While the regulatory atmosphere surrounding cannabis and cannabis-related products is still in flux, private equity and other investors have begun to consider the potential... CBD DD: Key Considerations When Conducting Due Diligence on Cannabis Companies

While the regulatory atmosphere surrounding cannabis and cannabis-related products is still in flux, private equity and other investors have begun to consider the potential for transactions in the industry. This article explores the key due diligence and regulatory compliance considerations that both buyers and sellers should be aware of in the event of a potential deal involving the manufacture and/or sale of cannabis products, such as hemp and cannabidiol (“CBD”).

Clearly Defined Product Lines

In the cannabis industry, a company must maintain well-defined product lines. The terms cannabis, hemp, CBD, and others are used rather loosely, despite the fact that they are distinct and regulated differently.

  • Cannabis sativa, often called simply “cannabis”, is the plant species to which marijuana and hemp, as well as many other varieties, belong. Cannabis is currently considered a Schedule I drug under the federal Controlled Substance Act (despite multiple attempts of late to change this classification in Congress) and therefore is subject to the strictest level of control by the Drug Enforcement Agency (“DEA”). Cannabis is also heavily regulated by the Food and Drug Administration (“FDA”).
  • Marijuana is a variety of cannabis used to make compounds with psychoactive effects due to level of tetrahydrocannabinol (“THC”) contained therein.Marijuana is regulated similarly to cannabis by the DEA and FDA.   
  • Hemp, also called “industrial hemp”, is cannabis containing less than 0.3% THC. The Agriculture Improvement Act of 2018, also known as the 2018 Farm Bill, made cultivation of hemp legal, removing it from Schedule I, while imposing restrictions on production and use (e.g., among others, transfer of hemp across state lines is permitted, but must be compliant with individual state licensing and cultivation requirements).
  • Finally, CBD is a chemical compound that can be derived from both cannabis and hemp and that does not have the same psychoactive properties of THC. CBD has become popular in the commercial market in various forms including, among other things, oils, creams, dietary supplements, and food (both human and animal feed).  The FDA, however, has made it clear that CBD, regardless of whether it is derived from cannabis or hemp, cannot be marketed as a food additive or dietary supplement.  The agency maintains the stance that CBD was used as an active drug ingredient in an approved drug product before it was marketed as a food additive or dietary supplement, and, therefore, per the Food, Drug, and Cosmetic (“FD&C”) Act, cannot be used as a food additive or dietary supplement without FDA approval.

Due to the intricate distinctions identified above, and with the understanding that the regulatory landscape surrounding cannabis and cannabis-derived products is under development, it is crucial for companies to be transparent about their products and the specific ingredients that they contain. During a public FDA hearing over the summer of 2019, various consumer advocates testified that, based on laboratory analyses of popular commercially-available CBD-containing products, most do not contain the exact ingredients or concentration of key compounds (i.e., CBD versus THC) disclosed on the label. False and/or misleading labeling can lead to enforcement action by both FDA and the Federal Trade Commission (“FTC”).

Therefore, potential buyers or investors conducting diligence on cannabis companies should request that the target company produce certificates of analysis supporting the composition of their products, and should also consider conducting independent analyses to confirm the company’s findings. It is also critical to evaluate the target entity’s manufacturing practices to ensure that quality control systems are robust and capable of ensuring consistency across batches and product lines.

FDA Regulatory Considerations

Because FDA has clearly pronounced that CBD, even when derived from hemp, may not be marketed as a food additive or dietary supplement, buyers should be wary of companies offering ingestible products of any kind, and should closely monitor actions taken by FDA to discern any new developments in the regulatory landscape.  This includes a review during diligence of whether FDA has issued any Warning Letters to the target entity.  For instance, in November 2019, FDA issued Warning Letters to 15 companies offering CBD products for sale on the internet.  Not only did FDA target those companies manufacturing food and dietary supplements containing CBD, but the agency also targeted companies making therapeutic claims about their creams and oils containing CBD. FDA’s enforcement efforts have been targeted to products that the agency views as posing significant consumer risk, such as those purported to be effective in treating serious diseases or conditions, including cancer, depression, Parkinson’s, and others. In light of FDA’s current posture, companies marketing CBD products that include aggressive health related claims should be closely scrutinized, and the risk of FDA enforcement should be considered as part of the overall risk analysis in the diligence context.

State-By-State Variances in Regulatory Details

States vary widely in their regulation of cannabis, hemp, and CBD products.  For example, some states allow the use of only “medicinal marijuana”, while others now permit “recreational marijuana”.  Some states permit the manufacture and sale of “hemp-derived CBD products”, despite the FDA’s clear position that such products are unlawful in absence of prior marketing authorization by the agency.  As such, a compliance program involving regulatory and industry experts and that monitors relevant legislative and regulatory activities is important for a company offering products and services in the cannabis space, particularly if the company is offering products across state lines. Diligence teams should conduct a thorough legal and regulatory review from this angle.

In addition, as discussed above, the 2018 Farm Bill changed the regulatory regime of hemp.  One result of the 2018 Farm Bill was the implementation of the shared regulatory responsibility over production of hemp between federal and state governments; the 2018 Farm Bill allows states to develop their own state hemp regulatory plan or to default to the federal hemp regulatory plan, the U.S. Domestic Hemp Production Program, developed by the United States Drug Administration (“USDA”). If a target entity is in the industrial hemp business, then a potential buyer conducting diligence should ensure there is an adequate compliance program in place to ensure the business operations are in line with applicable regulations.

Vendor and Supplier Management

Companies in the cannabis industry may use vendors and suppliers in the development of their products, and as such a close look should be taken at whether quality-related provisions are included in the contracts with those partners. Potential buyers should ensure that there are written contracts in place that, either in the terms of the agreement or in the associated statements of work, clearly specify the quality standards and production requirements, as applicable. Further, agreements should provide appropriate protection for the target company should any harm or loss result from actions by the vendor or supplier. In particular, it will be important over the next few years for written agreements to acknowledge the changing regulatory landscape and to allow for good faith negotiations in the event a material regulatory or legal change impacts the services being offered.

In light of the complexity and regulatory uncertainty surrounding cannabis in the United States, investing in this industry raises risks that are not necessarily fully quantifiable or foreseeable. Those interested in investing in this space should proceed with caution and, in addition to standard due diligence considerations, also closely scrutinize a product’s ingredients, sourcing, and claims; the target’s contractual relationships with third parties; and the robustness of the quality system under which the product is manufactured.

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