their initial draft of new cannabis rules on April 28, 2017.

This long-awaited event puts some meat on the ‘til-now skeletal ideas of what is going to happen in California as the expansion of the state-legal cannabis industry into adult recreational use moves forward, and as the industry transitions from a non-profit to a for-profit model that will allow more room for entrepreneurs.

These regs leave us far from the end of the transition. We aren’t even at the beginning of the end. This may, though, come to be considered the end of the beginning.

The three agencies are: the Bureau of Medical Cannabis Regulation of the Department of Consumer Affairs, which announced its regulatory standards for transportation, distribution, and retail; the Cannabis Cultivation Licensing arm of the Department of Food and Agriculture, responsible for cultivation standards; and the Office of Manufactured Cannabis Safety of the Department of Public Health, responsible for manufacturing standards. Together, this is a lot to absorb: 209 pages of text.

The “elevator” version of all that text is this: those wanting lawfully to cultivate, manufacture, retail, distribute or transport cannabis will each have to apply for one of a range of respective licenses. Each application will have to include background information on all the “owners,” and the word “owner” in this context is a term of art.

Getting Out of the Elevator

One has to get out of the metaphorical elevator to go further. The regs contemplate that some of the entities operating in these fields will be publicly traded companies and some will not. What the word “owner” means varies accordingly. An owner of a publicly traded company is the CEO or any person or entity with an aggregate ownership interest of 5% or more.

The owner of any other entity is an individual with an aggregate ownership of 20% or more, or the CEO or board of director of an entity with 20% ownership or more, or “an individual that will be participating in the direction, control, or management of the licensed commercial cannabis business.”

Individuals who have a lesser interest than that are said to have a “noncontrolling interest in the commercial cannabis business and are not required to submit the information required of owners in the application for licensure.”

The new regulations do not bar out-of-state companies from applying for licenses, for any of the five categories, so long as they are registered to do business in California. This is big.

All this is still far short of a full “normalization” of the industry. For example, licenses once awarded will not be transferable and any change of ownership structure will require either a new application from scratch or, at the minimum, an all-clear from the relevant regulating agency. Also, “vertical integration” isn’t allowed: the cannabis has to pass from hand to hand, from one distinct licensee to another, repeatedly, as it moves from farm to caretaker and patient.

Until Some of These Applications Are Granted

It has until now been the case, and until some of these applications are actually granted it will remain the case, that all legal cannabis operations in California have been medical nonprofits. Further, no third party has been able to own an interest in a non-profit without being a member of the non-profit.

The law has created an indirect residency requirement. That is, non-Californians cannot be patients under the state’s medical cannabis guidelines, and only patients can be members, so non-Californians cannot be members.

It’s a given that non-Californians can and do profit by playing any of a number of roles that don’t touch the plant, including technology, software assistance, staffing services, building equipment loans, and so forth. The building equipment can of course be agriculture, which makes for the literal application of the widely-used phrase “picks and shovels” for such supportive industries.

More directly, there are management companies that currently contract with nonprofit cannabis collectives and it is through these management companies that out-of-state investors have historically provided capital.

Litigation and Messy Divorces

The non-profit model also has resulted in a good deal of litigation, as the contractual control asserted through a contract does not provide the same control that a direct ownership in a corporation would provide.

Just to offer one quite prominent example of this litigation: in April 2012, a California company, Medical Marijuana Inc. (OTC:MJNA) and a Colorado company, Dixie Holdings, jointly formed Red Dice, a California LLC with its principal place of business in San Diego. Dixie, the “outsider” entity, had a 40% interest in Red Dice; MJNA had the remaining 60%.

The two owners of Red Dice entered into a detailed operating agreement. The parties soon had a falling-out, and in July 2013 Dixie Holdings filed a derivative lawsuit on behalf of Red Dice against MJNA, alleging breach of contract and seeking declaratory relief. The filing raised issues that go to the heart of proper corporate, or business-entity, governance, involving transparency, the need for appropriate formal board meetings, and allegations that the officers of MJNA had filed amendments to its articles of incorporation that sometimes increased and sometimes decreased the authorized capital of MJNA without shareholder approval.

A year later the parties settled the lawsuit. Essentially, Dixie and MJNA agreed to dissolve Red Dice and go their separate ways.

Because that sort of divorce can be messy, one may say that while it is legal for non-Californians to invest in management companies under contract with non-profit cannabis collectives, it is certainly not advisable.

Two Distinct Statutes

It is well to recall the underlying mandates. California has two laws: The Medical Marijuana Regulation and Safety Act, commonly referred to as MMRSA, governing for-profit medical marijuana operations, and The Adult Use of Marijuana Act, known as AUMA, governing for-profit recreational operations. These laws are intended to replace the legacy non-profit structure in January 2018. While California regulators are struggling to reconcile the differences, and there are many, between the two laws, the state has recently selected certain key provisions converging the two laws, while ignoring other key provisions.

Thus, one has to give both a “yes” and a “no” in answer to the unambiguous question whether non-Californians can invest in California legal cannabis operations.

Non-Californians cannot presently be owners under AUMA but may be owners under MMRSA. AUMA expressly prohibits this until Dec. 31, 2019. Further, non-Californians cannot be licensees under either AUMA or MMRSA.

Regulators may not yet have fully thought through the reasons why other states, such as Colorado, have restricted investment by non-residents. There are two main policy considerations: to assure that there is no interstate movement of investment funds that will trigger federal prohibition; and to keep criminals, or at least criminals from outside the state, such as foreign cartels, out of the state-legal industry. These may or may not be good reasons, but neither singly nor together do they generate a distinction between medical and adult-use operations which would justify different treatment of out-of-state investors.

There are clear financial opportunities for out-of-state investors. These opportunities include minority interests in operations, positioning for more expansive roles when and if California regulators begin to focus more on these issues. Eventually, the competition between states looking to attract investor dollars will push regulators toward the eventual elimination of all restrictions on out-of-state investment activities.

Lawrence W. Horwitz, General Counsel and Board Member of MJIC, is a founding partner of Horwitz + Armstrong, LLP, based in Orange County, Calif., practicing in general business and securities.
Christopher C. Faille, a Jamesian pragmatist, was one of the first reporters taking the hedge fund industry as a full-time beat, at the turn of the millennium, with HedgeWorld. His latest book, Gambling with Borrowed Chips, treats of common misunderstandings of the crisis of 2007-08.

Guest Contributor designates a writer who is guest publishing content with MJINews.

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