Will California’s Section 5032 Disrupt the Cannabis Market?

By Ian Stewart 

On December 7, 2018, California’s three cannabis licensing authorities submitted final versions of the state cannabis regulations scheduled to be approved by January 16, 2019. California’s Bureau of Cannabis Control (Bureau) submitted a final version of Section 5032 of the regulations that substantially limits commercial cannabis activity between licensed and unlicensed entities. Section 5032(b) states that “Licensees shall not conduct cannabis activities on behalf of, at the request of, or pursuant to a contract with any person that is not licensed under the Act.”

The Bureau’s reasoning behind this change is scant but appears focused on the concern that unlicensed entities have exerted control over the operations of license holders through brand licensing, white labeling, trademark and other intellectual property (IP) transfer agreements. The Bureau simply explained that it “has learned that some licensees may be conducting commercial cannabis business at the direction of non-licensees who may be considered to have an ownership or financial interest in the commercial business and should thus be reported in accordance with … the regulations.”

This suggests that white label and other agreements may be allowed by the Bureau so long as the licensor is disclosed as an owner or financial interest holder under the state cannabis license. The Bureau has not yet commented on this theory, however, and it has not yet been tested in the courts. We point out that licensors and other business partners often do not want to be formally listed as an owner or financial interest holder on a cannabis license due to the onerous background information that must be disclosed and made accessible to the public.

Section 5032 is expected to stifle existing and new business relationships shaped by white labeling, contractual manufacturing, brand licensing, IP licensing, use of software apps and online services. Prohibiting IP licensing deals with non-licensees will restrict the number of brands and products available to consumers because most California licensees do not have access to cutting-edge IP. The regulation also will limit online marijuana delivery services or websites that facilitate transactions between consumers and businesses.

Before submitting the regulations for approval, the Bureau received and responded to numerous public comments from industry stakeholders. There were some statements in support, though the majority of comments voiced concern over the expected dire business consequences of Section 5032. Below we briefly highlight several arguments in favor of and against Section 5032.

Stakeholder Arguments in Support of Section 5032

Those in support of Section 5032 point out that white labeling makes it difficult to determine the identity of the responsible party under the license, and that all products should come from a licensed manufacturer. Some raise fairness concerns over smaller California businesses having to compete with unlicensed out-of-state brands, while others argue that eliminating white labeling will ensure the proper regulation of the license holder’s ownership and financial interests. Common threads for those in support of Section 5032 include concerns over the ability of the state to regulate opaque business relationships, outsiders directing control over the state market and protectionism for California state-licensed businesses.

Arguments against Section 5032

The arguments made against Section 5032 center on the need for flexibility in IP-sharing and white labeling relationships to facilitate the emerging cannabis market and to prevent backsliding to the illicit market. Many are concerned that the change will result in substantial harm to the California cannabis industry and to the general public by depriving California consumers of safe, consistent, and reliable products. Opponents argue that unlicensed businesses provide essential technology, expertise, brand consistency and consumer safety processes critical for the cannabis industry to responsibly exit the illicit market, and that preventing the ability to access this technology and expertise through contractual relationships will harm the quality, consistency and safety of manufactured cannabis products.

The manufacturing processes necessary to create high-quality and consistent manufactured cannabis products are complex, and without access to state-of-the-art IP most licensees will ultimately have to choose one of three outcomes:

1. They will be unable to manufacture cannabis products and exit the market,
2. They will be forced to manufacture lower-quality cannabis products, or
3. They will be forced to expend time and financial resources to research and develop their own reliable processes.

Despite the protectionist concerns raised by proponents of Section 5032, the counter-argument is that the outcome is bleak for most smaller licensed operators in the state that do not already have established processes, technical know-how and brand recognition of their own.

Opponents further point out that the inability of California licensees to affiliate with brands is short-sighted because brands facilitate consumer education and safety through product quality, consistency and brand awareness. Licensors of technology and other IP serve as de facto regulators of consumer safety and state compliance for products that are branded and marketed under the licensor’s IP. A licensor has a vested interest in assuring that its state-licensed partner strictly adheres to applicable state and local laws since that state-licensed entity represents the brand in the state.

Branding is particularly important for cannabis products due to the large number of novice adult-use cannabis consumers in California who must be provided with products that have a known level of quality and consistency. Due to limitations caused by federal law, opponents of Section 5032 point out that the ability to create high-quality brands that are trusted by the public is limited without the ability of licensed cannabis operators in California to enter into brand licensing and IP technology transfer agreements.

Growth of the cannabis illicit market also is a concern with Section 5032, which may lead to the unintended consequence of less inventory on retailer shelves. When presented with a choice of fewer products of lower quality and with less brand recognition, many consumers may turn to or remain in the illicit market.

Summary

Whatever one’s position on Section 5032, there is no disputing it will serve to disrupt the current California cannabis market and cause many existing business relationships to change or cease. It remains unclear whether the Bureau will allow these contractual relationships to continue through disclosure of the licensor or other business partner.  Additional industry guidance is anticipated from the Bureau’s Lori Ajax, but this guidance may not be announced until after the final regulations have taken effect in January 2019.  While the industry waits for clarity, the prudent course is to embrace full disclosure.