cannabis customers for trade vendors - 02 - crf march 2019 ......presentation, what are we referring...

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Cannabis CustomersKey Considerations for Trade Vendors Selling to a “Budding” Industry

Andrew Behlmann973‐597‐[email protected]

Jeffrey D. Prol973‐597‐2490

[email protected]

2Cannabis CustomersKey Considerations for Trade Vendors

DISCLAIMER

By continuing to attend the following presentation, read the following materials, or both, you

acknowledge and agree that this presentation

• is intended solely as an informational overview to educate participants on the general

regulatory landscape associated with selling goods, services, or both to customers involved in

the cannabis industry;

• does not constitute legal advice or a legal opinion;

• is not intended to encourage participants to, or to inform participants how to, engage in or

assist others with tax evasion, structuring, money laundering, or other illegal activities;

• does not create an attorney‐client relationship between any participant and Lowenstein

Sandler LLP or any of its attorneys, and no such relationship will exist unless and until an

engagement letter has been fully executed; and

• may not be complete or up to date due to, among other things, ongoing changes in federal,

state, and local laws and regulations and the time and other constraints imposed by the

presentation format.

All participants are strongly encouraged to consult with their legal, financial, accounting, and tax

advisors when making business decisions related to the cannabis industry.

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OVERVIEW

•Lay of the Land: Legalization and Regulation

• Industry Overview

•Market Growth

•Who Are Cannabis Customers?

•Business Risks

•Regulatory Issues

•Legal Concerns

•Practical Considerations

LAY OF THE LANDTHE HISTORY OF CANNABIS PROHIBITION AND THE SHIFT TOWARD WIDESPREAD STATE LEGALIZATION

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LAY OF THE LANDALPHABET SOUP: CANNABIS, MARIJUANA, CBD, THC, BHO, CSA, DEA?

Source: Merriam‐Webster


LAY OF THE LANDALPHABET SOUP: CANNABIS, MARIJUANA, CBD, THC?

• Cannabinoids: • 113 identified to date• Cannabinoid receptors in cells of the human body

• THC: Delta‐9‐Tetrahydrocannabinol• Psychoactive compound found in cannabis• CSA Schedule I substance• Dronabinol: Synthetic THC approved by FDA as appetite

stimulant for AIDS patients, antiemitic for chemotherapy • CBD: Cannibidiol

• CSA Schedule I substance• Up to 40% of a cannabis plant’s extract• Epidiolex: CBD‐based drug approved by FDA in

September 2018 for two epilepsy disorders; Schedule V

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LAY OF THE LANDALPHABET SOUP: CANNABIS, MARIJUANA, CBD, THC?

• When we refer to “Cannabis” or “Marijuana” in this presentation, what are we referring to?

• Broadly:

• The cannabis plant itself

• Products derived from the cannabis plant

• Marijuana – dried flowers / leaves

• Hashish – resin of the cannabis plant

• Oils – most potent cannabis products


LAY OF THE LANDFEDERAL REGULATION: HISTORY

1937

Marihuana Tax Act

Effectively prohibited cannabis at the federal level. Medical use was permitted, with heavy regulation and costly fees.

1970

Controlled Substances Act

Completely prohibited cannabis at the federal level, with no medical exceptions.

1990

Solomon‐Lautenberg Amendment

Used federal highway funds to encourage states to suspend drivers’ licenses of anyone who commits a drug offense.

2014

Rohrabacher‐Farr Amendment

Prohibits U.S. Department of Justice from interfering with state medical cannabis laws. Requires annual renewal. Does not change legal status of cannabis under CSA.

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LAY OF THE LANDFEDERAL REGULATION: TREATMENT OF MARIJUANA UNDER THE CSA

• CSA: Federal statute that regulates the use of certain drugs and potentially harmful chemicals

• Controlled substances are divided into five schedules based on medical use, potential for abuse, potential for addiction – lower number = “worse” drug



•Marijuana is a CSA Schedule I Drug

• Classified with and treated similarly to hard drugs like heroin, LSD, peyote, MDMA (ecstasy), methaqualone (Quaaludes)

•Marijuana is technically “worse” from a regulatory standpoint than drugs like cocaine, codeine, fentanyl, methamphetamine

Schedule Description Examples

I Substances have a high potential for abuse, have no currently accepted medical use in treatment in the U.S., and have a lack of accepted safety for use under medical supervision

MDMA (Ecstasy)HeroinLSDMarijuanaMethaqualonePeyote

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• November 30, 2011: Governors of Rhode Island and Washington submitted a petition to DEA / HHS seeking to reclassify marijuana as a Schedule II drug

• To be classified in Schedule II‐V, a substance must have a “currently accepted medical use in treatment in the U.S.”

• Five elements:

• Drug’s chemistry is known and reproducible

• Existence of adequate safety studies

• Existence of adequate and well‐controlled studies proving efficacy

• Drug is accepted by qualified experts

• Scientific evidence is widely available



• In response to the 2011 petition (and prior petitions in 1992 and 2001), HHS concluded in July 2016 (and DEA concurred):

the scientific evidence is insufficient to demonstrate that marijuana has a currently accepted medical use under the five‐element test. . . . No studies have scientifically assessed the efficacy and full safety profile of marijuana for any specific medical condition. The limited existing clinical evidence is not adequate to warrant rescheduling of marijuana under the CSA.

• For now, marijuana remains a CSA Schedule I drug

• We’ll revisit the significance of this classification in a little bit

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LAY OF THE LANDTHE TIMES THEY ARE A‐CHANGIN’ ‐ PUBLIC OPINION HAS CHANGED A LOT IN 50 YEARS


Prohibition

1911‐1933

Massachusetts (1911) –required a prescription

By 1933, 29 states had criminalized cannabis.

Decriminalization

1973‐1978

States, starting with Oregon, began passing statutes decriminalizing cannabis possession to varying degrees (some were later repealed). After 1978, no more decriminalization took place until 2001.

Medical

1996

Starting with California, states began legalizing medical cannabis through legislation and ballot measures.

Medical use is now legal in 33 states.

Recreational

2012

Colorado and Washington became the first two states to legalize recreational cannabis.

10 States + DC now permit recreational use.

LAY OF THE LANDSTATE REGULATION: HISTORY

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LAY OF THE LANDSTATE REGULATION: THE SURGE OF STATE LEGALIZATION

Source: Business Insider Jan. 4, 2019

INDUSTRY OVERVIEWWHO ARE THESE “CANNABIS CUSTOMERS” ANYWAY?

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INDUSTRY OVERVIEWTHE U.S. CANNABIS INDUSTRY IS EXPLODING

• Nearly non‐existent industry ten years ago

• $10.3 billion industry in 2018

• 25% annual revenue growth 2013‐2018

• Industry revenues projected to surpass $23B by 2022

• State legalization efforts have driven exponential growth

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10

20

30

2013 2017 2018 2019 (Est) 2022 (Est)

$ Billions

Total U.S. Cannabis Sales


INDUSTRY OVERVIEW…WITH RECREATIONAL USE AS THE FASTEST GROWING SECTOR

• Recreational sales are the fastest growing segment

• Projected to be almost two thirds of all revenues by 2022

0

10

20

30

2013 2017 2018 2019 (Est) 2022 (Est)

$ Billions

Total U.S. Cannabis Sales

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INDUSTRY OVERVIEWONE BOOMING EXAMPLE: COLORADO



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Five‐Year Revenue CAGR

17.7%


INDUSTRY OVERVIEWMASSACHUSETTS: $9.3M SALES IN THE FIRST FOUR WEEKS

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INDUSTRY OVERVIEW

WHO ARE THE PLAYERS?


INDUSTRY OVERVIEWINDUSTRY PARTICIPANTS: THE CANNABIS SUPPLY CHAIN

•Producers – Plant Growers – “Cultivators”

PRODUCTIONPRODUCTION

•Flower Products

•Edible Products

•Topical Products

•Cartridge Products / “Vape” Pens

•Oil Extracts / Concentrates

PROCESSINGPROCESSING

•Wholesale Distributors

DISTRIBUTIONDISTRIBUTION

•Dispensaries

•Healthcare Providers

RETAILRETAIL

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INDUSTRY OVERVIEWPRODUCTS AND SERVICES SEGMENTATION, 2018

Edible Products, 13%

Oils / Extracts / Concentrates, 23%

Pre‐Rolled Joints, 5%

Flower Products, 57%

Other Products, 2%


INDUSTRY OVERVIEW

WHAT DO THEY ALL HAVE IN COMMON?

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INDUSTRY OVERVIEWCANNABIS INDUSTRY PARTICIPANTS PURCHASE A WIDE VARIETY OF PRODUCTS AND SERVICES

Cultivator

Greenhouses

Utilities

Fertilizers

Soils

Growing Vessels

Logistics

Industrial Space

Office Space

Quality Testing

Payroll Services

Accounting

Payments

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Processor

Utilities

Packaging

Shipping Services

Warehouse Space

Office Space

Quality Testing

Payroll Services

Accounting

Payment Processing

Marketing

Equipment

Security Services

Office Supplies




Retailer

Utilities

Warehouse Space

Storefronts

Office Space

Payroll Services

AccountingPayment Processing

Marketing

Equipment

Security Services

Furniture

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CRF MEMBERSHIP POLLEXPERIENCES WITH CANNABIS CUSTOMERS


POLL RESULTS

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POLL RESULTS


POLL RESULTS

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POLL RESULTS


POLL RESULTS

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POLL RESULTS

BUSINESS RISKSNEW INDUSTRY, NEW (AND OLD) CHALLENGES

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BUSINESS RISKSIS THE “GREEN RUSH” REALLY A NEW GOLD RUSH?


BUSINESS RISKSA BETTER ANALOGY: THE ALCOHOLIC BEVERAGE BUSINESS POST‐PROHIBITION

U.S. Annual Liquor ConsumptionBefore Prohibition140,000,000 gallons

During Prohibition200,000,000 gallons

2016 U.S. Marijuana SalesLegal$6.9 billion

Illegal$46.4 billion

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BUSINESS RISKSSTILL LARGELY A STARTUP‐DRIVEN INDUSTRY

• Industry maturity varies drastically by state and type

• California (Medical 1996 / Recreational 2016)

vs.

• Delaware (Medical 2011 / Recreational 2015)

• Like any emerging, high‐growth industry, lots of . . .

• . . . high‐profile institutional investment and M&A

• . . . hype and speculation

• . . . startups with various levels of capitalization and little or no operating history

The overall cannabis industry profile is very reminiscent of the tech boom of the late 1990s – early 2000s!


BUSINESS RISKSCOMMON PROBLEMS AND RISK FACTORS

• Inadequate capitalization

• Overly optimistic financial projections

• Loosely affiliated management teams and “advisors”

• Reliance on widely publicized deals and investments

• Inadequate understanding of relevant regulatory overlays

• Market saturation

• Unavailability of banking services

• Political risks

• Asset forfeiture

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LEGAL AND REGULATORY CONCERNSWE’RE FROM THE GOVERNMENT AND WE’RE HERE TO HELP.


LEGAL AND REGULATORY CONCERNSFEDERAL, STATE, AND LOCAL LAWS AND REGULATIONS CREATE A MYRIAD OF UNIQUE RISKS

• Federal Law

• Banking

• Money Laundering

• Tax

• Bankruptcy

• Intellectual Property

• Civil Litigation

• State Law

• Local Law

• Zoning / Land Use / Permitting

• Landlord / Tenant Issues

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LEGAL AND REGULATORY CONCERNSCANNABIS IS STILL PROHIBITED BY FEDERAL LAW

FOR THE TIME BEING, CANNABIS REMAINS A CSA

SCHEDULE I CONTROLLED

SUBSTANCE


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: RISK OF FEDERAL CRIMINAL PROSECUTION OF CANNABIS BUSINESSES

2009 Ogden Memo: “As a general matter, pursuit of these

priorities should not focus federal resources in your States on individuals whose actions are

in clear and unambiguous compliance with existing state laws providing for the medical use of marijuana.”

2011 Cole Memo I: “The Ogden Memorandum was never intended to shield

such activities from federal enforcement

action and prosecution, even where those activities purport to

comply with state law.”

2013 Cole Memo II: “Prosecutors should continue to review marijuana cases on a case‐by‐case basis and weigh all available information and evidence, including, but not limited

to, whether the operation is demonstrably in compliance with a strong and effective state regulatory

system.”

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: RISK OF FEDERAL CRIMINAL PROSECUTION OF CANNABIS BUSINESSES

2014 Cole / FinCENMemos: Opened the door (a little bit) to banking of cannabis businesses, subject to burdensome reporting

requirements.

2018 Sessions: Jettisoned the Cole memos – “a return to the rule of law”: “[P]rosecutors should follow the well‐established principles that govern all federal prosecutions. These principles require federal prosecutors deciding which cases to prosecute to weigh all

relevant considerations of the crime, the deterrent effect of criminal prosecution, and the cumulative impact of particular

crimes on the community.”

2019 Barr: Stated in confirmation hearing

testimony that he doesn’t plan on using federal resources to “go after” cannabis companies if they are complying with

state law.


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: CIVIL AND CRIMINAL RISKS FOR SUPPLIERS

• Harsh penalties for violating the CSA – or aiding and abetting

• Imprisonment

• Fines

• Asset forfeiture

• Property used in (equipment, supplies, real estate, vehicles) or derived from (cash, purchased items) criminal activity

• Criminal, administrative, civil• Including real estate (landlords)

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: LIMITED AVAILABILITY OF BANKING SERVICES

Because cannabis remains a CSA Schedule I controlled substance and Congress has not expressly authorized federally chartered

and/or regulated banks or credit unions to bank cannabis businesses without penalty, what guidance exists generally

comes from the executive branch of the federal government and is subject to change with shifts in leadership.



• Single largest regulatory issue facing cannabis businesses

• Many banks are unwilling to take on the hefty regulatory burdens that come with banking cannabis businesses

• Filing Suspicious Activity Reports (SARs) pursuant to the 2014 FinCEN Guidance

• Ensuring customers comply with state law

• Ensuring customers comply with federal regulatory guidance (which has whipsawed in the past 6 years)

• There is a growing willingness, particularly among smaller, local banks, to do business with cannabis companies

• But, at least for now, this still remains a heavily cash business

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• FinCEN SAR filing requirements extend to any transaction that “involves funds derived from illegal activity”

• FinCEN Memo: “. . . financial transactions involving a marijuana‐related business . . .”

• This verbiage technically includes the receipt by a cannabis company’s vendors (i.e., you) of payments from the cannabis company

• Wire or ACH payment probably qualifies

• Unclear whether a non‐cannabis business depositing a cash or check payment from a cannabis business qualifies as a transaction “involving” a cannabis business


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: MONEY LAUNDERING

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: AVOIDING INVOLVEMENT IN MONEY LAUNDERING

• Potentially an issue when dealing with any cash business

• Bank Secrecy Act anti‐money laundering compliance requirements do not apply to nonfinancial businesses

BUT . . .

• The federal criminal money laundering statutes (18 U.S.C. §§ 1956 and 1957) apply to everyone (including you)

• Federal criminal statutes have various mental state requirements applicable to each element



Three primary methods:

• Placement

Sneaking “dirty” money into the financial system in ways designed to avoid raising suspicion / reporting requirements

• Layering

Separating proceeds of illegal activity from their origin through multiple layers of transactions

• Integration

Reintroducing laundered money into lawful trade via a “front” with a facially legitimate explanation of the source

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18 U.S.C. § 1956Whoever, knowing that certain property represents the proceedsof some form of unlawful activity, conducts or attempts to conduct such a financial transactionwhich in fact involves the proceeds of specified unlawful activity . . . • with the intent to promote the carrying on of specified

unlawful activity; or with intent to engage in [tax evasion]; or• knowing that the transaction is designed in whole or in part to

conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds of specified unlawful activity; or to avoid a transaction reporting requirement under State or Federal law . . .



18 U.S.C. § 1956. . . shall be sentenced to a fine of not more than $500,000 or twice the value of the property involved in the transaction, whichever is greater, or imprisonment for not more than twenty years, or both.

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18 U.S.C. § 1957Whoever . . . knowingly engages or attempts to engage in a monetary transaction in criminally derived property of a value greater than $10,000 and is derived from specified unlawful activity, shall be punished as provided in subsection (b).• Punishable by fines and/or up to ten years’ imprisonment• Must be conducted by, to, or through a financial institution• Designed to make it difficult for criminals to spend proceeds• Impacts third parties who provide opportunities to spend

proceeds of SUA• But: Each transaction is a separate offense – no aggregation• Defendant has to know that the property is proceeds of

some form of criminal activity


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: MONEY LAUNDERING – TRADITIONAL RED FLAGS

• Insistence on dealing in cash, near‐cash, or cryptocurrency

• Unwillingness to ID principals

• Fictitious principal IDs

• Multiple cash payments under $10K on open account, even with larger account balance

• Multiple COD/CIA purchases in a short time, each under $10K

• Payment from personal accounts / credit cards

• Requests not to file IRS Form 8300 for large cash payments

• Requests not to comply with state reporting requirements

• Unusually large purchases, especially large purchases of a small number of items

• Cash overpayments on account requesting refund by check

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: INCOME TAX

Internal Revenue Code, § 280E

No deduction or credit shall be allowed for any amount paid orincurred during the taxable year in carrying on any trade or businessif such trade or business (or the activities which comprise such tradeor business) consists of trafficking in controlled substances (withinthe meaning of schedule I and II of the Controlled Substances Act)which is prohibited by Federal law or the law of any State in whichsuch trade or business is conducted.


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: WHAT IS THE IMPACT OF IRC § 280E?

• The only deduction a taxpayer is allowed on its federal return in connection with the sale of a CSA Schedule I controlled substance (like cannabis) is for the cost of goods sold.

• Senate Report: “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.”

• Does not prohibit paying business expenses

• Only prohibits deducting business expenses other than COGS for federal income tax purposes

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LEGAL AND REGULATORY CONCERNSBANKING + TAX ISSUES = IRS REPORTING REQUIREMENTS FOR CASH TRANSACTIONS


LEGAL AND REGULATORY CONCERNSBANKING + TAX ISSUES = IRS REPORTING REQUIREMENTS FOR CASH TRANSACTIONS

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: BANKRUPTCY

Because cannabis is illegal to cultivate, possess, process, or sell

under federal law, the United States Trustee (an arm of the USDOJ) has taken the position that “marijuana assets” cannot be administered (i.e., sold or used) by a bankruptcy estate

or trustee.

The UST will, as a matter of policy, move to dismiss any bankruptcy case involving “marijuana assets” and has attempted (with varying success) to extend this policy to

equipment vendors and landlords of cannabis businesses.


LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: INTELLECTUAL PROPERTY

• Cannabis businesses cannot register federal trademarks because their primary business is prohibited by federal law

• Some IP protections are available to cannabis businesses:

• Registration of trademark for non‐cannabis business use

• State‐law trademarks

• Common‐law trademarks

• Common to all of the above: Aggressive enforcement

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LEGAL AND REGULATORY CONCERNSFEDERAL ISSUES: PRACTICAL TAKEAWAYS

The current federal regulatory environment suggests that federal authorities will not attack legitimate payments to trade vendors by cannabis companies

that are operating in substantial compliance with state law, not running afoul of the eight “enforcement

priorities” set forth in the 2013/2014 Cole memos, and not otherwise violating other federal criminal laws


LEGAL AND REGULATORY CONCERNSPRACTICAL TAKEAWAYS

• Only deal with state‐licensed cannabis businesses

• Insist on receiving copies of applicable state/local licenses before doing business

• Verify that the customer is the correct, licensed party

• Require customer to provide periodic updates of license information

• Require immediate notice of any loss of licensure of any governmental enforcement actions

• Require robust representations, warranties, and covenants re: compliance with applicable state laws and regulations

• Your contracts should provide you with the ability to terminate in the event of a change in law, failure of customer’s legal and regulatory compliance, or failure to provide periodic license updates

• Choice of forum / choice of law clauses should designate cannabis‐friendly state for customers in the cannabis business

• Stay up to date on federal law and shifting enforcement priorities

• If a large cannabis customer files bankruptcy, consider joining UST’s motion to dismiss and suing in a cannabis‐friendly state court

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FREQUENTLY ASKED QUESTIONSNOW WHAT?


FREQUENTLY ASKED QUESTIONS

How are vendors getting paid by recreational cannabis businesses

that are unable to obtain traditional bank accounts?

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Do I have to continue selling to a customer with a supply contract if they enter the cannabis business and I have a moral or ethical

objection?



My customer wants to pay a large balance in cash. How can I accept the payment while keeping my business and employees safe?

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What about doing business with Canadian cannabis companies?

cannabis customers for trade vendors - 02 - crf march 2019 ......presentation, what are we referring...

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