The uncertainty of the legal regime governing cannabis makes thorough due diligence on prospective business partners essential for those who want to ensure that they are complying with state law and minimizing their risks of federal investigation. In this two-part series, we first discuss some key compliance lessons from recent events and then offer a checklist for use when conducting due diligence on potential partners.

Lesson I: Even “legal” companies sometimes violate state law

“It’s o.k. – they’ve got a license.” But it may not be o.k. Several recent cases have shown that mere possession of a license is not a guarantee that a cannabis business will comply with all state laws. For example, Pennsylvania regulators recently revoked the cultivation permit of Agrimed Industries, a licensed medical marijuana grower, due to a “flagrant disregard” of regulations, “grossly mismanaged” plants and the possibility that some plants had been diverted to the black market. In Massachusetts, regulators recently froze the operations of licensee Nova Farms, LLC upon learning of criminal charges against one of its owners. Meanwhile, a criminal case involving alleged interstate smuggling by former executives of Vireo, a licensed multi-state operator, is pending in state court in Minnesota.

Even licensed operators can get into trouble and verification of possession of a state license should therefore be the beginning, not the end of due diligence.  Risks associated with state-licensed operators may not be readily apparent, but can often be detected by thorough due diligence such as the measures recommended in the checklist in Part II.

Lesson II: Get to the ultimate beneficial owner

As the Nova Farms case illustrates, thorough due diligence on owners is essential.  Yet the most thorough due diligence is not worth much if it is conducted on the wrong counterparty. Many multi-state cannabis operators have unusually complicated corporate structures composed of layers of subsidiaries and affiliates. These arrangements are partly the result of efforts to manage risks around inter-state commerce and the challenges of raising financing in the cannabis industry, but the result is that it can be difficult to (1) identify the beneficial owners of a cannabis company, and (2) determine who truly controls a license in a given state.

State regulators, who obviously have an interest in knowing exactly who will control the operations of licensed cannabis businesses in their states, are growing increasingly frustrated by the complicated ownership structures and contractual agreements developed by multi-state operators. A prime example of this is Harvest Health & Recreation, an Arizona-based company that has been scrutinized by regulators in Pennsylvania and Ohio for allegedly violating caps on the number of licenses it can control, or using a combination of corporate structure and contract agreements to “control” licenses that it does not own. Harvest recently abandoned two of its permits in Pennsylvania after regulators determined that it had exceeded the license cap of five permits per company. Several other large multi-state operators were the subjects of an investigative series from The Boston Globe, “The Hidden Titans of Pot,” that focused on ownership structure and control in Massachusetts.

State regulators are becoming more savvy about enforcement of license caps and ownership rules. Those looking to partner with cannabis businesses need to be similarly diligent in identifying the ultimate beneficial owners of those businesses to be able to confirm that ownership complies with relevant state law.

Lesson III: Just because hemp is legal does not mean that it is unregulated

The 2018 Agriculture Improvement Act, more commonly known as the “Farm Bill,” decriminalized hemp (defined as cannabis containing less than .3% THC on a dry weight basis). The passage of this legislation unleashed a wave of new cannabidiol-infused products across the US, from capsules to coffee, including products for sale in retail pharmacies.

However, the Farm Bill did not exempt hemp companies from compliance with the requirements of the Food, Drug & Cosmetic Act (FD&C Act). As then-FDA Commissioner Scott Gottlieb pointed out upon passage of the Farm Bill, the FDA requires a cannabis product (hemp-derived or otherwise) that is marketed with a claim of therapeutic benefit, or with any other disease claim, to be approved by the FDA for its intended use before it may be marketed. Cannabis and cannabis-derived products claiming that they can be used to diagnose, treat, or cure diseases must go through the FDA drug approval process. The FD&C Act also makes it unlawful to introduce food containing added CBD or THC into interstate commerce, or to market CBD or THC products as, or in, dietary supplements, even if the substances are hemp-derived.

An example of what can go wrong: In July, the FDA issued a warning to Curaleaf, Inc., a multi-state operator in both the cannabis and hemp spaces, for making unapproved health claims regarding its hemp-based CBD products. This case highlights the importance of compliance with the regulatory scheme that will continue to govern even legal products. When conducting diligence on a potential partner, it is important to remember that a hemp business is not risk-free, and legal does NOT mean unregulated.

Lesson IV: Not all licenses were obtained legally

The cannabis industry suffers from the same corruption risks that plague other high-risk industries, like mining and gaming. When applying for a license to operate, cannabis companies often need approval from a range of municipal and state authorities including, sometimes, the local zoning board, the city council, mayor, and state regulator. Under these conditions, there are many opportunities for bribes to smooth the way, and in a cash-heavy industry like cannabis, these transactions can be hard to catch.

Federal law enforcement now appears to be targeting corruption in the industry. In a recent FBI This Week podcast, entitled “Public Corruption Threat Emerges in Marijuana Industry,” an FBI spokesperson explained: “As an increasing number of states change their marijuana legislation, the FBI is seeing a public corruption threat emerge in the expanding cannabis industry.” On the same show, an FBI Supervisory Special Agent said “We’ve seen in some states the price go as high as $500,000 for a license to sell marijuana. So, we see people willing to pay large amounts of money to get in to the industry.” The podcast ended with the following plea to listeners: “If you suspect a dispensary is operating with an illegally obtained license, or suspect public corruption in the marijuana industry, contact your local FBI field office.”

The podcast was not just scaremongering. Less than a month later, the US Attorney’s Office in Massachusetts indicted the mayor of Fall River, Massachusetts for extorting more than $500,000 in bribes from four cannabis license applicants. The bribes were allegedly paid in exchange for “non-opposition” letters, which are a necessary component of the state license application in Massachusetts. This is not the only known incident of public corruption in cannabis licensing. Cases of bribes being offered or demanded in exchange for licensing have also been reported in California and Michigan. Given the FBI’s focus on corruption in the industry, more cases are likely. Therefore, it is extremely important to follow up on any indications that a license may have been obtained illegally.

In a follow-up post, we will provide a practical checklist of questions to help detect red flags and avoid the risks we have discussed above.

Author

Tom Firestone is Co-Chair of the firm's North American Government Enforcement practice and is a member of the Firm's Global Compliance & Investigations Steering Committee. He represents clients in matters involving anti-corruption and the US Foreign Corrupt Practices Act (FCPA), internal investigations and transactional due diligence. He is also a member of the firm's Cannabis Review Committee and has advised clients on compliance issues related to cannabis.

Author

Tanya Hoke is the Managing Director of Galen Diligence, which has provided investigative due diligence services focused on the legal cannabis industry since 2015. She is a Certified Fraud Examiner, Certified Anti-Money Laundering Specialist, and a member of the National Cannabis Industry Association's Banking & Financial Services Committee.