Our client Periodic Edibles has launched a podcast focused on the business and science of cannabis. Wayne Schwind, the CEO and Founder of Periodic Edibles — a cannabis-infused caramel company — hosts the show. The podcast takes a deeper look at business owners, founders and executives inside the cannabis industry and features stories about how they entered the industry, what they’re currently working on and where they see the cannabis industry going. Give it a listen!

Determining the fair market value of an interest in a cannabis business is a difficult task. Existing and potential clients frequently ask us how cannabis businesses should be valued and whether or not there are any “trends” in assessing value. These questions are not surprising given the various instances where a valuation is important. You may find yourself asking how much a cannabis business is worth in any of the following circumstances:

  1. Estate Planning
  2. Business Succession Planning
  3. Shareholder/Member Agreements
  4. Business Disputes
  5. Securities Offerings
  6. Dissenter’s Rights
  7. Mergers & Acquisitions
  8. Lending & Finance
  9. Tax Planning
  10. Transfer Pricing

Certified appraisers generally use three different approaches to valuing an asset, including a cannabis business.  Those approaches are:

  1. Asset Approach —Also known as replacement cost. How much would it cost to rebuild the asset?
  2. Market Approach — What are the value-comparable businesses? Relies heavily on the availability of comparable datasets and subjective adjustments.
  3. Income Approach — Commonly used for income-producing real estate. Value is determined using the expected future cash flow of the income-producing asset.

There are advantages and disadvantages to each approach. Furthermore, business owners and potential investors should make valuation adjustments given the inherent risks involved and the speculation of federal legalization. It may be appropriate to discount the value of a business given the inherent risk of federal enforcement. However, it may also be appropriate to inflate the value of a business given the potential impact of federal legalizations.

We encourage our readers looking for additional information from the experts themselves to check out this great blog.

Most government agencies rely on an informal rulemaking process when drafting and finalizing rules interpreting the law. This process generally requires the appropriate government agency to notify the public of the proposed new rule or proposed modifications to existing rules. The government agency generally must consider all comments received before finalizing a rule.

An exception to the public-comment period generally applies for “emergency” or “temporary” rules. Emergency and temporary rules are usually effective immediately, but are temporary in length. Unless the agency takes additional action, most temporary and emergency rules will expire.  A formal rulemaking and comment period generally applies before an emergency or temporary rule becomes permanent.

We encourage our clients and blog readers to participate in the rulemaking process.

The Oregon Department of Revenue (ODOR) issued a Notice of Proposed Rulemaking on October 19, 2017. ODOR scheduled a public hearing regarding these proposed rules on November 28, 2017 in Salem, Oregon.

ODOR proposes the adoption of two new rules – OAR 150-475-2030 and 150-475-2030. The stated need for the latter rule is to “codify the tax categorization of various products sold by marijuana retailers.” However, our review of the proposed rule includes a drafting error, inconsistent defined terms between the proposed rule and state statute, and an attempt to subject the sale of cannabis “seeds” to the state’s 17 percent retail sales tax. Our view of the applicable Oregon statute is that the retail sales tax does not apply to cannabis seeds as currently drafted and the proposed rule improperly classifies cannabis seeds as “immature plants.” Our Cannabis Team drafted and submitted the following public comments to ODOR and intends to attend the public hearing in Salem later this month.

A federal judge in Colorado recently upheld a summons issued by the IRS to the Marijuana Enforcement Division (MED) of the Colorado Department of Revenue. Rifle Remedies, LLC v. U.S., 120 AFTR 2d 2017-5447, (DC CO), 10/26/2017. The ruling contains very few facts but suggests that a taxpayer actively engaged in the cannabis industry objected to an IRS summons issued to MED for information related to such taxpayer.

The IRS may enforce a summons when the following conditions are met:

  1. The investigation will be conducted pursuant to a legitimate purpose,
  2. The information sought may be relevant to that purpose,
  3. The information sought is not already in the IRS’s possession, and
  4. The IRS follows the required administrative steps.

In this particular case, the IRS asserted that it sought records from MED pertaining to the taxpayer’s federal tax liabilities to 1) verify financial records and 2) determine if the IRS could substantiate information contained in the taxpayer’s returns.

The taxpayer’s arguments against the summons focused on whether or not the IRS had a legitimate purpose for obtaining MED records. The taxpayer argued the IRS summons was pretext for a criminal investigation. The fact that an IRS summons could have a criminal investigation impact is not relevant to determining its validity when the summons has an otherwise valid and non-criminal basis such as revenue recognition or section 280E compliance.

The taxpayer also asserts that the IRS summons includes MED “Transfer Reports” that could be used by the IRS as a fishing exercise for determining other taxpayers in the cannabis industry and subject to section 280E. According to the court, the taxpayer’s argument did not put “much meat on the bone” because the summons applied to a single taxpayer. So-called John Doe summons are subject to section 7609(f) when a summons does not identify the person with respect to the potential tax liability.

IRS examination of taxpayers in the cannabis industry may lead to John Doe summons in the future. See U.S. v. Coinbase, Inc. 120 AFTR 2d 2017-5239 (DC CA), 07/18/2017. In general, an IRS John Doe summons is valid when:

  1. The summons relates to the investigation of a particular person or ascertainable group or class of persons,
  2. There is a reasonable basis for believing that such persons or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law, and
  3. The information sought to be obtained from the examination of the records (and the identity of the person or persons with respect to whose liability the summons is issued) is not readily available from other sources.

The first and third prong should not be much of an IRS obstacle. The validity of an IRS John Doe summons will likely depend on the second prong — whether or not the IRS can assert a reasonable basis for believing cannabis-industry taxpayers generally fail to report revenue includable under section 61 or comply with section 280E. A systemic failure of taxpayers to accurately report revenue or calculate taxable income may lead to widespread issuance of John Doe summons of MED (and other state’s) records.

The takeaway? Taxpayers subject to state seed-to-sale tracking requirements should expect and anticipate that the IRS (and state taxing authorities) have complete and full access to such records. Furthermore, taxpayers lucky enough to have access to bank accounts should expect their financial institution to perform due diligence including comparing seed-to-sale records to financial records and tax returns. See FinCEN memo — “BSA Expectations Regarding Marijuana-Related Businesses.” Any differences should be reconciled and explained.

Constellation Brands Inc. — the company behind Corona beer — will invest nearly $200 million for a 9.9 percent stake in Canopy Growth Corporation, a publicly traded Canadian cannabis company, plus the right to acquire a greater ownership interest over the next 30 months.  In addition to the Corona brand, Constellation sells a variety of beer, wine and spirits.  The business reasons for the investment appear to be twofold.  First, the U.S. market for beer in states with adult-use cannabis laws are experiencing declining sales while cannabis sales are increasing.  Second, Constellation Brands Inc. notes the potential to develop cannabis-infused drinks.

Our colleague and HoochLaw blogger, Brian DeFoe, paints a dismal picture for non-craft beer sales in states that regulate adult-use cannabis:

“Beer sales in Colorado, Oregon and Washington (three states with laws permitting adult-use cannabis) fell by 4.4% from January 2015 through December 2016. Correlation does not necessarily equal causation, however.  And overall trends for beer were pretty dreadful during most of that time — with sales in the category down 1.5% (or 2.8% if you exclude the craft beer segment) during 2016.”

The press release issued by Canopy Growth Corporation ignores the product diversification issue, but highlights the potential benefits of Constellation’s branding and marketing teams:

“The strategic relationship will see Constellation provide broad support in the areas of consumer analytics, market trending, marketing and brand development to Canopy Growth. In addition, the Companies will collaborate to develop and market cannabis-based beverages that can be marketed as adult-use products in markets where and when such products are federally legal.”

This suggests that we will not see THC-infused Corona until we deschedule cannabis in the U.S.  However, Canada may provide a significant test market in the interim.  While Constellation and Canopy Growth test the Canadian waters, it is worth noting that state regulated adult-use markets are not chomping at the bit for alcohol-infused cannabis products given the federal control over alcohol by the Alcohol and Tobacco Tax and Trade Bureau (TTB).

Ethanol is commonly used to chemically separate THC and other cannabinoids from cannabis flower and other plant material.  Oregon permits the use of ethanol in the separation process, but requires its removal before sale as a cannabis product.  Further, ORS 471.446(2) provides the OLCC with the authority to prevent the sale of alcohol containing adulterated ingredients.  Washington and Colorado similarly prohibit the sale of THC-infused alcohol.  Therefore, we should expect to see U.S. based investment in ethanol based extraction techniques, but zero alcohol-infused products until we see change at the federal level.  Until then, the bulk of product development should occur outside the U.S.

The notable exception is CBD-infused alcohol containing hemp-derived CBD.  The TTB has approved CBD-infused formulas, but recent guidance from the DEA suggests conflict between the federal agencies.  The continued availability of CBD-infused alcoholic beverages is uncertain.  For better or worse, the U.S. is unlikely to be at the forefront of cannabis-infused alcoholic beverages.

In the recent issue of GQ magazine, an article entitled, “The Great Pot Monopoly Mystery,” sought to unravel some of the mystery behind the “shadowy” BioTech Institute LLC. The article made a particular point that should be of immediate concern to those in the Cannabis industry — BioTech’s burgeoning patent portfolio.

BioTech has taken the unprecedented step of acquiring utility patent protection for the Cannabis plant itself. BioTech is attempting to exert control over access and use of the various Cannabis strains that are covered by its patents. Such control over one of the most vital elements of the budding Cannabis industry will impact all parties involved, from growers through all aspects of the supply chain and ultimately to consumers.

While the fear and impact of the BioTech patents are understandable, they are also misplaced for two main reasons. First, no entity can patent ideas or plants that are well-known in the public domain. Because the Cannabis industry is emerging from the shadows of a formerly illegal market, little to no formal documentation of the progression of Cannabis plant strains and Cannabis-related innovation exists, which is known as “prior art” in the patent world. This prior art is traditionally reviewed by patent examiners during review of applicants’ patent applications and is often cited against applications to reject them if the idea an applicant tries to claim has already been publicly known. Without that prior art library, the patent examiners are left with no choice but to allow the patents to issue. Applied specifically to the BioTech Institute portfolio, Cannabis industry leaders may be able to find documentation of well-known strains of Cannabis with coordinated, collaborative effort and build a bank of prior art related to Cannabis plant strains from unique sources not typically used. Such an effort will require cooperation among like-minded industry leaders moving towards a common goal of prohibiting commercial exploitation of well-known ideas. The prior art research will need to be balanced with concerted efforts to also foster protection of new innovation, the driving force of capitalism.

Additionally, many other industries experience — and weather — similar marketplace challenges to those presented by BioTech’s patent portfolio. The modern bioscience industry, for example, is rife with companies using patents to carve out market niches for themselves at the exclusion of others. Similar parallels are found in the tech industry too; the value of an industry drives participants to create zones of exclusion to further their business interests. As the Cannabis industry continues to grow in the U.S. and abroad in both value and legitimacy, it will attract serious and well-funded players (like BioTech) — with big appetites for risk — all vying for the immense reward at stake. Each of them is looking to capitalize on the existing market conditions and to monetize their investments.

Cannabis and Cannabis-related businesses can take steps now to protect themselves and prepare for the industry changes that are coming. It is not an “if” the Cannabis industry will face the same patent-related market pressures that the bioscience and tech industries face, it is merely a matter of “when.” The business risks posed by BioTech Institute and other players like them will affect each Cannabis business in unique and individual ways. Each sector and individual business in the Cannabis industry needs to evaluate its intellectual property position to face these coming challenges. Businesses need to begin developing and executing balanced strategic initiatives now to weather these challenges and to be proactive — rather than reactive — to the threats. Steps such as entering strategic partnerships, engaging in tactical contract negotiations, developing targeted innovation protection plans, cross-licensing intellectual property from key technology owners, pooling resources for common threats and lobbying for favorable legislation, establishing regulatory standards, and the like, will help businesses meet these new challenges and chart a pathway to longevity and prosperity in the industry. Each Cannabis company’s position in the market is unique, which drives a need for a custom strategic plan — there is no generic answer. The Lane Powell team of highly-experienced practitioners in intellectual property and corporate matters has deep industry knowledge and is uniquely positioned to partner with clients to create tailored business strategies to help clients thrive and achieve longevity in an intense and fast-evolving Cannabis industry.

* Sun Tso quote from The Art of War

The Washington Clean Air Act governs air emissions and that includes the production and processing of marijuana. Whether the regulatory body is the Washington Department of Ecology or one of seven regional clean air agencies that also have regulatory authority, the bottom line for any marijuana production and processing facility is that some level of compliance with odor and other emissions limits is required. But what it takes to comply depends on where the facility is located in the state, as illustrated by two Pollution Control Hearings Board (Board) cases involving marijuana facilities in two different regional clean air agency jurisdictions.

Central Puget Sound Area

If a facility is located in King, Pierce, Snohomish, and Kitsap Counties it comes under the jurisdiction of the Puget Sound Clean Air Agency (PSCAA), which has concluded that producing and processing marijuana has the potential to emit air contaminants, such as odors and volatile organic compounds. Therefore, those facilities must submit a pre-construction application to PSCAA that usually results in a permit with site-specific requirements. This may include requiring the use of carbon filters or other emission control technology.

So far, PSCAA has approved more than 45 Notices of Construction for marijuana production and processing facilities under its jurisdiction, but a failure to obtain PSCAA’s approval can result in first, a notice of violation and, if unresolved, an order to prevent construction. That’s what happened to a marijuana facility in Snohomish County in the case of Avitas Agriculture, Inc. v. Puget Sound Air Pollution Control Agency. The facility operator argued that it did not need to obtain PSCAA approval because the Clean Air Act exempts agricultural activities. PSCAA disagreed and the Board determined that the exemption did not apply to this facility.

To qualify for an exemption for “agricultural activities” under the Washington Clean Air Act, at least five acres of land must be devoted primarily to the commercial production of livestock, agricultural commodities, or cultured aquatic products. The Avitas facility was located on 8.64 acres and was licensed as a Tier 2 marijuana production and processing facility, meaning it could have no more than 10,000 square feet of plant canopy. The actual plant canopy at the site was between 1,000 and 3,000 square feet. The marijuana plant canopy, even at full Tier 2 capacity, would be well short of the statutory minimum for the exemption to apply. Furthermore, even if the square footage of the production and processing buildings were included, there still would not have been enough to meet the five-acre requirement.

Avitas contended that other agricultural activities were taking place on the property. It argued that half of the property was commercially farmed for hay and used to feed goats kept on the property and supplement compost used for marijuana production. Avitas, however, did not submit any current photographs or documentary evidence to substantiate the commercial hay business nor did PSCAA inspectors see any hay production when they visited the property. Avitas also did not help its case when it ultimately submitted a Notice of Application that contained an environmental checklist stating the site had been used as pastureland for the previous owner’s animals, but made no mention of any crop or grain cultivation on the site.

PSCAA concluded that Avitas’ production and processing covered less than the statutory minimum five acres for agricultural land and, therefore, were not exempt from the Clean Air Act and PSCAA’s requirements for odor control devices. The Board concluded that Avitas had not met its burden of demonstrating that its activities took place on agricultural land and, therefore, could not establish that its production and processing facilities were exempt from PSCAA’s requirements.

Even if the agriculture exemption might apply to a marijuana production and processing operation, PSCAA has taken the position that a processor still is required to submit a Notice of Construction because the agricultural exemption applies only to odors and fugitive dust. The agency takes the position that the agricultural exemption in RCW 70.94.640 does not exempt facilities from the approval requirements if the facility has the potential to emit an air contaminant such as volatile organic compounds. Because PSCAA has determined that marijuana production and processing facilities have the potential to emit air contaminants, a marijuana production and processing facility in PSCAA’s four-county central Puget Sound jurisdiction must go through the approval process.

Olympic Peninsula

An example of a different approach, at least as to odors from marijuana processing and production facilities, is Green Freedom, LLC v. Olympic Region Clean Air Agency, where a facility was fined for emitting odors that unreasonably interfered with a person’s use and enjoyment of their property.

The Olympic Region Clean Air Agency (ORCAA) covers Thurston, Mason, Pacific, Grays Harbor, Jefferson, and Clallam Counties, but does not have specific regulations applicable to marijuana. Thus, unlike PSCAA, there is no requirement for a marijuana production and processing facility in the ORCAA jurisdiction to submit an application for approval. ORCAA, however, does have a general rule that prohibits odors that “unreasonably interfere with another person’s use and enjoyment of their property.”

In the Green Freedom case, a neighbor who lived 300 feet from a marijuana growing operation near Elma, Washington, complained frequently about odors. An ORCAA inspector visited the site after one complaint in January 2016 and detected a “skunky” marijuana odor as well as wood smoke. ORCAA issued a Notice of  Violation and, later a Notice of Civil Penalty Assessment for $750.

After the Notice of Violation, the facility operator installed carbon scrubbers on exhaust fans to mitigate odors, but also appealed the Notice and penalty. The operator contended on appeal to the Board that the odor did not unreasonably interfere with the neighbor’s enjoyment of her property because the smell occurred on a rainy, cool January day and was only identified within 20-25 feet of the fence line, not 300 feet away at the neighbor’s house. The operator, however, conceded that had the odor been present in the summer, there would have been an unreasonable interference with the neighbor’s ability to enjoy their property.

The Board affirmed the penalty, saying that there was sufficient evidence the marijuana odor unreasonably interfered with the neighbor’s use and enjoyment of her property. Even though it was unclear how much of the neighbor’s property was affected, the Board said that it was clear the property was impacted.

The opinion’s recitation of the facts noted that there also was an odor associated with wood smoke, but neither ORCAA nor the Board made any legal determinations on that point. Nevertheless, it is important to note that WAC 173-400-040(8) prohibits the installation or use of any means that conceals or masks an emission of an air contaminant that would otherwise be a violation of the Clean Air Act, which prohibits odors that unreasonably interfere with another property owner’s use and enjoyment of their property.

The lesson from both of these decisions is that a marijuana production or processing facility regardless of its location in the state is subject to air pollution regulations that can be used to enforce limits on odors and other emissions from the facility.

In the past two weeks, the SEC has temporarily suspended two marijuana stocks that trade on the OTC Markets. The suspensions lasting until June 5, involved, respectively, a questionable press release concerning a proposed acquisition and a lack of information provided to investors concerning the company’s controlling interests. While specific to these two companies, it is possible that the SEC may apply more careful scrutiny concerning publicly-traded cannabis-related businesses in the future.

The Oregon Legislature recently passed Senate Bill 1057, which currently sits on the Governor’s desk awaiting her signature. The bill primarily addresses the Oregon Liquor Control Commission’s (OLCC) control over the state’s medical cannabis program and includes seed-to-sale tracking requirements for cannabis businesses. Two notable provisions would affect adult-use cannabis businesses operating in Oregon:

Regulating Immature Plants

SB 1057 removes a Measure 91 restriction on the OLCC regulation of immature plants, which are any plants that are not flowering. (The term flowering is not defined by statute.) ORS 475.070(3)(B) currently limits OLCC control over (i) the number of immature plants possessed by a producer, (ii) the size of the grow canopy a producer uses to grow immature plants, and (iii) the weight or size of shipments of immature plants made by a producer.

Section 56 of SB 1057 will remove these restrictions on OLCC regulation of immature plants and immature plant canopies. Section 57 will amend ORS 475B.075 such that the OLCC will be required to regulate both immature and mature plant canopies and to take into consideration the market demand for adult-use cannabis in the state and whether the availability of adult-use cannabis is commensurate with market demand.

Even without SB 1057, the OLCC is obligated to regulate mature plant canopies to ensure a balance of supply and demand. SB 1057 expands on the OLCC obligation to regulate both immature plant canopies and mature plant canopies.

While the reasoning for expanding the OLCC’s control over immature plant canopies remains unclear, the likely explanation is that the state wants additional control and oversight to avoid conflict with the 2013 Cole Memo. A priority of the Cole Memo is to prevent diversion of cannabis from states where it is legal to other states.

The OLCC cannabis tracking system (CTS) does not currently require that producers track immature plants. The published FAQ states that individual plants must be tracked once they reach 24 inches in height, and immature plants may be included in a larger lot under a single tracked identification. Therefore, CTS is not a true “seed-to-sale” tracking system and arguably permits diversion of products grown by licensed producers to the gray market. While licensed producers may dislike additional OLCC oversight, reducing the amount of product available on the grey and black markets would likely push more adult users to the regulated market.

Disclosing Financial Interest Holders

The second notable provision of SB 1057 is located in section 8.  This provision gives the OLCC the explicit authority to require a licensee or applicant to disclose the name and address of each person that has a “financial interest” in a licensed business, as well as the nature and extent of that interest. This is of particular interest given the broad authority already granted to the OLCC in ORS 475B.025. The existing statute grants the OLCC authority to grant, refuse, suspend or cancel licenses. The existing statute also includes the authority to adopt, amend or repeal rules necessary to carry out the intent and relevant statutory provisions.

OAR 845-025-1030 details the Oregon license application process. Among the requirements, an applicant must include the names and other required information for individuals with a financial interest in the applicant but who are not an applicant under the rules. This begs the question, “Why does SB 1057 grant the OLCC statutory authority to obtain this information?” The logical answer is that the OLCC believes either it may not have the regulatory authority, or that one or more applicants have questioned the OLCC’s authority. Regardless of whether the Governor signs SB 1057, prospective applicants should be prepared to disclose all individuals that have a financial interest in the applicant.

Adult consumption of marijuana for medical or recreational purposes is legal in many states, including Washington State.  Consumption also effectively is decriminalized (but still illegal) in British Columbia, Amsterdam, and other cities and provinces. Yet foreign citizens who have ever smoked pot or consumed any type of cannabis — even where it is legal — can be caught in a trap when they come to the U.S. border.

When a foreign traveler flies, drives or sails into the United States, an Immigration Officer with Customs & Border Protection (CBP) under the Department of Homeland Security may inquire about marijuana use. They may ask questions, or, if the traveler permits access to cell phones or other technology devices, they may draw inferences from information on the technology, including from photographs or Facebook or other social media posts. Vacation photos, including visits to Seattle that feature the traveler posing in front of retail marijuana shops, can result in several hours in a CBP detention room, followed by denial of entry into the United States.

Under U.S. immigration law, if the foreign traveler admits to use of marijuana that is in any way unlawful, the person will be refused entry.  This rule applies even if the consumption was outside the United States (in a country where such use is illegal) or inside a state within the United States where consumption was legal under state law.  And don’t expect the CBP officer to cut you any slack; he or she simply has no discretion to ignore admitting to the facts of an illegal act, even if made under duress. The person will be found inadmissible and removed from the U.S. as soon as possible. The bar is “permanent,” unless the person is granted a waiver of inadmissibility.

There are three factors weighed in a waiver decision:

(1)       The risk of harm to society if the applicant is admitted into the U.S.;

(2)       The seriousness of the prior violation; and

(3)       The reasons for wishing to enter the country.

Canadians can make a waiver application at a U.S.-Canada port of entry. Citizens from other countries apply through a U.S. consulate or embassy outside the United States. The waiver process can take the better part of the year, but, if successful, should result in a waiver. Even then, the waiver is only good for five years though it can be renewed (which is a recent improvement over the prior one-year waiver period).

When a CBP Immigration Officer asks questions, your answers must be truthful (and no, there is no exception for “but I didn’t inhale”). However, a foreign traveler can decline to answer a question — and also can refuse to relinquish a cell phone or to grant social media access. Foreign travelers declining to answer are best served by being polite and as composed as possible. The Immigration Officer’s response may be, “I guess you’re not coming in today.”  However, a temporary delay is almost always a more favorable result than a permanent bar, and allows time to contact an immigration lawyer to assess options or to apply for a waiver before your next visit to the United States.