State Regulators Consider Better Ways to Determine Who Controls Cannabis Business
More flexibility is needed when assessing whether leases and lending and brand licensing agreements create a controlling interest
It’s no secret that there is an oversupply of legal cannabis, and as a result, wholesale prices have been falling in many states. According to Cannabis Benchmarks, this combination of oversupply and historically low prices has likely weakened demand from wholesale cannabis buyers.
To get a leg up on the competition, some cannabis growers and purveyors of processed cannabis products are turning to celebrities to make their offerings more unique in the minds of consumers. Legalization of recreational cannabis in California apparently has contributed to this heightened interest in celebrity branding activity. Recently, film director Francis Ford Coppola made a deal with a California grower to produce three “limited edition” strains of cannabis. Boxing legend Mike Tyson is hoping to play himself in a new TV sitcom based on his life as a cannabis entrepreneur, which apparently would feature his grow operation’s merchandise. Longtime musicians Jimmy Buffett and David Crosby have also announced plans to enter into branding deals.
This increased cannabis branding activity has apparently also attracted the attention of regulators in California. Recently, California’s Bureau of Cannabis Control proposed new regulations mandating that the businesses it licenses conduct commercial cannabis activities only with other California-licensed cannabis businesses. Prohibited commercial cannabis activities would include a licensee “packaging and labeling cannabis goods under a non-licensee’s brand or according to the specifications of a non-licensee.” This proposed new regulation would likely expand the number of licensees in California to include persons receiving royalty payments from branding agreements. Royalty payments emanating from cannabis branding agreements based on sales revenue or profit may trigger additional reporting obligations in other states as well.
Washington is amending its rules defining who must be vetted in connection with a state-issued commercial cannabis license, known as a true party of interest. This move comes in the wake of calls for an amnesty program for state-licensed cannabis businesses with undisclosed true parties of interest. However, the proposed amnesty program was never approved by the Washington State Liquor and Cannabis Board (WSLCB). An industry participant who requested anonymity noted, “The problem is [Washington’s true party of interest rule] forced the industry to continue to operate in the shadows, as illustrated by the WSLCB’s meetings regarding a delayed amnesty program.”
Why do these discussions about who should be licensed to own and operate a cannabis business matter for consumers and cannabis industry participants? As a consumer, does it matter who is responsible for making the food you eat and the prescription medicines you may take? How about your loved ones? It matters to most people, which is why they frequently rely on branding to help guide them in their purchase selections.
For state-licensed cannabis businesses, the concern seems to be mainly about creating and maintaining a more level playing field. Industry participants say that the bigger firms, with greater access to financial resources, have a decided advantage. Another concern is that, because cannabis brands and funding do not necessarily respect state boundaries, state-licensed cannabis businesses need to be better equipped to compete in a market that is becoming more national in scope. In addition, there is a social justice aspect to consider. A small grower who also requested anonymity said, “I am really trying to survive this industry, but as a female owner [it] seems to be a little tougher than most.”
Currently, the WSLCB rules say that a true party of interest is someone who receives or has the right to receive a percentage of a licensee’s sales or sales minus cost of goods sold, or who controls a state-licensed cannabis business. However, landlords who receive “reasonable” fixed rental payments, financial institutions and others who contract with the licensed cannabis business are excluded from this definition, if they do not exercise control over or participate in its management. Employees of a licensed cannabis business are also excluded from this definition if their bonuses are not too large, which would make it appear as if they are truly in charge of operating the business.
It is worth noting that, depending on the specific terms of leasing, lending and branding agreements, they all potentially impact how a state-licensed cannabis business may operate. In addition, the sharing of sales revenue and profits with landlords, lenders and brand licensors may be beneficial to a state-licensed cannabis business because it shares risk. Therefore, true party of interest regulations should be more flexible in determining who really controls a state-licensed cannabis business. In other words, regulators should weigh the substantive terms of these individual agreements more heavily in determining whether a landlord, lender or brand licensor is a true party of interest. Placing greater weight on the substance of these agreements, instead of their form, would actually make it harder for industry participants to circumvent the rule’s intent.
In the context of accounting for business combinations, International Financial Reporting Standard (IFRS) 10 has been used to determine whether one legal entity controls another. Under this rule’s framework, a landlord, lender or brand licensor would be deemed a true party of interest if it had both the right to receive variable returns and the ability to affect those returns by exercising its contractual power over the tenant’s, borrower’s or brand licensee’s commercial cannabis activities. Therefore, it may be worthwhile for California and Washington regulators to consider using an adaptation of IFRS 10 to determine whether leases and lending and brand licensing agreements create a controlling interest in a state-licensed cannabis business.