Budding Companies Part 4: Jurisdiction Choice in Forming Cannabis Startups
By Charles S. Alovisetti, Partner and Caitlin Wightman, Law Clerk
Nov 8, 2019
This is the fourth post in our “Budding Companies: Forming Cannabis Startups” series, where we explore different issues involved in the formation of new cannabis and hemp companies. This part focuses on the choice of jurisdiction – which is the next decision for founders to make after deciding on the right entity type.
Where Should You Form Your Startup Entity?
The standard advice for startups is to form their entity (at the least the holding company that will be used to raise capital) in Delaware, regardless of where their physical operations will be located. Why? Because investors prefer it.
Delaware developed a series of laws, including the Delaware General Corporation Law (DGCL), as well as a court system and case law familiar with the types of legal issues faced by corporations. Professional investors and their counsel know and rely on these rules too. That’s why, absent unique circumstances, startups are generally advised to form in Delaware and qualify as foreign corporations in their other states of operation.
So, what about cannabis startups? Because some courts have decided not to enforce cannabis contracts due to policy concerns regarding the federally illegal status of cannabis, legal practitioners debate whether it is a better idea to use a state such as Nevada, California, Colorado, or Massachusetts, where adult-use cannabis is legal at the state level. The logic is that an adult-use marijuana company should take advantage of the corporate law of a state where such activity is expressly permitted.
In this article, we explore the legal issues associated with forming cannabis companies in Delaware and evaluate the perceived advantages of alternate jurisdictions. Finally, we examine what the largest companies are doing in practice.
Forming an Entity in Delaware: Business Purpose Issues
Because Delaware does not have a legal adult-use cannabis market, there is a concern that the purpose of an adult-use cannabis business incorporated in Delaware may not fall within the allowable purpose for a Delaware corporation. Delaware law provides that a certificate of incorporation must include a statement regarding the business’s purpose. The law also provides:
It shall be sufficient to state, either alone or with other businesses or purposes, that the purpose of the corporation is to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware, and by such statement all lawful acts and activities shall be within the purposes of the corporation, except for express limitations, if any.
Delaware law also states that “[a] corporation may be incorporated or organized under this chapter to conduct or promote any lawful business or purposes, except as may otherwise be provided by the Constitution or other law of this State.” There is very little case law regarding the purpose for which a company is incorporated in Delaware; however, it has been noted that:
Delaware law does not charter lawbreakers. Delaware law allows corporations to pursue diverse means to make a profit, subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue “lawful business” by “lawful acts.” As a result, a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profit by violating the law.
There is currently no case law related to the stated purpose of adult-use cannabis companies incorporated in Delaware; however, casinos incorporated in Delaware are somewhat analogous to cannabis companies that choose to incorporate in that state. This precedent may be the most relevant example we have, but it is imperfect because gambling, while it was illegal under Delaware law, was never criminalized at the federal level in the same way cannabis is criminalized.
Delaware has only recently legalized sports betting, and there are casinos that have been incorporated in Delaware allowing sports betting long before it was legal in that state. Companies that are incorporated in Delaware are not required to do business in Delaware, and while these casinos do not operate in Delaware, they are operating lawfully under state law in the state(s) in which they do business. So, while the casinos’ activities were illegal under Delaware law, the casinos were not violating Delaware law because they were not operating in the state.
While Delaware does not have a legal adult-use market for cannabis, companies that choose to incorporate in Delaware are likely not violating Delaware law if they are only serving the adult-use market in states where it is legal. Regulated industries, such as gaming, alcohol and motor vehicle manufacturing, often deal with conflicting regulations and laws in different states. These companies are not required to follow Delaware laws in all jurisdictions just because they are incorporated in Delaware. However, because cannabis is still federally illegal, there is still a risk that Delaware could treat cannabis companies differently than federally legal businesses.
Forming an Entity in Delaware: Entity Name Issues
In addition to concerns regarding the enforceability of contracts and business purposes, certain business names may also pose a problem in Delaware. It was reportedthat Delaware rejected the name of a cannabis business due to the use of the word “marijuana” in the business’s name. According to the Delaware Department of State’s website, “[t]he Division of Corporations reserves the right to review each name reservation for compliance with the [DGCL], Section 102, upon submission of the legal document for filing. We reserve the right to reject a filing for non-compliance with the Delaware Code.” The DGCL Section 102 provides, in relevant part, that businesses seeking to incorporate in Delaware must list the business name on the certificate of incorporation and that name:
shall not contain the word “bank,” or any variation thereof, . . . however, that this section shall not be construed to prevent the use of the word “bank,” or any variation thereof, in a context clearly not purporting to refer to a banking business or otherwise likely to mislead the public about the nature of the business of the corporation or to lead to a pattern and practice of abuse that might cause harm to the interests of the public or the State as determined by the Division of Corporations in the Department of State.”
Delaware has used this provision to deny incorporation to an entity name that it believed “has a negative connotation,” and “might cause harm to the interests of the public or the State as determined by the Division of Corporations in the Department of State.” Recently the Department of State has cited this provision to deny incorporation to Illegal Pete’s, a restaurant chain based in Colorado, because the “plaintiff’s name is not in the best interests of the people of Delaware.”
There is very little case law concerning entity name rejection in Delaware, and published cases are related to the use of the word “bank” or names that are similar to existing corporation names. However, Illegal Pete’s has filed a lawsuit in federal district court against the Delaware Department of State alleging that the decision to reject the corporation’s name was arbitrary and capricious and viewpoint discrimination in violation of the First Amendment. As this lawsuit moves forward, there may be more clarity as to how Delaware makes decisions regarding entity name rejection.
Vicente Sederberg LLP communicated with the Delaware Department of State, who stated that all submissions of documents that contain the name “marijuana” or “cannabis” are subject to management review before filing. The representative did not know what factors are considered in deciding whether to allow incorporation. Currently, a Delaware entity search returns 38 results for company names that contain the word “cannabis” and five results for company names that contain the word “marijuana.” While Delaware has allowed entity names containing the words “cannabis” and “marijuana,” these words flag the incorporation documents for further review and, as of today, it is unclear what these documents are being reviewed for.
Side Note: Delaware Repurchase Provisions
In addition to concerns about investor preferences and contract enforceability, another issue for cannabis startups is the need to potentially repurchase shares held by investors or employees. If a startup holds or plans to hold a cannabis license or is otherwise closely connected to a licensed entity (as a lender, for example), it will likely be subject to background checks and vetting of owners. That means having a bad apple shareholder could put the whole business at risk. In order to mitigate this risk, cannabis startups are advised to consider adding a provision to their governing documents that permit the repurchase of shares from an equity holder who creates a licensing issue.
In Delaware, the right to redeem shares must be spelled out clearly in the certificate of incorporation; the right of redemption will not be inferred from ambiguous words or phrases. This right is further set forth in § 151(b)(2) of the DGCL which authorizes redemption of stock by a corporation that holds a government license or franchise to prevent the loss of such license, franchise or membership or to reinstate it. The certificate of incorporation must also set out the terms, conditions, and procedures applicable to redemption. The certificate of incorporation or the resolution or resolutions issuing such stock must also state the redemption price which may consist of “cash, property or rights, including securities of the same or another corporation. . . .”
The takeaway for cannabis companies in Delaware is simple: put all the repurchase and redemption rights in the certificate of incorporation, not in the bylaws or shareholder agreement.
Forming an Entity in Other Jurisdictions: State Cannabis Contract Enforceability
Given the challenges in Delaware, it may seem more logical and less risky to form a cannabis startup in a state that has legalized adult-use cannabis, but that may not resolve issues associated with a company operating in multiple jurisdictions (which is almost all major cannabis companies). This is because state statutes that explicitly make cannabis contracts enforceable typically only reference activities licensed by the state in question.
For example, in Colorado C.R.S. § 13-22-601 states that, “[i]t is the public policy of the state of Colorado that a contract is not void or voidable as against public policy if it pertains to lawful activities authorized by section 16 of article XVIII of the state constitution and article 453.4 of title 12, C.R.S.” Note that this Colorado statutory reference explicitly references a constitutional amendment and statutes that permit commercial cannabis activity in Colorado. It does not mention anything regarding activities outside the state of Colorado- something that would be a critical component of any national cannabis company.
This issue arises in California as well, where the applicable statute Civil Code Section 1550.5 reads “[n]otwithstanding any law, including, but not limited to, Section 1550, 1667, and 1668 and federal law, commercial activity related to medicinal cannabis or adult-use cannabis conducted in compliance with California law and any applicable local standards, requirements, and regulations shall be deemed to be all of the following: (1) A lawful object of a contract[,] (2) Not contrary to, an express provision of law, any policy of express law, or good morals[,] (3) Not against public policy.” Again, only the policy issues around enforceability to the extent the cannabis contract deals with licensed activity in the state in question (California) are covered. Similar statutes are also on the books in Nevada and Massachusetts.
Given the absence of explicit public policy support for contracts dealing with out of state activities, which would be the case for any nationally-focused cannabis startup, it seems of questionable value to forgo the advantages of forming in Delaware and use an adult-use cannabis state as the jurisdiction of formation. However, it may be easier to deal with business purpose and naming issues in states like California, Nevada, Colorado, and Massachusetts than it is in Delaware.
Where Have Other Cannabis Startups Formed Entities?
Finally, setting aside the array of theoretical options and issues, as a practical matter, almost all of the major financings in the cannabis industry have used an entity incorporated in Delaware. The chart below uses publicly available data to show what vehicles the five largest public US-focused cannabis companies used to raise capital prior to pursuing an RTO (reverse takeover) to become public.
|Public Company||Parent Entity Prior to Public Listing*|
|Curaleaf Holdings||Delaware corporation|
|Acreage Holdings||Delaware limited liability company|
|Green Thumb Industries||Delaware limited liability company|
|MedMen Enterprises||Delaware limited liability company and a California corporation|
|Trulieve Cannabis||Florida corporation (Florida law required applicants to be existing Florida nurseries)|
*Note that this represents a simplification based on public filings. Many CSE listed issuers used multiple entities to raise capital, though typically a parent holding company was used.
Stay tuned for the next article in the “Budding Companies” series, where we address broader issues of cannabis contract enforceability.