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The Complexities of Enforcing Cannabis Contracts in Federal Court

By Robert Selna, 
Selna Partners, LLP

Since California legalized commercial cannabis in 2018, the expected “green rush” has fallen short of expectations. Forecasts of enormous profits have given way to the reality that the state’s cannabis industry is confronted by unique challenges, which have curtailed revenue and caused many businesses to close. A well-documented short list of industry hurdles includes disproportionately high taxes, a shortage of local business permits, competition from a thriving black market, and commercial banking limitations.

A lesser known, but equally important hurdle is the difficulty of enforcing cannabis industry contracts in federal court. As an alternative to state court, federal court is attractive for many reasons, including generally faster case resolutions, judges who never face election, and more exacting expert evidence standards. The federal court option took on new relevance in March when state courts began to close due to COVID-19. Superior courts recently began to hear cases remotely, but the courts’ backlog is enormous and is expected to stay that way for some time. 

For the cannabis industry, enforcing a cannabis industry contract in federal court – even when a defendant contractor has clearly violated an agreement – is not simple. Instead, it is nuanced, and depending on the specifics of the subject matter in dispute, may not succeed, even though the party seeking to enforce the contract may be in the right. 

The well-established California cannabis industry hurdles noted above, and challenges associated with enforcing cannabis contracts in federal court, have collided in a single case that our law firm, Selna Partners LLP, filed in the San Francisco-based federal Northern District court. 

California Cannabis Industry Hurdles

We represent a large, vertically-integrated California cannabis company that cultivates and distributes cannabis, and sells products at retail outlets in several cities. The company, which started its operations in 2010 under non-profit medical regulations in the existence at the time, is now fully-licensed and compliant under California law. As such, it has been hit hard by regulations and taxes. The company pays a city gross receipts tax, and state excise, sale and cultivation taxes, making the company’s effective tax rate approximately 40 percent. In addition, the company’s ability to expand has been limited by the fact that only one-third of California’s 540 cities and counties permit commercial cannabis (state law dictates that personal use is legal everywhere). An added dilemma is competition from the black market, which is estimated to sell eighty-percent (80%) of the cannabis cultivated in California. 

Adding to the companies’ woes is the absence of standardized commercial banking for the California cannabis industry. Despite our client’s compliance with all state and local laws, and a business model that has had more success than many, through 2019, the company had not been able to maintain a banking relationship with a traditional bank or credit union. This forced our client to hold revenues in a steel vault and deliver cash tax payments to government agencies in armored cars, among other workarounds. The company also often paid vendors and employees in cash. 

Cannabis Industry Banking is in Short Supply

The reason for the traditional banking shortage is straightforward:  marijuana (the federal government’s term for cannabis) is listed as a controlled substance, and is therefore, illegal to grow, import, possess, use, or distribute in the U.S., despite the fact that 43 states have legalized medical and/or adult-use cannabis. Meanwhile, the vast majority of banks and credit unions are regulated by the federal government.

Recognizing the expansion of state-legal cannabis, the U.S. Treasury Department, has issued guidance for banks that want to serve cannabis companies while avoiding prosecution. The guidance directs banks to provide on-going “suspicious activity” reports to the Treasury Department regarding the practices of their cannabis clients and whether they appear to comply with state laws, or instead, are illegal operators. The number of banks and credit unions willing to take on these responsibilities is incrementally increasing, but the conventional wisdom is that there still are only 300-400 such institutions in the U.S. 

In 2019, our client sought a solution and was introduced to a payment processor in Seattle, Washington, where, similar to California, commercial cannabis is regulated. A contract was signed for executing payments to vendors, employees and the State of California taxing authority and our client deposited approximately $8 million with the Seattle-based payment processor. 

Things went as planned for several months, but then the payment processor began delaying payments or failing to make them altogether. Lacking a viable alternative, the cannabis company stuck with the payment processor despite its poor service. The company hit a tipping point when the processor claimed to have made a $1.2 million tax payment to the California Department of Tax and Fee Administration (CDTFA), which the CDTFA documented that it never received. 

Confronted with proof from the CDTFA that the $1.2 million never arrived, the processor vowed to clear up the problem, but failed to do so. Our client finally demanded its remaining $3 million (including the $1.2 million returned). The processor stopped making payments and returning phone calls altogether. 

The processor’s refusal to return the $3 million left our clients with few options for getting their money back or paying the state and vendors. State court justice has been slow in most jurisdictions for decades. COVID-19 has only made that situation worse. Also, filing a lawsuit in state court against an out-of-state operator made the case vulnerable to the Seattle-based defendant’s motion to remove the case to Washington. 

Reporting the issue to law enforcement was an alternative, but when recouping funds is the top goal, a California company asking the Seattle police department to investigate what could be described as a contract dispute, did not appear to be the most efficient solution. 

Cannabis-Related Contract Claims and the “Illegality Defense”

In the end, our firm and our client believed that the best bet for getting the $3 million back efficiently was to file a breach of contract and fraud case in federal court. But while federal court was the top choice available, we knew it would not be easy. 

It is hard to argue that the processor did not breach the payment processing contract. It had our client’s money and failed to make payments that it agreed to make. But the analysis does not end there, because the processor, like defendants to cannabis contract disputes before it, is relying on the so-called “illegality defense.” In short, the defense is that, because cannabis is illegal under federal law, a federal court cannot enforce a contract that involves a cannabis company. In essence, the argument is as follows: “the merits of the case do not matter because the parties contracted to do something illegal and a federal court cannot review a case involving an illegal contract.” 

If the illegality defense were iron clad, our client’s case would have been dead on arrival. Fortunately, the reality is far more subtle. While there are older federal cases standing for the principal that federal courts cannot enforce “illegal contracts,” judges interpreting those cases have inserted a key exception to that baseline rule. The now well-established exception is that a federal court may enforce an illegal contract (or parts of an illegal contract) if, in doing so, the court fashion a legal remedy that does not compel future unlawful conduct. 

At first blush, it may seem hard to imagine how it would be possible to enforce a contract that involves an “illegal” company and not compel future illegal conduct. But, as it turns out, such circumstances are common in the cannabis industry, in which cannabis companies are paying vendors and individuals to perform services that are not inherently unlawful. Our case provides examples of potential orders that would not compel unlawful conduct:  a requirement to pay the CDTFA taxes that are required under the state’s cannabis laws and payments vendors such as PG&E. Returning  a company’s so that it can make such payments also would seem to pass the test. 

So, what are the key issues that courts consider when deciding whether to enforce an illegal contract? Based on California federal cases, it appears that the court’s top consideration is whether the court’s order would further a specific violation of federal law. In the case of cannabis, the law in central law at issue is the Controlled Substances Act (CSA) and its prohibition on manufacture, importation, possession, use, and distribution of marijuana. Other relevant laws include money-laundering statutes, which prohibit transactions in which the funds involved in the transactions are derived from illegal activity. The definition of “transaction” is key to this crime and would require a much longer explanation than is appropriate for this article. 

Given the context, in cannabis breach of contract cases, where defendants have raised the illegality defense, courts have mulled whether they can order a remedy that makes the plaintiff whole, such as restitution, for example, but is neither derived from – nor results in – the manufacture, importation, possession, use or distribution of marijuana. 

A few examples where the court found that it could not enforce a contract involving cannabis are as follows: Tracy v. USAA, where the court ruled it could not require an insurance company to pay for the replacement of the plaintiff’s marijuana plants; J. Lilly v. Clearspan, in which the court determined that awarding lost profits from a marijuana cultivation operation would further violate the law; and Hemphill v. Liberty Mutual, in which the court ruled it could not require Liberty Mutual to pay for the future use of medical marijuana expenses, because doing so would violate the Controlled Substances Act.

In contrast, federal courts have enforced cannabis-related contracts (or parts of them) where the result would not violate the CSA or other federal statutes. In Bart Street III, a case that involved financial transactions, the court said it could enforce parts of two promissory notes between a lender and a cannabis cultivation company because each note included provisions that directed defendants to use the loaned funds for solely legal acts (paying off prior lenders and purchasing property).

A court used a similar analysis in Ginsburg v. ICC Holdings There the court stated, “[E]ven if a contract is illegal, it is not automatically unenforceable. Under federal law, the illegality of contract defense involves a balancing of the ‘pros and cons of enforcement,’ taking into account the benefits of enforcement ‘that lie in creating stability in contract relations and preserving reasonable expectations’ and the ‘costs in foregoing the additional deterrence of behavior forbidden by the statute.’”

Ginsburg appeared to be influenced by a line of cases starting with Bassidji v. Goe. Bassidji, did not involve marijuana, but its analysis was followed by a Northern District case, Mann v. Gullickson, which involved a contract between two companies that served the cannabis industry. Both courts opined that “[A] court only needs to dismiss a claim for breach of contract when the contract is “illegal” if the lone remedy available would, itself be illegal.

The case between our client, the vertically integrated California cannabis company, and the Seattle-based payment processor is on-going. Central to our argument is that a court order, in which our clients’ funds were returned,  or which compelled payments to the State of California and legal vendors, such as PG&E would not violate the CSA or federal statutes. 

The story of our case is to be continued, but any California cannabis company which is considering suing for breach of contract should give serious consideration to the pros and cons of both state and federal court. Filing a case in federal court, while likely more complex, may still be the best choice. 

Robert Selna is a founding partner of Selna Partners, LLP. The law firm serves clients across California combining specialized practices in the real estate and cannabis/hemp industries with decades of experience handling complex commercial litigation, class actions and product liability litigation.  Rob has built upon his real estate work and experience with local and state government to represent clients in the real estate and cannabis industries. He advises developers on zoning, environmental and subdivision laws and the many other legal details that complicate nearly all projects. His transactional work includes leases and purchase and sale agreements. Rob specifically advises cannabis clients on licensing, regulatory matters and legislation, entity formation, contracts, real estate transactions, litigation and taxes. He can be reached at robert@selnapartners.com, (415) 601-5385.

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Finance – Economics of Legalizing Cannabis – Pricing and Policing are Crucial

Written by: Alice Mesnard, Reader in Economics, University of London
Originally published in The Conversation
29 July 2019

Legalising cannabis can have major benefits for all citizens. If carried out correctly, everyone will benefit from less crime and stronger rule of law. Legalising the drug will especially help protect young people and may even lower their consumption of the drug. It is also a way of raising taxes for the state, instead of fuelling criminal organisations, which currently control the illegal market.

These benefits are increasingly recognised by the public. Crucial to seeing these benefits come about, is the way legalising cannabis is done and how the drug is priced once it is made legal. These are the findings from research I’ve carried out with colleagues in France. There must be a combination of getting the price level right and cracking down on illegal activities to reach the right balance between reducing criminality and avoiding increases in cannabis consumption following legalisation.

To fight the black market, the price of legal cannabis has to be relatively low. For example, it could be set around or slightly below the current illegal price. This will attract current users of the drug away from their existing dealers.

But if nothing else is done, this will not be enough to eradicate the black market. Dealers will simply lower their prices to attract customers back. They are able to do this because there is currently a high markup in the illegal market.

There is a large range of prices and cannabis products sold illegally but the average price of high-quality cannabis is roughly US$300 per ounce in London, according to the crowd-sourced website priceofweed.com. This is up to three times as high as production costs based on evidence from the US market.

Controlling consumption

The increased competition that the legal market would bring would likely substantially increase consumption – not something most policy makers want. So as well as implementing a legal market, there needs to be a mix of policies to control consumption, including sanctions that are enforced against illegal activities. This would allow a government to price out dealers, while keeping the price of legal cannabis relatively high.

The reasoning is simple: if production or distribution costs of illegal cannabis increase, it is easier to drive criminals out of business by selling legal cannabis. My research shows that the harsher the punishments you put in place against people selling cannabis illegally, the higher you can set the price of legal cannabis to price out dealers. We call this the “eviction price”.

Other instruments governments can use to increase the eviction price are to deter consumers from buying illegal cannabis through enforced sanctions or warning them against the dangers of using illegal cannabis compared to high-quality, safe products supplied on the legal market.

Viable alternatives

It’s also important to introduce incentives for illegal cannabis producers and sellers to turn their activity toward the legal sector. So as well as investment in law enforcement to crack down on criminal activity, it’s important that former cannabis dealers are given viable job alternatives. Otherwise they may just switch to selling alternative illegal drugs or close substitutes.

Dealers often live in deprived neighbourhoods and are trapped in vicious cycles of crime where low aspirations and job prospects push them into illegal businesses. Investment in these communities is therefore needed to support and train those that make a living from drug dealing.

The money that will be generated by selling and taxing legal cannabis should be largely redistributed towards these kinds of initiatives. Plus, legalising cannabis may enable the police to reallocate their efforts towards other crimes, improving police effectiveness against class-A drugs and non-drug crimes. This was found in the London borough of Lambeth after penalties were reduced in 2001 for those holding small amounts of cannabis.

History also shows that prohibition increases violent crimes. Famous gangsters such as Al Capone in Chicago in the 1920s profited from the imbalance between demand and supply of alcohol by establishing organised crime to supply and serve alcohol illegally in speakeasies. In illegal markets, violence is often seen as the only way to resolve conflicts and secure market power.

Our research was inspired by recent examples of cannabis legalisation in Canada and Uruguay. The stated objectives in both countries was to combat drug-related crime. It is too early to evaluate the overall effects of these policies but evidence from Canada suggests that illegal transactions linked to the black market shrunk as a result of legalisation. And we also learnt from what did not work so well there: a shortage of legal supply helped the illegal market persist. So it’s important to avoid making the same mistakes and propose more effective policies to control the overall consumption of cannabis.