This and future articles will focus on prominent business, intellectual property and litigation issues for those operating in, or looking to enter, the legal cannabis market.
2018 was a massive year for the legal cannabis industry in California and across the US. In January, California legalized recreational cannabis use, and is now one of 31 states permitting recreational and/or medicinal cannabis. Many thought and still perceive the industry as a potential gold mine for business opportunities, but the realities of regulation (including taxation) and increasing competition have forced many to reassess business strategies, goals and projections. In the face of these challenges, it’s imperative that cannabis firms know the laws, requirements, risks, and opportunities.
Growth of Investment and Partnership Opportunities
The Cannabis market was estimated at $8.3 Billion in 2017 and projected to grow to $25 Billion by 2025. Beyond the numerous grassroots-level startups and entrants into the cannabis market, 2018 saw larger, more established businesses begin to explore the market. Brands like Heineken and Coca-Cola partnered with dedicated cannabis companies in 2018, and it seems like only a matter of time before more big market players get in on the cannabis wave.
Entrants to the market aren’t just taking the operational approach either—cannabis both in the US and Canada has seen a surge in investment over the last year, as hedge funds, venture capitalists, and other investors look to benefit from successes in the industry. Pitchbook reports that 2018 saw over $880 million invested in the cannabis space (a new high for the market), and with close to $100 million already invested before the end of January, this trend seems like a solid bet to continue.
Intellectual Property: Challenges as Protection Begins in Earnest
As the legal market grows, so does the level of competition- and one of the most valuable assets for cannabis business is intellectual property. As a result, protecting brands against infringement and dilution is critical; however, the continuing federal illegality of marijuana severely inhibits effective trademark protection. That is, legal operators cannot register trademarks relating to marijuana activities with the United State Patent and Trademark Office, and thus cannot enjoy the benefit of nationwide federal protection for their brand. State registration remains a possibility, as do other common law rights that a company might accrue, but such protection is a weak substitute for federal registration and leaves companies open to infringement from competitors in other states.
Some businesses have successfully enforced their state trademark rights across state lines through licensing agreements (most notably in the 2018 Court of Appeals of Washington case Headspace International, Llc v. Podworks Corp.). Licensing may be more of a key issue going forward for certain California firms engaged in “white labeling” practices. White labeling, the practice of self-branding products made by a different manufacturer/distributor, will require strict compliance with new state licensing and other regulatory hurdles for California cannabis businesses—previously, companies had been able to skirt licensing requirements by avoiding steps in the business process through changing product labels.
Regulations, Bumpy Implementation, and Operational Impacts
Legalization has resulted in a complex regulatory framework governed by a licensing system for all aspects of industry operations including cultivation, manufacturing, retail, distribution, and so on. This licensing system is mandated by the state, which then looks to local cities and municipalities to create their specific rules and regulations within the licensing framework. Hence, if you want to operate a cannabis business, you need to first identify the local rules and regulations, and in many instances obtain local permit/license, and then seek state license approval.
Complicated regulatory differences between jurisdictions and the staggered roll-out and implementation of the new laws have significantly disrupted business plans and revenue projections. Today, all marijuana products needed to comply with strict lab testing rules regarding pesticides, impurities, potency, etc., as well as abide by specific packaging and labeling requirements. Business finance within the industry has also been impacted by heightened disclosure requirements for owners, landlords, and other industry stakeholders. With California Prop 64’s cultivation and excise taxes on cannabis, as well as numerous other state and local sales tax on marijuana, legal cannabis businesses are more challenged to maintain profit margins. A potential consequence is that untaxed, unregulated illegal operators will continue and thrive, generating unintended competition for law-abiding businesses. In any event, licensed operators must meet all state and local standards to avoid the risk of enforcement actions by authorities.
The cannabis industry continues to rapidly evolve going into 2019.
Increased Regulations: New and Changing Transparency and Disclosure Obligations for Investors and Operators
California has already announced more regulation to come into effect in 2019, with laws covering everything from restrictions on internet advertising to minors, and Prop 65’s new warning requirements for cannabis smoke in products and businesses, to new rules regarding veterinarians and cannabis for pets. One certainty is that the CA state rules mandate public disclosure of information, as the state’s ultimate aim is greater transparency to push out shadow operators. However, statutory definitions of “owners,” “managers,” and “financial interest holders” are rife with ambiguity, and the rules continue to evolve. Private business deal terms such as economic interests, equity interests, and royalty arrangements must all be disclosed. Even consultants providing services in exchange for profit interests may fall within the definitions of owners or financial interest holders, and have to be disclosed.
Increasing Litigation: Government Enforcement and Private Party Disputes
While most of the government and law enforcement focus to date has been on creation and implementation of licensing regulations, state and local officials will soon inevitably turn their focus towards compliance and enforcement. Firms must be ready to address potential governmental investigations and actions by local, state, and federal agencies.
The next few years will also undoubtedly feature more disputes between private parties. As businesses and their competitors face inevitable challenges, disputes will arise between competitors, investors, partners, customers, or all of these at once. Competitors may challenge branding and intellectual property, investors and partners may engage in disputes over disclosures, business practices, or partnership agreements, or customers may initiate lawsuits based on products liability, among other things.
Thus, operating with an eye towards avoiding and overcoming potential disputes can impact all areas of a business. Cannabis companies especially, due to the rapidly changing marketplace, need to be prepared with agreements that detail their relationships and liabilities with their investors, ownership, vendors, and customers. And when litigation is unavoidable, owners need to be ready to fight.
Intellectual Property Trends: Non-Tradition and Creative Protection Strategies
Since the market is so heavily influenced by innovators and entrepreneurs, intellectual property protection will be even more critical for businesses, not only to protect against competitors, but also to attract financing and facilitate growth.
A structured intellectual property plan can signal to current and potential investors the company is on the right track and able to effectively protect against copycat competitors. Trade secret protection for cannabis companies’ plant strains, proprietary systems and processes, recipes is a viable option but it requires attention to detail to ensure that the protection remains legally enforceable. State and common-law trademark protection is available for cannabis brands, but the federal prohibition continues to hinder abilities to protect against infringement. The result is a questionable and seemingly wide-spread practice of applying for trademark for ancillary goods (non-plant touching) in a way that some define as “trademark laundering.”
More cannabis research labs than ever before are now being federally approved, and it may be only a matter of time before cannabis is legalized at the highest level across the US. Once this happens, whether in 2019 or years down the road, there is sure to be a massive rush on nationwide registration for cannabis firms; however, there are steps that cannabis companies can take now to improve their chances of getting that coveted federal recognition.
We will cover many of these challenges and opportunities for industry stakeholders in more depth in subsequent articles including crucial intellectual property strategies for businesses in an increasingly competitive market. When disputes do inevitably arise, litigation isn’t always the answer, but in many cases, it’s unavoidable. We will discuss specific steps businesses can take to mitigate, deter and manage disputes. Of course, all of this starts with sound operating choices. 2018 was big, but 2019 stands to be an even bigger and more pivotal year for the growing cannabis industry, and as the industry matures, cannabis businesses will need to grow and mature with it.