Preparing for the Rising Demand for Due Diligence in Cannabis Transactions

By Charles Alovisetti, Elliot Choi, Sahar Ayinehsazian, Corey Cox

May 5, 2020

This article has been published in PLI Current: The Journal of PLI Press, Vol. 4, No. 1 (January 2020). Not for resale or redistribution.

The continuing growth of the cannabis and hemp industries has given rise to the need for specifically tailored due diligence. As detailed below, an up-to-date understanding of applicable state and federal frameworks and a mastery of the constantly evolving state-specific (and often locality-specific) cannabis and hemp landscapes are necessary to competently perform this unique and increasingly in-demand type of due diligence.

Federal Law Update for Cannabis

Cannabis remains, with certain narrow exceptions, completely illegal under federal law. Because virtually all cannabis-related activities are federally illegal, it is also illegal to aid or abet, or to conspire or attempt to engage in such activities. An individual or ancillary (i.e. non-plant-touching) company may be liable for aiding, abetting, counseling, commanding, inducing, or procuring another person to commit a federal offense, and may be punishable as a principal. In certain cases, like leasing property to a cannabis company, a non-plant touching business will directly violate the Controlled Substances Act (CSA), as it is currently federally illegal to lease, rent or manage a premise that is used for activities that violate the CSA.  

Nonetheless, growing bipartisan federal support for cannabis has produced certain limited protections for state-legal cannabis operators. Since 2015, Congress has used a rider provision in the FY 2015-2019 Consolidated Appropriations Acts (currently the Joyce Amendment and previously called the Rohrabacher-Blumenauer Amendment and, before that, the Rohrabacher-Farr Amendment) to prevent the federal government from using its funds to prevent the implementation of state medical cannabis programs. If the amendment, or a similar amendment, is not renewed before it expires on November 21, 2019, such protections would end. Notably, the SAFE Banking Act, which is primarily aimed at protecting financial institutions working with state-legal businesses, has passed the House and is currently going through the Senate. While support for pro-cannabis bills continues to build at the federal level, it is important to remember that none of these bills have been enacted into law as of this writing.

Due Diligence Generally

Because of the jurisdiction-specific nature of cannabis and hemp laws (state and local), it is difficult to provide guidance on due diligence that will be applicable across all jurisdictions. Despite the disparate nature of these laws, there are still commonalities that arise across states. This article focuses on properly identifying these common issues rather than black letter law.

Deal Structure

Permissibility of Transaction

The cannabis industry is full of companies and promoters seeking to put deals together now and worry about regulatory compliance later. In most cases, the real aim is to maintain the appearance of compliance, while still pushing forward any profitable activities. This aggressive approach often pays off, resulting, at most, in manageable negative impacts.

While a fine could be devastating for many companies, it may be worth it for a large public company to close a deal quickly. Irrespective of the ability to withstand large fines, all parties should enter a deal fully aware of when they are pushing regulatory limits. Thus, the first step of due diligence should always be looking at the transaction from an aerial view to determine whether it is permissible and what potentially negative regulatory outcomes may arise.

Most importantly, potential buyers should not assume that a license can be sold simply because a broker has advertised it as “for sale.” Likewise, when it comes to regulatory workarounds, it’s best to trust, but verify. Finally, think through any disclosure issues that might arise before beginning work in earnest on a transaction. Depending on the state in question, there may not be a materiality threshold at which regulators care about ownership. Some regulators will expect to know the names of all parties to a transaction, no matter how insignificant or passive. In some cases, local regulator's disclosure requirements, if any, may differ significantly from state requirements.

Mergers and Acquisitions

The first step in confirming an M&A transaction’s deal structure is ensuring that the license in question, or the licensed entity, can be sold. It is important to note that many states prohibit the transfer of cannabis licenses, making it imperative that the licensed entity be sold. Some states, like Maryland, have enacted laws that prohibit the sale of a licensed entity until the business has been operational for a certain period. Other states have residency requirements which may limit the scope of potential buyers. Deal structure analysis may also be necessary at the local level depending on the state in question. For example, California localities vary greatly in how they handle cannabis license ownership changes, ranging from pre-closing approval requirements to a simple post-closing notification. It is important to understand local requirements early in the process to ensure any discrepancies with state requirements are appropriately addressed.

Regulators may also take an inconsistent approach as to what constitutes a sale of cannabis or hemp-related license. For example, as stated above, merely changing the ownership of a company that holds a cannabis license may not necessarily constitute a sale, especially if the ownership of such a company has not completely changed. Further, the definition of ownership also varies between both states and localities. In those jurisdictions which prohibit the transfer of a cannabis or hemp license from one entity to another, it would be preferable to structure the transaction as a stock deal or merger rather than an asset sale.

Almost all states restrict the ability of an entity with an interest in a cultivation, manufacturing, distribution, transportation, or dispensary/retail license to have an interest in a testing license as well.

Another very common issue with cannabis deal structures is perceived or actual violations of ownership restrictions. An early form of ownership restriction that is becoming less common is a residency restriction: Some states, such as Washington, require that all owners (those directly participating in or entitled to the revenue or profit of a business in addition to equity holders) be residents of the state in question. Another restriction becoming more common in states with a limited number of licenses, like Pennsylvania, is a prohibition on owning more than a certain number of licenses. In the same vein, many jurisdictions apply a strict numerical cap on the number of licenses that can be held by one person or entity. Almost all states restrict the ability of an entity with an interest in a cultivation, manufacturing, distribution, transportation, or dispensary/retail license to have an interest in a testing license as well. Sellers will often propose alternative deal structures to avoid a clear license cap violation, but regulators have taken mixed approaches to scrutinizing these structures. Having too much control over a license can constitute de facto ownership for license cap purposes.

One common workaround for these issues is to have the licensed entity enter into a management agreement, often containing an option to purchase the licensed entity itself for nominal consideration once transferability is legal. This may or may not resolve an ownership restriction, depending on the state. Increasingly, regulators have required management agreements to be pre-approved or have banned them entirely.

Debt Financings

Cannabis regulations seldom directly address the types of issues that arise with debt agreements (both secured and unsecured). For example, very few states explicitly prohibit taking a security interest in cannabis or cannabis products, but all states prohibit the ownership of cannabis (personal possession aside) by a non-cannabis licensee. For example, Nevada explicitly prohibits granting a security interest in a cannabis license without approval from the Department of Taxation. Thus, some practitioners posit that taking a security interest in cannabis inventory is prohibited. Likewise, there is rarely an explicit prohibition on attaching liens to cannabis licenses themselves. Nonetheless, some regulators take the position that such liens are forbidden due to the approval process typically necessary to transfer such licenses or license holding entities. The enforceability of such non-explicit restrictions remains to be seen.

Pledge agreements in debt financings may present another potential issue. If the pledged equity belongs to a licensed cannabis company, it may not be possible to execute on a pledge agreement without going through a regulatory approval process.

Equity Financings

In an equity financing, the most common structuring issue is the question of new owner approvals. In some jurisdictions, like Illinois, any owner, no matter how little or indirect their interest in a licensee may be, must be approved and added to the list of owners of a license. In other states, like Florida, where adding owners is easier, there may be a materiality threshold below which new owners do not need to be disclosed or pre-approved. It is, therefore, integral to understand the regime in question and its interplays with the proposed deal. In a jurisdiction with strict approval processes for new owners, like Colorado prior to the implementation of HB 1090, companies often seek to bring owners into intellectual property holding companies or management companies. Similar structures are used in states, such as Arizona, that prohibit for-profit entities from owning licenses. Investors should understand the structure of their investment to determine what they are truly buying, as some companies are not open about the fact that the investment may not be in the licensed entity.

In some states, ownership caps are tied to materiality threshold. For example, in Massachusetts, no entity or individual may control or own more than ten percent of more than three adult-use licenses of the same type. It is important to ensure that potential investors would not violate these restrictions and prevent the consummating of an acquisition.

Finally, equity investors should understand how any license violations of an issuer will impact their other license holding entities and future licenses. If an investor owns equity in several companies that have licenses in different states, a compliance issue that occurs with one of these licenses may trigger an obligation to disclose the violation to the other states. Such disclosure violations are generally more common in the context of competitive licensing processes.

Intellectual Property Licensing Deals

Intellectual property licensing arrangements are increasingly common in the cannabis space given the prohibition on interstate transfers of cannabis. As such, a cannabis company with an established presence in one state may ultimately choose to enter an intellectual property licensing deal in another state instead of obtaining its own license. To maintain consistency, intellectual property licensing agreements will often have strict specifications, including the use of certain non-cannabis terpenes. It is imperative that such agreements do not inadvertently give too much control over the cannabis licensee to the IP holder, thereby necessitating regulatory approval requirements.

The form of payment in an intellectual property licensing deal is also critical to analyzing whether the contemplated transaction can be accomplished. Direct (i.e., percentage-based) participation in the revenue or profit of a licensed business can create ownership issues in many states, such as California. If ownership is implicated, regulatory approval and background checks may be needed. For this reason, many deals are structured as packaging arrangements, whereby the IP holder sells packages to the licensed cannabis business, who in turn uses the packages for the sale of the cannabis product.

Regardless of the form of payment, control of the licensed business operations and premises needs to remain entirely with the license holder. It can be possible for employees of the IP holder to come onto the premise to assist with production, but they must remain subject to the control and direction of the licensee. Companies have gotten in trouble for turning over their facilities, without supervision, to an IP holder that wants to take direct control of the production process.

In addition, some states, like Nevada and New York, require pre-approval of new products or product logos or names being sold by a licensed business. All states have requirements regarding products sold by licensed businesses, such as dosing, as well as packaging and labeling rules. These rules must be reviewed in advance of closing the transaction to ensure the new products will not create any violations.

Ancillary Transactions

Many investors prefer to make investments in ancillary or non-plant-touching companies due to their lower perceived risk than investments in plant-touching cannabis companies. Investors may also assume that equity holders of ancillary companies are not subject to regulatory scrutiny or background checks. This is not necessarily the case and, if the proposed deal is contingent on investors avoiding background checks, it is better to confirm this upfront. The exact nature of an ancillary company and the jurisdictions in which it operates need to be scrutinized in order to determine if a background check will be necessary. It is also important to realize that even if no background check or regulatory disclosure is required as a matter of course, regulators often maintain broad authority to investigate further (including requesting investor information) if they feel it is necessary.

Status of Licenses

Licenses

The most obvious diligence step with respect to a cannabis company target is to ensure that all its licenses are in good standing and that regulators recognize the individuals and entities that claim to hold them as the proper owners. Some states make this easy by providing online directories of licenses, though it is unusual for local jurisdictions to publicly report this information. In cases of non-public data, target companies will need to provide up-to-date copies of licenses and, where necessary, license applications. Depending on the jurisdiction, regulators may release information to individuals with the written consent of licensees.

Not all licenses are equal. Typically, a state regulator will initially award a provisional license that becomes final once the company has passed inspections and is ready to operate. A provisional license can be subject to additional ownership change restrictions, and there is usually a deadline by which a provisional license must become operational or risk relinquishment. Thinly capitalized companies have frequently faced challenges after winning licenses and needing to scramble to raise capital to fund build outs within regulatory timing constraints. Notably, however, many states are being lenient on these timelines and there have been numerous cases where companies were given additional time to get up and running, but it is still important to be aware of any such timing constraints.

To fully confirm a license in certain cases, it may be necessary to carefully review the application materials. In other cases, such as a license that can be confirmed online for a business that has been operational for a long period of time, reviewing an application may not be as important. In certain jurisdictions, like Ohio, regulators expect any entity awarded a license to fulfill any plans set forth in a license application. As an example, a company may tout that it will hire workers in a certain community, and some regulators will hold a company to its promises – creating licensing risks if these plans are not brought to fruition. There also may be errors in an application that will only come to light later during buildout. Errors in an application could have adverse consequences, including the right of the regulators to rescind or cause forfeiture of the license

Background Checks

In addition to the typical value of running background checks on key members of the management team, biographical information about the executives and founders of a company can also help shed light on licensing risks. Most licensing regimes have strict requirements about the backgrounds and criminal statuses of cannabis company owners and employees. If an owner or executive has an issue in the past that was not disclosed to the regulators or that indicates a risk to future licensure, such issues must be addressed in negotiations, as they can have a ripple effect of negative outcomes for investors. For example, a founder with a drinking problem could get a felony DUI, which could cause that founder to be removed from the ownership of a company as well as their management role because of the strict requirements most licensing regimes have about the backgrounds and criminal statuses of cannabis company owners and employees.

Legacy Regulatory Violations

It can be particularly important to check a business’s past regulatory violations because regulators often view a violation as attached to an individual license, such that the violation will travel with the license through any transfer of ownership. Consequently, regulators may be less lenient in the future regarding compliance issues due to a perceived history of bad acts.

Compliance

Enforcement Overview

It is hard to predict when and how cannabis regulations will be enforced. Long periods of lax enforcement can be followed by quick, decisive action. This issue is compounded by the fact that regulators in new jurisdictions are often overwhelmed with the process of setting up a new framework and lack the resources to uncover licensing issues. Enforcement is often political and varies dramatically across jurisdictions and over time. For example, in Massachusetts, where there are caps on how many licenses a single company can own, several publicly traded companies had commercial arrangements with more licenses than allowed by the state limitations. After the Boston Globe came out with a series of articles exposing these arrangements, regulators quickly began investigations that negatively impacted these companies’ share prices. Such a risk would have been difficult to determine during a diligence process.

Adding to the difficulty of sniffing out past and potential regulatory violations, not all states provide public information about licensing violations. Localities are also less likely to provide public information about licensing violations. For states and localities that do not publish violations, investors and acquirors will need to rely on disclosures from the companies themselves.

Due to the multiple challenges regarding identifying compliance issues, compliance diligence is often focused on the culture of compliance at a company. Almost all cannabis companies at this stage of the industry claim to take compliance seriously. However, this is often purely a marketing line. Cannabis compliance is exceptionally challenging due to the ever-shifting regulatory environment, the number of unique jurisdictions that any large company must consider, and the dynamic nature of the industry itself. Companies that take compliance seriously typically have some combination of the following:

• an internal compliance team that has a direct line to senior management;
• dedicated regulatory counsel that covers all relevant jurisdictions;
• internal or external compliance audits;
• lobbyists on retainer;
• an understanding of the common compliance issues that cannabis companies face; and
• a willingness to forego business opportunities in order to follow the law.

Ancillary Companies

Simply because a company does not hold a cannabis license does not mean that it does not need to worry about compliance with state cannabis rules and regulations. If an ancillary company works with or provides services to licensed businesses, it needs to avoid regulatory issues to prevent getting its licensed counterparties in trouble. Compliance is increasingly important for ancillary businesses as cannabis regulators expand their enforcement powers onto ancillary companies as well as licensees.

Products Liability and Vaping

With some notable exceptions, there have not been many product liability suits involving cannabis filed to date. However, as the cannabis industry expands, so too will litigation from consumers alleging injury from the use of cannabis products. A company’s response to the recent vaping crisis can provide insight into potential product liability risks in the future. A company that appropriately handles the vaping challenges is likely at lower risk of product liability claims in the future, though all cannabis and hemp companies face some risks. Under general principles of product liability law, if a product causes personal injury or harm to a person, anyone in the chain of distribution, including a seller, can be held liable for placing that product into the stream of commerce.

With respect to the recent vaping illness crisis, the following steps may be helpful in evaluating a target company’s risk of liability:

1. Consider whether any injuries or deaths have been linked to a company’s products. Most of the vaping fatalities are linked to products distributed by unlicensed illegal producers – it would be a very bad sign for a licensed company to be directly implicated in a vaping illness.
2. Consider whether the company has complied with the rapidly evolving state laws regarding vaporized products.
3. Review any company statements released in connection with the vaping crisis.
4. Consider whether the company has mechanisms in place to deal with a recall. A well-run company should have structures in place to respond to consumer compliances and potential product recalls.
5. Finally, consider whether a company has adequate insurance coverage in the event of product liability claims.

Insurance

Many cannabis and hemp businesses struggle to obtain adequate insurance coverage, as options are sparse and expensive. Many insurers simply will not write policies in the space, while other insurers have included standard policy exclusions that make coverage illusory (such as excluding Schedule I substances), and the costs of certain types of insurance (e.g., D&O coverage) are prohibitively high. Although there is still significant uncertainty, courts are trending away from enforcing policy exclusions that make coverage illusory, especially where an insurer has accepted premiums from an entity that it clearly knew was operating in the cannabis space. All cannabis company insurance policies should be carefully reviewed during the diligence process, especially the policy exclusions and coverage limits.

Real Estate

Traditional real estate due diligence takes on heightened importance in cannabis transactions due to the siting challenges faced by the industry. It can be exceptionally difficult to find a suitable location for a cannabis (and sometimes hemp) business due to set-back restrictions (e.g., the need to be a certain distance from schools), building code classifications, zoning restrictions, and associations and restrictive covenants. It should also be noted that numerous states prohibit the colocation of cannabis and hemp operations within the same facility.

On top of these challenges, it can be difficult to move a cannabis business’s location. Typically, regulatory approval is required to change the location of a licensed premise and new locations are in short supply in many instances. Some regulators further impose an obligation for a business to remain active for a license to stay in good standing, so being caught without a new location while having to move from a prior location can be an existential threat for a cannabis business.

It is, therefore, not enough to assume that a business won’t face siting risks simply because it has been operational for a period of time. There have been numerous instances where regulators have noticed an ongoing compliance issue long after it should have been caught. That is why real estate due diligence must include a review of any applicable application materials in addition to any ongoing operations. If a mistake was made in an application (e.g., the presence of a school was ignored) this can put the license in question at risk. In cases of leased real estate, it’s important to assess the relationship with the landlord and the regulatory compliance of any leases. As an example, cannabis leases that contain participation rent can constitute ownership, raising regulatory approval and suitability issues.

Banking Issues

Transparency

Given the difficulties of accessing banking services in the cannabis and hemp industries, it is important to verify the status of a company’s banking relationships. The principal issue to confirm is if the financial institutions servicing the company are fully aware of the nature of the business, as many cannabis and hemp businesses are not upfront with their bankers. Any company that has obtained a depository account through dishonest means is at greater risk of losing their bank or credit union account and finding themselves running a cash-only business.

Bank Secrecy Act Compliance

It is also advisable for investors to investigate a cannabis operator’s compliance with “BSA Expectations Regarding Marijuana-Related Businesses,” guidance issued in 2014 by the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of Treasury. Companies whose operations would be likely to implicate the guidance’s red flags will often have a difficult time obtaining and maintaining access to banking services.

Payment Processing

Investors should also take a hard look at any payment processing offered by a business. The branded credit card companies will not work with cannabis companies, and if dispensaries are taking payments from credit cards, it is generally a sign that fraud may be involved. This is less of a concern, however, for hemp business, which now have greater access to legitimate payment processing systems after the passage of the 2018 Farm Bill.

Cryptocurrency

Any exposure or use of cryptocurrencies should also be carefully vetted. While it is unfair to associate all digital currency use with illicit activity, there is a perception, reinforced by certain bad actors, that digital currencies are being used to launder money, divert revenue to criminal enterprises, and traffic illicit drugs. Many cryptocurrency companies are simply not acting in accordance with FinCEN’s guidance on cannabis banking, causing them to be non-compliant with the sole federal guidelines on cannabis banking.

Large Cash Payments

Finally, if a company has a history of making or accepting cash payments in excess of $10,000, it is important to understand if the required Form 8300s were filed. Any business which receives more than $10,000 in a single transaction, or in related transactions, must file a Form 8300 with the IRS within 15 days of receiving the money. Because there are significant civil and criminal penalties associated with failure to file a Form 8300, this can be a major hidden liability for cannabis companies with long operational histories.

Tax Issues

280E Exposure

Analysis of the 280E exposure of a cannabis company should be undertaken by tax lawyers and accountants, not by regulatory counsel. The relevant language in Section 280E of the IRS Tax Code 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) consists 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.”

However, despite this blanket prohibition on deductions and credits, the U.S. Supreme Court has determined that all taxpayers, even drug traffickers, should pay tax only on their gross income (which is gross receipts less the costs of goods sold (COGS)).

Current case law has not established a clear definition of COGS and many companies are taking aggressive positions that are vulnerable to audit. Another common tactic for companies dealing with the financing burden of 280E is using a management company to siphon off profit in a tax-efficient manner by claiming the management company, as a non-plant touching business, is not subject to 280E. Courts have not been open to this structure and have imposed 280E on management companies resulting in significant tax burdens.

Finally, many companies have taken other legal approaches to avoid the impact of 280E, including claiming the provision is unconstitutional. These arguments have not been persuasive to courts. And investors should not expect any future amnesty for past-due taxes even if the law changes. Note the recent bills introduced that would remove the impact of 280E do not include any changes that would result in forgiveness of past-due taxes.

State Tax Considerations

In addition to paying increased federal taxes, there are also cannabis-specific state taxes that can create issues. Failure to pay these taxes can present both hidden liabilities and licensing issues for a cannabis operator and investors, as regulators may decline to approve a change of ownership or renewal a license if back taxes are owed.

Hemp and CBD Operations

Federal and State Law

The 2014 Farm Bill and the state pilot programs enacted pursuant thereto currently govern hemp production in the United States. The 2014 Farm Bill authorizes the domestic cultivation of industrial hemp by permitting institutions of higher education or state departments of agriculture to cultivate industrial hemp for research purposes, notwithstanding the CSA or any other federal law, provided certain conditions are met. The scope of the 2014 Farm Bill is limited to cultivation that is:

• (a) for research purposes (inclusive of market research, which multiple federal agencies have confirmed includes commercial sales with a research purpose);
• (b) part of an “agricultural pilot program” or other agricultural or academic research; and
• (c) permitted by state law.

Further, “Industrial Hemp” is strictly defined in the 2014 Farm Bill as the plant Cannabis Sativa L., and any part of such plant, whether growing or not, with a delta-9 [THC] concentration of not more than 0.3 percent on a dry weight basis. Notwithstanding the recent passage of the 2018 Farm Bill, which provides a federally sanctioned regulatory structure for domestic hemp cultivation, the 2014 Farm Bill will remain authoritative until October 31, 2020, when the 2014 Farm Bill is repealed.

States take various approaches to implementing 2014 Farm Bill pilot programs. Many states only regulate cultivation, while others also regulate processing and handling. Additionally, some states regulate CBD solely under legal cannabis statutes, while others have passed laws specifically governing industrial hemp-derived CBD. Although the 2018 Farm Bill provides minimum federal standards for hemp production that states that wish to have a hemp program must implement to maintain primary regulatory authority over their hemp programs, states can adopt regulations that are more stringent than the 2018 Farm Bill minimum standards. Consequently, state regulatory regimes may continue to prohibit certain activities related to hemp, and some states will likely retain authority to prohibit or limit the production of hemp-derived CBD and/or its sale as a food additive.

Many states only regulate cultivation, while others also regulate processing and handling.

A hemp product introduced into interstate commerce is subject to regulation by the U.S. Food and Drug Administration (FDA), provided it meets the definition of an FDA-regulated article (e.g., food, dietary supplement, cosmetic, or drug). The FDA is responsible for ensuring public health and safety through regulation pursuant to its enforcement authority under the Federal Food, Drug, and Cosmetic Act (FD&C Act). Before a product may be lawfully marketed, the FD&C Act requires demonstration of the safety of uses of ingredients added to such products under provisions specific to each category.

While the 2018 Farm bill made no amendments to the FD&C Act, by removing hemp-derived CBD from the CSA, the 2018 Farm Bill provides avenues for research into hemp that may cause the FDA to evolve its stance on CBD in food or as a dietary supplement. In fact, in April 2019, then-commissioner of the FDA Scott Gottlieb, M.D., publicly indicated that the FDA was aware of the growing public interest in cannabis-derived products, and that the agency was considering how certain cannabis-derived compounds might be permitted in food or dietary supplements in the future. The FDA public hearings on products containing cannabis and cannabis-derived compounds, held May 31, 2019, represents a critical next step in the FDA’s continued evaluation of CBD.

Like the 2014 Farm Bill pilot programs, states have also taken various approaches to the sale of hemp-derived food products. Many states have adopted the Uniform State Food, Drug, and Cosmetic Act, which was created in 1984 by the Association of Food and Drug Officials (AFDO). The AFDO’s model Uniform Act includes a provision to automatically incorporate changes to the FD&C Act into state law. However, variation exists between state Food, Drug, and Cosmetic Acts both because not all states have adopted this provision, and because not all states have adopted the Uniform Act.

States that have adopted the Uniform Act, like California and Ohio, generally prohibit the addition of CBD to food or its marketing as a dietary supplement, due to the FDA’s position that the FD&C Act prohibits the marketing of CBD as a dietary supplement and the addition of CBD to food. However, in states that have implemented robust commercial industrial hemp programs, like Colorado, the production and sale of hemp-derived and CBD-containing consumable products is expressly permitted. State food and drug laws must be considered when determining whether hemp and hemp-derived CBD products can be sold in a state. It is, however, critical to note that compliance with state law does not affect the FDA’s determination as to a product’s compliance with federal law and cannot prevent FDA enforcement actions for violations of the FD&C Act.

Intermingling

When evaluating a hemp or CBD company, the first question should be whether that company also has any cannabis operations. Any intentional involvement with the cannabis industry in the United States, however minimal, implies the violation of federal law and the attendant risks. In addition to the risk of federal prosecution, a hemp or CBD company can face real practical issues around banking, 280E, insurance, and access to capital markets if it is viewed partially as a cannabis company.

Product Issues

As noted, the FDA has taken the clear position that CBD cannot lawfully be added to food or marketed as a dietary supplement. A company selling CBD-containing foods or marketing CBD as a dietary supplement cannot be fully compliant with U.S. federal law as interpreted by the agency; it can, at best, mitigate its risks. If it is critical for investors that a company be fully compliant with federal law, the range of hemp products that may be sold in interstate commerce will be extremely limited and should be restricted to certain cosmetic products, as well as foods, such as hulled hemp seed, hemp seed protein, and hemp seed oil, which are recognized as GRAS.

State Issues

A handful of states continue to regulate CBD as a controlled substance. Consequently, and although rarely enforced, there is a risk of criminal prosecution for the possession and sale of hemp-derived CBD products in these states. Other states have removed “industrial hemp” or “hemp” from the definition of “marijuana” under state law, but have either:

• (a) amended such definitions to only include “hemp” or “industrial hemp” that is possessed or handled by an approved grower or pilot registrant under a particular state hemp program or produced pursuant to the USDA-approved 2018 Farm Bill program;
• (b) allowed for the production of all types of CBD products
• (c) do not have law or policies restricting the types of CBD products that may be produced and sold; or
• (d) do not regulate the post-harvest processing and sale of CBD products.

It is, therefore, critical to understand the states where a hemp or CBD company is producing, selling, and transporting its products.

Source Rule

Due to the current hemp legal framework, it is critical to understand where a CBD company is obtaining the material it uses to extract its CBD. If a CBD company sources its product from cannabis and not hemp, or “hot” hemp (i.e., hemp that is testing above the .03% threshold) then the business is in violation of the CSA, making it as illegal as any cannabis company. A CBD company could also be sourcing its products from a state which does not permit such activities. Again, this would mean that a potentially legal activity was, in fact, violating state law and expose the acquiror or investor to potential criminal and/or civil penalties.

Marketing Issues

The easiest way for a CBD company to get into trouble with federal regulators, including the FDA and FTC, is to make unsubstantiated medical or therapeutic claims about its products. A review of marketing and labeling practices is quite technical, but the central goal should be to avoid making any claims that establish the products are intended for use as a “drug,” that the product is “intended to affect the structure or any function of the body of man,” or is “intended for use in the diagnosis, cure, mitigation, treatment, or prevention of disease.” Examples of problematic claims would include suggesting CBD will cure all anxiety problems and provide lasting relief to chronic pain. Additionally, regardless of the content of a given claim, it is critical that CBD companies have adequate evidence to substantiate all claims made in order to mitigate risk of deceptive advertising under the Federal Trade Commission Act.

License Issues

Unlike cannabis licensing regimes, which often have complex rules around changes of ownership, hemp licensing regimes tend to barely discuss ownership issues. Hemp regulators often prohibit transfers of licenses, while not prohibiting changes of ownership in the license holding entities. Hemp licenses, additionally, are usually much easier to obtain than cannabis licenses. It’s often not an impediment to a deal to have to obtain a new license for the post-investment entity. This is not the case, however, in all states, and similar analysis to structuring cannabis transactions should be undertaken in any transaction that involves hemp licenses.

Conclusion

Diligence on cannabis companies is a unique area of law and is a more involved process than the typical due diligence conducted on less regulated industries. In addition, the rules and regulations pertaining to cannabis and hemp companies are in considerable flux and investors should not assume they can replicate deals and deal structures from year to year. Each legislative session usually involves some material changes to a cannabis or hemp regulatory regime and new opportunities and threats are constantly emerging.