[Thanks to Wendel Rosen business attorney Karen Balderama for this post.]

More than a year after legalization of recreational cannabis in California, the maturing California cannabis industry has seen an exponential increase in capital raising and M&A activity. Sophisticated investors and established companies are jumping in and making deals happen, infusing operators with capital and betting on even more growth if and when federal legalization occurs. Investors from Canada, where recreational marijuana is legal, are particularly interested in the California market. California cannabis companies are a popular target because they represent a foothold in the largest legal cannabis market in the world.

Before jumping in, however, investors should conduct thorough due diligence to uncover any potential landmines. The cannabis industry is unique in that many companies are emerging out of the illegal “black” or semi-legal “gray” market and may be operated by individuals who are not familiar with conventional business practices. Investors should be aware of the unique issues they will encounter when reviewing companies newly subject to complex and quickly evolving rules and regulations. In this environment, the potentially high upside is tempered by significant risk.

Investors who are new to the cannabis industry should be aware of the key areas that may require increased focus during the due diligence process. Along with my colleague, Rob Selna, I will be discussing these key due diligence issues and how investors can address them at the O’Cannabiz Conference in Toronto on April 27, with real-life examples from recent financing and M&A transactions.

1. Local and State Licensing

Without a local permit and state license to operate, a company cannot do business in the legitimate California cannabis market. While this sounds like a no-brainer, investors must ensure that any company they review has all the proper required state and local permits it needs to operate. Given the new and untested California licensing process, an investor must ask some basic questions, such as: If the company does not have a permanent license, is it in the process of obtaining one? Is there any risk that it can be denied a local permit or a permanent license?

2.  Capitalization and Corporate Records

One particular problem for cannabis companies, is that they may have been started and operated without legal help. While some disorganization can be accommodated, a company ready for investment or acquisition should have some level of basic corporate housekeeping. Due diligence questions may include: Have corporate actions been properly documented and approved? Is the company in compliance with its own articles of incorporation and bylaws? Are there risks of other “founders” coming out of the woodwork to claim ownership in the company?

3.  Tax and Financials

It’s common knowledge that cannabis companies are taxed heavily. Some companies may have come up with creative solutions to try to get around this, or they may have handled tax issues themselves without getting sound advice from accounting professionals. Questions to ask include:

• What banking arrangements, if any, does the company have in place?
• Has the company filed accurate tax returns?
• Has it paid all of its local, state and federal taxes?
• Is it at risk for an IRS audit?
• Could there be a large tax liability?

Like corporate records, companies also may have neglected to keep complete and proper financial records. Investors should engage accountants well-versed in the cannabis industry to review a target company’s tax returns and financial information so they understand the risks involved.

4.  Intellectual Property

After it obtains a license to operate, a company’s intellectual property (trademarks, trade secrets, patents, etc.) may be some of the most valuable assets that a cannabis company has. An investor should examine how well the company’s IP is protected, understanding that federal registration of certain intangible assets may not be available for an “illegal” business activity. It is also critical for investors to know whether any other parties (such as employees or partners) have a valid claim of ownership on the IP, or whether the company’s IP infringes on another party’s intellectual property.

5.  Business Operations and Agreements

Investors should carefully examine how the business has been operated to assess other possible risks. This bucket includes employment issues (such as proper classification of employees, wage and hour issues, etc.); lease agreements and other real estate matters; contracts with customers and suppliers; adequate levels of insurance coverage; adoption of and compliance with internal controls, policies and procedures; compliance with environmental laws; and compliance with other rules and regulations that may apply. Noncompliance in each of these areas could present a risk of liability to investors.

Ideally, once due diligence on a cannabis company is completed, there are no significant issues that present a heightened risk of liability. If there are issues, it is best to uncover these issues and address them early in the process. If the company presents too high a risk of liability, investors can negotiate better terms and demand certain protections, or they might decide to pass on a particular opportunity altogether.

[Thanks to Wendel Rosen environmental attorney Wendy Manley for this post.]

State Water Quality Permit

In 2017, the State Water Resources Control Board (State Board) issued a general permit for all cannabis cultivation to protect water quality (State Permit). Cannabis cultivation is broadly defined as “any activity involving or necessary for the planting, growing, pruning, harvesting, drying, curing, or trimming of cannabis,” including water diversions, preparing a cultivation site, or activities otherwise to support cannabis cultivation, and which discharge or could discharge waste to waters of the state. “Waste” includes any kind of pollutant that might reach surface waters or groundwater, such as nutrients in irrigation tail water and hydroponic wastewater. The State Permit is potentially far reaching, to include even indoor operations unless they meet certain conditions and file for a Waiver. See the State Permit here. 

Conditional Exemption

To be “Conditionally Exempt,” an indoor cannabis operation must occur in a structure with a permanent roof and a permanent, relatively impermeable floor (e.g., concrete or asphalt); discharge all wastewaters to the sanitary sewer in accordance with sanitary sewer system requirements; and implement “best practical treatment or control” measures or “BPTC,” which consist of numerous restrictions and express requirements for cultivation site development, fertilizer and pesticide use, activities in and around riparian areas and wetlands, water storage and conservation, among other things. Conditionally Exempt dischargers are also required to obtain the “Waiver.” In other words, “Conditionally Exempt” doesn’t mean you don’t have to do anything.

Outdoor cultivators who do not qualify for a Waiver as Conditionally Exempt are designated as either “Tier 1” (operations disturbing 2,000 square feet to one acre (43,560 square feet), or “Tier 2” (cultivating outdoors on more than one acre. In addition to BPTC, permittees must implement a monitoring and reporting program. 

Upcoming Workshops

Everyone in Cannabis cultivation, including indoor operators, should determine how the State Permit may affect their operations. Those planning to establish a new growing operation should examine the State Permit as early as possible, since site development and road building are subject to the State Permit, and there are numerous opportunities to organize the operation to minimize the costs and complications of implementing the BPTC measures. Those subject to the regional permits issued by the North Coast and Central Valley Regional Water Boards are expected to be transitioned to the State Permit this year.

Staff from the State Water Board will be available to describe the program and assist cultivators with permit applications and questions in two upcoming workshops co-hosted with other entities with oversight of the cannabis industry, including Cal Fish and Wildlife, Cal Department of Food and Agriculture CalCannabis, local planning departments, and CalFire. The workshops are in Laytonville March 26 (Mendocino County) and in Clearlake March 13 (Lake County). 

The State Permit is only one piece of the complex regulatory puzzle. For example, conditionally exempt cultivators may still need to apply for a water right to divert and use water.    

“Krümel Monster Muffins” by Xitu is licensed under CC BY-SA 4.0

Wendel Rosen attorney Bill Acevedo, who co-chairs the firm’s Food & Beverage Practice Group, posted a new blog at FoodLaw.com addressing the “confusion” in the marketplace regarding the use of CBD as an additive or ingredient in food and dietary supplements. 

Bill provides an overview of the way four nationally influential states are handling the issue due to the lack of direct enforcement by the FDA of its unequivocal regulatory prohibition of CBD use in food or dietary supplements.

You can read the full post here:

“C” is for “Confusion” When It Comes to CBD

2018 was a big year for the commercial cannabis legalization and provided some clues for what’s to come. The year started with California’s recreational market kicking off just as now-former U.S. Attorney General Jeff Sessions rescinded the Cole Memo. By year’s end, the number of states allowing medical and recreational cannabis rose to forty-four and ten, respectively.

Some major milestones for 2018 included:

• The introduction of the STATES Act, which would give states the power to regulate commercial cannabis within their own borders.

• California’s first full year of legalization.

• Canada’s national legalization of commercial cannabis.

• High taxes on cannabis businesses and less than expected tax revenue for many states and localities.

These topics are discussed in greater detail in an article by Rob Selna and myself published in mg Magazine, which you can read here.

Court Ruling on 280E

Another major legal development came in late 2018: after a long battle, a US Tax Court ruled that the IRS can continue prohibiting cannabis companies from taking standard business deductions based on Internal Revenue Code Section 280E. 

As discussed in a previous post, Section 280E prevents any trade or business that consists of trafficking in controlled substances from taking deductions or credits for business expenses other than the cost of goods sold. 280E has been a thorn in the side of attorneys, CPAs, accountants and business owners working in the cannabis industry for as long as cannabis companies have been filing their taxes. It has greatly increased the cost of doing business and has prompted even small cannabis companies to adopt complex corporate structures, including management and holding companies. Another tact has been to undertake extremely careful, and sometimes creative, bookkeeping in order to minimize the overly heavy tax burden.

Fed up with what it perceived to be unfair treatment, Harborside Health Center, a major cannabis retailer headquartered in Oakland, decided to take a stand against Section 280E. Unfortunately, a Tax Court didn’t buy their argument. On December 20, 2018, the court ruled that Harborside would have to repay business deductions, estimated to be tens of millions of dollars, that it took on its taxes between 2007 and 2012.

Harborside argued that 280E did not apply to their dispensary earnings because about two percent of revenue came from the sale of non-cannabis related products like clothing and lighters. Harborside relied on the language in 280E, which states that its restrictions shall apply to any trade or business that “consists of trafficking in controlled substances” to mean consists “only of controlled substances.” The U.S. Tax Court disagreed with this interpretation and held that the sale of non-cannabis products was “neither economically separate nor substantially different” from Harborside’s primary business in selling cannabis products. Harborside has said it will appeal the ruling, but for now, 280E’s ban on standard business for cannabis operators stands.

[Note: A previous version of this article ran on Wendel Rosen’s cannabis industry blog at www.calcannabislawblog.com on June 8, 2017.]

In June 2017, the California Assembly passed California AB 64, an omnibus bill regarding medical and recreational marijuana, and the bill is currently working its way through the California Senate committee process.

Federal cannabis trademark registration appears unlikely for the foreseeable future. The California cannabis industry and intellectual property lawyers are anticipating a trademark filing frenzy on January 1, 2018, when the California Secretary of State is scheduled to begin accepting trademark applications for cannabis goods and services.

California Currently Follows Federal Lead on Cannabis Trademarks

Under current law, the California Secretary of State will only register marks that are “substantially consistent with the federal system of trademark registration and protection under the Trademark Act of 1946 (15 U.S.C. §1051 et seq.) as amended.  To that end, the construction given the federal act should be examined as non-binding authority for interpreting and construing this chapter.” Cal. Bus. & Prof. Code §14272.

The United States Patent and Trademark Office (“USPTO”) will only register trademarks relating to commerce “which may lawfully be regulated by Congress.” 15 U.S.C. §1127, and specifically the USPTO requires that “use of a mark in commerce must be lawful use to be the basis for federal registration of the mark.”  Trademark Manual of Examining Procedure §907.

AB 64 Untethers California from the USPTO Limitations

The Legislative Analyst’s Digest for AB 64 identifies the conflict between California and Federal law relating to marijuana’s legality, and clarifies AB 64’s intended effect on marijuana trademarks:

(6) Existing law, the Model State Trademark Law, provides for the registration of trademarks and service marks with the Secretary of State and requires the classification of goods and services for those purposes to conform to the classifications adopted by the United States Patent and Trademark Office.

This bill, for purposes of marks for which a certificate of registration is issued on or after January 1, 2018, would, notwithstanding those provisions, authorize the use of specified classifications for marks related to cannabis, including medicinal cannabis goods and services that are lawfully in commerce under state law in the State of California.  (Emphasis added).

Specifically, Section 2(a) of AB 64 adds Section 14235.5 to the Business and Professions Code, which will establish two new cannabis trademark and service mark classifications:

Classification “500 for goods that are cannabis or cannabis products, including medicinal cannabis or medicinal cannabis products;” and

Classification “501 for services related to cannabis or cannabis products, including medicinal cannabis or medicinal cannabis products.”

Countdown to January 1, 2018

In plain English, on January 1, 2018, cannabis businesses will finally be able to register trademarks and service marks for cannabis goods and services, including trademarks for specific cannabis strains, assuming the proposed marks satisfy the other registration requirements (i.e. distinctiveness, lack of likelihood of confusion with existing registered marks, etc.)

Given that California is the most populous state, that the California cannabis market is projected to reach $6.5 billion by 2020, and that it is currently impossible to obtain a nationwide trademark for cannabis products, the California Secretary of State should anticipate receiving a tsunami of cannabis related trademark applications on January 2, 2018 (January 1 is an official State holiday).

Unlike the USPTO, which does not require an applicant to have used a mark in order to file an application (though proof of use is eventually needed for registration), California requires proof of actual use in commerce to file and register a trademark.  Cal. Bus. & Prof. Code 14202(h).  While existing cannabis trademarks already used in California may  already have common law trademark protection, registration with the Secretary of State would confer statewide rights and additional remedies.  Therefore, smart cannabusinesses should begin finding and using marks that will ultimately qualify for well in advance of the January registration date.

* A Californian cannabusiness would have zero chance of obtaining Acapulco Gold trademark because it would be geographically misleading and because the strain’s name is already widely used.

Marijuana is still listed as a Schedule 1 Controlled Substance by the U.S. Drug Enforcement Agency,  but a number of states have legalized it, even for recreational use. What’s a cannabis related entrepreneur to do to protect his or her intellectual property?

IPWatchDog just published How Can You Protect Cannabis-based Intellectual Property Under Federal Prohibition, addressing many of the obstacles and opportunities in the marijuana IP arena, including my input on common law trademark rights.