Authored By: Jon E Drucker

 

Law Offices of Jon E. Drucker
8306 Wilshire Boulevard # 638
Beverly Hills, California 90211
tel. (323) 931-6363  fax (310) 861-5480
Email: JDrucker@lawyers.com

As a legislative aide in the U.S. Senate I worked on a worldwide oil crisis with skyrocketing prices, gasoline lines and windfall profits taxes. As the owner of a solar energy company, I navigated my way through a maze of federal and state tax credits, utility company rebates, local incentives, building permitting, and a legislatively-set expiration date for the industry. Early in my decades-long career as a lawyer, I worked with savings & loan clients through the thrift industry’s wild rise and fall. But as I prepared to launch Maccopay, a cashless and paperless payment platform to serve the State’s cannabis industry, nothing prepared me for the clusterf*k facing California’s cannabis industry.

There is no aspect of the industry, from growers to manufacturers, distributors, testing labs, retailers and consumers – and anyone else who deals with the industry, that works smoothly and without complication. So let’s start with the big and obvious issues that face all cannabis businesses in California, and then look at some of the particular difficulties facing individual sectors of the industry.

Federal Disarray

California is among more than 30 states that have legalized cannabis for at least medical purposes. But cannabis is still illegal under federal law – as a “Class I” controlled substance. This federal-state conflict creates a disconnect.

Consequently, relatively few people wish to test their states rights against a zealous federal official. Fearing federal wrath, he California State Senate committee recently killed a bill to create a State bank to support the cannabis industry–or at least its payment of taxes to the State. Governor Brown has also vetoed several bills that seem likelier to trigger a federal reaction.

Likewise, many cannabis business owners–out of concern for themselves and their investors–keep a low profile. And even “tertiary” cannabis related businesses, who don’t touch the substance—like accountants and lawyers, remain cautious. Banks regularly close their accounts for having cannabis-related clients. Recently, Wells Fargo and another bank even closed the accounts of political candidates simply because they advocated the legalization of cannabis.

Banking on Chaos

The biggest practical impact on the industry from the federal designation of cannabis as a Class I illegal controlled substance, however, is the unwillingness of financial institutions to bank the cannabis industry.

For virtually the entire cannabis industry, this means that it must do business in cash. It is no way to run a business.

Counting cash is time consuming; employees driving around to pickup and deliver it is expensive and nerve wracking; and holding large sums of cash makes anyone subject to robbery or worse – with questionable backup in the form of police protection or an insurance payout. And that is with regard to the otherwise-legal cannabis trade. The remaining estimated 75% of the industry that remains illegal is in an even worse position.

Of course, businesses handling millions of dollars in cash are also less inclined to pay taxes. Even more nefarious, all that cash poses a challenge to the integrity of the legal system – especially in the cannabis arena, which is dominated by lawmakers and regulators. Michigan tells a cautionary tale: It is currently dealing with a political bribery case involving the permitting of a medical marijuana dispensary. Limitations on the number of operating licenses in every given jurisdiction further heightens the temptations.

The Legal Labyrinth and Regulatory Morass

A Byzantine labyrinth of law is the next challenge that cannabis businesses must cope with. With legalization, California was determined to make cannabis a legitimate, even benign, industry, with rules and regulations just like any other. Instead, the State created the most extensive, complicated, burdensome and expensive regulatory framework to ever have existed.

It now takes a small fortune to open and maintain a legal cannabis or marijuana related business, or “MRB.” Further, every additional dollar that it takes to operate a legal cannabis business prevents poorer entrepreneurs — like former pot dealers — from entering the legal industry, and boosts the viability of the black market.

Next, at least five state agencies control regulation of various aspects of the industry, having issued an array of regulations effective January 1, 2018. Many MRBs must acquire licenses from all five.

Meanwhile, even before applying for state licenses, MRBs must first obtain licenses from their local authorities, including cannabis and general business licenses, fire and building permits, and more.

Further complicating things, about two of every three cities in California do not even allow cannabis businesses to operate within their boundaries.

And the one in three municipalities that deign to allow cannabis businesses to operate are also free to promulgate their own widely varying laws.

On the state level, cannabis laws are based on the laws governing the alcohol industry. So for no particular reason, the new regulations created an entirely new distribution sector of the industry. For more readily apparent political reasons, businesses with more than 20 employees—10 in L.A. and some other cities—must enter into Labor Peace Agreements that allow unions to organize their workers.

Mandated security measures cost in the range of $50,000 for small office or warehouse locations. One is left to wonder why MRBs, like jewelry store owners, cannot decide for themselves how much security they need.

State licenses are also expensive: A retail store with (mediocre) income of $2.5 million, for instance, must pay $64,000 per year. Local fees are additional and are also steep.

Tax treatment of MRBs is also punitive—and also now complicated. Federal tax rules prohibit businesses that “traffick” in illegal substances from deducting ordinary expenses from income. Governor Brown recently rejected an attempt to change that rule on the State level, which seems ludicrous on the grounds of principle.

The regulations and licensing procedure are so dense that it is common for cannabis businesses to spend $25,000 or more to lawyers and accountants to help them navigate the legal weeds. It’s a level of complexity that even most experienced business people are unaccustomed to dealing with. Many others who have been in the cannabis business for years just give up in frustration. Others vow to continue in the shadows.

The State mandated computerized compliance system, METRC, dubbed “track and trace” “from seed to sale,” to ensure the legitimacy of the market, is still not ready for implementation. Once ready, METRC will require days or weeks of training of accounting and computer-savvy employees.

In Los Angeles, the State’s largest market, the situation has been especially murky. It promised to issue regulations to coincide with the State’s on January 1, 2018. That date came and went. An April 1 deadline for new applications also passed without explanation.

It was not until August 1 that the City’s Department of Cannabis Regulation, the LADCR, even began accepting applications for temporary licenses. The City’s regulators explained the long delays by claiming they wanted to “do it right.”

While City regulators were working on doing it right from January 1 to August, 2018, the overwhelming number of businesses that were in place in 2017 could not legally conduct any business. They were effectively shuttered. But their expenses–payroll, rent, utilities and others–continued.

There were three main results: businesses weathered tremendous financial stress; they went out of business or out-of-town; or they just went (or stayed) underground, continuing to do business without legal sanction.

It is hard to overstate the problem. There are now roughly 165 temporarily licensed businesses in the City—but there are an estimated close-to-2,000 illegal establishments. The number of previously legal businesses that had to close is unknown. The City said in June that it will likely eventually issue roughly 1,200 cannabis business licenses in total.

Many Los Angeles cannabis businesses also discovered that they were located in areas of town that were not zoned for cannabis activity. The City has limited cannabis friendly zones to a handful of depressed neighborhoods. This immediately drove up the price of MRB rents to double or triple those of other businesses. Needless to say, rent increases also drives up the price of opening and operating a MRB, as well as the price of the retail product, thereby incentivizing people to buy on the black market.

Social Equity

In August, shortly after the August 1 milestone of Los Angeles promulgating its rules and accepting applications for temporary licenses, the Director of the Department of Cannabis Regulations, Cat Packer, spoke to an auditorium full of cannabis businesspeople. and spent virtually all her time addressing the evils of the “War on Drugs,” and her new “social equity” rules to remedy it. It was no surprise. Packer describes herself as “agitator turned regulator” who cut her teeth as the California Coordinator for the Drug Policy Alliance, organizing for the victims of the “War on Drugs.”

A variety of forms of assistance, she announced, are now in place to help members of “marginalized communities” to enjoy preferential treatment. They are first in line to be considered, stand to receive a lion’s share of the MRB licenses (2:1 on retail, and 1:1 on non-retail), receive some financial assistance, a waiver of City fees, and regulatory compliance training, among other benefits.

The State also recently offered $10 million – statewide –to funding local social equity programs. Los Angeles stands to garner a substantial piece of that.

Combine those benefits with mandatory geographic “concentration limitations” (like exist with liquor stores), and along with early medical marijuana dispensaries, there’s a theoretical chance those applicants could hold all the available retail licenses in Los Angeles.

This, evidently, is what the City means by wanting to “do it right.”

For all that the new social equity rules and assistance are designed to do, however, one has to wonder how much good they can or will do. First, people must ask themselves which of three “tiers” of social equity candidacy they qualify for. If they have a cannabis-related conviction and are poor or live in a “marginalized” area—the best and highest tier, was their conviction at the right time and was it the right type, e.g., not selling to kids, or did it include a significant other crime? They must also ask themselves how “marginalized” they are. “Have I been living in a ‘marginalized’ area of town? Have I lived there for a sufficient amount of time (5 or 10 years)? Am I sufficiently poor? Is my neighborhood poor?” Their councilmembers, who fought hard for that designation, might be able to tell them.

All these and more are questions that flummox lawyers, let alone most poor marginalized people and ex-cannabis cons.

Predictably, lacking such resources, some enterprising members of those marginalized communities have hired themselves out as social equity candidates to partner with moneyed interests. But the LADCR anticipated that gamesmanship, Packer calls it a “predatory” business practice, and is determined to kill it in its crib: There are strict rules requiring that the marginalized community members retain substantial stakes (>51% or >33-1/3%, depending on the equity tier) in the business for at least three years. If there is ever a change in ownership, the LADCR can refuse to renew a business’s license. This type of restraint, like so many regulations, is well intentioned, but it constrains the upside potential of any business—and its equity candidate—hoping to sell in the next three years – or ever.

At best, a relative handful of ex-cannabis cons and poor people will reap a windfall from the legal cannabis industry. Is that what a successful social equity program looks like?

Regardless of what happens to that handful of fortunate people, however, an enormous irony remains: The social equity program, which was contemplated and designed to make reparations to the victims of the War on Drugs, is only a small part of the picture. The harsh reality dominating the landscape is an all-embracing regulatory regime that is restrictive in the number of businesses, incredibly regulated, making it very difficult and expensive to own a business and comply with the law —at its best.

This drives those who can ill afford–or are unable–to comply with the legal requirements to continue doing business in the black market. It also explains why agriculturally fertile California ships approximately three times the amount of the cannabis it consumes in-state to the illegal out of state market.

Moreover, to protect and promote this new legal system, the authorities will eventually have to enforce the rules. The police –and landlords, who face up to $10,000/day fines for leasing to illegal cannabis businesses – will inevitably close down the illegal cannabis industry, relegating illegal operators to the scale and status of moonshiners after the repeal of alcohol prohibition. The inevitable result is that the “have nots” will again get the short end of the stick. Some, with justification, will undoubtedly call it the “War on Drugs 2.0.” A far more effective solution would be to find a way to make most of the illegal operators legal.

Ironically, the very red State of Oklahoma, which approved medical cannabis less than two months ago—and has a population roughly equal to that of Los Angeles, may show the way. It has a very different approach that seems roughly reduceable to: “Limitless licenses: So long as people pay us $2,500 for the license; promise not to sell cannabis to children and not poison their customers, they can obtain a license and try their best.” As of this writing, Oklahoma has approved 666 dispensary licenses, 1,087 grower licenses and 280 processor licenses. Why can’t the “pro-cannabis” state of California do that?

Testing, testing, testing

But it’s not just the poor and marginalized who are ill-served by the current state of affairs. Another new requirement – the laboratory testing of cannabis, effective July 1, 2018, is fraught with a myriad of problems affecting the entire marketplace.

There are few confirmed instances of cannabis poisoning since the 1960s, back when people bought God-knows-what from God-knows-whom. Yet testing requirements are now far more rigorous than those of any other product. There are over 100 test results required–from THC and CBD potency to 64 kinds of pesticides, mold, mycotoxins, microbes, moisture, filth and more—to be performed on samples of all cannabis to be sold. The list of tests seems to be growing and the tests becoming stricter. The cost of testing went from approximately $200 per battery of tests pre-regulation to $500-900 now.

A recent widely publicized report in California estimated that over 80% of all cannabis would fail one or more of the tests. This is because the pesticide standards that far exceed those applying to any vegetables or fruits. Put differently, if the same rules applied to fruits and vegetables, no one in California could enjoy a sorbet or a salad. Legal growers are thus striving to make their cannabis crop as clean as possible–while keeping their costs at a reasonable level. It is an unnecessary and expensively tall–some growers say impossible–order.

Meanwhile, testing labs must deal with an inexorable conflict of interest. On the one hand, they are the designated gatekeepers of the public’s health and safety. On the other hand, their clients are focused on receiving high passing marks. If a lab flunks a client’s product, the client will be sorely tempted to seek another lab to do its testing.

Couple that conflict with the fact that test results are extremely variable in any event, and the result is a mess. As anyone who has ever grown flowers in their yard can attest, one plant can look healthy and beautiful while the one next to it is stunted or wilting. Even different branches of the same plant can yield visibly different results. Although commercial enterprises minimize that variance, the variance is still considerable. This is especially true when sampling a very large (up to 50 pound) batch of cannabis flower, which cannot be homogenized for testing.

Another man-made problem is the absence of established testing protocols for an ever-widening range of cannabis products. Different labs follow different testing procedures – yielding vastly different results. Labs with rigorous procedures, who may not so easily certify a product, will be disfavored by businesses over labs with lax procedures that give high marks to questionable products. Unfortunately, there seems to be no shortage of the latter. Again, the pressure is on labs to produce passing–not reliable–grades. Loose rules yield loose results.

The solution to this latter problem, at least, lies in the quick standardization of cannabis test procedures – so that all labs will yield similar results, just like blood and urine testing in the clinical medical field. There is negligible movement so far from State authorities for standardization, however. This daunting task is left to determined, well-intentioned, collaborative lab owners. But the conflict of interest is so great that lab owners advocating for such standardization fear for their safety. Standardization threatens the dirty labs and “snitches get stitches” is the word on the street.

Another major problem with the State’s testing regime is that testing is handled at the wholesale distribution level, not the manufacturing level. Distributors – not manufacturers – are required to arrange for testing. This results in the cost per unit of product being much higher—because less product is being tested at any one time.

For instance, for the sake of discussion, let’s say the state mandated battery of tests costs $800 per batch, and a grower/manufacturer has produced a batch of 400 units. If the entire batch could be tested at one time, the added cost of the product would be $2 per unit ($800/400 units).

But the State has required that the esting be done at the wholesale distributor level. So, if that same grower/manufacturer with the batch of 400 units is distributing its product to, say, ten distributors throughout the State, each distributor has an average of only 40 units per batch. But they are each still required to have their products tested, and testing per batch still costs the same $800. The result is now an additional average cost of $20 per unit ($800/40 units).

Moreover, if any one of those five tests yields a failing result, the entire batch of 400 units must be destroyed. Assuming a passable product eventually replaces the failed batch, there will be tremendous economic pressure to make the unit price dramatically higher, especially in the case of manufactured products, as manufacturers will lose not only the defective cannabis but the delivery mechanism, e.g., vape pen, and expensive packaging as well.

This new reality largely explains why cannabis products that a few months ago cost $20 now cost $60.

And woe to that lab diligent owner who issued the failing grade.

These testing rules, which place a premium on batch size, also put enormous competitive pressure on wholesale distributors to carry larger quantities of product. After all, it is only with large batch sizes that distributors can minimize their testing costs—and their prices to retailers. Smaller distributors—who might have carried a wide variety of manufactured products and supply small quantities on a trial basis to retailers—can no longer compete.

The same dynamic applies to smaller growers and manufacturers. Go big or go home is now the rule. It leaves little room for small businesses to thrive—or even exist.

Stimulating the black market and the future

Economists (and common sense) will tell you that people will not pay any price for a legal product when they can buy a similar illegal product for much less money. Demand is not infinitely elastic. The journal “Addiction” recently featured an academic research study of 700 users in states where cannabis is fully legal. It reported that when legal cannabis costs $20 per gram, 36% of people said they would patronize a legal shop, whereas 64% said they’d buy it illegally. An illegal market can thrive on far less than 36% of the total market—and we are already in the range of $20 per gram.

It is thus apparent that California’s cannabis clusterf*k is actually stimulating the illegal market—at the expense of the dreamed-of legal one.

Governmental reduction in the number of MRBs—from the thousands to the hundreds—also inevitably forces prices up. It further prevents enterprising business people from conveniently satisfying a public desire and limits sales.

The governmental stated goal was to make the cannabis industry legal, just like the liquor industry. But a comparison with the liquor industry illustrates just how the two are treated so differently.

Start with two-thirds of the cities in the state not allowing any cannabis business within their city limits.

Next, consider a comparison with the alcohol industry. The number of beer and wine licenses that can be issued in California is limited to one for each 1,250 people. Given the state’s population of 40,000,000, that would equate to 32,000. Somehow, though, there are over 80,000 active liquor licenses, double the allowable limit. Meanwhile, there are only approximately 7,000 cannabis licenses.

Next, consider even cities that allow cannabis. West Hollywood is a case in point. It is a city with 37,000 people. It has 234 active retail liquor licenses. By contrast, it t is now in the process of considering hundreds of applications for eight cannabis licenses.

Politicians and regulators must thus consider criteria far beyond business viability. Are you a social equity candidate (and which tier), have you had a business in the City, are you a resident of that town, are you a person of color, disadvantaged, LGBTQ+, a woman? These are some of the current coin (in addition to traditional actual coin) to appeal to governmental authorities who now have the power to pick just a few winners and many losers.

All these restrictions—on the number of businesses in a given area, burdensome and expensive regulations, both inadequate and excessive testing requirements, disproportionate taxation, badly designed social equity programs, and the absence of banking solutions, are counter-productive if a legal cannabis industry in California—comprised of both large and small businesses—is to thrive.. 

Whether and how these issues will work themselves out only time will tell. The only sure thing is that people – legislators, regulators, businesses and consumers – who care about the future of cannabis will have to pay close attention to all developments – business, legal, financial, regulatory, health and more. They will also have to advocate strongly if they want a thriving, safe and economically viable industry open to all.

For the foreseeable future, however, it seems that everyone will be contending with the California cannabis clusterf*k.

Jon E. Drucker practices law in Los Angeles and is the founder of Maccopay, an electronic payment platform for the cannabis industry