As usual, we’ve been monitoring both brewing and active trademark disputes in the cannabis space, and the most recent example involves the institution that is the Girl Scouts. For background, here are some of the other disputes we’ve covered in the past:

According to a recent article in Forbes, California cannabis-edibles company Kaneh Co. was promoting its cannabis-infused cookies as similar to several of the Girl Scouts’ cookie brands. According to the article, Kaneh was comparing its “Toasted Coconut Caramels (‘flecked with vanilla and sea salt’) to the Scouts’ Samoas; its Lemon Sugar Cookies to the Scouts’ Lemonades; and its Salted Toffee Blondies (‘a brown sugar blondie swirled with toffee chips and a generous dose of sea salt’) to the Scouts’ Toffee-tastic cookies.” All of these descriptions were included in an emailed advertisement for Kaneh’s goods, and a representative from Kaneh stated that the Girl Scouts comparison would not appear in any print or online advertisements.

The Girl Scouts, however, were not amused by Kaneh’s likening of its products to the Girls Scouts’ cookies, particularly given the connection to cannabis. A statement from the Girl Scouts said, “We consider … such use of our [cookie names] trademarks to be misappropriation, which we take seriously and, when applicable, [we] will send a cease and desist request.”

This is not the first time the Girl Scouts have gone to bat against a cannabis company, previously having clamped down on the use of the strain name “Girl Scout Cookies.” See: How an LA Weed Dispensary Pissed Off the Girl Scouts.

Quite frankly, it’s understandable that a youth organization would object to the use of its intellectual property in conjunction with a Schedule I controlled substance. But what is interesting about the Girl Scouts’ current beef with Kaneh’s use of its intellectual property (IP) is that the Girl Scouts representative didn’t argue that Kaneh was infringing the Girl Scouts’ trademarks (as was the case in the disputes we’ve covered in the past and linked to above). The representative instead asserted that such use of the Girl Scouts’ cookie names was “misappropriation,” and this is an important distinction.

As we’ve covered before, a trademark is a word, phrase, symbol, and/or design that identifies and distinguishes the source of the goods of one party from those of others. And trademark infringement is the “unauthorized use of a trademark or service mark on or in connection with goods and/or services in a manner that is likely to cause confusion, deception, or mistake about the source of the goods and/or services.” In the case at hand, the Girl Scouts would be hard pressed to show that Kaneh’s use of the names of its cookies (which are protected by trademark registrations), was likely to cause consumer confusion or mistake about the source of the goods, since Kaneh was only referencing the cookies in a comparative manner, to explain to customers what its cookies tasted like. In fact, this comparative manner of use would make it very clear to customers that Kaneh’s cookies were not Girl Scout cookies.

But are companies allowed to make these kinds of comparative statements? And what is “misappropriation” in the context of trademarks? The theory of misappropriation in a trademark context is tenuous, but there are three basic elements (J. THOMAS MCCARTHY, 2 MCCARTHY ON TRADEMARKS AND UNFAIR COMPETITION § 10.72 (4th ed. 2006)):

1. Plaintiff has made a substantial investment of time, effort and money into creating the thing misappropriated such that the court can characterize that “thing” as a kind of property right [the creation element].
2. Defendant had appropriated the “thing” at little or no cost, such that the court can characterize defendant’s action as “reaping where it has not sown” [the appropriation element].
3. Defendant has injured plaintiff by the misappropriation [the injury element].

The idea here would be that Kaneh was free-riding on the goodwill that the Girl Scouts have worked to establish over the years. But there are also “fair use” exceptions to trademark infringement, including for comparative advertising. It is unclear whether such comparative advertising principles would apply in this case, since traditional girl scout cookies fall within a completely different product category from cannabis-infused cookies. Still, this is something that all cannabis business owners should be mindful of. Use of another company’s trademark in comparative advertising may be allowed under certain circumstances, but businesses must be very careful to avoid advertisements that could be deemed false and misleading.

Even if you think that your use of another’s trademark does not constitute trademark infringement, or that your use falls within a fair use exception like comparative advertising, it is important to consider claims that could be made against you like misappropriation, or false and misleading advertising, and it is important to run these types of advertisements by your IP lawyer.

Previously I wrote about insurance generally (see here) and products liability insurance specifically (see here). Today I want to look at some policy exclusions to point out potentially problematic terms that you may notice when reviewing your insurance contract during your annual insurance audit.

First, I need to mention some truths that I believe are accurate in the insurance context, based upon my many years of interacting with business clients:

Many business owners never read their policies. Insurance contracts are often dozens or hundreds of pages long. They are complicated, and they are not written like other contracts, which makes them worse to read than a normal business contract. This results in many business owners meaning to read the contract but rarely getting beyond the coverage jacket on the first page of the policy.

Many business owners never have anyone on their team read their policies. Business owners generally intend to (and do) delegate the insurance review and renewal to someone on their executive team, but that rarely results in anyone reading the contract beyond the first page of the policy. Many insurance owners do not want to pay their lawyer to review their policies, so they will often rely on their broker to assure them as to what coverage they have. Because insurance claims arise only intermittently, the importance of the insurance contract seemingly pales when compared to supply and customer contracts that are the lifeblood of the business, so these tend to fall by the wayside until the next annual renewal.

The right insurance broker or agent can be your ally. First, some terminology. An insurance broker represents an insurance buyer, and an insurance agent represents one or more insurance companies. If you are familiar with real estate, you can analogize to the commercial insurance context. An insurance broker is similar to a real estate buyer’s agent, while an insurance agent is similar to a real estate dual agent who represents both the buyer and the seller in a transaction. Each of these individuals can be helpful to you in the right context with the right motivation. An insurance broker will always be your ally because they work for you and can shop your needs around to various insurance companies. An insurance agent is generally “captive” to the company or companies they represent and has to sell you insurance products offered by those companies, but they are still motivated to sell you a good product to keep your recurring business year after year. In both scenarios, you will not know all of the types of policies that are available, even if you are familiar with the basic insurance policies: commercial general liability, employment practices, workers’ compensation, directors & officers, property casualty, product liability, commercial vehicle, business interruption, and key person insurance. It is better to rely on someone within the industry than try to decipher the purchasing process by yourself.

Insurance companies are not your friends. I know many insurance agents and brokers, and many are good people who are motivated to provide good service, but there is a reason why companies hire good, experienced law firms to help negotiate with insurance companies when they want to make a claim for a loss against their policy. I also know many lawyers who work for insurance companies doing “insurance defense work” where they fight hard to help their insurance company clients avoid paying out funds to their insured. It is not pretty to be on either side of the table. But you do not want to try to navigate the technical and complex morass by yourself.

Let’s shift from these general points to the topic of insurance riders:

Insurance riders explained. A cannabis company growing hemp or marijuana will typically obtain a commercial general liability policy in response to a statutory requirement to carry insurance, like this language from Washington:

The licensee shall at all times carry and maintain commercial general liability insurance or commercial umbrella insurance for bodily injury and property damage arising out of licensed activities. The limits of liability insurance shall not be less than one million dollars.

(a) This insurance shall cover such claims as may be caused by any act, omission, or negligence of the licensee or its officers, agents, representatives, assigns, or servants.

(b) The insurance shall also cover bodily injury, including disease, illness and death, and property damage arising out of the licensee’s premises/operations, products, and personal injury.

These broad categories above are, in theory, the items that will arise in the life of a cannabis company, but the ubiquitous insurance riders (contract amendments) chip away at this protection. Your policy will not cover every event on purpose, even if you try to buy the most comprehensive policy you can find. And if you do want to procure a policy that covers every potential event, it will almost always be too expensive for your budget. It is to your benefit to audit your policies and understand what events are and are not covered and know your business well enough to know what events are most likely to arise based upon your business plan.

When auditing your insurance coverage, pay close attention to the insurance riders that appear at the end of most sections of an insurance contract. After reviewing hundreds of pages of insurance policies as part of my due diligence for a recent M&A transaction, I point out the following language from actual insurance policies that may cause the typical cannabis business owner to pause:

1. This policy does not cover seeds, seedlings, vegetative plants, flowering plants, or harvested material that is not yet finished stock.
2. This insurance does not apply to bodily injury and property damage arising directly or indirectly from alcoholic beverages.
3. This [workers’ compensation] policy excludes volunteers and employment practices liability.
4. This [workers’ compensation] policy does not cover business owners.
5. This policy excludes nutraceutical substances such as essential oils.
6. This policy excludes vaporizing devices.
7. The insured must notify the company regarding a change of ownership. (This is not, strictly speaking, an exclusion like the others above, but it was significant enough that I wanted to include it here.) This clause becomes relevant in the M&A context and is different from the standard change of control language in other contracts (like bank financing agreements) that could impact whether you decide to do a stock deal or asset deal. A change of ownership impacts the covered company’s experience rating, and insurance companies love any excuse to reassess a company’s risk profile, find increased risk, and raise a premium as a result.

Attorneys get paid to deal in details. Often business owners believe they are covered by an event when they really are not, but you have to look beyond the insurance coverage jacket and diagram the effect of your insurance riders. This is why we always recommend a comprehensive insurance audit at least once per year.

For more information on the twists and turns of insurance policies, see the following posts:

We try to cover cannabis-related trademark issues thoroughly on this blog, because branding and trademark protection form the most basic foundation for most businesses. In our most recent posts, we’ve focused heavily on trademark disputes, because as the industry matures, litigation has become inevitable. For reference, you can check out some of the big trademark disputes from the last couple of years here:

But what we haven’t done recently is a recap of the trademark basics for cannabis companies, as well as a rundown on the updates regarding what products are and aren’t eligible for protection. There have been some positive changes in the last year with the implementation of the 2018 Farm Bill – the USPTO released updated guidance regarding the registration of hemp-related trademarks, which can be found here.

I’ll give a brief overview of the cannabis trademark landscape, but at this point, I think it’s safe to say that nearly every cannabis company has at least something that should be the basis for obtaining trademark protection.

Trademarks 101: A trademark is a word, phrase, symbol, and/or design that identifies and distinguishes the source of the goods of one party from those of others. More commonly, a trademark is recognized as a brand. The importance of trademarks is two-fold: On one hand, owners of successful brands want to rest assured that other parties will not be able to use and exploit their brand without the brand-owner’s permission. But on the other, perhaps more important hand, trademarks are crucial from a consumer protection standpoint. As a society, we want consumers to know where the goods and services they purchase are coming from, and to make informed purchasing decisions based on factors like quality and safety. The primary way consumers are able to distinguish the goods of one company from the goods of another is via branding.

There are three ways in which a brand owner can establish trademark rights:

1. By using the mark in connection with their goods or services (legally) in commerce;
2. By registering the mark with the United States Patent and Trademark Office (USPTO); and
3. By registering the mark with an appropriate state trademark registry.

Registering a trademark with the USPTO is the best way to protect one’s mark, but because cannabis is still illegal under federal law, and because one requirement for registration of a federal trademark is that the applicant has made “legal use” of the mark in commerce, the USPTO has continually refused to register marks for use on cannabis and any other goods and services that violate the Controlled Substances Act (CSA).

The crux of the analysis for any cannabis company’s federal trademark eligibility is whether or not the company sells goods or offers services that comply with federal law. To the extent that it does, those goods or services are likely eligible for trademark protection. In addition, to the extent that a company is selling products that comply with both the Controlled Substances Act (CSA) and the Food Drug and Cosmetic Act (FDCA), those products are likely eligible as well. For example, while the FDA maintains that CBD cannot be added to food products without violating the FDCA, its position on CBD in topical products is quite different. Those products, as long as they comply with the 2018 Farm Bill, are likely eligible for trademark protection. Likewise, certain hemp products are Generally Recognized As Safe (GRAS) by the FDA – these products, including hemp seed oil, for example, are also eligible for federal trademark protection.

For products that do not meet the threshold for federal trademark protection, there’s a good chance that state protection is available. Though the protection afforded by a state trademark is geographically limited to the state of the registration (and sometimes just the area of use within that state), state trademarks usually provide more extensive geographic protection and legal remedies than common law rights. Common law rights are almost always limited to the geographic area in which you are using the mark, meaning that if you only do business in San Francisco, your common law trademark rights could only protect you within the city of San Francisco. And if you want to avail yourself of the statutory remedies available to trademark owners in infringement cases, you will need to register your mark.

While trademark protection in the cannabis industry still presents challenges for business owners, the law is in constant flux, and opportunities are beginning to emerge. If you haven’t worked with your cannabis intellectual property lawyer to develop a strategy for protecting your trademarks now and going forward, now is the time to do so.

California cannabis regulators are slowly getting into enforcement mode under the Medicinal and Adult-Use Cannabis Regulation Act (“MAUCRSA”). Ostensibly, enforcement to date has been around illegal sales and/or around the manufacturing of illegal products (like vape cartridges). It’s only a matter of time though before enforcement becomes more sophisticated around licensing, including the state increasing scrutiny around “owners” and “financial interest holders”.

• Owners are any person or company that owns 20% or more of the licensee or that exercises any management, direction, or control over the licensee (including board members, managers, and officers).
• Financial interest holders are anyone or any company that owns 19% or less of the licensee or that invest in, lend to, or profit share with a licensee.

For whatever reason (but likely because of a lack of enforcement), many cannabis businesses in California don’t take very seriously the requirement to both accurately identify and timely disclose their owners and financial interest holders. And not all of that is their fault, as all three agencies in charge of California cannabis businesses essentially have different rules and interpretations around the disclosure process (though they should all be applying the same standards for owner and financial interest disclosures across the board).

According to the 2018 Bureau of Cannabis Control (“BCC”) disciplinary guidelines, failure to disclose a change in ownership is a tier 3 violation. Tier 3 violations are recommended for “Knowing or willfully violating laws or regulations pertaining to commercial cannabis activity; and Fraudulent acts relating to the licensee’s commercial cannabis business.”

Tier 3 violations also include the illegal sale of dangerous drugs or other controlled substances, so that category is reserved for the most serious rule violations. In addition, securing a license by fraud, deceit, or misrepresentation also constitutes a tier 3 violation. In my opinion, failure to disclose every single owner as required by MAUCRSA’s regulations can easily fall into a tier 3 violation depending on how egregious the business’s design is, if its intent is to hide certain owners or those in control of the business. The same potentially goes for financial interest holders that may be secretly funding or investing in a California cannabis business as far as I’m concerned. And, either way, under MAUCRSA, the state agencies have as much discretion as they want when deciding what penalties to apply for various violations; the disciplinary guidelines are just that–guidelines–and they’re not binding on the state.

The recommended penalties for a tier 3 violation are significant. At minimum, you’re facing a 45-day suspension or a fine according to a formula set by the state (some of which are staggering depending on license type), or some combination of both of those. At maximum, your license is getting revoked. Again, it’s up to the state to decide how they want to proceed, taking into account relevant mitigating factors depending on the violation at issue.

What I’m beginning to see now are a host of companies that never disclosed various owners or financial interest holders to the state. The state is now making the rounds on annual licensure, or because of changes of ownership, to really determine who the owners and financial interest holders are of a given licensee. Even more so, I’m seeing investors and owners just learning of these disclosure requirements and turning tail in the face of potentially invasive disclosures and background checks, or because they simply cannot comply with the disclosure requirements. For example, some of the investment funds in this space that have hundreds of participants typically have trouble when it comes to full disclosure of those individuals. Certain foreign investors also have immigration-related liability, or liability for cannabis investments in their home country.

Even if an investor or owner (which includes any director, manager, or officer) wants to bail on a cannabis company, if they were never disclosed their departure will not absolve the cannabis company of a major rule violation. Additionally, the investor or owner may face additional, personal liability for failing to adhere to state disclosure requirements depending on whatever shareholder agreement, operating agreement, investment agreement, or governance document they signed with the licensee. Typically, the foregoing agreements are all going to include representations and warranties and other covenants around knowledge of the regulatory process, accepting all requirements to maintain licensure in good standing, and cooperating with the licensee to ensure total compliance around licensing.

In the end, failing to disclose owners and financial interest holders can leave a cannabis business without a license and at the same time create significant personal liability for the owner or financial interest holder that doesn’t want to–or now cannot–disclose themselves to the state. As a result, all would-be owners and financial interest holders need to intimately understand the state’s disclosure requirements (and the timing around those requirements) and be prepared to perform accordingly. The alternative is to decide to stay in the ancillary space and spare themselves this step).

Any cannabis company still playing around with disclosure is going to find itself hurting when the state kicks into more robust enforcement around these owner and investment concepts.

WHAT IS AN NDA?

An NDA is a contract in which the person receiving the sensitive information (“Receiving Party”), usually a business partners, an employee, or a customer, agrees not to share that information with any other party without the prior written approval of the owner of this information (“Disclosing Party”).

Most states, including Oregon, have adopted a version of the Uniform Trade Secrets Act (“UTSA”). Under Oregon law, a trade secret is defined as

information, including a drawing, cost data, customer list, formula, pattern, compilation, program, device, method, technique or process that:
(a) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and
(b) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”

This means that to be legally protected, business information must be valuable and its owner must take reasonable steps to keep it secret. For example, informing new employees that confidential information will be shared in the course of their employment, specifically when requiring them to execute an NDA, should prove that reasonable efforts were made.

In addition, NDAs are enforceable provided they are “fair,” meaning the NDA is not overly restrictive or unduly burdensome on the Receiving Party.

WHAT PROVISIONS SHOULD BE IN AN NDA?

Whether an NDA is needed for business or employment purposes, an effective NDA should include the following provisions:

1. A clear definition of the confidential information that will be shared with the Receiving Party during the term of the agreement. Depending on the state law that governs the NDA, an overly broad definition could expose the Disclosing Party to legal actions and render the NDA unenforceable.
2. The reasons for which the sensitive information is shared with the Receiving Party.
3. Terms under which the sensitive information may be disclosed. Generally, confidential information may be disclosed to a third-party on a need-to-know basis, such as when required by law.
4. The consequences for disclosing the confidential information, which usually include large monetary fines and a court order preventing the breaching party from continuing to disclose the protected confidential information.
5. The length of time during which the Receiving Party must retain the information confidential. Ideally, the Receiving Party will be required to maintain the confidential information secret after their employment agreement terminates.

NDAs are a relatively inexpensive investment for companies given the protection they afford over valuable business information. Accordingly, any business, particularly those engaged in growing markets like Hemp-CBD, should consult with experienced business attorneys to help them prepare sound NDAs.

The concept of starting a cannabis business on a shoestring budget has never really existed. As a result of this, I often see loan agreements and promissory notes between individuals/companies and cannabis operators of all sizes on loans secured by collateral belonging to the cannabis operator or cannabis business. In these sorts of loan deals, as is true in any secured lending situation, the value of the collateral is what matters most, and with cannabis businesses, secured parties typically want a few prized items included in the collateral description, such as the cannabis business ownership interests, its license, its inventory, its equipment, and its accounts receivable. However, unlike in more traditional secured transactions, foreclosing on a cannabis business and its secured assets depends very much on state law and it is often a very complicated process.

My clients that lend to cannabis businesses routinely ask me whether their security agreements will be enforced in the event of a dispute. My usual answer is, “Yes, if the security agreement will be/should be upheld pursuant to the state laws in which the loan was made or where the cannabis business operates.” In other words, this only occurs in a state with laws that recognize commercial cannabis conduct as legal. These states usually enforce cannabis contracts despite federal illegality. In cannabis legal states like California (where I’m located), the state usually has laws making commercial cannabis contracts enforceable. Smart lenders ensure their security agreements are enforceable based on the cannabis laws in the state in which any disputes will be handled.

Once a lender gets past the enforceability hurdles, its next legal hurdle is usually state-required disclosures. Depending on the state, if you’re a secured party dealing with a cannabis business, you almost certainly will need to disclose your financial interest in the cannabis business to state regulators in a timely and transparent manner (as required under the specific state’s law) or the state will not allow your loan to go through at all. It is important to mention that the Uniform Commercial Code (“UCC”) adopted in the relevant state still applies, and this means your security agreement should be drafted and authenticated in accordance with state UCC requirements.

In almost all cannabis states, state licenses are not transferable, and they therefore should not be listed as individual collateral in a security agreement. If a lender wants a cannabis license in a security agreement, it almost always should get the cannabis business to pledge its ownership interests in a separate pledge agreement. And if a cannabis business signs away its license and then seeks to transfer that license in the event of default, most cannabis states will just cancel the license due to an illegal transfer. In addition, if a lender wants the cash belonging to the cannabis company or its customer accounts or its inventory, the lender usually will first have to become an “owner” of the cannabis business, which creates its own complex and lengthy regulatory process outside the confines of the UCC.

Of course, certain other collateral belonging to the cannabis business, like its equipment, won’t trigger these ownership issues because foreclosing on equipment usually does not impact control of the business or its license.

In certain states, merely holding a security interest from a cannabis business does not trigger any disclosure requirement. But in some of these same states, the loan to the cannabis business triggers minimal disclosure requirements because the state considers the originating loan a minor financial interest in the business. If your collateral list includes ownership interests in the cannabis business or its inventory, most states require you first go through mandatory personal and financial disclosures to foreclose on that collateral. This is another reason why cannabis security agreements are not your run-of-the-mill secured transactions and why it is so critical for cannabis security agreements to properly account for these particular regulatory issues.

Bottom Line: Lenders should proceed with caution with cannabis secured transactions and not just trot out their boilerplate security agreements/pledge agreements because those do not sufficiently address the unique issues presented by cannabis companies.

One of the most fundamental questions facing any businessperson in the cannabis industry and every other industry is: “What type of business entity should I use?”

This is such a loaded question that your lawyer or accountant will first respond with, “That depends,” and then they will need to ask you at least ten follow-up questions to understand your goals and expectations, as well as the goals and expectations of your business partners and financiers. Some of these follow-on questions are tax-driven; others are regulatory-driven; others are dictated by financing relationships; and still others deal with control and flexibility within your business.

This is Part 1 of a two-part series. In Part 2, I will discuss more in depth the difference between and among various legal entities from which you can choose. For those who are wondering whether it is “really necessary” to use a business entity instead of just hanging out your shingle, know that your properly established and maintained business vehicle puts the “limited” in “limited liability.” And don’t forget insurance (here and here) and clean business contracts (here), both of which are also essential in helping you sleep at night.

Some types of industries are relatively low risk (NOT cannabis); some business owners are relatively judgment-proof (but it’s hard to start a business if you have no assets); and some business owners like to drive their cars without windshields and seat belts (neither they nor their businesses tend to last very long). I get that many potrepreneurs are used to taking on more than their fair share of risk, but my short response is: forming a business entity is a relatively inexpensive foundation upon which to build a solid business. Don’t ever cut corners in your business, but really don’t cut corners when it comes to your business entity (or getting good insurance or having great contracts in place).

Let’s go over some of these important questions to help you decide how to move forward with your entity selection.

The tax-related questions:

• Do you or any of your fellow owners need to offset revenue in other business ventures?
• Do you or any of your fellow owners need to maximize losses in this business venture? (i.e. will you be 50/50 in the business ownership, but your business partner wants to capture 100% of the losses in the startup years of the business?)
• Are any of your owners non-residents?
• If taxed as a pass-through, will you and other owners be prepared to pay all taxes owed while the company builds out its balance sheet?
• Does your business plan involve real estate ownership?
• Will your business own other assets that are likely to appreciate over time?
• What is the anticipated impact of IRC 280E on your business model?

The regulatory questions:

• Do your state’s cannabis regulations require you to use a particular business entity? (i.e. some states required all licensees to be nonprofit entities or “entities operated on a not-for-profit basis”).
• Do your state’s regulations require full transparency in entity ownership?
• If possible, do you want to keep some of the business’ owners out of the public eye?

The purpose-related questions:

• Are you going to operate your business with a specific mission so that you can draw investment funds from particular types of investors?
• Are you going to operate your business with a specific mission so that you can provide something good to the world by furthering education, providing charitable assistance, or stepping in to help where governmental resources cannot address needs in your community?

The financing-related questions:

• Do you intend to have outside financiers involved, such as private equity or venture capital? If so, have your prospective investors made any requests regarding the type of entity in which they prefer to invest?
• Do you intend to give all owners equal rights to profits, or do you intend to have different classes of ownership (i.e. preferred vs. common ownership interests and voting vs. nonvoting interests)?
• How many owners do you expect to have in the first five years of the business?
• Will any of your owners consist of C corps or S corps?
• Do you intend to take the company public as soon as your business model and U.S. laws permit it?
• How do you intend to get funds from the company to the owners: via salary, debt payments, distributions, or something else?

The control and flexibility-related questions:

• Do you intend to have a small group of owners or a larger group?
• Do you intend that all owners will have equal rights to profits and to decide when profits are distributed?
• Are you a part of the minority owner group or majority group?
• What type of governance structure do you envision working best for your company? Small or large?
• Do you intend to hire outside management for the business?

The answers to these questions will help your legal or tax advisor help you make the right decision on what type of entity to choose and what to do with that business entity. For instance, just because you are already using an LLC does not mean that you cannot take advantage of making a Subchapter S election with that LLC. You just need to have a good reason for doing so, time it correctly, and your accountant needs to know and agree with you. The same is true if you want your business to be taxed as a C corporation or you want to convert your entity to another type of entity.

In a future post we will dig in more deeply to the advantages and disadvantages in the various types of entities you can choose. Stay tuned!

I recently attended Utah’s annual securities law workshop with some heavy-hitting headliners: Ben McAdams from Utah’s Congressional delegation; the chief accountant for the SEC’s enforcement division; and the head of Utah’s Division of Securities, Tom Brady (the slightly less famous one). Mr. Brady confirmed for me that Utah has more than its fair share of fraud and that the fraud has a particular Utah flavor, with confidence schemes dominating the landscape, often perpetuated by fraudsters who work their church, neighborhood, and family connections in a state that rivals China for its interconnectedness (in Chinese it’s called guanxi (gwon shee) – 关系). Many of Mr. Brady’s examples of fraud perpetuated in Utah began with a hot tip provided by a well-regarded businessperson who was extremely likeable and therefore seemed trustworthy. Utah has a very trusting population, and it also has a growing elderly population, both of which are vulnerable to fraud. Although it is currently only appearing as an intermittent blip on the radar of Utah’s Division of Securities, the Utah cannabis scene is ripe for fraud opportunities. Caveat investor.

Utah is on the cusp of rolling out its medical marijuana program. The Utah Department of Health will begin issuing medical marijuana cards no later than March 1, 2020. Even before Utah voters passed the ballot initiative on November 6, 2018, the green rush had already started in Utah, with would-be investors looking at getting in on the ground floor in Utah’s new marijuana marketplace. Heavy cannabis investments are happening in all the states where we have attorneys: Washington, Oregon, California, and Utah, which means that bogus investments (not just bad investments) are also being shopped to would-be investors as an alternative to the evergreen oil-and-gas venture fraud in the West. How can prospective investors in a Utah cannabis venture avoid losing their money in a fraudulent scheme? It helps to ask the right questions and to know what the right answers sound like.

Is the company or individual raising funds using a law firm to help with the transaction? Does that law firm know both securities and cannabis?

These questions are partially self-serving, but I put this point first because you do not want to dabble in securities law, whether you are a company, an individual businessperson, an investor, or a lawyer. Whatever your role in business, if money is changing hands between investors and a business venture, the investor is investing in securities being offered by the company. Even if it is “just” a promissory note or you are “just” loaning some funds to a friend or family member, unless you do not care about getting your money back, make sure there is a qualified securities attorney involved. There are a lot of great attorneys in Utah. There are at least two good cannabis attorneys in Utah. I am not aware of any other lawyers in Utah who know both securities and cannabis. You need good securities attorneys representing the company and each investor.

If the company is using an intermediary to solicit investments, is that intermediary licensed to solicit investments? Are they registered with the SEC, FINRA, or the State of Utah? Has the intermediary been disciplined by any of these entities?

Intermediaries or “finders” are (by definition) not involved with the day-to-day operations of the company that is soliciting investment, and they must be registered with state and federal regulators because they are in the trusted position of soliciting funds for investment. If the intermediary is not registered as a broker or investment advisor, they should not be soliciting investments unless they have a direct and substantial role with the company. If the company thinks the intermediary is registered but the intermediary is not registered, you should think twice about investing with the company. If the company does not know that their intermediary needs to be registered, you should also think twice about investing with the company.

What type of investment registration statement is the cannabis venture required to file?

The company either has to register its investment securities or qualify for an exemption from registration. If the company owners do not know what a securities offering is, you should think twice before investing with the company unless the company is willing to get competent advice from a securities lawyer. If the company or its attorney has not heard of Reg D, Rule 4(a)(2), or Rule 506, you should probably walk away or insist a qualified securities attorney get involved.

What parts of a cannabis business can be invested in, or what are the limits to the company’s business purpose?

Some states (like Arizona) allow full integration of marijuana business activities; others (like Washington) do not. If, for instance, the company seeking investment plans to develop a cannabis testing facility and have a fully integrated cannabis business (cultivate, manufacture, distribute/transport, and retail sales), but you know that the company can only do what its license permits, then you may want to look for another company to invest in. In Utah, only eight companies have been authorized to grow medical cannabis: Dragonfly Greenhouse, Harvest of Utah, Oakbridge Greenhouses, Standard Wellness Utah, True North of Utah, Tryke Companies Utah, Wholesome Ag, and Zion Cultivars. There will initially be only up to 14 privately-operated medical cannabis pharmacies licensed by the Utah Department of Health, but the RFP for applications has not yet been issued.

What can be found out about the principal owners and operators of the business by (1) word of mouth, (2) a simple Google search, and (3) checking with state and federal securities regulators?

I cannot tell you how many instances of investment fraud could have been avoided by doing a simple Google search. This was stressed recently in another conference I attended with the Washington State securities regulators. Do your homework or pay someone else to do your homework. In the legal world, that homework is called “due diligence,” which is a crucial part of any business transaction.

When it comes to investing in cannabis, know your counterparts, know their business, and know their flaws and weaknesses. Know all of this before you invest.

Recently, Jonathan Bench wrote about the importance of insurance coverage for your hemp or recreational marijuana business. His first article provided the basic anatomy of such policies and his second discussed the importance of product liability insurance. This post highlights recent litigation in which insurance is at issue, or ought to be.

Hemp insurer seeks declaration of no coverage

Regular readers may recall the Big Bush Farms case —in which Big Bush brought a $57 million lawsuit arising from a hemp production contract against Boones Ferry Berry Farms and others. (See here for more detail). That lawsuit has now given rise to a coverage lawsuit by Boones Ferry Berry Farms’ insurer.

Recently, American Family Insurance filed a lawsuit in the federal district court of Oregon seeking a declaration from the court that it has no duty to extend to a defense to co-defendants Boones Ferry Berry Farms, LLC and its principals the Snegirevs (together the “Insureds”). American Family sold the Insureds a farm/ranch policy in which it agreed to provide the Insureds “a defense against liability for pay damages because of ‘property damage’ caused by a covered ‘occurrence.”  The policy excludes coverage for “‘property damage’ expected by, directed by, or intended by any ‘insured.’” I expect your eyes are glazing over so I’ll cease quoting language from the insurance policy!

The gist of the federal lawsuit is that American Family contends the claims against the insureds in the underlying state-court lawsuit do not give rise to a duty to defend or indemnify the insureds.

Oregon retailer sued for damages allegedly caused by exploding vape pen

As I noted, Jonathan also wrote about the importance of product liability insurance. (See here). He described is as a non-negotiable priority. A recent lawsuit filed in Oregon state court demonstrates why.

The plaintiff alleges personal injury resulting from a vaping device exploding while touching his mouth, causing part of the device to shoot through his teeth and into his face. The plaintiff alleges he bought this device from an OLCC retailer based in Bend, which device was manufactured by Korean company. The plaintiff sued both the Oregon-based retailer and the Korean company. The plaintiff alleges claims for strict liability, negligence, breach of the implied warranty of fitness for a particular purpose and breach of the implied warranty of merchantability and seeks $1 million in economic and non-economic damages.

For those thinking this lawsuit arises from the recent ban on flavored vape products, it does not. The events at issue occurred in October 2017 but the lawsuit was not filed until October 2019. Questions for the Oregon retailer include: Do you have product liability insurance? Did you have coverage during the applicable period (occurrence v. claims-made)? When, if at all, did you tender the claim to your insurer?

What ought you do?

First—have insurance.

Second—at the outset of any business dispute consider whether the loss may potentially be covered by insurance. This is not usually an enjoyable experience, as Jonathan pointed out, given the labyrinth of policy language, endorsements, exclusions, and exceptions to exclusions. As someone who has represented numerous insureds in disputes with their commercial general liability and other policies, my advice is to tender any potentially covered claim to your insurer ASAP. And I mean do it immediately after the loss or as soon as you become aware of the potential of a claim so that your insurer cannot argue you did not timely tender the claim. Your policy will spell out the how and when of tendering.

Third—review the insurers coverage position with a coverage attorney if the insurers denial or reservation seems at all tenuous. After you tender a potential claim, the insurer will provide its own coverage analysis and either accept coverage, decline coverage, or accept coverage subject to a reservation of rights. The insured then has the option of disputing the insurer’s coverage analysis and this is where a careful reading of your policy is just the first step. Determining whether to challenge an insurer’s coverage position requires insureds to evaluate policy language in light of general insurance law principles of the insureds jurisdiction as well as relevant case law interpreting terms within different kinds of policies. Insureds should remember that the duty to defend is broader than the duty to indemnify and that ambiguities in policies are resolved in favor of the insured. Nonetheless, insurers often find reasons to decline coverage and your coverage attorney may help you gain leverage and reach an agreement with your insurer regarding defense and/or indemnity.

Fourth—consider commencing a declaratory judgment action. The purpose of the action is to have the court “declare” whether or not the facts alleged in a complaint give rise to a duty to defend and/or whether or not the insurer must indemnify its insured’s loss. This is usually a last resort but it may be necessary in some circumstances.