When litigating a cannabis case, an understanding of the playing field is important.
It is a mistake to assume a cannabis business operates like any other business. In some respects, it does. They have gross sales revenue, costs of goods sold (COGS), gross profit, labor costs, operating expenses, net profit and taxable income, etc. They need key performance indicators (KPIs) and standard operating procedures (SOPs). They need to procure licenses, file local, state and federal taxes. A cannabis business can be organized at the state level using the operating vehicle of choice, partnership, LLC or corporation, and produces financial statements that look similar other businesses.
That’s where the similarity ends. A cannabis business may look like any other business, but it’s not. Below is a summary of the unique challenges that face cannabis businesses that inevitably impact or are a contributing factor in the cannabis litigation landscape.
Regulations
Cannabis business operations are burdened with regulations that would normally apply to life threatening activities like brain surgery, new medicines and handling enriched uranium. High compliance costs and higher penalties for non-compliance create an administrative burden on cannabis operators few can understand. Compliance is exceedingly time consuming.
When preparing to prosecute a lost profits litigation case on behalf of non-public cannabis operator, lead counsel may discover staffing levels at their client are insufficient to gather the needed documentation and evidence to support the legal task at hand.
Be prepared to roll up your sleeves when gathering and organizing evidence. Compliance is mandated by the states, so operators are loath to assign this staff to support the lawsuit. Additionally, they don’t want their employees to know any details. This is a delicate matter that must be handled discretely. Consider allocating a budget to research and gather new evidence to support the litigation team.
High Taxes
Cannabis businesses are burdened with high taxes at the local, state and federal level. No other business in the country has a similar tax burden. Additionally, under IRS Regulation 280e, cannabis businesses cannot take the standard tax deductions for operating expenses. According to Viridian Capital, the 280e tax burden can be as large as 30% of the gross income of the cannabis enterprise.
This means cash flow may be significantly impacted, if not impaired. Low cash flow impacts the operating decisions of principals and investors differently and limits the range of settlement opportunities to be considered. Low cash flow could very well impact a cannabis operators’ ability or the investor’s willingness to fund litigation.
Low cash flow may endanger ongoing payment to the law firm considering taking the case. Also consider that the books and records will likely not be as accurate or thorough as similar non-cannabis businesses. Less availability and less accuracy mean more work for the legal team gathering financial records to build a solid damages case.
Black Market Competition
Cannabis businesses must compete with black market operators that still control 65% of the market and have none of the costs of compliance, taxation or licensing. This alone is putting extreme pressure on the retail MSRP for all products at cannabis dispensaries.
Except in unique situations, room for price expansion is limited. Everyone in the cannabis sector feels the margin squeeze. This is not to say that there aren’t elite brands, but the black market puts downward pressure on retail MSRP across the board, while high regulations and taxation limit the ability of compliant operators to drive costs down. It is an unhappy position for cannabis operators to be caught between two immovable market forces. The result is shrinking profit margins.
Bankruptcy Limitations
Cannabis businesses cannot file for bankruptcy and therefore have no legal mechanism to modify or change any investor terms or debt obligations, except mutual agreement.
In representing investors for breach of contract, this fact may at first seem to benefit the investor, but in my experience it doesn’t. The fate of both the investor and operator are handcuffed together in a high-pressure situation with few good options. If the investors play hard ball, the operator may retreat into secrecy and non-responsiveness. Operators may further be tempted to revert to “non-compliant” revenue streams, i.e., selling out the back door under the radar of the Metrc tracking system. Cash may be king, but investors don’t want to see it diverted away from the company while simultaneously reluctant to accept it as a form of payment.
Investors may come to understand that their choice may be as simple as agreeing to a reorganization as a better alternative to dissolving the company. They want accurate financial data to consider the possible choices. Getting transparent financial information in an investor dispute might be optimistic. Diplomacy is advised.
Banking & Lending Access
Cannabis businesses do not have access to traditional banking services and lending.
No growth capital; no growth. It’s that simple. When compressed margins shrink cash flow, growth and opportunity shrink as well. Any loans that have been made to the cannabis company will likely carry interest rates and terms that many would view as draconian. These loans typically include rights to future cash flows and/or the premises housing the cannabis operation and are potentially an unavoidable liability.
On the plus side, if your client is the lender with a lien on future cash flows or the operating premises, then chances of a resolution increase if everyone can remain cool, calm . . . and honest.
Successful cannabis businesses have been forced to grow their business out of free cash flow and have mercifully avoided the need to take on excessive debt. Operators who made the decision to leverage up hoping for future revenues, often end up as patients in the litigation emergency room.
Public Stock Exchanges
Cannabis businesses cannot be listed on the public stock exchanges in the United States. Currently, there is not a robust market to sell a cannabis business at any level of premium.
The lack of a liquid merger and acquisition marketplace and non-available public stock exchanges forces operators and investors to look at cash flow as their primary option for repayment and/or growth. Investors who have lost patience are not interested in growth, so the fight becomes the allocation of cash flow between operations versus investor repayment. This tug of war severely limits the options to both operator and investor when embroiled in a dispute. The operator may react more like a cornered animal than a calm business professional, which further dampens the probability of equitable resolution.
Market Data
There is scant public information available about cannabis operating metrics. Sales revenue is available from multiple Point-of-Sale (POS) vendors, but this data is quite expensive and typically used by retailers for pricing data on their portfolio of products and on competitors. This data may or may not support the legal points needed. Reporting to Dun & Bradstreet is sporadic and unreliable. Data on comparable companies may not exist to meet the California requirements of the Sargon Enterprises precedent.
This has a major impact on any case where economic damage or lost profits are involved. Often there isn’t available or public market data to compare to the client’s cannabis company making it more difficult for the legal team and the expert witness to justify and explain his or her findings. It’s not impossible to find the data needed to support a lost profit damage claim, but – be forewarned – funds need to be allocated up front to pay for this data from the few vendors who have it. A budget of $6,000 to $10,000 is not unusual depending on the length of time in question and the scope of the data needed.
As evidence is gathered and organized, the case theory often evolves based on the veracity and relevance of the evidence. In some cases, it is possible to reverse engineer existing data to support a beneficial position. Often discovery can lead to exploring alternative avenues to secure admissible evidence that wasn’t readily apparent or traditional. The role of a consulting cannabis expert witness in this process is to map out the interconnections between all the starting evidence and seek to fill in the weak or missing areas to buttress the case.
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Cannabis litigation can be more daunting than traditional business litigation. Most judges and juries know very little about the actual conditions on the ground for cannabis operators, the regulations or industry standards, and the industry culture and protocols. The litigation team must work extra hard to overcome “Cheech and Chong” stereotypes.
An experienced cannabis litigation expert witness can help with discovery, organizing and prioritizing evidence, with planning and strategy, with evaluating the strength of evidence, with evaluating the actions and motivations of the parties and with an overall understanding of the operating conditions in and around the cannabis business. All this context is woven into the narrative of a report supported by the facts, circumstances and evidence.
