Top Legal Trends for Cannabis Businesses in 2023

December 22, 2022

In this episode of CannaCast, Eric Altstadter, Partner and leader of EisnerAmper’s Cannabis and Hemp Group, speaks with Neil Kaufman, Managing Member of Kaufman McGowan, PLLC, and one of Cannabis Law Report’s top cannabis lawyers. The two take a deep dive into some of the legal issues, trends, and developments industry leaders need to know going into the new year, from both federal and local levels.


Transcript

Eric Altstadter:Thanks for tuning into this episode of CannaCast. I'm your host, Eric Altstadter, EisnerAmper's National Cannabis and Hemp Practice Leader. Please welcome our guest, Neil Kaufman, managing member of the law firm of Kaufman McGowan, PLLC. There his practice focuses on providing counsel to businesses, individuals regarding corporate law, securities law, and cannabis. Neil was one of the first attorneys to work in the cannabis space and has been advising clients all over the country for over five years now. He was named the top cannabis lawyer by the Cannabis Law Report. Welcome, Neil.

Neil Kaufman:Thanks, Eric. Glad to be with you.

EA:Neil, you were one of the first attorneys to work with cannabis companies. How did you first get into the cannabis space?

NK:Well, it's been eight or nine years now, Eric. We started representing an applicant for one of the New York medical licenses back in 2014 or '15, and like many clients when we first inherited them, they needed a little bit of cleanup work. They ended up conducting multiple rounds of private financing. And of course, when we represent a client raising capital, we have to learn their business because we have to make full disclosure about their business to potential investors. So we learned the business and this client kept saying, "You know, Neil, now that you know the cannabis industry, you really ought to go into it heavily. There aren't that many good lawyers in it, and you'll really do well." And I kept saying, "No, no, leave me alone. I'm so busy anyway. Enough."

But we did a few deals for them, and I went to MJBizCon and a couple of other conferences, and before you knew it, cannabis was 80% of our practice. We were fortunate to get involved at a time when they were right, there were not that many good lawyers involved. We were real securities and corporate lawyers bringing those skills to bear, combining that with our hands-on knowledge of the industry, we were able to successfully brand ourselves as a high quality provider, and it's been all up from there. We've now participated in over $2 billion of cannabis industry transactions.

EA:That's great. Neil, there's been some limited movement toward federal legalization. In early October, we had what is being referred to as Biden's marijuana pardon. What does this proclamation do and what doesn't it do?

NK:The Biden marijuana pardoned federal convictions for simple marijuana possession offenses, and that included offenses within Washington DC itself, but it did not cover convictions under state or local law, so it really had somewhat of a limited impact. I would characterize that as not really much movement towards federal legalization. In fact, there's been very little movement towards federal legalization.

Now, the Biden administration also asked that the federal government review the current scheduling status of cannabis as a Schedule 1 drug under the Controlled Substances Act. That is a time consuming process which needs to jump through a whole bunch of regulatory hurdles. There's a whole specific legal process that has to be followed, where ultimately the decision will be made by the Attorney General based on the recommendation by the Secretary of Health and Human Services.

That process has at least begun, but I don't think we should be holding our breath for that to legalize cannabis anytime soon. In fact, rescheduling cannabis down to a higher schedule would not really solve the structural legal problem with cannabis, because FDA approval would still be required for any cannabis product that made medical claims, and that would put in jeopardy the entire medical marijuana industry, where all these companies right now under state law are making medical claims about their cannabis products. I don't think anyone can really predict how those would be treated by the FDA and the DEA under a new regime that still required FDA approval of making medical claims for drug products.

What we really need is a statutory remedy like what has been done for tobacco and nutritional supplements. That would be a much better fix. That's probably ultimately the way that cannabis will be legalized on a federal level in this country, and there's no sign of that happening whatsoever.

EA:The SAFE Banking Act has passed the house now about six times only to fail in the Senate each time, which it did again last month. What happens to it now? What's the future for the SAFE Banking Act?

NK:Well, nobody really knows for sure, because Mitch McConnell got it stripped out of the Defense Authorization Act and continues to refuse to allow it to be included in the federal budget bill, which is what proponents are pushing for. We don't really know. There's going to have to be a deal to be made about the federal debt ceiling and the budget, and SAFE Banking may be in it may not be in it. It's looking less and less likely that the HOPE Act, which would provide additional federal judicial relief for cannabis convictions and other offenses, will be included. It's looking less likely that that'll be included. That jeopardizes Republican support, because that was really spearheaded by Congressman David Joyce, who's really the leader now of the Congressional Cannabis Caucus. It also jeopardizes support from the progressive wing of the Democratic Party. So it's not looking great, but stay tuned. We should know within a couple of weeks.

EA:Even with the SAFE Banking Act where it is, is the banking landscaping opening up a little bit or is it still a major issue?

NK:Well, it's still a challenge for many cannabis companies, especially with respect to credit card processing. The entire retail cannabis industry struggles because the credit card processors will not process cannabis transactions, and so they're limited to more creative solutions like debit cards and pseudo ACH type transactions. For most of our sizable cannabis companies, they're able to find commercial banking accounts. They're often more expensive than regular banking accounts, they often take a long time to get set up, but in most states, there are at least some banks willing to provide traditional bank account services to cannabis companies. There are several, at least four in New York that I know of, several in California. It really varies state by state.

These are usually state chartered institutions and some credit unions, so it's not as hard to get a bank account, but the credit card processing problems still remain a huge challenge.

EA:It's interesting when you mentioned that. I can't tell you how many times people have told me they have a workaround around the credit cards, and I roll my eyes because any workaround is usually an illegal workaround and it really doesn't accomplish it.

NK:Well, Eric, there are some workarounds. You can take debit cards. There's sort of an ACH type structure that some companies use. Or you can run your processing through a foreign credit card processor, which is far more expensive. So there are a few workarounds, but they're cumbersome and expensive.

EA:I've been reading a lot about the cashless ATMs and how those don't really work either these days. So Neil, besides tax ramifications, and we can go into tax a little bit later, how does the legality or illegality of cannabis at the federal level affect how cannabis companies really operate day to day?

NK:Well, Eric, as you alluded to, the tax ramifications are enormous. Besides those, obviously the biggest structural obstacle is the lack of interstate transportation is one of the main reasons why the cannabis industry struggles to scale. Because infrastructure needs to be replicated on a state by state basis. It's also one of the major reasons why we've not seen the development of major national brands. There are a few more prominent brands in multiple states, but nowhere near the level of widespread branding that we have in industries that do allow interstate commerce, like every other industry, every legal industry.

That's really crippled the industry requiring it to invest significant additional amounts of capital to replicate infrastructure state by state, and that's been a major issue, especially in the climate nowadays, where capital is very tough to come by.

EA:What will it take for cannabis to develop those national brands? When I go to a store in New York or California and I buy a Diet Coke or a Gatorade, it's the same product and there's comfort that the product is the same product no matter where I buy it. When will we see that in this industry?

NK:Well, I think we'll see it when we have interstate commerce permitted. Also, there are very, very strict restrictions on advertising and marketing in most states, so that's somewhat similar to restrictions on cigarette and alcohol advertising. Even more stringent, though, in many cases. So when we see those regulations rationalize a little bit and interstate commerce, so that it becomes cost effective for companies to advertise on a more rational cost basis, that's when I think we'll start seeing more national brands.

Now, look, some of the MSOs are investing significant amounts in trying to create multi-state brands, but they can't be truly national until you have the ability to have a national footprint. We're still limited state by state. That may never change. So it's a challenge.

EA:We talk about the different states and the laws in each different state. How different are the laws in each state? An are any state laws that are universal?

NK:There are many commonalities and many differences. The state legislative and regulatory regimes generally fall into a few categories. Almost all states require that cannabis businesses be licensed, that all products are subject to lab testing. They impose severe restrictions on marketing, advertising, packaging, and labeling, with some variability. They all require tracking cannabis products from seed to sale, and they all impose fairly heavy taxes, which also vary significantly in structure and in amount.

The major flavors of state industry cannabis structures are, for starters, whether the state has a limited number of licenses versus open licensing. Some states, well, the states all vary in how they treat vertical integration as well. Some states require all cannabis companies to be fully vertically integrated, some prohibit vertical integration altogether, and some permit them to various extents.

The social equity programs in each state varies. Many states have them, not all, and they vary significantly. The social equity programs draw a lot of attention in the industry because they try to make it easier for historically disadvantaged applicants to get licenses, get funding, get help starting their businesses, all in an effort to try to reverse the calamitous effects of the war on drugs and the discrimination against minorities in the enforcement of the drug laws. So there are a handful of structures that are pretty common, but it varies and every state's a little different. And then you have local regulations as well that also vary. So it's a very complex regulatory structure.

EA:We've heard Tremaine Wright, and Tremaine is the chairwoman of the New York State Cannabis Control Board, say she expects to see legal sales in the state before the end of the year. Is that a realistic goal?

NK:Well, it's not really clear, Eric. The Office of Cannabis Management and the Cannabis Control Board here in New York have taken some steps to try to make that possible, including by allowing retail licensees to commence delivering product from warehouses. That's in response to the time delay we've all seen resulting from the inability of the state to sufficiently lease stores and get the initial 36 retail licensees up and running.

If we have any stores up and running by the end of the year, it may be one or two, and that seems unlikely. That said, there's a vast inventory of product that the New York cultivators, the provisional cannabis cultivators, have already harvested that are sitting, in some cases being turned into oil, in some cases being processed, ready for sale as flour. So there is some level of supply, but no stores. I think it's pretty difficult to get a delivery business up and running in a week or two. So we'll see the bulk of that industry starting up after beginning of the year, if not all of it.

EA:Under New York state's rules, local municipalities have the option to opt in or opt out of allowing adult use retail dispensaries are onsite consumption lounges. I think approximately 10% of the cities across New York State, about a third of the municipalities in the state, have opted out of cannabis sales in their jurisdictions, and those that opt in cannot opt out, and those that opt out can change their mind and opt in. How important is this and what effect does this have on that particular municipality?

NK:Well, for starters, Eric, it's important to note that opting out only applies to retail stores and consumption lounges, not other aspects of the industry like cultivation, manufacturing, and distribution.

As of a couple of weeks ago, about half of local municipalities have opted out of retail marijuana. As you said, a city or municipality that opts out, well, they cannot then issue any licenses for a retail facility in that municipality. The ironic thing is the people that live in that town, they're still going to consume cannabis products. So what'll happen? They'll go to the next town over or somewhere else nearby to buy their products, and that opting out city or town will just lose out on the tax revenues and the commercial activity that would've otherwise resulted from their local establishments.

Most of them will eventually realize that and probably opt back in. In some cases, the opting out has been a little bit of a political maneuver so that the local politicians don't get the blame for opting in. They then can put the issue up to a local referendum and say, "Look, the voters decided. Don't blame me." So it'll be interesting to see how that develops. I suspect more and more localities will ultimately opt in.

EA:Neil, what licenses are available in New York right now?

NK:Well, right now, none.

EA:What will be available in New York? Let me rephrase that question.

NK:Sure. Well, so, Eric, there's really two answers to that question. We've had the round of card licensees, which are the justice involved retail licenses. 36 of those licenses have been granted, and another 100 some odd are expected to be granted. Although there is a lawsuit that's frozen five of the local regions. That's one level.

The state has also granted provisional cultivation licenses to former hemp cultivators and provisional manufacturing licenses to previous hemp manufacturers. Those will all be convertible into regular cultivation and manufacturing licenses pursuant to the proposed rules that the Office of Cannabis Management published a couple of weeks ago.

Those rules are all just proposed though, they're right now subject to their public comment period. Once the public comments come in, the OCM will have to review them and either issue revised proposed rules or final proposed rules. At that point, the regular rounds of licensing would be expected to open up sometime most likely around second quarter of 2023, and that's when licenses will be become available.

EA:We're starting to see law enforcement act against unlicensed dispensaries. This is really important, considering licensed dispensaries are expected to open soon. What does New York plan to do differently from other states that have this similar issue?

NK:Well, that's very hard to tell, because we haven't seen anyone out there actually analyze exactly what's been done in each state. New York has taken several steps to address the black market, particularly because the legislators and the regulators that are formulating the new state legal market, they're motivated in part by rectifying the injustices of the war on drugs, so they were initially reluctant to take criminal action against black market cannabis operators.

But now that they're building their own system, they've developed a little bit less tolerance based on the view that, hey, I'm building a new legal system. We can't have these people circumventing what I'm building. And so the state passed a bill that empowered the OCM to seize cannabis from illegal operators, and the Tax and Finance Department to penalize them. So there are fines of up to $50,000 available to the Tax Department for each violation, as well as a Class A misdemeanor for one violation and a Class C felony for additional violations if within five years of each other.

Police have towed and seized cannabis products from the weed trucks on the streets of Brooklyn and Manhattan at various locations, mostly over community responses to parking complaints, even though some of those trucks were only selling CBD products.

OCM also has sent cease and desist orders to 52 unlicensed cannabis merchants in July, and they've told landlords that if they rent to unlicensed cannabis operators, then they will not be able to rent to licensed operators when the time comes. They've threatened fines. They've threatened criminal penalties. Hard to say how that compares to every other state, but that's the scope of what we've observed being done here in New York.

EA:Neil, Colorado and Washington were the first states to legalize adult use recreational cannabis. And in 2022, Mississippi, Rhode Island, Maryland, and Missouri joined the club, bringing the total number of states legalizing adult use, recreational cannabis to 21, number of states legalizing medicinal cannabis currently number about, I think, 38. What states do you see are the next to join the club and what states will never become a member?

NK:Well, Eric, we witnessed an interesting phenomenon in the 2022 elections, which is, until now, every time a state level ballot initiative relating to cannabis legalization had been put to a vote, it had passed. And for the first time in 2022, while two more passed, Maryland and Missouri, three fail, Arkansas and North and South Dakota all voted down legalization of recreational cannabis.

I think that gives us a sense that when we get into deep red states cannabis legalization ballot initiatives are not inevitable to pass. Now, Oklahoma is going to have a ballot initiative in March of next year, so that may be the next one up to pass. Oklahoma, of course, has a sprawling and chaotic medical program that's one of the probably worst in the country, but apparently they have an enormously high consumer usage rate. So it's possible that Oklahoma may pass legal rec.

Alabama looks like it has an activist group getting set to get reform on the ballot at some point in 2023. And there are also ballot initiative led by citizens in Florida, Idaho, Nebraska, and Wyoming. So Florida, maybe, the other ones, I don't know. It's tough to say.

EA:Neil, for our last question, let me ask you to pull out your crystal ball. What trends do you expect to see in 2023 in this industry?

NK:Well, Eric, when I was asked that question about six months ago, I projected that we would start to see defaults on some of the large secured credit facilities that many of the significantly sized cannabis companies have obtained in the current capital market where equity capital is very, very hard to come by, but there are billions of dollars available from hedge fund type, sophisticated, secured lenders.

Lo and behold, that prophecy has come true, and we are seeing defaults starting to trouble many cannabis operators, because it's just difficult to generate positive cash flow with the tax burden and the lack of economies of scale that are ever present in the cannabis industry.

I think I would predict now that 2023 will be the year of cannabis industry secure debt workouts as lenders and borrowers work through the covenant and payment defaults that have started and are likely to become more prevalent in the current price suppressed environment for cannabis companies.

The lenders can't very well start utilizing their remedies for the huge proportion of borrowers that are likely to fall into default over the next year or so, and so we're going to see workouts and renegotiations and waivers and all that kind of activity. All these bankruptcy lawyers who haven't had much to do for the last few years, while cannabis is not eligible for bankruptcy in the US, they'll be able to start focusing on some of these workout deals.

EA:Do you expect to see a lot of consolidation?

NK:Well, we have seen a huge amount of consolidation over the last several years. The M&A market in cannabis was red hot until a few months ago. It has now cooled down significantly as many of the big players have run out of cash and/or seen their stock prices under pressure, thus making acquisitions more expensive. So the market has definitely cooled. I think what we're going to see now is more of a surge... Well, and I think we already are seeing a surge in distressed acquisition.

EA:Thanks, Neil. And thanks for listening to CannaCast as part of the EisnerAmper podcast series. Visit eisneramper.com/cannabis for more information and podcasts. Also, please visit www.kaufmanmcgowen.com for more information about Neil and the law firm Kaufman McGowan, PLLC. Join us for our next CannaCast podcast, we'll discuss other budding issues.

Transcribed by Rev.com

About Eric Altstadter

Eric Altstadter CPA is an Audit Partner and Chair of the firm's Cannabis and Hemp practice with over 30 years of experience working with public companies and privately held businesses


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