The “Illegality Defense” in Cannabis Contracts

 In recent years, courts across the country are sending mixed signals as to whether the “illegal contract” or “illegality” defense prevents the enforcement of cannabis contracts. The inconsistencies among courts present significant hurdles for investors and distributors who cannot be certain any contract will be enforced by a federal court. After what appears to be a pattern of enforcing such contracts, two recent cases may indicate a slowing of the momentum, or may be outliers from one federal court.

Specifically, for the second time in two months, a federal court in Seattle indicated it may be prohibited from enforcing a contract between cannabis companies based upon the illegality doctrine and the fact that marijuana remains a controlled substance under federal law. In Left Coast Ventures v. Bill’s Nursery, No. 2:19-CV-1297-MJP, (W.D. Wash. October 31, 2019), the plaintiff asked the court to enforce a contract requiring Florida grower Bill’s Nursery to sell its marijuana distribution business to Left Coast Ventures. Bill’s Nursery moved to dismiss, claiming the contract terminated several years before Left Coast purported to exercise its option. After the parties completed briefing on the motion to dismiss, the court sua sponte issued an order to show cause, finding “the contract at issue may be unenforceable” under the Federal Controlled Substances Act (“CSA”). According to the court, it is precluded from awarding an ownership interest in a business that is illegal under federal law.

In response, Bill’s Nursery argued the court may not order an illegal act. Because the sale, distribution and cultivation of marijuana remains illegal under federal law, Left Coast’s claim for specific performance – which would effectively award an ownership interest in an illegal business – failed as a matter of law. Unsurprisingly, Left Coast disagreed, arguing (1) the majority of federal courts to consider the illegality defense under similar circumstances refused to dismiss on that ground, and (2) enforcing the contract does not mandate illegal conduct. According to Left Coast, it seeks both monetary damages and specific performance of an option agreement to purchase shares in Bill’s Nursery. The court has yet to render a decision.

The Left Coast case follows on the heels of a similar decision by the Western District of Washington in Polk v. Gontmakher, No. 2:18-CV-01434-RAJ, 2019 U.S. Dist. LEXIS 146724, at *2 (W.D. Wash. Aug. 28, 2019). In that case, the plaintiff sued his former partner in a marijuana growing business, arguing he was entitled to an ownership interest as well as past and future profits. Treading lightly, the court held that federal law precluded enforcement of the agreement, because under the CSA, the production, distribution and sale of marijuana remains illegal. The court noted the “nuanced approach” in applying the illegality defense, acknowledging that it may have been permissible to award the plaintiff damages. However, because the complaint sought an ownership interest in the business, such a result would contravene federal law.

These recent decisions are squarely at odds with the general trend. In reality, federal courts are increasingly more willing to recognize cannabis related businesses – which are legal under the laws of several states – and enforce both the private and public obligations surrounding them. For example, in Street v. ACC Enters., Ltd. Liab. Co., No. 2:17-cv-00083-GMN-VCF, 2018 U.S. Dist. LEXIS 167299, at *13-14 (D. Nev. Sep. 27, 2018), a case involving the breach of a multi-million dollar loan agreement to fund a cannabis cultivation facility, the court was able to “provide a remedy for Plaintiff that both complies with Nevada substantive law and does not conflict with federal law. This finding comes from the fact that several requirements of the First and Second Promissory Notes command the Defendants to use the loaned funds for solely legal acts.” Because the potential remedy did not mandate illegal activity, the court denied plaintiff’s motion to dismiss.

In Mann v. Gullickson, 2016 WL 6473215, at *9 (N.D. Cal. Nov. 2, 2016), the Northern District of California rejected an illegality defense on summary judgment in a breach of contract action involving medical cannabis-related businesses, holding that mandating payment for the business did not require the defendant to “possess, cultivate, or distribute marijuana, or to in any other way require her to violate the CSA.” Similarly, in Ginsburg v. ICC Holdings, LLC, 2017 WL 5467688, at *9 (N.D. Tex. Nov. 13, 2017), the Northern District of Texas rejected the illegality defense to a breach of contract action regarding loans for a medical cannabis business, explaining “federal courts do not take such a ‘black-and-white’ approach to enforceability.” Rather, courts must balance “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 forgoing the additional deterrence of behavior forbidden by the statute.”

Likewise, in Kenney v. Helix TCS, Inc., 939 F.3d 1106 (10th Cir. 2019), the Tenth Circuit Court of Appeals held that a defendant could not escape its obligations under the Fair Labor Standards Act by relying on the illegality defense. In that case, Helix, a company that provides security to cannabis businesses, failed to pay its employee overtime as required by the FLSA. Helix moved to dismiss the claim, arguing that Kennedy was not entitled to protection under the FLSA because cannabis is illegal under the CSA. According to Helix, its employees assume the risk that they will be criminally sanctioned for their work and thus are denied the benefits of federal law. A three-judge panel disagreed, holding the FLSA indeed applies to cannabis businesses. The court stated that “employers are not excused from complying with federal laws just because their business practices are federally prohibited.”  The court further noted that its holding was consistent with that of Greenwood v. Green Leaf Lab LLC, No. 3:17-cv-00415-PK, 2017 U.S. Dist. LEXIS 125143, at *10 (D. Or. July 13, 2017), where the U.S. District Court for the District of Oregon addressed precisely the same issue.

In sum, the differing approaches are largely based on the remedy requested by a cannabis plaintiff. While courts have been willing to enforce contracts seeking monetary damages, they are generally unwilling to grant specific performance if it would require the court to order that a plaintiff be permitted to engage in activity illegal under federal law. This distinction highlights the need for careful evaluation when drafting agreements, and thoughtful consideration from counsel when seeking to enforce them through litigation.

If you have questions about remedies when a cannabis contract is breached, please do not hesitate to contact a member of Frantz Ward’s Cannabis Law & Policy team.

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