California Cannabis Owners and FIHs Get New Treatment Under DCC Emergency Cannabis Regulations

20 Sep California Cannabis Owners and FIHs Get New Treatment Under DCC Emergency Cannabis Regulations

I’ve preached before on the blog about how often our firm gets pulled into M&A deals where the parties have screwed up reporting the transaction to cannabis regulators on both the state and local levels. In California, in particular, changes of ownership have been a painful affair where the Bureau of Cannabis Control (“BCC”) routinely has changed its position around when a complete change of ownership (in violation of the regulations) has occurred.

As we previously wrote, the Department of Cannabis Control (“DCC”–the new sheriff in town regarding all things California cannabis) recently proposed emergency regulations that, among other things, create some much needed technical fixes to the state’s cannabis licensing program. Public comments on these regulations are due by today, September 20 (!), but the reality is very likely that these rules will be adopted as-is with some very interesting “Final Statement of Reasons” to follow from the DCC in the event these emergency rules become permanent.

Back to changes of ownership. Part of the previous issue with the BCC was identifying “owners” versus “financial interest holders” in the first place. The previous definitions of both terms were somewhat vague and hardly detailed by practical example in many cases. Now, the DCC is proposing the following changes:

An owner of the commercial cannabis business includes all of the following:

A person with an aggregate ownership interest of 20 percent or more in the person applying for a license or a licensee commercial cannabis business, unless the interest is solely a security, lien, or encumbrance. . . . “[A]ggregate” means the total ownership interest held through an entity. For example, an individual owning 50% of an entity that owns 50% of the cannabis business would have a 25% aggregate ownership interest in the cannabis business.

An individual who manages, directs, or controls the operations of the commercial cannabis business, including but not limited to:

(A) A member of the board of directors of a nonprofit.
(B) A general partner of a commercial cannabis business that is organized as a partnership.
(C) A non-member manager or managing member of a commercial cannabis business that is organized as a limited liability company.
(D) The trustee(s) and all persons who have control of the trust and/or the commercial cannabis business that is held in trust.
(E) An individual with the authority to provide strategic direction and oversight for the overall operations of the commercial cannabis business, such as the chief executive officer, president or their equivalent, or an officer, director, vice president, general manger or their equivalent.
(F) An individual with the authority to execute contracts on behalf of the commercial
cannabis business.

If the commercial cannabis business is owned in whole or in part by an entity and the entity includes individuals who manage, direct, or control the operations of the commercial cannabis business . . . those individuals shall also be disclosed as owners. The [DCC] may determine, on a case-by-case basis, that additional individuals have the ability to manage, direct, or control the commercial cannabis business and meet the criteria of an owner. Upon notification by the [DCC], the applicant or licensee must disclose the individual as an owner and submit the information required by [law] or demonstrate that the individual does not qualify as an owner.

And for FIHs, the DCC is proposing the following language:

A financial interest holder of the commercial cannabis business includes all of the following:

(1) A person with an aggregate ownership interest of less than 20 percent [with certain exceptions below].
(2) A person providing a loan to the commercial cannabis business [with certain exceptions below].
(3) A person that contracts with the cannabis business to cultivate, manufacture, package, or label cannabis or cannabis products under that person’s brand name.
(4) A person entitled to receive 10 percent or more of the profits of the commercial
cannabis business, including: (A) An employee who has entered into a profit share plan with the commercial cannabis business. (B) A landlord who has entered into a lease agreement with the commercial cannabis business for a share of the profits. (C) A consultant who is providing services to the commercial cannabis business for a share of the profits. (D) A person acting as an agent, such as an accountant or attorney, for the commercial cannabis business for a share of the profits. (E) A broker who is engaging in activities for the commercial cannabis business for a share of the profits. (F) A salesperson who earns a commission.

And under the DCC emergency regulations:

“Financial interest holders do not include any of the following: (1) A bank or financial institution whose interest constitutes a loan; (2) Persons whose only financial interest in the commercial cannabis business is through an interest in a diversified mutual fund, blind trust, or similar instrument; (3) Persons whose only financial interest is a security interest, lien, or encumbrance on property that will be used by the commercial cannabis business; and (4) Persons who hold a share of stock that is less than 10 percent of the total shares in a publicly traded or privately held company.”

The biggest impact of these changes are that the definition of owner is significantly expanded to include “owners” by aggregate ownership of more than 20%, trustees and those in control of trusts that own cannabis businesses, and those individuals or entities vested with authority on behalf of the cannabis company to undertake “strategic direction and oversight for overall operations”, or that can execute agreements on behalf of the company.

These last two criteria are incredibly broad and are likely to be massive disclosure headaches for California cannabis companies. Now, even minor employees with the power to execute any kind of “agreement” for the company could be deemed “owners” that need to be vetted and background checked by the state. And for FIHs, the new practical impact would be the removal of any question that IP licensing and white labeling arrangements with unlicensed parties must be disclosed to the DCC (as opposed to the previous confusion around that topic caused by the BCC).

The upside, however, is that individuals and businesses holding 10% or less (rather than the previous 5% threshold) in publicly traded or privately held companies don’t need to be disclosed at all. Note also that the DCC isn’t including a definition of “profits”, and if it’s carrying over the BCC’s reasoning here, disclosure doesn’t hinge on a party’s receipt of net or gross profits or even profits from individual sales of products– it all counts for FIH disclosure.

Notably, the change of ownership regulations weren’t changed by the DCC (except that they now apply across the board regarding all license types). All California cannabis companies have 14 days from the effective date of the change to report the transaction and get the new owners vetted. If all owners are departing the business, the business has to get a new license. And so long as one of the original owners remains an owner post-closing, the business can continue to operate with its existing license while the new owners are checked out by the state.

The question remains then whether “ownership” will mean both equity or the ability to exercise management, direction, or control, or whether the DCC will interpret changes of ownership only based on equity changing hands; meaning, even if an original owner remains an officer of the company post-closing (for example), but none of the original owners have any equity in the company anymore, the DCC will take the position that a complete change of ownership has occurred and a new license is therefore required. The BCC was all over the map on that one, wreaking havoc on business acquisitions.

In any event, we’ll continue to write about California cannabis M&A and will share what we learn from the DCC as it makes its way through cannabis ownership transitions under the new owner and FIH definitions, assuming these are adopted. Stay tuned!