folder Filed in Business, Legal
Risk Management in the California Cannabis Industry
Written Contracts Can Mitigate Risks
Dale Schafer

In 2015, when the state of California rolled out its first iteration of laws to regulate our cannabis market, it was clear to me, and other attorneys with experience in a regulated and licensed market, what was coming. Despite the protestations of people hoping to transition from illicit to licit commercial cannabis activities, regulated agricultural supply chains exist and can be navigated profitably. Many of the problems I’m asked to get involved in result from legacy operators having trouble changing their thinking about how things have been done. It’s a new day and if you don’t adapt, you are doomed.

The supply chain for commercial cannabis is well defined at this point and the places in that supply chain where things can go wrong are possible to identify. My advice to operators wanting to enter this supply chain as a licensed business is to start at thirty thousand feet to understand the big picture from seed to sale. Ask the questions about where you fit in the supply chain, how you will earn revenues and who you will be working with. Define the goods &/or services you provide, the other license holders you will work with, how to ensure you revenue stream and how does one deal with the risks involved with your business’s relative position in that supply chain.

Cannabis regulations in California have defined the plant, and its products, as agricultural products. The products produced are commercial consumer goods and will be dealt with through established legal frameworks. Because cannabis has been dealt with as a dangerous drug for so long, there will be special handling rules for the foreseeable future. It’s not tomatoes or alcohol. It will be treated like Vicodin on a bush so better to get used to it. I’m not saying that reality is right, but it is what we will be dealing with some time to come.

Once there is some clarity on your position in the supply chain, there are steps that can be taken to solidify relationships with other licensed operators and protect your business from foreseeable risks. The supply chain has production (cultivation), movement, tax collection and quality assurance (distribution), shape changing and packaging (manufacturing), testing and retail. Each license type requires supplies, employees, transfers and payments of cash. Regulations impose on each license type mandated and prohibited activities. Products are being produced that can cause harm to consumers and general laws will be brought to bear on dangerous or adulterated goods. With a general understanding of these legal realities, a more focused view can now be undertaken.

Way back in law school, I was taught that an agreement is a contract if there is a clear offer, a clear acceptance and consideration (money). Each license type has agreements that are necessary to carry out successful operations. An employer eventually needs employees and there are labor laws to be aware of. Employee relations can be defined and writing down the parameters of employment is necessary. If your business produces a product, selling that product is a goal. If your business provides services, defining the service is necessary. If your business sells to consumers, safe products and interactions with the public are the bread and butter and carry known risks. Getting paid for your goods or services is at the heart of business success so contracts need to clearly spell out payment.

For much of my legal career, I was an insurance defense lawyer. It was clear to me that without insurance, businesses don’t survive. Insurance is a contract designed to pay for known, and insured, risks to your business. The insurance market in California for commercial cannabis activities is not good yet. Last I checked there was only one fully admitted insurance carrier. There are several agencies offering policies that purportedly cover the commercial cannabis market but it’s too early to know what problems will develop from paying for insurance policies written by insurance companies not admitted in the state. Last year California changed the law to allow for cannabis specific contracts and it appears that policies are being clarified to specifically cover losses for legal cannabis businesses. The situation is getting better, but concerns remain.

A clear offer and acceptance in a business sense requires defining terms. If a cultivator wants to sell their crop, what is it about that crop that gives it value and what is that value. Old terms like “top shelf” or some strain name mean little in the face of required testing that will specifically state cannabinoid and terpene profiles. Processing techniques could be important for some transactions and defining the metrics for that portion of value in a product needs to be clear and written down. If a product needs to be transferred, who is responsible for any of the myriad problems that are foreseeable when people in vehicles enter the public roadways? If your business produces a specific product, whose responsible for packaging, failed tests, storage, transfers and dangerous products. If your retail business suffers a fire loss, what about product and business loss? What if the failed test is a false positive?

At this point in the build out of the supply chain, transparency between businesses is problematic. As some businesses gain market share, influence of the supply chain is a reality. Buying as low as possible and selling as high (no pun intended) as you can is a reality in a capitalistic market. If your business is not dialed into the full supply chain, you are vulnerable to others buying your goods or services as low as they can and gaining as much as possible from you. Not quite predator and prey, but close. If you aren’t negotiating for the best position for your business, you may be on the menu. If you do negotiate a favorable position, how do you then hold your position and enforce the terms of any agreement?

If your cannabis business needs goods or services, especially within the supply chain, define the terms of the goods or services, detail how problems will be dealt with and be clear about payment. For infrequent interactions with other businesses, specific contracts can be negotiated and signed for each necessary interaction. For more frequent interactions, a broader agreement can be negotiated that defines the terms in general that can be specifically modified for each individual interaction. I’m thinking here about distributors that transfer products, arrange for testing, QA, storage and tax collecting. Or a testing lab that will perform volumes of tests and fees and turn around time might be key. If your business wants a solid relationship with other licensed businesses, a well negotiated contractual relationship helps to dial in a business plan.

In the old marketplace, product was handed to brokers and from there, it was wishin and hopin for payment. A hand shake (some say a wink and a nod) might have sufficed when the courts were not open for contract disputes over illegal contracts. That’s not the case today. This is a cash business and will be for the foreseeable future. COD has a very different meaning when cash is involved. There are some larger shipments that are being completed with attorneys and/or accountants and safety personnel so that transfer of possession is accomplished at the same time money is received. For smaller sales, this is a problematic area and not getting paid can prove ruinous for some. Many of the problems I have been contacted over involve failure to pay. Without a written contract, litigation becomes a liar’s contest.

In my view, a thorough review of your risks should be done early, and often, as your business builds. Once risks are identified, contracting around the risks will help your business to succeed. If insurance can be obtained for known risks, then purchase policies. If insurance doesn’t cover an activity, or if your business does not want to carry a risk, then contract that others carry the risk and hold your business harmless.  Having clear, enforceable contracts, including insurance, helps lend stability to any business so dial in all agreements. That includes trade secrets and Intellectual property rights. That’s a discussion for another day though.