All participants within the cannabis industry should understand the potential risks of litigating disputes in the federal courts. Federal policy regarding enforcement of the Controlled Substances Act (CSA) has shown ambivalence where the possession and distribution of marijuana is consistent with well-regulated state law.

 

Authored By: Ian Stewart


Attorney at Law
Wilson Elser Moskowitz Edelman & Dicker LLP
555 South Flower Street Suite 2900
Los Angeles, CA 90071
213.330.8830 (Direct)
213.407.3124 (Cell)
213.443.5100 (Main)
213.443.5101 (Fax)
ian.stewart@wilsonelser.com

 

 

 

Cannabis and the Federal Courts

By Ian A. Stewart

 

All participants within the cannabis industry should understand the potential risks of litigating disputes in the federal courts. Federal policy regarding enforcement of the Controlled Substances Act (CSA) has shown ambivalence where the possession and distribution of marijuana is consistent with well-regulated state law. The federal courts, however, have taken a nuanced but strict position with respect to enforcement of cannabis-related contracts and other rights by evaluating whether doing so would require the litigant to actively violate the CSA. For example, various federal courts have enforced cannabis-related rights pertaining to insurance, federal labor and employment statutes, certain federal intellectual property protections, and contracts around ancillary products and services. In those cases, the courts determined that enforcement of the contract or right would not result in the litigant directly profiting from the possession, cultivation or distribution of marijuana.

 

Many federal courts have drawn a line, however, where enforcing the contract or right would mandate violation of the CSA. Federal courts also have refused to allow the cannabis industry access to protection under some federal laws such as the bankruptcy code and federal trademark registration, regardless of whether the person or entity is directly violating the CSA.

 

This article depicts how cannabis litigants may be forced to appear in federal court and provides recommendations on steps that may lessen the chances of a federal court invalidating cannabis contracts and other important rights. We also describe a spectrum of enforceability for cannabis-related disputes in the federal courts.

 

Federal Court Jurisdiction and the Application of State versus Federal Law

How do federal courts obtain jurisdiction to hear disputes, and once they do, will they apply federal or state law to decide the case?

Cases that are litigated in federal court must have the proper subject-matter jurisdiction, which primarily includes either “federal question” jurisdiction or “diversity” jurisdiction.

 

  • Federal question jurisdictionallows federal courts to hear a civil case where the plaintiff has alleged a violation of the United States Constitution, federal law or a treaty  to which the United States is a party.
  • Diversity jurisdiction allows a federal court to decide matters of state law when the amount in controversy exceeds $75,000 and where the parties in the case are “diverse,” meaning that the plaintiffs and defendants reside or are incorporated in different states or countries.

 

When a federal court resolves a dispute not directly implicating a federal question – most commonly when sitting in diversity jurisdiction – the court must apply state substantive law under the Erie doctrine. Although some cannabis-related matters heard in federal court have raised federal question jurisdiction where based on federal statutes covering intellectual property, misappropriation or employment and labor law, for example, most cannabis-related contract and commercial disputes that have been litigated in federal court are decided through the court’s application of state law under the Erie doctrine. The application of state versus federal law, and the question of which state law applies is therefore a critical initial inquiry that will often influence the outcome of the litigation.

 

Is the Federal Court Being Asked to Order a Violation of the CSA?

When answered in the affirmative, this question has resulted in cases being dismissed by federal courts, including the three recent federal court decisions briefly summarized below:

 

  • Polk v. Gontmakher, 2:18-cv-01434 (W. Dist. WA May 21, 2020) (federal court in Washington refused to grant plaintiff future profits in this breach of contract action where the profits are derived from the production and processing of marijuana in violation of federal law).

 

  • Lilly LLC v. Clearspan Fabric Structures International Inc., 3:18-cv-01104 (Dist. OR April 13, 2020) (in this breach of contract dispute arising from the plaintiff’s lease of a commercial greenhouse to a cannabis cultivation company, the Oregon federal court concluded that the CSA prevented an award of profits that the plaintiff would have earned from the manufacture or distribution of marijuana).

 

  • Bart Street III v. ACC Enterprises LLC, et al., 2:17-cv-00083 (Dist. NV Apr. 1, 2020) (federal court in Nevada refused to enforce a multimillion-dollar loan contract to finance the expansion of the defendant’s marijuana cultivation business where the loan terms would have allowed the plaintiff to profit from the sale of marijuana, and where an operating capital provision within the loan provided direct assistance to the defendant’s cultivation of marijuana).

 

Other cannabis-related federal cases have survived when the answer is no, including:

 

  • Kenny v. Helix TCS Inc., 939 F.3d 1106 (10th Cir. 2019) (rejecting defendant cannabis security company’s argument the Fair Labor Standards Act (FLSA) should not apply to cannabis businesses, noting that “employers are not excused from complying with federal laws just because their business practices are federally prohibited”); see also, Greenwood v. Green Leaf Lab LLC, No. 3:17-cv-00415-PK, 2017 WL 3391671 (Dist. Or. July 13, 2017) (also enforcing the FLSA against a cannabis delivery company).

 

  • Value Linx Services LLC v. Linx Card Inc., No. 3:18-cv-02126, 2019 WL 3502895 (Dist. Or. Aug 1, 2019) (breach of contract action involving the sale of gift cards sold at kiosks within cannabis dispensaries that allow customers to purchase cannabis without cash was allowed to proceed).

 

  • SIVA Enterprises v. Ott et al, No. 2:18-cv-06881 (C.D. Cal. Nov. 5, 2018) (denying defendant’s motion for summary judgment in this case brought under the federal misappropriation statute, holding that the dispute did not involve the actual production or sale of cannabis, but rather concerned the actions of defendants in allegedly misappropriating plaintiffs’ confidential business information and passing themselves off as SIVA to take SIVA’s clients).

 

  • Tarr v. USF Reddaway, Inc., No. 3:15-cv-02243-PK, 2018 WL 659859 (Dist. Or. Feb. 1, 2018) (the court held that the plaintiff in a personal injury action could seek an award of lost-profit damages based on the defendant’s failure to cite any authority that precludes an injured party in a personal injury action from pursuing a claim for losses sustained by a cannabis operation when the operation is permitted by state law but illegal under federal law).

 

  • Noffsinger v. SSC Niantic Operating Co. LLC, 273 F. Supp. 3d 326, 334 (Dist. Conn. 2017) (holding that because the CSA does not regulate the employment relationship, the employment antidiscrimination provision of Connecticut’s medical marijuana law does not conflict with the CSA in an employment discrimination case).

 

  • Ginsburg v. ICC Holdings LLC, No. 3:16-cv-2311, 2017 WL 5467688 (N.D. Tex. Nov. 13, 2017) (enforcing PPM contract on breach action for alleged misrepresentations regarding pending legality in Illinois market, despite defendant’s federal illegality argument).

 

  • Headspace International LLC v. New Gen Agricultural Services LLC, No. 2:16-cv-03917, 2017 WL 2903181 (C.D. Cal. June 19, 2017) (ruling on plaintiff cannabis manufacturer’s motion for default against competitor for Lanham Act and state trademark violations).

 

  • Green Earth Wellness Center, LLC v. Atain Specialty Insurance Co., 163 F. Supp. 3d 821 (Dist. Col. 2016) (denying defendant’s motion for summary judgment brought on the argument that federal prohibition of marijuana required denying insurance coverage for Green Earth’s losses for marijuana plants in fire and theft).

 

  • Mann v. Gullickson, No. 15-cv-03630-MEJ, 2016 WL 6473215 (N.D. Cal. Nov. 2, 2016) (enforcing a promissory note relating to the sale of shares in businesses that provide ancillary goods and services to licensed cannabis operators does not require any party to possess, cultivate, or distribute marijuana).

 

Enforcement of Illegal Contracts

Most courts typically do not robotically refuse to enforce a contract that has an illegal or otherwise unenforceable term, but will take a more nuanced approach. Even if the object of the agreement is illegal, “[i]n compelling cases, illegal contracts will be enforced in order to “avoid unjust enrichment to a defendant and a disproportionately harsh penalty upon the plaintiff.” Asdourian v. Araj, 38 Cal. 3d 276, 292 (CA 1985) “[T]he extent of enforceability … depend[s] upon a variety of factors, including the policy of the transgressed law, the kind of illegality and the particular facts.” Id.

 

Courts also consider “the avoidance of windfalls or forfeitures, deterrence of illegal conduct and relative moral culpability.” Bassidji v. Goe, 413 F.3d 928, 937 (9th Cir. 2005). Several federal courts also have justified enforcing cannabis-related rights based on the erratic federal enforcement posture and the erosion of the federal government’s underlying policy justifications surrounding the illegality of marijuana. See e.g., Green Earth Wellness Center LLC v. Atain Specialty Insurance Co., 163 F. Supp. 3d 821 (Dist. Col. 2016); Mann v. Gullickson, No. 15-cv-03630-MEJ, 2016 WL 6473215 (N.D. Cal. Nov. 2, 2016).

 

Unjust Enrichment

Unjust enrichment is an equitable theory of liability that provides no one should be unjustly enriched at the expense of another. Unjust enrichment often is asserted by one party in a contract dispute where certain defenses may prevent liability under the contract, but where other equitable factors nevertheless justify compensation.

 

A federal judge in Nevada recently refused to enforce a multimillion-dollar loan contract to finance the expansion of the defendants’ marijuana cultivation business in Nevada by finding that certain terms violated the CSA. Bart Street III, No. 2:17-cv-00083 (Dist. Nev. Apr. 1, 2020). The court also rejected the plaintiff’s claim for unjust enrichment, noting that allowing recovery for unjust enrichment “would undermine enforcement of federal law by giving prospective investors increased confidence in funding marijuana businesses.” The court further rejected the unjust enrichment claim on the basis that the parties’ contract involved “moral turpitude.” Apparently anticipating a negative public reaction to this conclusion, the court took the precaution of explaining that “it is not the job of the court to weigh the policy considerations behind federal marijuana prohibition against Nevada law and the growing trend of state ‘legalization.’”

 

Notwithstanding the court’s refusal to find unjust enrichment in Bart Street III, this theory may find better success in other courts, and particularly in state court proceedings.

 

Moral Culpability

When analyzing whether to enforce an illegal contract, courts will look to the moral culpability of both parties and whether they knew or should have known of the illegality. It is long-standing legal canon that ignorance of the law is no excuse, or ignorantia juris non excusat. As noted by the court in Mann v. Gullickson, the plaintiff certainly knew that marijuana was illegal under federal law before he signed the stock agreement at issue, such that a reasonable jury could find that both parties had moral culpability. Mann, No. 2016 WL 6473215 at p.17.

 

The doctrine of in pari delicto generally provides that when the parties are of equal guilt, the defendant will prevail. This doctrine was recently raised by the plaintiff in Polk, 2:18-cv-01434 (W. Dist. WA May 21, 2020), which involved the alleged breach of a cannabis contract that the plaintiff admitted was illegal under federal and Washington state law. Though acknowledging the doctrine, the federal court ruled that “in pari delicto will not rescue Mr. Polk’s complaint if he cannot articulate a basis for this Court to grant the requested relief, without simultaneously endorsing a violation of federal law.” The court therefore left open the question of whether the in pari delicto doctrine could be viable under other circumstances, including in a state court case where the underlying contract was not compliant with state law.

 

Severability

Illegal terms within a contract or agreement may be severable from the remainder of the agreement, which may then be enforced. This principle was addressed in the recent case of J. Lilly LLC, 3:18-cv-01104 (Dist. OR April 13, 2020). The federal court issued a ruling in this breach of contract dispute arising from the plaintiff’s lease of a commercial greenhouse to a cannabis cultivation company. The court concluded that the CSA prevented an award of profits that the plaintiff would have earned from the manufacture or distribution of marijuana. In determining whether to enforce the contract, however, the court emphasized that it should consider whether a remedy exists that would not require the court to order a violation of law. The extent to which an illegal contract is enforceable depends on whether the illegal terms are severable from the remaining terms. In some states, such as Oregon, even when illegal terms are not severable, the court will enforce the remainder of the contract to the extent that it does not violate the law. Courts in other jurisdictions may refuse to enforce the entire contract if the illegal terms are not severable.

 

Although the federal court in Oregon severed the lost profit claim as unenforceable, it nevertheless enforced other contractual terms at issue between the parties that did not directly violate the CSA.

 

If State Law Applies, Is Cannabis the Legal Object of a Contract in that State?

An essential element of a contract is that it has a legal object. Several states with commercial cannabis regulations have modified their respective state law by exempting commercial cannabis activity as being void for illegality. California, Colorado, Illinois, Massachusetts, Michigan, Nevada and Oregon have this type of statutory protection.

 

Was the Contract Legal at the Time of Formation and Does It Incorporate Later Changes to the Law?

Courts typically will evaluate whether a contract is illegal by determining whether it was illegal at the time of contract formation, not at the time of litigation. This principle was demonstrated in the recent case of Metsch v. Heinowitz, No. 37-2017-00028176 (Cal. App. 4 Dist. April 22, 2020). Although the California Civil Code was modified in January 2019 to expressly provide that commercial cannabis activity in compliance with state law is the legal object of a contract, the contract at issue in Metsch was executed in January 2014 at a time when the two cannabis companies were operating in violation of state law. The appellate court determined that the contract was illegal at formation and therefore was not enforceable.

 

The parties in Metsch could have avoided the unenforceability of the subject contract by expressly incorporating “subsequent changes in the law” as a contractual term. Because there was no evidence of this intent between the parties, the court refused to so modify the contract.

 

For those in the cannabis industry who may be operating under agreements formed prior to the enactment of state commercial cannabis regulations, consideration should be given to entering new contracts or at least modifying the existing contracts to expressly incorporate subsequent changes in the law.

 

Forum Selection, Choice of Law and Waiver of Removal to Federal Court

Any cannabis-related contract should include a carefully considered forum selection clause and a choice of law clause. There is no “one-size-fits-all” here – the proper forum and choice of law may depend on the most advantageous state court and state law based on such factors as the residency of the parties, the place of formation and the location of performance. Expressly waving any party’s right to remove the dispute to federal court also may be appropriate.

 

Mandatory Arbitration

One also should consider use of mandatory arbitration provisions in cannabis-related contracts. This is particularly important if the contract is subject to interpretation by state law that is not favorable to enforcement of cannabis-related agreements or if there is a chance that a dispute could be forced into federal court. As previously discussed, that can happen if the dispute gives rise to a federal question or if the parties are domiciled in different states and are subject to diversity jurisdiction.

 

It is important, however, not to reflexively incorporate arbitration agreements into all of the company’s contracts because there can be significant drawbacks to arbitrating disputes. Arbitration costs are typically much higher than litigation costs, arbitration often involves waiver of the right to appeal an erroneous arbitration decision, and arbitrators have a tendency to “split the baby” when making awards to a greater extent than would a judge or jury.

 

If it is decided that arbitration is the preferred method of dispute resolution, the arbitration agreement potentially may be enforceable even if other portions of the contract are deemed illegal. In the case of Williams v. Eaze Solutions Inc., No. 3:18-cv-02598 (N.D. Cal. Oct. 21, 2019), a federal district court in California enforced an arbitration agreement under the Federal Arbitration Act, and held that the arbitration provision was severable from the rest of the contract, which was being challenged as void for illegality considerations.

 

The Federal Abstention Doctrine

An interesting question is whether a federal court should decide to abstain from hearing a cannabis-related dispute to avoid disrupting state efforts to establish a coherent cannabis policy. In December 2019, a federal judge in the Western District of Washington decided to abstain on the question of federal illegality of a contract made under Florida law for this reason.

 

Left Coast Ventures Inc., 2:19-cv-01297 (W. Dist. WA Dec. 6, 2019) involved a contract dispute over the plaintiff’s right to exercise an option to purchase stock in the defendant’s company, which had been awarded a valuable medical marijuana license in Florida. The contract included a choice of law provision stating that it would be construed under Washington law and requiring all disputes to be adjudicated in the state and federal courts in Washington. The plaintiff filed suit in Washington state court, but the defendant then removed the case to federal court pursuant to diversity jurisdiction. The federal judge asked the parties why the case shouldn’t be dismissed due to federal illegality.

 

The plaintiff asked the court to abstain from adjudicating the issue and remand the case back to state court. Under established federal principles, abstention is appropriate “where there have been presented difficult questions of state law bearing on policy problems of substantial public import whose importance transcends the result in the case then at bar.” Colorado River Water Conservation Dist. v. U.S., 424 U.S. 800, 814 (1976). “Delay, misunderstanding of local law, and needless federal conflict with the State policy, are the inevitable product of this double system of review.” Burford v. Sun Oil Co., 319 U.S. 315, 327 (1943).

 

The court ruled that abstention was appropriate here because “the federal issues are not easily separable from complicated state law issues with which the state courts may have special competence and federal review might disrupt state efforts to establish a coherent policy.” Tucker v. First Maryland Sav. & Loan, Inc., 942 F.2d 1401, 1405 (9th Cir. 1991). The court further relied on the underlying policy objectives of federal abstention, which is “designed to limit federal interference with the development of state policy.” Id. at 1407.

 

On this basis, the court refused to evaluate state laws that are in direct conflict with the CSA and it expressed concern that invalidating the contract “might create disincentives for businesses to comply with state cannabis regulations by rendering their contracts unenforceable in federal court and could signal to those involved in the state cannabis industry that federal jurisdiction operates as an absolute defense to private contract claims.” Left Coast Ventures, 2:19-cv-01297, Order Remanding Case at p. 5 (Dec. 6, 2019). The “exercise of federal review in this case ‘would be disruptive of state efforts to establish a coherent policy with respect to a matter of substantial public concern.’” Id., citing Colorado River, 424 U.S. at 814.

 

When litigating a cannabis-related matter before a potentially hostile federal court, an attorney may find the federal abstention doctrine a useful tool to avoid an adverse decision on the merits.

 

The Spectrum of Enforceability

From the analysis above, a spectrum of enforceability of cannabis-related disputes begins to emerge. At one end of the spectrum are disputes governed by the law of a state with cannabis statutory protections and with no potential for removal to federal court; at the other end are disputes subject to federal jurisdiction where the federal court is asked to enforce a contract or right that would require the court to order a violation of the CSA.

 

These questions can help in evaluating the risk of non-enforcement:

 

  • Which state law controls the agreement and are there cannabis-specific statutory protections available under that state’s law?
  • Have the parties waived the right to remove a dispute to federal court?
  • If not, can the dispute be removed to federal court under diversity jurisdiction, or does the dispute give rise to a federal question that could be litigated in a federal court?
  • Would enforcement of the contract or right obligate the party to violate the CSA expressly?
  • Was the contract legal at the time of formation, and if not, has the contract been modified to incorporate later changes in the law?
  • Are potentially illegal or unenforceable terms within the contract severable from the remainder of the agreement?
  • Is any party more or less morally culpable, and would a court’s refusal to enforce the contract or right result in the unjust enrichment of one of the parties?
  • Have the parties agreed to mandatory arbitration?

 

Until cannabis is removed from the CSA and federal judges allow cannabis litigants access to all rights under federal law, the potential for litigating in federal court should be approached with clear strategies, including those described above, that mitigate the risks.