Cannabis Law and Policy
Turning Insight Into Action
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.
Frantz Ward Client Obtains Favorable Ruling in Dispensary License Litigation
An Ohio judge ordered the Board of Pharmacy to reconsider its denial of a provisional dispensary license to Frantz Ward’s client, Pure Ohio Wellness, LLC.
Pure Ohio was the highest-scoring dispensary applicant in the state’s Southwest-7 District, which includes Fayette, Madison, and Greene counties. However, the Board denied Pure Ohio a license and instead awarded a license to a lower-scoring applicant as a result of an Ohio statute that required the Board of Pharmacy Board to issue not less than fifteen percent of dispensary licenses to entities owned and controlled by members of economically disadvantaged groups.
The Court found this statute to be unconstitutional on its face and remanded the matter back to the Board. This ruling follows a decision by the Franklin County Court of Common Pleas to strike down a similar provision governing the award of Ohio medical marijuana cultivator and processor licenses.
After receiving a copy of the decision, Pure Ohio’s President, Larry Pegram, provided this statement:
“We were very happy to receive the Judge’s ruling today. As a currently vertically-integrated Ohio medical marijuana company we are focused on providing the best and safest cannabis available on the market. We look forward to ultimately receiving our third dispensary license so that we can provide much needed relief to more of Ohio’s patients.”
To view a copy of the ruling, please click here.
Cannabis Industry Faces Another Obstacle as Tax Court Upholds Section 280E
In a blow to the American cannabis industry, the United States Tax Court found that Section 280E of the Internal Revenue Code (“IRC”) did not violate the Eight Amendment to the United States Constitution. Northern California Small Business Assistance Inc. v. Commissioner, 153 T.C. 4 (2019). The Petitioner in Northern California was a legal medical marijuana dispensary in California, which challenged the application of Section 280E. Section 280E states:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consist of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
Despite legalization of marijuana use in several states, under federal law marijuana remains a Schedule I controlled substance within the meaning of the Controlled Substances Act.[1] The Petitioner’s challenge to Section 280E was based on three arguments: (1) that Section 280E is a penalty and an unconstitutional violation of the Eighth Amendment; (2) that Section 280E only limits the business deductions under IRC Section 162; and (3) that Section 280E does not apply to a legally operated marijuana business but instead only applies to illegal “trafficking” operations.
In his opinion for the Tax Court, Judge Goeke noted that Congress has the power to lay and collect income taxes under Article I, Section 8 of the Constitution and the Sixteenth Amendment. Additionally, that the United States Supreme Court has held that any deductions from gross income are a matter of “legislative grace” and can be reduced or expanded in accordance with Congress’ policy objectives. [2] Section 280E was enacted under Congress’ unquestionable authority to tax income pursuant to the Sixteenth Amendment and is directed at persons who operate a business in violation of federal or state law. Judge Goeke stated that he was unaware—and that the Petitioner had not cited—any cases where the disallowance of a deduction was construed as a penalty. Furthermore, the overwhelming precedent holds that deductions for determining income are a matter purely left to congressional discretion and that the disallowance of a deduction is not a penalty. Accordingly, the Tax Court held that Section 280E is not a penalty provision and consequently does not violate the Eighth Amendment.
Petitioner’s second argument was based on the fact that the language of Section 280E tracks the business deduction language of IRC Section 162, and therefore, the Petitioner argued that the restriction of Section 280E is limited only to the business expenses deducted under Section 162. Judge Goeke disagreed, finding that the broad language of Section 280E leads to the conclusion that it was written to deny all deductions under any IRC section for a business that trafficked in controlled substances.
The Petitioner’s third argument was that Section 280E only applies to illegal marijuana activities, based on the use of the word “trafficking” in Section 280E. Again, Judge Goeke disagreed and cited prior Tax Court precedential cases which held that the sale of medical marijuana pursuant to California law still constituted “trafficking” within the meaning of Section 280E. Lastly, Judge Goeke advised the Petitioner that the Petitioner’s remedy lies with Congress rather than the U.S. Tax Court because of the language of Section 280E.
Most decisions of the U.S. Tax Court are written in the name of only one judge, so it is worth noting that of the 19 Tax Court judges, the Northern California decision cited: (a) the agreement of nine other Tax Court judges, (b) the non-participation of one other Tax Court judge, (c) two concurring opinions (one agreed to by three judges and the second agreed to by another judge) and (d) a concurring in part and dissenting in part opinion. The fact that this opinion was reviewed by the entire U.S. Tax Court and that there were concurring and dissenting (in part) opinions, makes this decision more significant as legal precedent and indicates the importance that the judges of the U.S. Tax Court see in the Northern California case.
Dealing with Section 280E is a constant battle for American
cannabis companies, as it precludes the ability to deduct most normal business
expenses. While thoughtful tax planning may be able to mitigate some of the
harms caused by Section 280E, it still undoubtedly leads to reduced
profitability and lower market valuations. But all hope is not lost. Northern California will likely be
appealed to the Ninth Circuit Court of Appeals, and the dissenting opinions
from Judges Gustafson and Copeland may provide a roadmap to further legal challenges
to Section 280E. In addition, Congress appears primed to move on significant
cannabis reform, including the broad reform efforts captured in the S.T.A.T.E.S
Act and more limited reform efforts to address banking and the impact of
Section 280E specifically.
[1] Pub. L. No. 91-513, Sec. 202(c) and codified as amended at 21 U.S.C. Section 812(c); see also 21 C.F.R. Section 1308.11(d)(23).
[2] See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1982), and New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Company Faces RICO Lawsuit Over “Falsely Advertised” CBD Product after Employee Tests Positive for THC and Loses his Job
Public support for cannabis reform – whether to legalize medical or adult use marijuana or hemp and hemp-derived products – is at an all-time high. While marijuana reform is moving slowly at the federal level, the federal government legalized hemp and its derivatives as part of the 2018 Farm Bill.
Now, companies from Martha Stewart to Walmart are seizing the opportunity to enter the hemp-derived CBD market. And, while CBD (Cannabidiol) may be the most well-known hemp derivative, this nascent, emerging industry still lacks consistent regulatory oversight, making it sometimes difficult for consumers to verify the contents of hemp-derived products.
Legalization of marijuana and hemp have also inevitably meant increased work-related issues for applicants and employees who use these products, as evidenced by the Western District of New York case Horn v. Medical Marijuana, Inc. One of the named Plaintiffs in the case, Douglas Horn, had been a professional over-the-road hazmat commercial truck driver for 29 years. As such, Horn has attested in court documents that he was acutely aware that he was subject to regular and random drug-test screenings, and that he could not smoke marijuana or take any product containing THC (the intoxicating compound in cannabis). After seeing an ad for the Defendant’s CBD oil, which represented the product had a 0% concentration of THC, Douglass bought and consumed the CBD oil. He was later summoned for a random Department of Transportation urinalysis drug test required by his employer, informed that he had tested positive for marijuana at almost double the concentration limit, and was terminated shortly thereafter.
Horn and his wife sued the seller of the CBD oil, asserting claims for deceptive business practices, fraudulent inducement, racketeering, products liability, negligence, and intentional infliction of emotional distress. The Court recently granted summary judgment to the defendants on most of Horn’s claims, but ordered both the fraudulent inducement and civil racketeering claims to proceed to trial.
Given the rapid and unpredictable developments in this area of the law and industry, employers should continue to act thoughtfully when making decisions regarding applicants and employees who use marijuana or CBD.
Attorney Tom Haren Quoted in Crain’s Cleveland Business Article
“Marijuana’s Branding Problem”
Crain’s Cleveland Business
October 12, 2019
Excerpt from the article:
“As markets continue to expand and new companies enter different markets, you want to be able to distinguish yourself in the marketplace, and the ability to brand a product is one of the most important parts of being in a consumer-facing industry,” said Tom Haren, a lawyer with Frantz Ward. “The opportunity to come in and establish in a new market in marijuana is enormous. But you’ve got to have a protected brand, just like any other industry.”
Class Actions Come for Cannabis
The cannabis industry in the United States is relatively new. But a series of class actions filed within the last month alleging deceptive labelling of cannabidiol (“CBD”) products demonstrate that some of the legal issues the industry faces are not.
The first case, Gaddis v. Just Brands USA, Inc., S.D. Fla. No. 0:19-cv-62067 (Aug. 16, 2019), alleges that the labelling and packaging of JUSTCBD-branded CBD products overstates the amount of CBD in the products, and that some of the products contained no CBD whatsoever. The complaint also alleged that the company’s website misrepresented the amount of CBD in various products, including gummies, tinctures, vaping cartridges, and food products. The plaintiff is seeking to certify a nationwide class of consumers asserting claims for breach of warranty, fraud, and unjust enrichment, and a statewide class asserting a claim under a New York consumer protection statute.
Another potential class action against a CBD manufacturer was filed in the Southern District of Florida last week. Potter v. Potnetwork Holdings, Inc., S.D. Fla. No. 1:19-cv-24017 (Sept. 27, 2019) involves allegations that the labelling and packaging of defendants’ CBD products, including “CBD Oil,” “CBD Edibles,” “CBD Capsules,” “CBD Drinks,” “CBD Vape Oil,” as well as “Bath & Body” and “Cosmetics,” misrepresents the amount of CBD in those products. Comparing the CBD industry to the “Wild West,” the plaintiff accuses the defendants of “cheating every consumer who buys the Products” containing less than the represented amount of CBD. The plaintiff seeks to certify a nationwide class of consumers alleging an unjust enrichment claim, and a statewide class asserting a claim under a Florida consumer protection statute.
The same week, yet another class action was filed against a CBD manufacturer in the District of Massachusetts. Ahumada v. Global Widget LLC, D. Mass. No. 1:19-cv-12005 (Sept. 24, 2019), alleges that the defendants’ “Hemp Bomb” products, which include “CBD Gummies,” “CBD E-Liquid,” “CBD Oil,” “CBD Capsules,” “CBD Pain Freeze,” “CBD Lollipops,” “CBD Syrup,” “CBD Vape Products,” “Pet CBD Products,” and “CBD Shot,” also contain less CBD than represented in the products advertising and labelling. The plaintiff seeks to certify a nationwide class of consumers alleging breach of warranty claims, and a statewide class alleging a Massachusetts common law warranty claim.
Consumer class actions are only one peril facing manufacturers of CBD products. Deceptive marketing claims by competitors are also possible under the federal Lanham Act and analogous state statues. So, it is vitally important that manufacturers of CBD products make sure, and be able to document, that the information on their labels and websites is consistent with what is in their products.
Ohio Legislature Passes Bill Legalizing Hemp and Hemp-Derived CBD Products
Yesterday the Ohio General Assembly sent Senate Bill 57 – the bill to legalize the cultivation, processing, and sale of hemp and hemp-derived products – to the desk of Governor Mike DeWine for signature. Like most states, State Bill 57 delegates authority to the Ohio Department of Agriculture to create a framework for the licensure and regulation of hemp cultivation and processing. It will likely be six months or more before licensing regulations are in place. But even then, it should ensure that Ohio farmers are able to plant hemp for the 2020 growing season.
Importantly, State Bill 57 includes an emergency clause which allows for the immediate implementation of the law, which would immediately permit any person or business to sell imported hemp or hemp products (such as hemp-derived CBD oil). This change should eliminate confusion created when the Ohio Board of Pharmacy determined that hemp-derived CBD oil could only be sold in Ohio medical marijuana dispensaries.
Frantz Ward attorneys Pat Haggerty and Tom Haren, who are Board members of the Ohio Hemp Association, worked with policy makers in Columbus on Senate Bill 57 for months. Now that it has been passed, Governor DeWine has 10 days to sign the bill into law. All indications are that he will do so.
Administrative Control Lessens as New Amendments Take Shape
On July 23, 2019 at 1:00 p.m. in the West B & C Room, 31st Floor, Riffe Building, 77 South High Street, Columbus, Ohio 43215, there will be a public hearing concerning the Ohio Department of Commerce’s (“DOC”) proposed updates to the regulations of the Ohio Medical Marijuana Control Program. The updates consist of six proposed amendments to existing rules and one proposal for a new rule. With these amendments and new rule, State regulators appear to be lessening administrative controls over some aspects concerning the operations of medical marijuana facilities.
The first amendment is to the cultivator certificate of operation rule. The proposed amendment provides that the cultivation of marijuana is not “agriculture” for the purposes of R.C. 3781.061, which provides exemptions for agricultural buildings from certain buildings standards. The intent of the amendment is to establish a more uniform safety standard under the relevant building code. Although this is a codification of the existing practice, it may result in increased costs for cultivators in order to become compliant with applicable building and fire codes.
The next three proposed amendments remove the option of disposal by surrender that resulted in the DOC taking possession of and destroying medical marijuana waste material. The DOC does not have the appropriate means to dispose of the waste and this amendment would give sole authority to the licensees to dispose their waste. Additionally, the amendments to the cultivator, processor, and testing laboratory waste disposal rules would expand the types of employees who can supervise the disposal of waste from only Type 1 Key Employees, to any Type 1 Employee. The DOC expects these amendments to decrease the costs of disposal by relaxing the requirements for waste disposal and granting more autonomy to the facilities.
The next proposed amendment revises the rule for employee identification cards. Specifically, the amendment removes the following requirements for submission: a copy of the applicant’s social security card, documentation verifying the applicant’s principal place of residence, a sworn statement that the applicant has not been convicted of a disqualifying offense, verification that the background check has been conducted, and verification that the applicant had not been convicted of a qualifying offense. The mandated initial background check already provides much of this information, so these requirements were burdensome and duplicative. The DOC believes that the amendment will decrease the costs associated with application, although the $100 application fee, costs of the background check, and administrative costs are still required.
The last proposed removes the requirement that information obtained by the DOC is only disclosed to its employees, law enforcement, or any person deemed necessary, and language regarding the potential discipline to DOC employees if they violated this requirement. The intent of this is to harmonize the management of information from applicants and licensees with Ohio’s public records laws by narrowing the scope of confidentiality. The only costs that could result from this change would be the costs of investigation, enforcement, and legal action against a licensee for noncompliance.
The proposed new rule grants the DOC the authority to grant variances from the rules of the Medical Marijuana Control Program. The rule is limited to instances in which the variance is in the interest of the public, the provision is not statutorily mandated, and the rule from which variance would be granted is not unreasonable or unnecessarily burdensome. The proposal appears to be in response to issues that the DOC has encountered with provisional licensees and entities who have received certificates of operation. Given that this is a new industry, the DOC found this rule to be necessary in order to address unforeseen issues that are contrary to the intent of the Program.
This new rule on granting variances may result in a need for further clarification to determine what is in the “interest of the public” regarding the medical marijuana industry, and what constitutes unreasonable or unnecessarily burdensome regulations. The language may give the Department of Commerce the leeway that it wants in justifying the granting or denial of potential variances from the regulations.
A package with these rules had been sent to the Common Sense Initiative Office (“CSIO”) on March 8, 2019, when the comment period began. After the comment period closed, the CSIO concluded that it did not have any changes to the proposed rules. Now, the DOC has filed the notice of public hearing with amended rules and new rule with the Joint Committee on Agency Rule Review (“JCARR”). Before these amendments and new rule are adopted, they, along with the public notice, must be in front of JCARR for at least 65 days. JCARR may not invalidate rules, but may report to the General Assembly that the rules do not meet certain criteria. If JCARR approves, then the DOC must file the rules in the Electronic Rule Filing System (“ERF”). The rules’ effective date must be at least 10 days from the final filing date in the ERF. Even if everything moves along, these amendments and new rule would not become effective until September 3, 2019.
Hemp Legislation Introduced in the Ohio Senate
Over the past several months, we have been meeting with Ohio policymakers to assist in the development of sound hemp policy in Ohio. This work is starting to bear fruit. We predicted last week that legislation would be introduced soon in the General Assembly, and that has now happened. A new bill to legalize and regulate hemp in Ohio was introduced in the Ohio Senate this morning.
We are reviewing and analyzing this formal draft, but even after a brief review it is apparent that the goal is to take a free market approach to hemp in Ohio, legalizing not only hemp cultivation but also the extraction and distribution of CBD and other hemp extracts in the Buckeye State.
To read the draft hemp legislation, please click here. We will post another update with a more detailed analysis in the coming days.
Hemp in Ohio
As we’ve written about in the past, the recent passage of the Farm Bill is a watershed moment for hemp. The Farm Bill removed Hemp from the federal Controlled Substances Act and made the plant and its derivatives legal under federal law. Thus, under federal law, marijuana and hemp are treated separately: marijuana remains illegal while hemp is now legal.
Things are less clear under Ohio law, where state agencies have taken the position that hemp still falls under the same definition as marijuana. Therefore, they treat hemp the same and regulate it under the provisions of the medical marijuana law. They argue that the use of hemp or its derivatives (think CBD) outside these regulations violates Ohio law, and have begun cracking down on CBD sales in the state.
This situation has created significant uncertainty for all. The more we look for ways to address and resolve the uncertainty, the more we see just how confused people are concerning marijuana and hemp, and the confusion often centers on the nomenclature we use to talk about hemp.
Both hemp and marijuana belong to the cannabis genus. The Farm Bill, and state laws mirroring the Farm Bill, make a distinction between the two based only on THC content. Hemp is generally defined as a cannabis plant that contains less than 0.3% THC, while marijuana is a cannabis plant that contains higher levels of THC.
Importantly, though, both marijuana and hemp can contain CBD. In some states, for example, it can be legal under state law to purchase and sell hemp-derived CBD products but illegal to purchase and sell marijuana-derived CBD products.
There is no question that there is a market for CBD and other hemp-derived products, especially given the interest in CBD to manage pain, anxiety, insomnia, and even childhood epilepsy syndromes. But there remains a need for additional research to gauge the efficacy of CBD to treat these and other ailments.
Given the market for CBD and other hemp products in Ohio, it’s clear that Ohio law needs to change to accommodate this evolving industry – and the Ohio legislature is positioning itself to do just that. We told Crain’s Cleveland Business last year that we were working on hemp legislation and that we expected action in Ohio in 2019, and it’s looking like that next step is going to come very soon through the introduction of hemp legislation in the General Assembly.
If legislation is passed in 2019 – as we expect it will – then Ohio farmers should be able to begin cultivating hemp outdoors in the 2020 growing season. This will permit them to compete with farmers in other states, including those who will be growing thousands of acres’ worth of hemp in Kentucky this year.
We’ll continue to follow this issue closely and will provide regular updates on our efforts to develop and craft good hemp policy in Ohio. Stay tuned.