Top 10 Unknowns About California’s Cannabis Regulations

In California, under the Medicinal and Adult-Use Cannabis and Regulation Safety Act (MAUCRSA), temporary licenses began issuing to cannabis businesses on January 1, 2018. Since then, the state agencies in charge of MAUCRSA’s implementation (the Bureau of Cannabis Control (BCC), the California Department of Public Health (CDPH), and the California Department of Food and Agriculture (CDFA)) have worked pretty much round the clock on adopting permanent regulations. In case you forgot, the agencies dropped their initial proposed permanent rules this past summer, tweaked those, and then released another round of revised proposed permanent regulations last month (which are now in the hands of the Office of Administrative Law (OAL) for an overall review). That last round of proposed permanent rules (see here, here, and here) is very likely to become effective (pending OAL’s review) in early January. Right now, all licensees are still operating under the emergency rules that came out in fall of 2017. And pretty much everyone is racing to get their temporary licenses, which will NOT be available after December 31.

Despite the fact that the state has made great progress towards permanent rules, many questions and ambiguities around licensing and operational conduct remain. In fact, some of the grayer areas of the emergency regulations have been expanded by the proposed permanent rules for better or worse. In turn, with 2019 just around the corner, here’s my list of the top 10 unknowns that still remain for California cannabis:

    1.    IP licensing and white labeling restrictions.

In case you’ve been living under a rock, one of the most shocking proposed permanent rules to come from the BCC is section 5032(b) (which, yes, affects all licensees). Essentially, section 5032 (b), as originally written, basically prohibited all IP licensing and white labeling agreements between cannabis licensees and non-licensees. That rule stated that:

(a) Licensees shall not conduct commercial cannabis activities on behalf of, at the request of, or pursuant to a contract with any person that is not licensed under the Act. Such prohibited commercial cannabis activities include, but are not limited to, the following: (1) Procuring or purchasing cannabis goods from a licensed cultivator or licensed manufacturer; (2) Manufacturing cannabis goods according to the specifications of a non-licensee; (3) Packaging and labeling cannabis goods under a non-licensee’s brand or according to the specifications of a non-licensee; (4) Distributing cannabis goods for a non-licensee.

For more detail on that original rule, see our write-up here. During public comment on 5032, there was a good amount of dissent (including our own) in that it’s pretty obvious if such a rule went through a lot of branded product currently on the shelves would have to be tossed. In addition, California would be the only state in the cannabis union to adopt such a strict rule. When the BCC then released the revised proposed rules, 5032(b) was pared down to read as follows:

(b) Licensees shall not conduct commercial cannabis activities on behalf of, at the request of, or pursuant to a contract with any person that is not licensed under the Act.

As you can see, the IP licensing and white labeling examples were deleted, but the rule still makes clear that licensees can’t undertake commercial cannabis activity (i.e., manufacturing, labeling, processing, etc.) “on behalf of, at the request of, or pursuant to a contract” with a non-licensee. Just removing former examples (1)-(4) may have no impact whatsoever here, and it’s certainly confused the situation as a result. And while the BCC’s own comments to 5032 (in its Final Statement of Reasons) indicate that it takes no issue with non-licensee to licensee IP licensing and white labeling relationships, a plain reading of the rule indicates otherwise.

    2.    Ownership issues. 

The BCC struck again in the proposed rules revising “owner” disclosure standards to be much stricter at section 5003. Now, in addition to anyone with 20% or more in equity, the board of directors, the CEO, and anyone or any entity that exercises any direction, control, or management over the licensee, is also an owner. Any individual or entity merely entitled to profit share at or more than 20% is also an owner. This calls into question though how the BCC plans to treat things like cashless options and warrants that have no immediate entitlement to ownership in or profit sharing with the licensee. And what about husbands and wives (which are in community property marriages in California) since there’s no spousal disclosure requirement and they’re technically one person under existing law? The BCC has been silent on all of the foregoing and I have no doubt that these new revised rules may actually incentive people to be even more “creative” in order to avoid owner (and financial interest holder) status.

    3.   Financial Interest Holder woes.

Identifying financial interest holders (FIHs) is more complicated than owners because the FIH definition now encompasses a variety of folks and entities. I recently spoke to the OC Register about how now even lawyers who take a share of the profits of a cannabis business (in exchange for legal services) will now have to be disclosed as FIHs under the new rules. The BCC also made clear that it’s going to sort through more convoluted corporate structures around FIHs to get to the humans providing the capital to or profit sharing with cannabis businesses. At section 5004 of the proposed rules, the BCC now mandates that:

“When an entity has a financial interest in a commercial cannabis business, then all individuals who are owners of that entity shall be considered financial interest holders of the commercial cannabis business. For example, this includes all entities in a multi-layer business structure, as well as the chief executive officer, members of the board of directors, partners, trustees and all persons that have control of a trust, and managing members or non-member managers of the entity. Each entity disclosed as having a financial interest must disclose the identities of persons holding financial interests until only individuals remain.”

Of course, we have no way of really knowing how far the BCC will go here in vetting the individuals behind these structures, though I’m sure more than a few publicly traded companies are suffering severe heartburn at reading this new rule.

    4.    Packaging and labeling compliance in 2019. 

Under CDPH proposed permanent regulations, manufacturers will not have to implement child resistant packaging (CRP) for their cannabis products until 2020. In the interim, retailers will fill the gap by using CRP exit bags. And while CRP is going away for manufacturers, there are a slew of revised and new packaging and labeling standards being implemented upon the rules becoming effective in the new year. The outstanding issue then is that CDPH created no affirmative grace period for manufactured product that’s out there right now and compliant with the emergency regulations, but that doesn’t meet the new packaging and labeling regulations. (A great example is that manufacturers of certain products now have to put the universal symbol not only on outer packaging but also on the product container itself if that outer packaging is “separable” from the product container.) What’s for sure is that retailers cannot possess or sell finished product that doesn’t adhere to the new packaging and labeling rules. So, what exactly will happen to existing, non-compliant product in 2019? That remains a mystery.

    5.    Provisional licensing. 

Provisional licensing is the new temp licensing. (See here for more on the temp license race to secure provisionals for 2019.) Even though a provisional license is the new hot ticket in town, the BCC and CDPH have given no insight into how a licensee actually secures this license. I surmise that the issuance of provisionals will be automatic (similar to how the state was just renewing temp licenses automatically if a temporary licensee was in clear and earnest pursuit of its annual license). CDFA is the only agency that’s produced a fact sheet on the topic, but no agency has publicly announced the exact logistics around provisional licensing yet.

    6.    Social equity programs. 

For every city that’s done a social equity program, it’s been a challenge out of the gate to do it correctly and sustainably. Los Angeles is just getting started with its program while certain other California cities are trying but are producing meager results at best. While the state finally decided to financially back local social equity programs, it’s clear that the state and the cities need to study this particular social experiment for some time before a gold standard will actually emerge. In turn, the success of these programs is definitely a large unknown.

    7.    Banking.

Banking in California is the number question I get on a weekly basis at this point: namely, when the hell is it going to commence? I’m a firm believer that unless and until our permanent regulations are finalized and are proven to work relative to barriers to entry and vetting owners and FIHs, we will not see private sector banking in California. Our licensing and enforcement systems are still too loose/inchoate to satisfy the 2014 FinCEN guidelines, and no public bank is going to materialize here either for various complicated and practical legal reasons (be sure to watch out for banking fraudsters, too). And while California cannabis companies will likely continue to use management companies to help them alleviate some of the inability to access banking, it’s certainly not a long-term solution and it’s downright illegal when that relationship isn’t legitimate or at an arm’s length anyway.

    8.    Fee slotting agreements and anti-competitive tactics. 

On a regular basis now, I’m seeing retailers introduce to my cultivation and manufacturing clients a variety of fee slotting agreements so that my clients can secure known shelf-space in order to remain competitive. This month, I questioned whether such contracts were valid under MAUCRSA where anti-competitive behavior is strictly barred. Only time will tell whether regulators will address these agreements and their impact on the marketplace.

    9.    Tech platforms and delivery. 

The BCC seems to have developed an appetite for wading into increased regulation regarding retailers and delivery tech platforms. Pursuant to section 5415.1 of the proposed permanent BCC regulations, we now have a more robust code of conduct between retailers and tech platforms when it comes to delivery. Now that the BCC has finally opened the door to invading this relationship regarding contractual limitations and restrictions on advertising and marketing for licensees via tech platforms, it begs the question as to whether California is going to go further down the road of trying to essentially regulate tech platforms or not. Given the fact that California is one of the few states that’s embraced delivery, it’s a very important area for development, both legally and for public policy.

    10.    Corporate versus cottage debate rages on. 

Every single state that’s undertaken recreational cannabis has to battle between corporate and cottage interests. And every single state is different in how it’s handled the issue. In the proposed permanent regulations, it’s hard to tell which way California is leaning since those rules still contain some fairly big business friendly propositions (such as still being able to secure countless small cultivation license types, local law permitting, in order to aggregate big acreage) as well as some rules that cut against “Big Marijuana,” like having to disclose shareholders in a publicly traded company as FIHs unless they hold 5% or less of the equity. In 2019, I think we can fully expect the debate between small and large business interests to carry on, but where California lands remains unknown. That’s going to probably continue for quite some time as it works out the kinks spurred by the proposed regulations.