New California Cannabis Regulations Create Uncertainty For Corporate Owners

On October 19, 2018 California’s three state cannabis licensing authorities published proposed changes to the forthcoming state rules governing the cannabis industry.  While there are numerous revisions that will impact operators, one provision of the changes stands out for investors in the cannabis space.

Previous iterations of the cannabis regulations required limited disclosure of merely the identity of all persons that hold a “financial interest” in a cannabis licensee as part of the license application process, along with a government ID number.  That is still the case.  However, only a subset of persons with a financial interest are considered “owners,” and had to submit additional information including other cannabis investments and criminal history during the application process.  Those provisions too largely remain in place in the latest version.

However, earlier drafts of the regulations (§5003(c)) provided clear guidance that where an entity was an owner of a cannabis business, only a person that held a 20% or greater investment in the entity, and the chief executive officer and/or members of the board of directors of the entity, would also be considered “owners” of the cannabis business.  Other investors in the entity would not be “owners” in the licensing application process.  Indeed, the term “owner” is generally defined under California’s Business and Professions Code – which the cannabis regulations reference as the standard for an “owner” – as those that own at least 20% of a business.  The updated cannabis regulations also add a specific reference to an individual entitled to a share of 20% of the profits in a commercial cannabis business as an owner.  Such a limitation was clear and easy to abide by.

Significantly though, the revised rules appear to threaten to entirely pierce the corporate veil on cannabis entity investors that do not otherwise meet the 20% threshold or definition of an owner.  The revised §5003(c) now provides:

When an entity is an owner in a commercial cannabis business, all entities and individuals with a financial interest in the entity shall be disclosed to the Bureau and may be considered owners of the commercial cannabis business. For example, this includes all entities in a multilayer business structure, as well as the chief executive officer, members of the board of directors, partners, trustees and all persons that have control of a trust, and managing members or non-member managers of the entity. Each entity disclosed as having a financial interest must disclose the identities of persons holding financial interests until only individuals remain.

Proposed Regulation § 5003(c) (emphasis added).  Thus, apparently even a 1% owner of an LLC that holds a 20% or greater interest in a cannabis business “may be” considered an “owner” for purposes of licensure, and thus “may be” required to submit the full background information required of those that clearly meet the definitions of owners, rather than simply being listed as having a “financial interest” in the entity.  There are no criteria expressed for when someone would definitively be considered an owner.

The pending rules also specifically add in several other parties as having a “financial interest” in a commercial cannabis business, including employees with profit-sharing plans; landlords whose lease agreements provide for a share of profits; consultants, accountants, attorneys or brokers that accept a share of profits as payments; and salespersons who earn commissions.  These are not, however, declared to be “owners.”

There are just a few exceptions from the requirements that all persons with a financial interest be listed on a licensure application in a subsequent section (§ 5004(d)). That provision existed in the prior version of the regulation and exempts banks that made loans; investors in a mutual fund, blind trust or similar instrument; holders of security interest, liens, or encumbrances on property; and holders of less than 5% of a public company.  However, there are no minimums on the ownership percentages in private companies, for example, that would provide an exemption from being listed in the application for even the smallest investor – or from potentially being considered an owner.

The proposed rule changes are open for comment through November 5, 2018 at 5 p.m.

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