Two major President Trump-centric events have been unfolding these past few weeks, and each has alternatingly claimed the limelight and been overshadowed by the other. First, we have the ongoing Senate impeachment hearings, which began January 16, and second, phase one of the U.S.-China trade deal, which was signed and made public on January 15.

With respect to the trade deal, certain commentators have highlighted the appearance of hemp in the agreement. One prominent marijuana publication published an article the day after the trade agreement was made public, on January 16, claiming that, “China Must Import More Hemp From U.S. Under New Trade Deal.” That is an overly generous interpretation. We’ll investigate and clarify that optimistic claim below. The short gloss is that China may buy more hemp from the U.S. under the new trade deal, but China is definitely not obligated to buy more (or any) U.S. hemp as a result of the trade deal.

Even though China has been both officially and unofficially producing hemp for centuries, U.S. hemp is, like most U.S. products and even agricultural commodities, attractive to Chinese businesses and consumers. Like many sectors where China is working a 996 schedule to catch up and overtake the U.S. as the global economic superpower, China and Chinese companies are actively pursuing ethical and unethical ways to acquire U.S. technology and know-how, including our best agricultural practices, trade secrets, and the best crops our hemp geneticists can produce.

As I noted in a prior blog post, China has an outsized role in global hemp production, and Chinese companies own approximately half of the global cannabis patents. But it is interesting that China has not yet matured in large-scale way from the labor-intensive growing and processing of hemp to the technology-intensive production of cannabinoids (like CBD, CBG, and CBN) and cannabinoid-derived products. Currently, China only accounts for about 11% of the CBD produced globally, but as more global markets and consumers open up to hemp-derived products, China will exert its influence. Frankly, it is likely impossible for China to house 1/7 of the world’s population and not affect global markets by the mere discussion of a change in government support for China-based industries, companies, and products.

Now to the terms of the trade agreement. The phase one portion of the trade agreement covers the general categories of intellectual property (including pharmaceutical-related intellectual property that is rapidly becoming ground zero for the battle between big pharma/biotech and natural products companies), forced technology transfers, trade in food and agricultural products, agricultural biotechnology, financial services, macroeconomic policies and exchange rate matters, expanding trade generally, and bilateral evaluation of the trade relationship and dispute resolution.

Many commentators have expressed doubts that the trade agreement is good for the U.S. or that it will do anything beyond merely extending the rollout of the next round of tariffs post-the November presidential election on the way toward near-total decoupling between the U.S. and China. But if we take the terms of the trade agreement at face value, in 2020, China must increase its importation of “agricultural goods . . . no less than $12.5 billion above the 2017 corresponding baseline,” and in 2021, “no less than $19.5 billion above the 2017 corresponding baseline.” Also, a footnote in the agreement says, “At the request of the United States, China will strive to purchase and import $5 billion per year of the U.S. agricultural products…in addition to the minimum amounts set forth herein.”

Even though this “import” statement is not binding, it could represent additional purchases of agricultural goods. In the agreement, we find “true hemp (cannabis sativa l.), raw or processed but not spun; tow and waste of true hemp (including yarn waste and garnetted stock)” as one of 216 categories of agricultural commodities of which China is required to increase its purchases. If I were a gambler, I would not take those 1/216 odds (less than half of 1%) that China’s increased agricultural purchases are guaranteed to significantly impact the U.S. hemp industry. That 1/216 equals approximately $90 million of increased purchases in 2020, which would account for a roughly 7% increase in the projected 2020 U.S. hemp industry, which overall is projected to grow at 14% compounded annual growth through 2022. Chinese companies could just as easily decide they want to buy $90 million more human hair, which is also one of the 216 agricultural goods on the list with hemp. U.S. companies wanting to export hemp to international markets is an order of magnitude larger than those willing to research and put forth the investment in order to do so.

In a future post I will delve more deeply into the intellectual property implications of the trade deal on the U.S. and world cannabis (including hemp) industries. China has a big head start in cannabis patents compared to every other nation, but I think that western nations, especially the U.S., are particularly good at catching up, especially if Sputnik was any indication of what we are capable of when we are motivated to make significant advancements in any area we see as strategically important. In the meantime, do not hold your breath that this phase one trade deal will be a windfall for U.S. hemp farmers.

If you are interested in keeping up with China-focused legal developments, check us out on our award-winning China Law Blog.

The tides have been rapidly changing for hemp companies to gain access to banking, which has not traditionally been available to hemp companies due to the fact that hemp was (sort of) federally illegal until about a year ago. As we previously explained:

Commercial marijuana activity remains a federal crime,  and the Bank Secrecy Act (“BSA”) generally prohibits financial institutions from accepting marijuana-generated dollars. Financial institutions that work with marijuana businesses must conduct due diligence to ensure that marijuana businesses are complying with state law. That includes regularly submitting Suspicious Activity Reports (“SARs”) to the Financial Crimes Enforcement Network (“FinCEN”). Regulated commercial hemp activity is not a federal crime, but hemp’s close proximity to marijuana makes it a generally high-risk endeavor for financial institutions who generally don’t have a high risk tolerance to begin with. That has made it very difficult for many hemp and hemp-derived CBD (“Hemp-CBD”) businesses to access bank accounts.

Since the 2018 Farm Bill was signed and hemp was removed from the Controlled Substances Act, our hemp attorneys have seen more and more banks and credit unions take on various kinds of hemp clients (including hemp cultivators, processors, and even Hemp-CBD sellers). But still, many financial institutions have been hestitant when it comes to servicing hemp clients. As of the last few months, that has been changing.

As we reported over the summer, in August, the National Credit Union Administration (“NCUA”) released Interim Guidance on Serving Hemp Businesses. This guidance, though short, is fairly robust and provides ways for credit unions to verify that hemp clients are engaged in lawful business.

This week, on December 3, 2019, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Financial Crimes Enforcement Network (“FinCEN”), and the Office of the Comptroller of the Currency in consultation with the Conference of State Bank Supervisors released joint guidance entitled, “Providing Financial Services to Customers Engaged in Hemp-Related Businesses”. The guidance was intended to “provide clarity regarding the legal status of commercial growth and production of hemp and relevant requirements for banks under the Bank Secrecy Act (BSA) and its implementing regulations.”

There are a few key points from the joint guidance:

1. The quoted language (and other language in the joint guidance) refers just to commercial growth and production of hemp and even notes that the FDA retains jurisdiction over foods, drugs, and cosmetics. The 2018 Farm Bill only regulates hemp production, and does not really discuss hemp processing or the sale of Hemp-CBD goods. It’s not totally clear from the text of the joint guidance whether it was intended to cover only cultivation, and it certainly can be read that way. Therefore, it’s not yet clear whether banks will service clients engaged in those activities.
2. The joint guidance makes clear that banks won’t need to file SARs for clients based solely on the fact that they are engaged in cultivation of hemp. Banks will still need to follow standard SAR procedures and file SARs if there are indicia of suspicious activities.
3. The joint guidance makes clear that banks have discretion about what services to offer, but that bank clients must comply with applicable law. This puts the onus on banks to vet their customers to ensure compliance with hemp laws and regulations. Some things that the joint guidance expressly requires banks to do are to have BSA and anti-money laundering (“AML”) compliance programs commensurate with the level of complexity and
   risks involved, comply with applicable regulatory requirements for customer identification, SARs, currency transaction reporting, and risk-based customer due diligence (including collecting beneficial ownership information for legal entity customers).
4. Though the joint guidance does cover marijuana businesses, it makes clear that banks servicing those businesses should follow the FinCEN guidance FIN-2014-G001 – BSA Expectations Regarding Marijuana-Related Businesses.

The joint guidance also states that additional FinCen guidance will be released in the future. Hopefully by then, banks will have more comprehensive guidance for servicing hemp clients. But for now, this joint guidance is certainly a step in the right direction.

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.

Earlier this month, on October 3, the California Department of Business Oversight (the “DBO”) issued a Cannabis Banking Guidance memorandum to its state-chartered financial institutions (banks and credit unions) to help them make appropriate risk assessments in serving cannabis-related businesses and comply with federal guidelines.  The memorandum is in the form of an extensive questionnaire. The DBO’s Commissioner, Manuel P. Alvarez, commented: “If financial institutions choose to serve the cannabis market, they must understand risks and build out their compliance infrastructure accordingly.” “By making this questionnaire available to our licensees, we hope it can serve as an additional resource for banks and credit unions as they roll out their cannabis banking programs.”

With a focus on ensuring banks and credit unions thoroughly examine a Marijuana Related Business, or MRB, the first section of the questionnaire is titled “Program Governance.” Questions in this section include whether there is a comprehensive assessment of the business, and whether a financial institution has a contingency plan in case federal or state guidelines change. This section also focuses on due diligence, as determining where an MRB’s money comes from is critical.

Other sections include recommendations for business file review, account testing/identification of FinCEN red flags, and FinCEN filings.

The questionnaire also pulls from the now-rescinded Cole memorandum in one of its sections. It asks, “Does the financial institution specifically monitor for the eight priorities found in the Cole memo?” which include preventing the distribution of marijuana to minors, preventing revenue from the sale of marijuana from going to criminal enterprises, and preventing the diversion of marijuana from states where it is legal under state law in some form to other states.

California Bankers Association’s Senior Vice President, Beth Mills, said the guidance is helpful to have in written form but that much of it is a reiteration of what the department has said verbally in the past. “It is helpful for banks who are sort of weighing the pros and cons of trying to wade into that.” She added that the California Bankers Association is “still focused on a federal fix,” in the form of a change “that would really, truly make it okay for our members to bank this industry.”

In line with Proposition 64 and actions by other states, the DBO also reaffirmed on the same day that it would not bring regulatory actions against state-chartered financial institutions for solely establishing a banking relationship with licensed cannabis businesses. These financial institutions will still be required to comply with FinCEN’s BSA expectations, including the FinCEN guidance and priorities set forth above, and they were urged to identify, evaluate, and manage risks appropriately. Commissioner Alvarez stated, “We stand ready to assist our licensees to make sure they properly develop their cannabis banking initiatives.” “We will not be an obstacle to banks and credit unions that adhere to federal expectations regarding cannabis-related businesses and responsibly manage their risk.”

As veteran marijuana business owners (and virtually every other type of industry owners) know, there may come a point in time in the business when you are sitting across the table from someone who is offering to put money into your business. They may be your prospective business partner. They may be your close friends or family members. They may be friends of friends. They may be a private equity group, angel investors, or venture capitalists. Many of your closest family and friends have been close to you during your business growth. The ones who trust you because they have a close personal connection probably will not ask too many prying questions because they are investing in your strength, tenacity, and vision, not primarily in the strength of your business prospects. There are several right ways and many wrong ways to accept money from outside financiers for your business, but this post is not about how to do a securities offering the right way. (See here and here for some prior posts on that topic.) This post is about preparing yourself as the business owner for the types of questions you should expect to receive when you are discussing your business with potential investors.

All savvy investors are savvy because they are experienced. When we are feeling especially erudite, we may call them “sophisticated investors.” We call investors with a lot of assets “accredited investors,” which does not necessarily mean they are sophisticated, though many are. While sophisticated investors will not know everything about every product in every business market, they know the fundamentals of a good business. Many investors, especially in the venture capital and private equity world, have owned businesses. And they will be able to determine whether your cannabis business venture is worth investing in, regardless of whether you are primarily involved in cultivation, processing, manufacturing, R&D, distributing, or selling retail marijuana products. Prospective investors are literally everywhere: in your community, in your state, and in larger national and international markets. The U.S. has been and will continue to be the safest place to earn a good return without introducing unnecessary risks. Prospective investors are looking for a good return in a good business, and yours may be it, depending on how well you address the types of concerns below.

1.     Does Your Management Team Know What They Are Doing?

Sophisticated investors are really not that different from your parents or grandparents. Your family and friends believe in you and invest in your business because they know you. Your prospective investors who do not know you need to understand both the human side of you and your business acumen. If you convince them that you know your market, your niche within that market, and that you are committed to doing what you know or can reasonably develop through talent acquisition, they will trust that you will take care of their money as if they were your family or friend. This is the ultimate test of your fiduciary duties to your investors – proving that you can keep both the duty of care (make sound business judgments) and the duty of loyalty (put the business’ interest above your own). Your temperament will also matter. If you are a jerk to work with and they can sense that, it may not kill the investment opportunity, but it might.

2.     Do You Understand the Financials of Your Business?

This is not a legal issue, but it is an extremely important issue because your investors are probably well versed in business finance. If your bookkeeping skills are atrocious because you are a DIY kind of person or your bookkeeper does not have good organizational skills; if your financial statements are incomplete, inaccurate, or just plain wrong; or if your Quickbooks accounts have not been closed out every month, no sophisticated investor will touch your business until you get it all cleaned up. Why not? Your financials are the easiest way for someone to understand your business at a glance.

If your financial inputs are sloppy, then your outputs are unreliable, giving your prospective investors no real metrics to compare your business to other businesses they have invested in or are considering. If you do not have good financial statements, there is zero chance that you really understand your market or can plan for future growth because you also have no good data from which to base your business decisions. You need to know your key business metrics (KPIs = key performance indicators) so you can explain to your potential investors exactly what great things you want to accomplish with their investment in your company. If you just need money because “cash flow is tight”, you will walk away with zero investment dollars.

3.     Do You Understand Your Business Risks?

Your prospective investors will want to know that you are aware of your business risks. Do not shy away from giving your cold-blooded appraisal of your business, your employees, your business partners, your products, your weaknesses, and your acknowledgment that even though you believe in your company and will work relentlessly, success is never certain. Litigation lawyers love undisclosed or underrated risks, uncertainty, and ambiguity in investment relationships and contracts because this environment creates a cornucopia of ways for them to sue your company on behalf of your disgruntled investor, even if they are (were) your close friends.

Good transaction or “deal” lawyers want to make sure you think through every possible risk of your cannabis business before you start hinting to anyone that you might want to take on investors. You need to learn to think like a paranoid lawyer who sees risks everywhere. Remember that not all risks are created equal. A great transaction lawyer will help you see your risks, evaluate them, and weigh them according to their relative likelihood to arise in your business.

4.     Do You Have Your Owner Relationships Soundly Grounded in a Written Contract?

One of the worst things you can do is start a business and never get around to putting key relationships in writing. I see this way too often in the cannabis world in businesses with two or more partners. Either everything was done on a handshake or the operating agreement or shareholder agreement is not good, does not reflect reality, or is just plain wrong.

Recently, I reviewed a contract for some LLC owners who used an agreement intended for a partnership. That was a huge problem because it gave all of the LLC owners equal rights, which is appropriate in some scenarios but not in others. That is one of the reasons why today we almost never form partnerships but instead use LLCs and other vehicles. Get your ownership agreements in place and discuss the difficult “what if” scenarios now during your business honeymoon phase. If prospective investors catch wind that you and your business partners are not in sync on all issues, they will not be willing to invest.

Take heart that very few businesses who are preparing to take on investors have everything in perfect form. As business owners you always have two or three or ten times more things to do than you have time to do, even if you have trusted and competent people working with you in your business. The best thing you can do is keep a running list of potential due diligence items (see here and here) and work through your list with competent professionals.

Just a few weeks ago, Curaleaf Holdings (“Curaleaf”) announced that it would pay $875 million, mostly in stock, to acquire a Chicago based cannabis company, Grassroots. (See here.) This followed news in May that Curaleaf had reached a nearly $1 billion all-stock deal with one of Oregon’s biggest cannabis companies, Cura Partners, Inc. (See here).  These deals made Curaleaf one of the world’s largest marijuana companies, if not the largest.

Not much later, Curaleaf found itself on the wrong side of the FDA with respect to health claims Curaleaf had made about its CBD products. As this CNBC report explains,

The FDA told the cannabis company earlier this week that it was ‘illegally selling’ CBD products with ‘unsubstantiated claims’ that the products treat cancer, Alzheimer’s disease, opioid withdrawal, pain and pet anxiety.”

The article explains that in response to the FDA warning letter, Curaleaf (wisely) scrubbed its website and social media accounts of health claims about its CBD products. How and why a company of this size was making these types of claims in the first place, however, is truly puzzling.

We have written extensively about the FDA’s increasing intolerance for companies making “over the line” health claims about CBD and warned that retailers ought to be concerned about selling hemp-derived CBD in cosmetics. Yet everywhere our CBD business lawyers go, including in our Washington, Oregon and California offices, we see products extolling the benefits of CBD for nearly any kind of ailment – whether it affects adults, children, or pets. Although the FDA’s enforcement against businesses making health-related CBD claims has not been universal, that doesn’t make its warning letters without force as Curaleaf has learned. (Even if consumers don’t appear overly concerned.)

As a result of its claims about CBD and the subsequent warning from the FDA, Curaleaf now finds itself on the wrong side of a class-action securities complaint that was filed on August 5 in the Eastern District of New York, Michael Skibbe v. Curaleaf Holdings, Inc. et al., No. 1:19-cv-04486. The complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 promulgated by the SEC. (Feel free to email me if you’d like a copy of the lawsuit).

The gravamen of the lawsuit is that Curaleaf violated federal securities law by making knowingly making materially false and misleading statements to the investing public that artificially inflated the market price of Curaleaf securities. The complaint quotes liberally from Curaleaf’s press releases and audited financial statements concerning its line of hemp-based CBD products.  These include statements such as:

CBD has been shown in initial third-party studies to support a pet’s overall wellness including the potential to help manage pain and anxiety.

Our human customers are already reaping the benefits of CBD with Curaleaf Hemp. The same care and research went into the development of Bido. We are excited to be extending our high quality, trusted products to pet owners,” said Joe Lusardi, President and Chief Executive Officer of Curaleaf. “The launch of Bido is just one more way we are the most accessible cannabis company in the U.S.”

These statements and others drew the ire of the FDA. The FDA letter warns Curaleaf that some of the CBD products it sells are classified as “drugs under section 201(g)(1) of the FD&C Act, 21 U.S.C. 321(g)(1), because they are intended for use in the diagnosis, cure, mitigation, treatment, or prevention of disease and/or intended to affect the structure or any function of the body.” The FDA letter goes on to say that Curaleaf is wrongly marketing CBD products as “dietary supplements . . . because they do not meet the definition of a dietary supplement under sections 201(ff)(3)(B) and 201(ff)(2)(A)(i) of the FD&C Act, 21 U.S.C. 321(ff)(3)(B) and 321(ff)(2)(A)(i).” And finally, the FDA letter takes issue with Curaleaf’s marking of “Bido CBD for Pets” line of products.

The FDA letter, says the complaint, caused damage to investors when shares of Curaleaf fell 7.27% on July 23, 2019. The plaintiffs now seek to represent a class of “all person other than defendants who acquired Curaleaf securities” between November 18, 2018 and July 22, 2019 with damages to be calculated at trial. Will this lawsuit mark the end of Curaleaf? Probably not, but my guess is that Curaleaf won’t get rid of it for pennies.

Once again:  regardless whether your company is publicly traded, your company is at risk if you are making claims about the therapeutic value of CBD products. Setting aside Curaleaf, companies making health claims about CBD may be subject to claims arising under state laws prohibiting unfair and deceptive trade practices, or under the federal Lanham Act for false and misleading advertising, or even run-of-the mine personal injury claims allegedly caused by your product.

So ask your hemp-CBD regulatory attorneys to review your marketing and merchandising materials before you find yourself on the wrong side of a lawsuit. And take their advice! Curaleaf probably wishes it had done exactly that.

Our cannabis business attorneys see more and more deals where foreign individuals or companies want to invest in or acquire licensed cannabis businesses. It’s often easy for foreign companies to assume that because cannabis is state-lawful, it is similar to any other investment. This couldn’t be farther for the truth. Even for local companies, the cannabis industry is much different from any other industry.

But for foreign companies, the cannabis industry is filled with pitfalls and potential liabilities. Many of these can be resolved if foreign investors understand and prepare for the issues ahead of time. Below, I walk through some of the more pertinent issues that our cannabis attorneys see in deals with foreign investors on a fairly regular basis.

#1 Residency Requirements

One of the biggest problems for foreign investors is states that have residency requirements. Washington State, for example, requires that all cannabis business owners be residents of the state. An investment into or acquisition of a Washington-based cannabis company that renders foreign citizens (or even out-of-state) owners may jeopardize the license.

#2 Differences in Laws Between Jurisdictions

Another potential problem for foreign investors is the difference in laws in the US and their home countries. State-lawful cannabis activity here may still be a crime in a foreign investor’s home country. Even if it’s not, there may be a host of different laws in a person’s home country that don’t square with US cannabis laws. For example, there are onerous ownership disclosure requirements (that I’ll get into below), which could include shareholders or members in foreign companies. Certain laws in a foreign resident’s home country might not allow or might just put roadblocks in the way of compliance with US state-lawful cannabis regulations. And good luck explaining to a regulator that the laws of a foreign country don’t allow compliance with cannabis laws here.

#3 Ownership Disclosure Rules

One of the most important things for foreign companies or person to consider before investing in or acquiring a US-based cannabis company is the concept of “ownership” (which we recently wrote about here). All states that regulate cannabis have ownership disclosure requirements that are often very onerous and invasive and, in some cases, require disclosure up through all parent companies to actual persons.

These disclosure requirements can be immensely difficult to comply with for foreign, and even some domestic, cannabis companies or investors. It’s not always clear who is an owner, and equity in a company is usually not the only trigger for ownership. For example, California cannabis regulators consider LLC managers, corporate directors or officers, and anyone else who exercises direction, management, or control in a licensed entity to be owners. At least one California cannabis agency considers companies or people who are entitled 20% of the profits of a licensee to be owners. Even more significantly, if an owner is a company, then certain persons who own or run that company may be considered owners. For at least one agency, owners are required to disclose many different kinds of equity holders, directors, officers, and managers, all the way up the corporate chain.

#4 Financial Interest Holder Requirements

Like with owner disclosures, some states also require disclosures for certain classes of people who hold smaller equity interests in a cannabis company or who have less significant investment, loan, or profit-sharing relationships with those companies. In California, these people are called “financial interest holders”, and still have to disclose information to the state.

In California, financial interest holders are persons with less than 20 percent equity, as well as persons with loans to, investments in, or profit-sharing agreements of any kind in a cannabis company. There’s a number of exceptions, including that persons with less than 5 percent of the equity in a publicly traded company don’t need to be disclosed as financial interest holders. Just like with owners, if a financial interest holder is a company, it may need to disclose certain persons all the way up its corporate chain.

#5 Constant Reporting Obligations

State-lawful cannabis companies have constant reporting obligations throughout the life of their license. In California, almost any change (sometimes even seemingly insignificant changes) in the business needs to be reported to the applicable agencies within 10–14 calendar days. Other states are similar.

Monitoring reportable events is difficult for foreign companies. If they want to be fully compliant, they will need to either have US cannabis counsel or trust the licensee’s US-based counsel. Some things can be significantly challenging to report, like changes in financial interest holders. Take for example, a Canadian public company where shares may be constantly sold. Companies would need to constantly monitor transactions to ensure that new persons who acquire significant amounts of shares make disclosures within the tight timeframes set by the US state regulators.

Moreover, reporting is almost always the actual licensee’s obligation, meaning that an investor can’t actually communicate with agencies on the licensee’s behalf and will need to hope that the licensee actually makes disclosures after being provided with information from the investor. This can be frustrating for foreign companies who don’t actually have control over the licensee, so it is important to ensure in any kind of written agreement that the licensee meets its reporting obligations, and to spell out what happens if the licensee is penalized because it failed to make appropriate disclosures.

#6 Immigration Concerns

Being involved in the US cannabis industry can bar a person from entering the United States, obtaining a visa, or obtaining citizenship if they are here. We’ve written about cannabis immigration issues for foreign investors and owners in the past (see here, here, and here). It goes without saying that these are issues that must be considered in any deal. Failure to consider them before inking a deal could lead to disastrous effects and potential breaches that could have been avoided had the foreign investors consulted with US immigration counsel before inking the deal.

#7 Tax Issues

Cannabis is STILL illegal at the federal level in the United States. Internal Revenue Code Section 280E is a major roadblock for US-based cannabis companies and leads to extremely high taxes in most cases. Many foreign investors may not even be aware of some of the 280E issues, and there could be other problems in their home jurisdictions based on these high taxes.

I chuckled in spite of myself and said, “That is not going to happen that soon, and it may not be possible to accomplish even in a few months.” China’s government has a tight grip on its money (technically renminbi (人民币) means “the people’s money”, but the people can’t be bothered to look after their own money, right?). Even when times are good, China controls foreign currency leaving the country, especially U.S. dollars. But times are not good in China, despite recent reassurances from Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission. How do we know times are not good in China? There are a lot of smart people in the world who track where money flows and how that movement (or lack thereof) impacts our qualities of life. They are called macro (big picture) economists. These economists have noticed that (a) although China is encouraging foreign investment in its banking and insurance sectors, promising ownership of up to 100% by foreign investors, so far no one is biting, and (b) foreign lending institutions are loathe to provide capital to Chinese banks and industries, seeing economic risks in China everywhere they look.

Chinese would-be investors in U.S. ventures, including hot market cannabis enterprises, are finding it exceedingly difficult to get money out of China, even their allotted USD $50,000 in foreign currency that each Chinese national is supposed to be permitted to purchase and transfer out of China, according to China’s State Administration of Foreign Exchange. But in practice, such applications are being more closely scrutinized by China’s ever-present bureaucratic machine, and even China’s elites like the former central bank adviser, Yu Yongding, are being denied access to foreign currency. That means your prospective Chinese investor or business partner (or customer who owes you money for your raw inputs, such as U.S. timber) will not be able to get you those U.S. dollars you have been waiting for any time soon, no matter how well connected they are.

Why is China holding onto U.S. dollars? We’ve discussed this (and all things related, on our firm’s China Law Blog) but China needs to maintain its foreign exchange reserves (largely held in dollars) for several reasons. One of the primary reasons is so that China can continue to fund its global export machine that does business in U.S. dollars with the rest of the world. Chinese exporters buy their raw inputs in U.S. dollars, so China’s central bank needs to keep foreign exchange reserves on hand to facilitate those transactions. A second reason is that to the extent China can keep U.S. dollars out of circulation, China can artificially keep its currency value low, which makes its exports more affordable to the U.S. and the rest of the world. China holds more than $3 trillion in of its assets in a foreign currency, which equals approximately $2,142 per capita in China’s 1.4 billion population (in comparison, the U.S.’ $126 billion in foreign exchange reserves equals approximately $385 per capita in the U.S.’ 327 million population). China’s currency restrictions are not new. These restrictions are an integral part of China’s economic policies under which China wants to keep its yuan valuation at least seven times higher than the U.S. dollar. China can also use its foreign currency holdings to buy up yuan when others are trying to dump it, to keep the yuan from freefalling in foreign exchange markets due to concerns like a trade war or ongoing economic restrictions or sanctions.

To bring this discussion full circle, if your would-be cannabis business investors are Chinese or have money in Chinese bank accounts that they are having “a little trouble” getting to your U.S. bank account, do not make any near-term plans that rely on their promised dollars, especially if the promised amount is more than $50,000. Chinese currency leaving for foreign markets is a form of capital flight to which China is keenly attuned and to which it will take great measures, both overt (currency manipulation) and covert (denying individual foreign exchange transactions in Chinese banks, even when those transactions are in sync with Chinese law).

Also, if your international investor has already applied or wants to apply for a fast-track EB-5 visa path to U.S. citizenship, their investing your marijuana venture (regardless of current state legality) is a huge red flag that will derail their application process and impact their ability (if they are or become a green card holder) to become a naturalized citizen because they will have been involved with a controlled substance under U.S. federal law. If the potential investor’s immigration attorney is not aware of that minor detail, then you can do your investor a favor and let them know. For a primer on foreign investment in U.S. cannabis businesses, read this. It is reasons like this, the intersection of our firm’s international practice and our cannabis practice, that make my daily law practice so interesting, intellectually rigorous, and fun.

A significant player in the burgeoning hemp industry is Hemp, Inc. , (“Hemp”) a publicly traded company that trades between 50 and 100 million shares a day, according to its website, which also notes that its CEO, Bruce Perlowin, has been in the cannabis industry since at least 1978. Unfortunately, Hemp and others, including Perlowin, are the subject of a civil enforcement action filed in 2016 by the Securities and Exchange Commission (“SEC”) that is pending in the District Court of Nevada.

This post concerns a recent order (“Order”) in the SEC civil enforcement action by the federal magistrate which decided two motions for sanctions brought by the SEC against four of the defendants — Perlowin, Barry K. Epling and two entities he controls, Ferris Holdings, Inc. and Hobbes Equities, Inc. The SEC alleged these defendants fabricated evidence and gave false testimony at their depositions.

What is the lawsuit about? The SEC alleges that the defendants “engaged in a comprehensive, years-long scheme to defraud investors and evade securities law by selling restricted shares of Hemp without registering the sales.” The SEC claims the defendants sold hundreds of millions of unregistered and purportedly unrestricted shares of Hemp to public investors. To accomplish this scheme, the defendants exchanged gifts and entered into consulting agreements that the SEC does not believe were bona fide. Allegedly, Epling—through the entities he controls, Ferris and Hobbes—sold $9.8 million in securities, of which $1.8 million was used to pay expenses on behalf of Perlowin and Hemp. The defendants have claimed these payments were personal loans from Ferris to Perlowin.

The first motion concerned allegedly falsified evidence produced by Epling and false testimony given by Epling and Perlowin. To determine whether the consulting agreement were bona fide, the SEC served a discovery request on Epling asking for copies of his filed tax returns between 2011-2015, including schedules and forms. Epling did not initially produce the requested documents and later produced tax documents that were unsigned and undated printouts bearing the watermark “DO NOT FILE.” The SEC then sought copies of his returns from the IRS and learned that Epling’s returns were filed on the same day – May 5, 2017, nearly three months after the SEC made its discovery request, and after Epling had told the SEC he had just found his returns.

The SEC argued that the tax returns never existed and were in fact created by Epling in response to the SEC’s discovery request. The SEC characterized the produced returns as falsified evidence and sought to exclude this evidence from trial. The SEC asked the court to impose an adverse inference and adverse jury instruction that the consulting agreements were not bona fide (effectively deciding this issue for trial). The SEC also sought sanctions against Perlowin and Epling because of their deposition testimony. Both testified there were no documents memorializing the $1.8 million in loans. Several weeks later they produced copies of documents they claimed memorialized those same loans. The SEC asked the court to exclude all evidence related to the claimed loans and for an adverse instruction that there were no loans.

The second motion alleged that Ferris (one of Epling’s companies) provided falsified evidence in the way tax returns that were never actually filed but were produced by Ferris to the SEC in response to a request for “as-filed” returns. For this offense and Epling’s other offenses, SEC sought the drastic sanction of terminating sanctions against Epling and the two defendant-companies he controls, Ferris and Hobbes. (This means the SEC believed the discovery violations so egregious that it asked the Court to enter default judgment against these defendants, effectively terminating the case as to these defendants without a trial.)

The Order is thorough, concluding that the defendants’ conduct was “egregious” and a waste of a “huge amount of judicial and party resources.” Nonetheless, the Court denied the SEC’s request for terminating sanctions, despite finding Perlowin and Epling’s testimony at the motions hearing not credible and that Epling deceived the SEC (and his own) counsel with respect to his tax returns. The defendants’ deception and discovery violations warranted sanctions, but were not enough to interfere with Epling and Ferris’s right to a trial on the merits, said the court.

Although these defendants may have escaped default judgment, I do not envy their counsel’s task at trial because the Court ruled that:

• Defendants are precluded from offering any evidence at hearing, in motion practice, or at trial related to the loan documents produced after Epling and Perlowin’s depositions;
• The jury should be instructed that the defendants failed to comply with their discovery obligations;
• The jury should be instructed that Epling deceived counsel for the SEC and defense counsel by falsely representing that his personal tax returns he produced for 2012-2014 were “as-filed” copies; and
• The jury should be instructed that they may consider evidence of the defendants’ discovery violations and Epling’s deception about his personal tax returns along with all other evidence in the case in reaching their verdict.

The moral of the story is here is plain: Don’t play fast and loose with the facts should you or your company find yourself the subjects of an SEC investigation. The chances of you succeeding at doing so are minimal. One wonders how long defense counsel—some of whom were deceived by their own clients—will continue this representation. A better strategy is for you to retain legal counsel and be forthright about the strengths and weaknesses of the SEC’s case (and your own) so that you and your legal team can implement the appropriate strategy.

(The defendants have since filed an objection to the magistrate’s order, which will now be reviewed by the trial judge.)