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Marijuana 2016: Dance with the Angels or Swim with the Sharks

A primer for potential investors, current owners of marijuana businesses, banks that may be considering dipping their toes in the water, and others that do or wish to provide services and products to the legal marijuana industry

April 2016 | Revised March 2017

Marijuana 2016 Update: The McIntosh Decision and Federal Enforcement

More about Sacks Tierney's Marijuana Business Law practice

 

Introduction

Explosive Growth

On March 20, 2016, USA Today published a full-page article[1] reporting that total U.S. legal marijuana sales had reached $5.7 billion in 2015 and were expected to increase to about $7.1 billion in 2016. The article further noted that projections indicated 2020 sales of about $23 billion from states likely to have legalized some form of marijuana by then. Other reports project sales could be as much as $35-$44 billion by that year, depending on the number of states that enact some form of decriminalization.

The information in this article will be of interest to potential investors, current owners of marijuana businesses, banks that may be considering dipping their toes in the water and others that do or wish to provide services and products to the industry, in each case here in Arizona and elsewhere.

As many are aware, the principal impediment under federal law to the legalization of medical marijuana is its classification as a “Schedule I” substance. The criteria for its inclusion in that category are (i) high potential for abuse and (ii) no accepted medical efficacy or safety. In a late- breaking development, by letter dated April 4, 2016, the U.S. Drug Enforcement Administration (DEA) confirmed that it had received a “scheduling recommendation” from the U.S. Department of Health and Human Services (HHS) and that it “hopes to release its determination in the first half of 2016.” No indication was given with respect to what the HHS recommendation is. Legalization proponents, while pleased, are not particularly optimistic. The potential implications of this development are discussed subsequently in this article in the sections dealing with federal law.

Window of Opportunity

Recent experience and information that we have gained in transactions related to Arizona’s legalized marijuana industry substantiates what many observers believe – that current circumstances have created rapidly narrowing windows of opportunity for:

  • high net worth and angel investors that have a tolerance for uncertainty and wish to stake out a beachhead before more institutionalized investors enter the market, increasing competition for ownership opportunities and, almost certainly, the price of entry;

  • current owners of Arizona marijuana businesses that need, or will almost inevitably need, substantial capital to remain competitive, or wish to cash out now, and would prefer to dance with angels than swim with the sharks as the landscape of investors undergoes a dramatic evolution from speculator to angel to corporations and institutions;

  • owners and investors that are interested in multi-state opportunities and believe that a successful track record in one state will provide at least some competitive advantages in (i) acquiring licenses in states that have legalized marijuana and are still entertaining license applications, as well as those that may legalize it in the future, and (ii) national branding;

  • banks and other financial institutions that would like to get in front of the competition and, thereby, generate the large deposits and substantial, non-price-sensitive fee-based income from a vastly underserved market, presumably providing a unique opportunity to create customer loyalty that will enhance the prospects of customer retention even as the developments described in this article inevitably draw more and more banks into the mix; and

  • ancillary businesses that do or will serve the industry, including service providers, such as lawyers, accountants, consultants of all kinds (e.g., operational, marketing, branding), logistics/transportation companies and testing laboratories, as well as construction and property maintenance businesses, developers and providers of technologies for the extraction and processing of cannabis oils, and manufacturers of hydroponic and other equipment.

EXECUTIVE SUMMARY

The window of opportunity in Arizona and elsewhere is the by-product of a combination of developments at the state and national levels. These developments are accelerating, indeed compelling, both (i) an evolution in the universe of investors to progressively larger and more institutionalized players, and (ii) the increasing investment in and application of agricultural, hydroponic, extraction and other technologies, as well as botanical and other sciences, to enhance productivity and quality while controlling costs and protecting margins.

This has already begun to increase the price of admission to the industry and the costs of meeting competition. At the same time, developments at the national level have led many to believe that a tipping point may be fast approaching that legalization supporters hope and expect will mitigate, perhaps eliminate entirely, the impact of the “elephant in the room,” i.e., the continued illegality of marijuana under federal law.

At the national level, the marijuana industry appears to be rapidly moving out of the shadows and into the mainstream as more states decriminalize medical and/or non-medical marijuana and more reliable, official data is becoming available regarding the economic and social impact of doing so. The economic data is thus far substantiating the prospects for the industry’s growth and the billions of dollars of new taxes states can generate. While not enough time has passed to draw meaningful conclusions regarding legalization’s social impact, its supporters believe that no significant red flags have yet been raised. As a result, it appears that the potential public image concerns are diminishing and the likelihood increases of a resolution – favorable to the industry and its participants – of the conflict between federal and state law that has kept many potential players on the sidelines.

Our experience and related due diligence have informed us with respect to (i) the challenges and uncertainties faced by marijuana businesses and their investors in Arizona and in other states, and some possible approaches to addressing them, and (ii) the potential impact of changes in the mindset and legal framework nationally. As a result, we have developed, and continue to nurture, a growing pipeline of information, contacts and other resources that can assist clients participating or that wish to participate in the industry.

These resources include:

  • experience-based familiarity with how the marijuana industry currently operates and is regulated;

  • how marijuana businesses now operating in Arizona flow funds in the face of the state’s current non-profit operating requirement;

  • an increasing flow of contacts we are receiving from mid to ultra-high net worth, corporate and hedge fund investors actively seeking investments in Arizona and elsewhere;

  • knowledge of and/or access to potential sources of acquisition/investment opportunities; and

  • familiarity with the variety of structures being used for acquisitions and investments.

These resources also include more mundane but equally critical capabilities such as the ability to provide added value through the identification of (i) banks willing to accept, or at least consider, deposits from, and provide other services to, an industry that has largely been denied access to those services, (ii) consultants that can assist in licensing and operations, (iii) accounting firms familiar with the arcane ins and outs of special tax provisions applicable to the industry, and (iv) sources/providers of emerging technologies that are likely to change the face of the industry.

Against this background, the objectives of this article are to briefly summarize and provide context with respect to:

  • the challenges presented by current Arizona and federal law;

  • developments on the national level which have already had, or could or are likely to have, an impact on the marijuana industry here and elsewhere and, potentially and critically, on federal law.

Caveats

We are lawyers, so of course we need to have caveats.

Although this article discusses potential developments that could be impactful, particularly with respect to possible changes in federal law and actions that may be taken at the state level, nothing in this article should be interpreted as a prediction of what will actually happen or legal advice with respect thereto.

ARIZONA: PAST, PRESENT AND FUTURE

Historical Perspective

In 2010, Arizona became the 15th state to decriminalize medical marijuana. Under Arizona law, a dispensary certificate (license) is required to engage in cultivation, processing and distribution of medical marijuana, but the law does not require a dispensary to also cultivate and process the marijuana it sells. Certificate holders are permitted to wholesale marijuana to other, unaffiliated dispensaries.

Direct, top-line revenues in Arizona from medical marijuana tripled year over year from 2013 to 2014. Based on reported sales for the first ten months of 2015, it is likely that revenues for that year will total $140-$160 million.

Responsibility for the issuance of certificates, as well as the administration of the law and regulation of the industry, was vested in the ADHS. That agency began issuing certificates in 2012, using a lottery process, limiting the number of licenses on a formula basis tied to a combination of the number of pharmacies in the state and a limitation of one certificate for each Community Health Analysis Area (CHAA). Initially a total of 126 certificates were offered, but there were no applicants for 18 CHAAs. In response to a recent inquiry, the ADHS advised that there are 92 licensed dispensaries currently operating in the state.

The lottery process resulted in an eclectic mix of owner/operators. Essentially, the only criteria were (i) having been selected, (ii) being able to pay the fee, and (iii) surviving a background check. Not surprisingly, a percentage of the lottery winners lacked business experience and/or expertise in the cultivation of marijuana or had unrealistic expectations or inadequate resources to meet unforeseen challenges. The results of their operations have been mixed. Some appear to have been quite successful, others less to much less so, and still others are currently experiencing some level of financial distress. In fact, several are actually in receivership, primarily as a result of ownership disputes over money. Of those entities operating profitably, a number lack both the financial and operational/management resources to successfully operate in the increasingly competitive environment that is being driven by those that have access to those resources and are rapidly creating/acquiring and deploying technology and science that enhance productivity and quality while reducing or controlling costs.

Current Circumstances: Challenges Presented Under Arizona Law

Arguably the most significant anomaly of Arizona’s current law is presented by A.R.S. § 36-2806(A), which requires that marijuana businesses (at least dispensaries) be “operated on a not-for-profit basis,” thereby effectively precluding profit distributions. However, it also specifically provides that marijuana businesses need not be incorporated under the not-for-profit provisions of Arizona’s corporation law, presumptively thereby authorizing their organization under its for-profit provisions.

This non-profit operating and for-profit organizational structure anomaly impedes investment due to the challenges it presents in providing investment returns while, at the same time, offering the most direct current path for entering the business in Arizona.

Although ADHS issued a release indicating that it would award a limited number of new certificates in the summer of 2016, until the agency does so and since the certificates themselves are not transferrable, acquisition activity has focused on investing in or acquiring control of business entities that either own certificates or have contracts to provide services and products to them. The ADHS release did not specify how many new certificates would be available or exactly when the process would begin. ADHS officials have advised that there will be a 10-day prior notice that applications would be accepted and, thereafter, a 30-day period for the submission of applications. As distinguished from the initial lottery system, these new applications would be scored, but specifics regarding the metrics which will be used to score applications are not yet available. In addition to familiarizing themselves with what the ADHS has indicated, and remaining attuned to future releases, there are things potential applicants should be doing now.

The significance of the organizational “flexibility” under A.R.S. § 35-2806(A) is that corporations organized under the for-profit sections have shareholders, while those organized under the non-profit sections do not. Thus, while the non-profit operating requirement has created challenges (discussed below) on the investor side, there is nothing in the law that prevents or limits the realization of value by owners through the sale of all or a portion of their ownership interests in the business entities that hold the certificates or, under contractual arrangements, provide various goods and services to them.

The non-transferability of certificates that prevents investment through an asset acquisition has complicated acquisition/investment transactions, requiring complex and careful structuring in various respects. Among other things, contrasted with an asset acquisition where liabilities can be left behind, acquiring an entity requires purchasers to take into account the risks of undisclosed and/or contingent liabilities. To address the liability risks, some transactions involve a holdback, perhaps requiring the payment of all or a portion of the purchase price or investment into an escrow. To address the current owners’ optimistic expectations, and to provide them with continued motivation, some control acquisitions have been structured to leave the seller with some form of continuing operational participation and/or carried interest.

Many, if not most, of the acquisition/investment transactions of marijuana businesses in Arizona have been done through limited liability companies or partnerships taxable as pass-through entities for income tax purposes. The inability to make distributions to owners due to Arizona’s current non-profit operating requirement creates a very significant challenge for investors, i.e., potential tax liability for pass-through income that cannot be covered by distributions from the operating entity at which most, if not virtually all, income is derived. Although there is a 100% solution available to eliminate this tax issue, it would involve double taxation, at least until the law is changed to eliminate the non-profit operating requirement, an anathema to most investors.

As briefly discussed in a subsequent section of this article, this tax issue is magnified by special Internal Revenue Code (IRC) provisions that are applicable to the marijuana industry and that have the effect of increasing taxable revenue by denying the industry certain deductions available to other businesses.

These circumstances have resulted in the creation of multi-entity organizations with a complex of inter-company transactions in an effort to avoid running afoul of the non-profit operating requirements. These complexities can have a chilling effect on investment. Combined with the mainstreaming of the industry, enabling operations on a for-profit basis would be an important step in facilitating the entry into the market by progressively larger and more institutionalized investors.

FEDERAL LAW: CONTROLLED SUBSTANCES, TAXATION AND BANKING

The interaction between federal and Arizona law regarding marijuana is complex, and the balance of this section of the article is intended as only a summary of several key elements of federal law and certain implications they have with respect to the conduct of and investments in cannabis businesses:

  • Marijuana is currently classified as a Schedule I drug under the Federal Controlled Substances Act (CSA), which defines Schedule I drugs as those (i) presenting a high potential for abuse; (ii) having no currently accepted medical use in the United States; and (iii) in respect of which there is a lack of accepted safety under medical supervision.

  • The operations of and investments in marijuana businesses also implicate various federal financial crimes laws beyond the CSA, including the Bank Secrecy Act and the Patriot Act. Thus, for example, the principal inhibition to the access of marijuana businesses to banking services, other than the optics which are likely to change as the industry enters the mainstream, is the burden of compliance with regulatory record keeping and reporting requirements.

  • Special tax provisions are applicable to cannabis businesses under the IRC.

The CSA and Related Financial Crime Laws

Notwithstanding a series of Department of Justice (DOJ) policy releases beginning in 2009, which articulated a modified “hands off” approach with respect to marijuana activities conducted in conformity with state law, the cultivation, processing, distribution and possession of marijuana remain illegal under federal law. Accordingly, unless and until the CSA is amended, or the Schedule I classification of marijuana is changed, the risk of a return to strict enforcement remains and continues to have a chilling effect on investment. While many observers believe that anecdotal data and increasing evidence of medical efficacy being reported in clinical trials will inevitably result in a removal of marijuana from the Schedule I category, no one can predict if or when that might occur. Even if it does, the impact of doing so may facilitate only medical marijuana which, as previously noted, is itself a substantial business. Supporters of legalized medical marijuana maintain that federal government policies are unjustifiably constraining the clinical testing process.

As a result, in private placement memoranda in connection with investments offered in marijuana businesses operating legally under Arizona law, we have included four pages of risk factors outlining both federal law and the DOJ policy guidance releases. The list of risk factors concludes with the following caution:

PROSPECTIVE INVESTORS SHOULD BE AWARE THAT, SHOULD IT BE DETERMINED UNDER THE CSA THAT THE ISSUERS ARE ENGAGED IN ACTIVITIES IN VIOLATION OF THE CSA, THE FEDERAL GOVERNMENT COULD COMMENCE CRIMINAL ACTIONS AGAINST THEM AND SEIZE THEIR ASSETS, WHICH WOULD LIKELY RESULT IN THE COMPLETE LOSS OF SUCH INVESTORS’ INVESTMENTS.

FURTHERMORE, SHOULD IT BE DETERMINED UNDER THE CSA THAT THE ISSUERS ARE ENGAGED IN ACTIVITIES IN VIOLATION OF THE CSA, INVESTORS IN THOSE ENTITIES COULD BE SUBJECT TO FEDERAL CRIMINAL PROSECUTION FOR AIDING AND ABETTING A VIOLATION OF THE CSA AND/OR FOR FINANCIAL CRIMES IN CONNECTION WITH MARIJUANA-RELATED CONDUCT.

Taxation: Words Matter - the Art of Accounting

Section 280E of the IRC denies businesses deemed to be involved in “trafficking” in substances classified as Schedule I or II substances deductions for ordinary and necessary business expenses that are available to other businesses. It essentially limits deductions to those expenses which can properly be allocated to the cost of goods sold (COGS). The Internal Revenue Service (IRS) has been applying those standards strictly to even those marijuana businesses that are operating legally under state laws. As a result, taxes under the IRC are assessed based on revenues far in excess of actual “profits.”

If marijuana is reclassified due to acceptance of its medical efficacy and safety under medical supervision, this challenge may be mitigated or eliminated. Unless and until that happens (and it is impossible to predict if or when that might happen or how the IRS will deal with it in that eventuality), it is critical for marijuana businesses to have the benefit of accountants with experience and expertise in the industry to assure that all expenses that properly can be are allocated to COGS.

Banking

Although there are a few banking organizations that provide services to the marijuana industry, the vast majority have been deterred by compliance burdens and image considerations. The lack of access to those services, requiring that marijuana businesses be conducted on a cash basis, has been a major challenge in a number of respects. In addition to lack of access to deposit and other account services, the industry has not been able to accept credit or debit card payments.

This environment has created enormous operational and security issues for an industry that generates huge amounts of cash. It has also compromised the ability of these marijuana businesses to implement the kind of financial controls that would make investors more comfortable and that many observers believe would help address and mitigate money-laundering concerns underlying the Bank Secrecy Act, the Patriot Act and other federal financial crimes laws.

We have identified one bank doing business in Arizona that accepts marijuana business and another that is dipping its toes in the water. In addition, we have identified firms that have developed and customized proprietary software for the banking industry that essentially automates the compliance, reporting and audit processes and, in some cases, have created an automatic funds transfer mechanism that would enable customers to link their bank accounts to that of the marijuana business, enabling at least some cashless transactions.

Banks that can and are willing to offer services to the industry are attracted by the potential to create deposit and fee generation engines. The early entry banks are and will be able to realize substantial account maintenance and transaction charges, at least until enough other banks enter the market to create a competitive environment.

Other Service Provider Challenges

Lack of access to banking is not the marijuana industry’s only practical challenge with respect to service providers. At least two others are (i) securing adequate armored car service, obviously a high priority so long as the industry has to operate on a cash basis, and (ii) obtaining commercial insurance. Both are constrained by concerns over federal law.

The armored car industry is concerned over the potential application of federal financial crimes laws to any marijuana services, and the availability of commercial insurance services to the marijuana business received a systemic shock when, in 2015, Lloyd’s of London informed its underwriters that it was exiting the business until federal law issues are resolved.

The good news is that these developments have resulted in the entry of new providers of such services, but these kind of practical issues remain challenges for the industry.

NATIONAL TRENDS: MOVING INTO THE MAINSTREAM

Absent a major negative development, there is rising, albeit cautious, optimism among legalization proponents that the national trends discussed in this article that appear to be bringing the marijuana industry into the mainstream will result in full or partial decriminalization under federal law. These trends include (i) legalization in more than a majority of states, (ii) increasing involvement in the industry by influential investors, and (iii) the impact on the economies of and massive new state taxes generated by the states that legalize marijuana.

Combined with public image considerations, which the mainstreaming of the marijuana industry seems likely to diminish, concerns over federal law have deterred and slowed the entry into the arena of private equity firms and other larger, more institutionalized investors, as well as banks, a circumstance which the developments at the state and federal levels could change dramatically.

To recap, this anticipated growth, combined with developments anticipated on the national level, will almost inevitably:

  • dramatically increase the need for investment capital;

  • increase the availability of reliable, experienced-based data, thereby allowing the investment community to achieve a higher comfort level by enhancing their ability to evaluate projected revenues, profits and risks on a more traditional and credible basis and the states to more confidently project incremental tax revenues;

  • accelerate, perhaps to a tipping point, the transition of the marijuana industry from the shadows into the mainstream;

  • further whet the appetite of the investment community for investments, in Arizona and elsewhere, which will have the effect of progressively broadening the universe and changing the nature of investors, evolving from speculators to high net worth individuals to hedge funds and ever larger, more institutional investors exponentially increasing the amount of investment capital available;

  • increase competition for investment opportunities and, therefore, the price of admission;

  • increase competition within the industry, which, together with the higher cost of entry and progressively more sophisticated investors, will drive developments to increase efficiencies and enhance or protect margins, which will in turn drive more capital and investors to the industry as well as the professionalization of management and the streamlining of operations; and

  • increase both (i) the application of existing science and technology, i.e., botany, hydroponic growing, oil extraction technologies and the creation of consumables and (ii) research and development to advance these and other scientific and technological areas relevant to the marijuana industry and those industries that serve it.

[1] Information for the USA Today article, “Legal Marijuana Sales Forecast to Hit $23 Billion in Four Years,” was drawn from the Executive Summary of the 4th Edition of “The State of Legal Marijuana Markets Report” co-published by ArcView Market Research and New Frontier Financial. Available online at www.arcviewmarketresearch.com/executive summary, the Executive Summary is a must read for those interested in becoming involved in the marijuana industry and an interesting and informative read for anyone curious about the emergence of a major industry.