As any farmer knows, planting season waits for no one. Washington state lawmakers are showing they understand this as well.

While other states have moved more aggressively to encourage commercial hemp, Washington’s total hemp crop in 2018 was less than 150 acres, all grown by the Confederated Colville tribes northwest of Spokane. Lawmakers in Olympia are determined that 2019 will be better — Hector Castro, Director of Communications for the Washington State Department of Agriculture recently stated, “It makes sense to assist farmers to get seeds in the ground this season.”

Legislative changes have been proposed to harmonize Washington’s hemp laws with the federal government’s 2018 Farm Bill. A legislative fix is necessary for hemp-derived CBD sales and for out-of-state hemp export.

The Washington State Department of Agriculture is also stepping up to the hemp table and considering two rulemaking changes that would benefit the industry. If successful, these rule changes would allow hemp to be grown within four miles of marijuana cultivation, and  remove the requirement that hemp farmers get permission from the DEA before importing hemp seeds.

One open issue is how to pay for the hemp-licensing program that is compliant with the 2018 Farm Bill. The program is predicted to cost just over $200,000 annually. If that cost is passed on to farmers instead of being funded by the state budget, the current $300/year hemp license fee could increase dramatically, and undercut the momentum that Olympia is trying to build.

While the 2018 Farm Bill removed hemp from the Drug Enforcement Administration’s regulatory oversight, the Food and Drug Administration (FDA) continues to oversee foods, drugs or cosmetics that contain hemp or hemp products, the most popular of which is currently CBD. Meanwhile, states, farmers and other interested parties are clamoring for guidance on hemp commercialization, driven by the steadily increasing demand for CBD products among consumers who believe the hemp derivative is an effective treatment for a wide range of ailments.

FDA Commissioner Dr. Scott Gottlieb recently promised that hearings will begin in April to gather public comments before issuing new CBD regulations. Until then, the FDA will continue to evaluate CBD as a pharmaceutical substance that is unlawful in food and dietary supplements. Gottlieb recognizes the need for “an appropriately efficient and predictable regulatory framework for regulating CBD products,” but warned that it’s not a “straightforward process.”

Some observers predict that creating an appropriate framework may be a multi-year process that could require Congress to take an active role. As more states legalize hemp, however, bipartisan Congressional action becomes more likely.

Update: Hours after this blog was posted, Dr. Gottlieb announced that he will be resigning as FDA Commissioner. His departure adds yet another question mark into this uncertain situation, and may result in further delays in the FDA’s development of new CBD regulations. 

The U.S. Department of Agriculture (USDA), which was given federal regulatory authority over hemp by the 2018 Farm Bill, announced last week that it won’t be finalizing its hemp rules in time for the 2019 growing season, and instead is targeting the 2020 season. But many states are driving hard to develop their own regulatory plans in time for their farmers to plant this year.

Those states’ efforts were given a boost by the American Hemp Campaign (AHC), who released its model hemp production plan around the same time the USDA made its announcement. The AHC’s model plan is designed to help state officials develop their own regulations more quickly by providing basic policy considerations and a framework for regulating cultivation.

Time is of the essence, as many states have March deadlines for hemp growers to submit license requests, and Mother Nature’s own unappealable deadline for planting gets inexorably closer.

In a unanimous decision this month, the Supreme Court limited the scope of civil asset forfeiture, the controversial legal process whereby law enforcement officers can seize property they suspect was involved in illegal activities. In this post, we will discuss how the recent decision in Timbs v. Indiana affects a long-time cannabis industry boogeyman.

Civil asset forfeiture is something of a legal oddity – the government brings a civil action against the property itself, leading to such interesting case names as United States v. Article Consisting of 50,000 Cardboard Boxes More or Less, Each Containing One Pair of Clacker Balls, 413 F. Supp. 1281 (D. Wisc. 1976). The “civil” part of the action means that the government’s burden of proof is substantially lower than in a criminal action, such that assets can be legally forfeited even in the absence of a criminal conviction.

Forfeited assets typically get sold, auctioned or destroyed with net proceeds retained by the seizing authority. With the advent of the War on Drugs in the 1980s, changes to federal law allowed local law enforcement to take a cut of seized drug trafficking assets. While the principal that criminals shouldn’t be allowed to keep the fruits of their crimes is generally defensible, recent years have brought increased attention to the practice and allegations of abuse by law enforcement.

Civil asset forfeiture (CAF) casts a shadow over cannabis businesses. The practice places not only cash proceeds at risk, but also any property “used to commit, or to facilitate the commission” of a crime. This may include leased real property and vehicles, even if the owner of the property in question was not involved in the commission of the underlying crime. Notable targets include the landlord of Oakland’s Harborside dispensary, who ultimately prevailed after several years of litigation.

The issue considered by the Supreme Court in Timbs is whether there are limitations to the amount of assets that a state is allowed to seize. Timbs sold a small amount of heroin to an undercover cop. He was charged and convicted, and his crimes carried a monetary fine of up to $10,000. The state of Indiana brought a civil action to seize Timbs’ Range Rover, which he’d used to transport drugs, but which had been purchased with nearly $50,000 in legitimate funds from an inheritance. Nearly 30 years ago, the Supreme Court held that the magnitude of federal civil asset seizures are limited by the 8th Amendment’s restrictions on excessive fines. In Timbs, the Supreme Court held that these restrictions also apply to states.

So what’s changed post-Timbs? Likely, not much. The Supreme Court has repeatedly affirmed that the practice of civil asset forfeiture is constitutional. Timbs simply means that the amount of the seizure can’t be unreasonably large compared to the underlying crime. The Timbs ruling may not be much help, say, to the owners of a truck carrying hemp that was recently seized in Idaho. Under Idaho law, “trafficking in marijuana” carries a maximum fine of $50,000. This leaves a lot of leeway for Idaho authorities to constitutionally seize property used to facilitate what Idaho contends to be a crime.

Absent statutory reforms of asset forfeiture laws or the decriminalization of cannabis, asset forfeiture will continue to be a risk for cannabis business operators. Our attorneys regularly advise clients on forfeiture risks and help them develop strategies to minimize it. Our Cannabis and Investigations, Compliance & White Collar teams can assist if you or someone you know has property at risk.

Concerning news out of Idaho, where the U.S. District Court in Idaho delivered some bad news to the owners of the contents of a tractor trailer recently seized by the Idaho State  Police. The trailer contained nearly 7,000 pounds of Cannabis sativa en route from Oregon to Colorado. Seizures of outbound Oregon marijuana are an unfortunate status quo these days — overproduction and cratered prices in Oregon have led to regulatory lamentation over black-market sales across state lines.

This seizure is different, however, as Big Sky Scientific LLC (“Big Sky”), the Colorado-based owner of the plants, sued Idaho law enforcement for the release of the shipment. Big Sky claims that the plants are hemp, that hemp is now legal since the passage of the Agricultural Improvement Act of 2018 (“2018 Farm Bill”), and that the 2018 Farm Bill protects the interstate commerce of hemp. The case highlights important questions about what the 2018 Farm Bill does and doesn’t do with respect to hemp, and Magistrate Judge Ronald Bush provided some worrying initial answers to these questions last week when he denied Big Sky’s motion for an injunction to have the shipment released.

The crux of the dispute isn’t over whether the plants are or aren’t “hemp,” but rather whether or not the 2018 Farm Bill preempts Idaho law, which prohibits cannabis and makes no exception for hemp. Big Sky points to Section 10114(b) of the 2018 Farm Bill that states, “[n]o State…shall prohibit the transportation or shipment of hemp or hemp products produced in accordance with subtitle G of the Agricultural Marketing Act of 1946 (as added by section 10113) through the State.” Big Sky contends that Section 10114(b) prevents Idaho from prohibiting the transport of hemp.

Idaho law enforcement, however, contends that Section 10114(b)’s prohibition applies only to hemp that is “produced in accordance with subtitle G of the Agricultural Marketing Act of 1946.” The 2018 Farm Bill authorizes states and the U.S. Department of Agriculture to create plans regulating the production of hemp, but no such plans have been approved yet. Therefore, Idaho argues, the seized hemp was not “produced in accordance with subtitle G,” and is not protected by 10114(b).

Judge Bush agreed with Idaho’s arguments, holding that in the absence of state or federal plans approved pursuant to the 2018 Farm Bill, the hemp at issue was not “produced in accordance with Subtitle G,” and therefore not afforded the interstate commerce protections of the 2018 Farm Bill. Further, the 2018 Farm Bill doesn’t preempt state laws prohibiting cannabis if the cannabis is not produced in accordance with Subtitle G.

This decision should be taken with a measured portion of concern. On the one hand, it is deeply unsettling for the burgeoning hemp industry. Conventional wisdom held that the 2018 Farm Bill would immediately usher in a new era for hemp, which would be legal, protected from state prohibitions by federal law, and freely tradeable. This decision throws cold water on such exuberance — if it stands (which, more below), interstate commerce in hemp will remain risky, especially in states like Idaho that have chosen to aggressively police it. On the other hand, the decision is only the first step in answering the questions raised above. An injunction of the kind sought by Big Sky is an “extraordinary remedy,” which courts are generally reluctant to wield. Big Sky has appealed the decision, and will have another chance to argue its case before the 9th Circuit Court of Appeals. The 9th Circuit covers a broad swath of the west coast, where hemp production is prevalent. Further, there is language in the 2018 Farm Bill to suggest that hemp produced under a license issued by a 2014 Farm Bill pilot program (Oregon has one of the most permissive) may be “produced in accordance with Subtitle G.”

In the interim, anyone transporting hemp across state lines should be very careful about which state lines they cross. The Idaho seizure is not an isolated incident — we’ve seen similar seizures recently in Wyoming, Oklahoma and elsewhere. If you have questions about the production and transportation of hemp, our cannabis team can assist.

Pitchbook recently released its 2018 results for cannabis related investments, and the data is impressive: 139 deals scooped up a whopping $881 million. Those numbers are up over the prior year by 26 percent (number of transactions) and 120 percent (total amount invested), reflecting larger average deal sizes.  Leading the way, Privateer Holdings closed a $100 million Series C financing.

Clearly, the success of Canadian public offerings in the space is creating a “chimney” effect where a few big exits result in early-stage capital being pulled into the ecosystem.

For example, Green Organic Dutchman Holdings, Ltd. (TSX: TGOD) IPO’d in May of 2018 is currently trading at $1.0 billion market cap; Privateer’s Tilray (NASDAQ: TLRY) went out for $153 million in July and currently enjoys a $6.0 billion market cap. Canopy Growth Corp (NYSE CGC) is valued at $17.0 billion.

The Pitchbook report also lists the top dozen cannabis-related venture investors, led by Altitude Investment Manage, Casa Verde Capital and Salveo Capital, each with six or more investments in 2018.

The addition of sophisticated, institutional capital to the cannabis marketplace is, from our perspective, a welcome game-changer. The net result is likely to be increased scrutiny on the quality of management teams, the scalability and defensibility of business models and heightened attention to corporate governance. All of which should lead to a more stable and ultimately more profitable industry for stakeholders.

Join the World Law Group for its upcoming webinar series on the legalization of cannabis around the world. Each of the four webinars will focus on specific jurisdictions or regions, including Europe, Israel, Canada, Latin America and the United States. Our very own Josh Ashby will serve as a moderator for the upcoming Israel update on February 26, and as a panelist for the U.S. update on April 3. Register via the links below.

Schedule

  • Europe Update | Wednesday, February 13 at 8 a.m. PST | Registration
  • Israel Update | Tuesday, February 26 at 7 a.m. PST | Registration
  • Canada & Latin America Update | Thursday, March 21 at 7 a.m. PST | Registration
  • U.S. Update | Wednesday, April 3 at 7:30 a.m. PST | Registration

“Audit,” already an unpleasant word in cannabis circles, got a little worse this week with the release of a stern assessment of Oregon’s cannabis program by the Oregon Secretary of State. The 42-page report, the first such review since Oregon voters legalized recreational marijuana in 2014, catalogues numerous gaps in Oregon’s regulatory oversight of cannabis. While offering qualified praise for the theoretical scope of Oregon’s adult-use regulations, the audit found that a lack of resources has led to spotty enforcement.

The audit is organized around four key findings:

  1. Oregon Liquor Control Commission (OLCC) staffing and inspections have not kept pace with the number of licenses;
  2. Oregon Health Authority (OHA) lacks the resources and statutory authority to conduct any meaningful level of oversight;
  3. Oregon does not require that cannabis be tested for heavy metals or microbiological contaminants, jeopardizing public health; and
  4. Oregon’s testing program does not do enough to ensure the accuracy of results and insulate labs from industry pressures away from best practices.

We’re still sifting through the findings, but initial review of the audit confirms what many already knew. There’s too much cannabis being produced by too many licensees — the audit estimates that Oregon can legally produce somewhere around five times more than the state consumes. Oversupply has pushed per-gram prices down over 50 percent since October 2016, incentivizing producers to divert cannabis outside of regulated channels and often across state lines.

Problems of oversupply and diversion are compounded by overmatched regulators. The OLCC’s ratio of inspectors to licensees (about 1:88) is among the lowest of adult-use states, while the OHA has six inspectors for over 7,000 grow sites (nearly 14,000, counting smaller home grows).

The audit also expresses concerns about consumer safety due to Oregon’s testing laboratories. Oregon requires testing for pesticides, but not heavy metals or microbiological contaminants. Testing requirements for medical marijuana, whose consumers are often particularly vulnerable to contaminants, are inconsistent. The testing that is required is performed by labs that lack consistent standards or compliance procedures, and that are subject to market pressures to provide favorable test results.

To their credit, the audited agencies agreed with the audit and its recommendations. Across the board, the issues raised by the audit are rooted in lack of resources, not lack of willingness. And while the audit is unsparing, this kind of tough love is necessary for the health of the industry as a whole. Consumer protection and robust oversight are crucial for a new industry, especially while pioneering states like Oregon try to avoid the ire of the federal government.

We will be spending more time with the audit results and discussing some of the specific implications for the future of cannabis Oregon here. Stay tuned!

With 10 states and the District of Columbia having legalized recreational cannabis (representing nearly a quarter of the U.S. population, including the most populous state), an emerging issue is how to deal with the odor generated by marijuana production facilities. A December 19, 2018 article in The New York Times noted a growing number of neighbors of cannabis farms are complaining about “skunky” odors caused by certain volatile organic compounds generated during growing and processing. The Times cited Sonoma County in California, which it reported received more than 730 complaints about cannabis last year, nearly two-thirds related to odor. Regulators at the state, regional and local levels are attempting to deal with these issues through a combination of permitting, land use and nuisance rules.

In states such as Washington and Colorado, where recreational cannabis has been legal since voter initiatives passed in 2012, regulators have addressed odor as an air quality issue. For example, in the Puget Sound region, the Puget Sound Clean Air Agency — typically recognized in the industry as “PSCA,” or the organization you may have received an unexpected and nondescript invoice from — does not have a specific regulation for marijuana odors. It does, however, have jurisdiction to impose limitations on marijuana production facilities under the state’s general regulations for air pollution sources (WAC 173-400). PSCA regulates odors through the Notice of Construction process, which operates in conjunction with local permitting processes, such as a conditional use permit, and licensing by the Washington State Liquor and Cannabis Control Board.

The PSCA odor regulations set a “best available control technology” (BACT) standard, which is the maximum degree of reduction for each air pollutant subject to regulation under the Washington Clean Air Act (RCW 70.94) that the permitting authority determines is achievable, taking into account energy, environmental, economic and other costs. PSCA’s rules are based on a nuisance standard — causing or allowing an air contaminant in sufficient quantities and of such characteristics and duration as is, or is likely to be, injurious to human health, plant or animal life, or property, or which unreasonably interferes with enjoyment of life and property.

For marijuana producers under PSCA’s jurisdiction (King, Snohomish, Pierce and Kitsap Counties), the agency has determined that BACT means no detectible cannabis odor outside the facility property line. The agency in recent permitting actions has implemented this standard by requiring operators to design all exhaust points (e.g., vents, stacks, windows, doors) associated with an enclosure, building or greenhouse for cannabis production or processing to continuously control odors and volatile organic compounds (VOCs) using carbon adsorption technology, which involves placement of carbon canisters before emission points. At a minimum, these carbon units must be replaced every quarter. An operator also must have a person who has not been exposed to the smell periodically monitor the air at the property line to determine compliance with the “no detectible odor at or beyond the property line” standard.

One significant ramification of this standard is that PSCA does not believe outdoor cannabis production facilities can continuously achieve the “no odor outside the property boundary” standard without the proper use of an enclosure that routes emissions to a carbon adsorption system. PSCA also does not allow odor masking, such as spraying a curtain of scented oil vapor around the perimeter of greenhouses. Although the Times article mentions this system as a way one California grow operation has tried to mitigate odors, PSCA will not accept that as a control technology.

In Colorado, cannabis cultivation facilities are designated as agricultural activity and exempt from state air quality regulations unless they are a major source of pollution. The City and County of Denver, however, has an odor ordinance that requires cultivation facilities control the odor impacts of their operations. An August 2018 draft of the Denver Department of Public Health & Environment’s “Cannabis Environmental Best Management Practices” (BMP) recommends use of carbon filtration to reduce the VOC emissions from a cannabis cultivator. In addition, draft guidance recommends other best management practices, including:

  • Regular inspection and maintenance of HVAC systems;
  • Sealing the grow space within a greenhouse and circulating air for approximately one week and purging exhausts during low ozone formation periods (evenings, windy days, cloudy days);
  • Ensuring temperature and relative humidity are under control and within tolerances so that high temperatures and humidity do not perpetuate odor issues;
  • Having a system in place to record and respond to odor complaints;
  • Purchasing a “scentometer” or Nasal Ranger to quantify odors and record data from self-testing;
  • Timing harvests to minimize ozone impact and minimizing emissions during morning, early afternoon and summer; and
  • Train and allocate responsibilities among staff members to ensure consistent and continuous implementation of BMPs.

Colorado facilities manufacturing marijuana-infused product are subject to health and safety regulations and regulations on extraction processes in the Colorado Code of Regulations. Those facilities must estimate their VOC emissions from solvent uses and follow the state’s Air Pollutant Emission Notice and permitting requirements.

With the increasing production of cannabis for recreational purposes, more conflicts with neighbors are likely. This is a situation where an ounce of prevention by implementing a wide-range of BMPs could go a long way toward reducing the risks of litigation and enforcement.

We recently discussed the impact of the Harborside opinion on cannabis tax planning, a tax court decision that disturbed, but didn’t really surprise, those of us who regularly work on the application of tax rules in the cannabis industry. The industry faces a secondary assault following the U.S. Tax Court’s opinion in Alternative Health Care Advocates. The opinion in Alternative raises new — more surprising and more disturbing — concerns regarding common cannabis tax planning strategies and focuses on the use of management companies.

The facts in Alternative include the following persons:

  • Alternative Health Care Advocates (Alternative), a California nonprofit mutual benefit corporation classified as a C corporation for U.S. tax purposes.
  • Wellness Management Group, Inc. (Wellness), a California corporation classified as an S corporation for U.S. tax purposes.
  • Duncan (D), 80-percent owner of Wellness and President of Alternative.
  • Richard Kearns (K), 10-percent owner of Wellness and Secretary of Alternative.
  • Kwit (E), 5-percent owner of Wellness and patient-member/consultant of Alternative.
  • Rozmarin (R), 5-percent owner of Wellness and manager of Alternative.
  • The individual mutual benefit members of Alternative.

Alternative operated a medical marijuana dispensary. Wellness handled daily operations for Alternative, which included hiring employees and paying expenses (advertising, wages, and rent). Alternative and Wellness maintained separate offices (but shared a mailing address) and maintained separate books and records on a shared computer.

Alternative obtained cannabis from its patient-members. It would prepare and process this cannabis for sale to its patient-members, which included trimming, drying, breaking down cannabis into gram or eighth-of-an-ounce increments, and maintaining clones. Additionally, Alternative obtained edibles, tinctures, oils, concentrates and topicals from its members in a condition ready for resale. The opinion notes that Alternative hired “processors” “through Wellness.”

Interestingly, both Alternative and Wellness maintained bank accounts with Bank of America and Chase Bank. Alternative operated within a “closed-loop” system. The closed-loop system required Alternative to limit both purchases and sales to patient-members. As such, Alternative purchased items from patient-members and sold cannabis items to them. Wellness paid Alternative’s other expenses, including advertising, wages and rent. Alternative reimbursed Wellness for these items. However, at times, Alternative directly paid for such items.

For the years in question, Alternative filed C corporation returns (Form 1120) and Wellness filed S corporation returns (Form 1120-S) while reporting the distributable share of Wellness income or loss to each Wellness shareholder on a schedule K-1. Both Wellness and Alternative reported gross income and other deductions. Additionally, Alternative reduced its gross receipts by its cost of goods sold. The tax returns filed by Alternative and Wellness did not reflect any disallowed expenses under IRC section 280E, and the IRS challenged each taxpayer’s respective position.

It should not surprise any of our readers that Alternative, a California medical marijuana dispensary, was disallowed expenses other than cost of goods sold under section 280E. What may be surprising is that the Tax Court extended the application of section 280E to Wellness, an S corporation acting as a “management” company for the dispensary.

The opinion cites the Tax Court’s earlier opinion in Olive and a tax code provision related to criminal activities related to USPS stamps to define “trafficking.” Olive held that dispensing medical marijuana constitutes trafficking for purposes of section 280E. Section 7208 defines trafficking — for purposes of prohibited stamp transactions — as buying, selling, offering for sale or giving away. The opinion also cites the Controlled Substances Act, noting that it prohibits importing, manufacturing, distributing and possessing controlled substances.

The analysis is limited to the following quote:

 

[T]he only difference between what Alternative did and what Wellness did (since Alternative only acted through Wellness) is that Alternative had title to the marijuana and Wellness did not. Wellness employees were directly involved in the provision of medical marijuana to the patient-members of Alternative’s dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness’ primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling. Neither that section nor the nontax statute on trafficking limits application to sales on one’s own behalf rather than on behalf of another. Without clear authority, we will not read such a limitation into these provisions.

The analysis is troubling for several reasons. First, it ignores any contractual relationship between Alternative and Wellness. Second, it ignores any principal and agent relationship between Alternative and the employees provided by Wellness to Alternative. Third, a reasonable and logical expansion of the analysis suggests that dispensary employees are subject to section 280E. Fourth, the holding violates the tax principle that ambiguity in revenue raising provisions — notably IRC section 280E — should be construed in the taxpayer’s favor rather than the government’s favor.

The collateral damage of Alternative is unclear, and may suggest that cannabis companies should carefully (re)consider the use of management companies. Query whether it makes sense to restructure some management companies as so-called employee leasing companies. In the employee leasing arrangement context, the employees should be under the direction and control of the licensed entity rather than the employer of record. While the holding involves entities “directly involved” with cannabis, it suggests that real estate leasing and intellectual property leasing structures may face similar attacks in the future. Cannabis companies should carefully consider the tax risks of any tax planning strategies and determine if the potential benefits outweigh the associated risks.