Cannabis - Not a Weed Anymore

Published: Jun 5, 2019
Share

One of the hottest markets in the manufacturing sector today is, believe it or not, cannabis, and its cousin, hemp. In a meteoric recent rise to fame, cannabis is dominating many state legislatures and Congress as well.

It is a total non-sequitur. Cannabis, its manufacture sale and use, is illegal in the United States, and has been so since 1970. In the 1600s, the King of England encouraged the cultivation of cannabis in the Colonies. It remained legal until 1970, when the Marijuana Tax Act of 1937 was declared unconstitutional, and the Controlled Substances Act (“CSA”) was enacted. Marijuana is listed as a Schedule 1 drug under the CSA, thus making it illegal for all Federal purposes.

Yet, in a bizarre and unpresented twist, thirty-six states have now legalized cannabis for medicinal use, for recreational use, or both. This dichotomy between federal illegality and state legality presents a host of problems for industry participants.

In 2014, Assistant Attorney General James Cole issued the now-famous “Cole Memo” which merely set priorities for federal enforcement of illegal cannabis activities. The Cole Memo was echoed by the U.S. Treasury Department in a companion memo. Industry people took the Cole Memo as a “safe harbor” for permissive cannabis activities. At the same time, Congressman Dana Rohrabacher (R-CA) successfully added an “amendment” to the federal budget bill (known as the “Rohrabacher-Farr Amendment”) prohibiting the U.S. Justice Department from using federal funds to prosecute medical cannabis businesses and users. The cannabis industry exploded and states started to enact permissive legislation.

In January 2018, Attorney General Jeff Sessions revoked the Cole Memo. The industry barely blinked. Cannabis cultivation, manufacturing and sales exploded in 2018 despite Session’s attempt to stranglehold the industry. The new Attorney General, William Barr, seems uninteresting in prosecuting cannabis.

Nonetheless, the fact of federal illegality keeps U.S. public companies, many private equity funds and others wary of investment. Further, although many states have legalized cannabis activities, federal illegality means that cannabis seeds, plants and products cannot move in interstate commerce. So, everyone has to stay in their own state, or replicate their businesses in every state in which they wish to operate. This is expensive and creates diseconomies of scale.

Meanwhile, Canada legalized cannabis for all purposes in 2018. The Canadian Stock Exchange (“CSE”) has permitted cannabis enterprises to go public in Canada. Thus, many Canadian cannabis enterprises have gone public on the CSE and have used their public stock as currency to come to the U.S. and buy up many cannabis businesses. At last count, billions have been invested by Canadian companies in the U.S. cannabis market. Also, U.S.-based companies, such as MedMen, have gone public in Canada on the CSE and used their public stock to expand their U.S. operations. Some experts have reported that cannabis is expected to be a $20 billion market in the U.S. by 2021.

To make matters even more intriguing, cannabis has a cousin – hemp. Hemp is a cannabis plant that tends to produce less of the psychotropic substance THC (tetrahydrocannabinol) than cannabis strains, and more of the other substance in cannabis plants – CBD (cannabidiol). CBD is reported to have many possible medical benefits, so many that Fortune 500 companies are trying to put CBD in drinks and other edibles. Hemp was also illegal for federal purposes until December 2018, when Senator Mitch McConnell (R-KY) successfully appended hemp legalization provisions into the 2018 Farm Bill. Thus, hemp plants which contain less than 0.3% THC are now legal, although technically the FDA has to issue regulations. An entire industry is now born and accelerating at an astonishing pace.

Despite the swelling interest and significant investment, cannabis is far from a simple business. There are many challenges facing cannabis industry participants.

For example, many years ago in response to Pablo Escobar, the infamous drug czar, Congress added Section 280E to the Internal Revenue Code. IRC Sec. 280E prohibits any business engaged in trafficking in controlled substances to take any deductions or credits, except for inventory cost. Cannabis is a Schedule 1 drug. Thus, cannabis business can only take inventory deductions. A recent Tax Court case narrowly defined the costs that can even go into inventory expense. This decreases the EBITDA of cannabis businesses. Interestingly, since hemp is no longer a Schedule 1 substance, hemp businesses are not (since December 2018) subject to IRC Sec. 280E.

Each legalizing state has enacted tax statutes to capture revenue from the explosion of cannabis and hemp-derived CBD sales. State and local governments are collecting various sales and excise taxes from wholesalers, distributors, retailers and consumers. All get added to the price in the store – at least for now.

The legalizing states all have complex licensing, building code and other regulatory compliance laws that must be dealt with by cannabis enterprises. Some states have limited licenses, both for manufacturing and retail dispensaries alike. California has no less than twelve licensing categories at the state level, and each local government has their own categories as well. It is a virtual compliance nightmare.

There are real estate challenges as well. Zoning laws prohibit cannabis enterprises from operating except in discrete locations. Building codes and environmental laws are complex for cannabis businesses as well. A hoard of expensive and time-consuming issues result.

To make matters worse, there are few banks across the U.S. that will take accounts for cannabis businesses. At last count, around 450 banks, savings and loans, and credit unions across the country will accept deposits. Accepting deposits from cannabis enterprises is not, as one would suspect, illegal. To the contrary, the Federal Reserve has gone out of its way to accommodate cannabis banking. However, the banks deem it too risky, especially since they have to comply with anti-money laundering (“AML”) rules and, among other things, file suspicious activity reports (“SARs”) for every cash deposit. Since cannabis enterprises cannot get easy access to credit cards, most transactions are in cash. Ergo, bank are forced to file SARs. Most are not willing to establish compliance protocols, and if they do, they charge handsomely for the cannabis clients to bank with them.

Entering and succeeding in the cannabis and hemp business is not for the faint of heart. Significant risks exist at every level. This is the primary reason why so many investors are still on the sidelines.

Yet, the opportunity is tantamount to the fledgling alcohol business after Prohibition ended, gambling in Las Vegas and Atlantic City, and the dot com explosion of the late 1990s. Savvy investors already see the substantial (and quick) upsides. However, not everyone will prosper.

Who will? Those enterprises that have clear market goals and niches. Also, they must surround themselves with quality professionals – attorneys, accountants, consultants, insurance brokers, investment bankers. Why? Because this business is fraught with federal, state and local risks. As the end products becomes commoditized, the weak will fall by the wayside. The strong will dominate the industry.

M&D Intelligence - Q2 2019