Compliance Can Mean Sink or Swim for Cannabis Startups

This article was originally published on November 7, 2019.

Business opportunities abound the cannabis industry, and many entrepreneurs have already established highly profitable companies. Before entering into or doing business with a cannabis company, however, note that many legal issues remain unsettled. How these issues are resolved might significantly impact whether these companies can continue in business and their potential success. This legal uncertainty makes this industry akin to the Wild West, where the answer to a legal issue might depend on which court is deciding the issue or what comes from laws yet to be created. 

The reason for this uncertainty is due to the conflict between federal and state law. Many states have legalized the use of marijuana and cannabis, for either recreational or for medical purposes. In contrast, their production, possession, sale, and use are illegal for the most part under United States federal law. Under the U.S. Constitution, federal law is supreme to conflicting state laws. Accordingly, the legalization efforts by the various states would appear to conflict with existing federal law and therefore be void. Nevertheless, the cannabis industry is flourishing throughout much of the country, and it would appear that many businesses and their investors are counting on legalization in the near future and/or favorable discretion in federal prosecutions for businesses complying with state law. 

Nevertheless, no one can predict whether federal laws will be relaxed or tightened nor when the changes, if any, will occur. Meanwhile, prosecutions under federal law may depend on the discretion of national and local law enforcement, which differ from jurisdiction to jurisdiction. Moreover, discretionary practices may evolve over time, particularly with changes in administration. Thus, starting a business in a prohibited or regulated industry with the hope of future changes in the law creates risks that traditional companies need not face.  

Choosing the Correct Counsel  

Some of the key issues to consider when entering into this industry or doing business with a marijuana-related company include: 

• Financial Services: Federal and state banks are all subject to federal law, either directly or due to the existence of federal deposit insurance and regulation. Many banks and other financial institutions will not provide checking, deposit, savings or many other financial services to those engaged in the production or sale of marijuana products. Many credit cards are operated by banks, so their use in the industry may be restricted. This results in cannabis companies often having to deal with substantial amounts of cash with their attendant security risks. Marijuana Business Daily reports that there were 633 banks and credit unions providing banking services to the industry as of March 2019, out of thousands of banks nationwide. Developing a workable plan for handling cash flow will be an important consideration for these companies. 
• Taxes: Federal tax law may limit or disallow deductions for businesses conducting operations in “illegal” industries, including those involved in the drug trade. Understanding which items can be lawfully deducted will greatly impact the taxable net income of these companies. 
• Bankruptcy Protection: The ability of companies to use federal laws, like bankruptcy protections, remains unsettled. One court considering that issue declined to reach a definitive decision and instead ordered the debtor engaged in that industry to destroy all cannabis-related products and to cease operating in that industry. Another bankruptcy court recently dismissed a bankruptcy petition by a company leasing property to a marijuana-based company. Thus, even companies not directly engaged in the business may be adversely impacted by those who do so. 
• Other Federal Laws: The impact of other federal laws on this industry remains uncertain. For example, whether companies engaged in the cannabis business can protect their trade and service marks under United States trademark laws is uncertain. Experienced intellectual property counsel can assist in helping to avoid current restrictions when describing the fields their marks are being used. In contrast, the U.S. Patent and Trademark Office is allowing patents to protect goods in this industry, and strains of marijuana are recognized and protected under federal laws governing plant species.  
• Potential Litigation Claims: Companies doing business with those engaged in the industry might be included in lawsuits against the cannabis companies under various legal theories, including claims for conspiracy, racketeering and similar allegations. These claims might be premised on theories that the supporting companies were knowingly facilitating and aiding an illegal operation. It may be quite some time before it is known how the courts will treat those parties, but it could be quite expensive to defend regardless of the outcome. 
• Insurance Contracts: Companies engaged in this industry should carefully review their insurance contracts to be sure they do not exclude coverage for engaging in illegal activities. 
• Other Issues: The items noted above are only an example of the unique legal issues that might arise in this nascent industry. The interaction between existing state laws on marijuana with other existing and future laws will evolve over time, but leaving companies operating in the early years exposed to greater uncertainty or having to pave the way with establishing the future course through legislation, regulation, and litigation.  

Be Ready to Adapt

Entrepreneurs and established companies entering into this industry or doing business with a cannabis-related company should consult with professional advisors with experience in this industry. Note that they may be restricted by their respective professions in those engagements. For example, Arizona requires that its attorneys make certain disclosures to prospective clients in this industry concerning the illegality of that conduct under federal law, among other requirements.   

It is also helpful to select advisors who can counsel your company on this rapidly changing legal environment in a variety of fields. Advisors with experience in a broad range of legal issues can assist in dealing with the variety of issues that may arise, sometimes with little notice and rapid response times. Thus, it is helpful to find professionals who can assist you with issues throughout the business cycle, from before company inception and protection of its intellectual property, to the company organization, capital raises, financing, start-up operations, employment, third-party contracts, tax, litigation, and legal compliance. Experienced counsel can help your business navigate the many issues confronting a company in this uncharted legal landscape. 

Richard Lieberman is the Chair of the Corporate, Securities & Finance Department of Jennings, Strouss & Salmon, PLC. His firm represents a wide variety of businesses, from start-ups through established companies seeking an exit, in most areas of business law, from company formation, intellectual property, securities, mergers & acquisitions, financing, tax, employment, contracts, real estate, commercial litigation, and bankruptcy. He can be reached at 602-262-5935 or [email protected]. 

This article is intended for general information only and does not constitute legal advice to the readers, as each situation differs. Readers are encouraged to discuss their specific circumstances with counsel of their choice.