Risk Allocation in Cannabis Contracts

22 Nov Risk Allocation in Cannabis Contracts

One of the main reasons why I am such a vocal supporter of written cannabis contracts is allocation of risk and liabilities. Parties to a cannabis contract have a number of ways that they can allocate risks and liabilities that they just won’t have in a “handshake” deal. Today I’ll explore six of the top ways to allocate risk in a cannabis contract.

#1 Disclaimers

If you’ve ever read through a cannabis contract, there’s a good chance you’ve seen disclaimers of representations, warranties, or guarantees. By making a disclaimer, a party is refusing to make an express or implied warranty (promise) about a certain condition. If a seller sells a piece of equipment on an as-is basis and disclaims all warranties about the product, then if the product does not perform as desired, the buyer may not have recourse (except for warranties that can’t be disclaimed by law). Without the disclaimer, there may be implied warranties that give the buyer recourse against the seller.

Disclaimers can be general, such as a disclaimer of any warranty not specifically made in the contract. Even more generally, “as-is” language can serve as a disclaimer of sorts (i.e., “buyer acquires the asset as-is, with all faults, and without any warranty from seller”). They can also be specific, such as a specific disclaimer of the implied warranty of merchantability. In many cases, you’ll see both the general disclaimer, followed by non-exclusive carveouts of warranties.

A savvy counterparty will often push back against one-sided disclaimers. In most cannabis contracts where cannabis products are transferred (intellectual property licenses, white label contracts, distribution agreements, manufacturing agreements, supply agreements, etc.), the buyer or transferee will insist that the manufacturer/supplier/seller makes certain representations explicitly, such as that the products will be fit for human consumption, comply with applicable laws, and so on. I see lots of negotiation around these provisions, as they can make or break a cannabis contract.

#2 Assumption of Risks

Cannabis contracts can also force certain parties to assume specific risks. Risk assumption comes up frequently in contracts with percentage splits. Imagine a cannabis distribution contract where a distributor agrees to sell a manufacturer’s products in exchange for 15% of the profits. Usually, when the distributor sells the goods and is paid, it pockets its cut and remits the rest to the manufacturer.

These kinds of arrangements involve some deal of trust by the manufacturer – trust that the distributor will sell the goods, will sell them at the desired purchase price, will promptly collect payment, and will promptly remit payment. Most of this can be dealt with in a contract. However, the first part – making promises about sales levels – obviously is a risk for many distributors.

I have seen plenty of cannabis contracts like this where one party assumes the risk that some of the above things will not happen right. For example, if the distributor has to buy the cannabis goods from the manufacturer, it will assume the risk that it won’t resell the goods. If the contract is a consignment arrangement, the manufacturer may take the financial hit if the manufacturer can’t sell the goods.

Often, risk assumption is not expressed affirmatively but happens by virtue of assignment of specific obligations to a specific party, or even through warranty disclaimers as noted above. To really do a good job here, the parties will need to think of every step in performance of the contract, what could go wrong at each step, and who should be on the hook if/when things do go south. I’ve been writing these kinds of cannabis contracts consistently for more than five years now and can tell you that there are tons of blind spots that can lead to massive financial hurt if parties don’t consider these impacts early on.

#3 Risk of Loss/Title

Related to the last point, in purchase and sale or commercial-type contracts where products are sold or transported from one party to another, the concepts of risk of loss and transfer of title are immensely important. Our firm does a lot of international work and has seen first-hand the massive adverse impacts of failure to address these provisions in international shipping. But because cannabis deals don’t involve international (or even interstate) shipment, cannabis companies overlook these basic concepts, often to their downfall. I’ll go over why they are important now.

First, let’s talk title. Title to a good means ownership of that good. One can hold title to a good without being in possession of that good. If you lend your friend your phone, your friend possesses the phone but doesn’t hold title to it (you do). In some distribution contexts, the manufacturer may hold title to the good, while the distributor transports it to a retailer. This is consignment. In the consignment cannabis contract, the manufacturer will sell the good directly to the retailer, at which point title will transfer from the manufacturer to the retailer. The distributor will never hold legal title, will only possess the good while performing services, and will generally be paid as a service provider. Keep in mind that the parties can negotiate a different transfer of title, i.e., upon pickup by the distributor.

Second, let’s talk risk of loss. This just refers to who bears responsibility if a good is stolen, damaged, destroyed, lost, etc. In the foregoing example, let’s assume that the manufacturer and retailer sign a sales agreement before the distributor picks up the good for transport. The manufacturer may want risk of loss to transfer to the retailer upon the distributor’s pickup, whereas the retailer will want risk of loss to transfer upon delivery. The reason for this should be clear – neither party will want to bear the risk that the distributor loses the good. But, somebody will have to. One way to address this is to pick a time to allocate risk of loss between manufacturer and retailer, and separately have distributor bear responsibility in the distribution contract.

Third, let’s talk about acceptance and rejection. These concepts are not the same as risk of loss and transfer of title, but often are mixed in and/or in the same part of the contract. In the example I’ve used, when the retailer receives the goods, it will have some fixed period of time (say 48 hours) to inspect the goods, and will be able to reject the goods for a specific set of reasons within that period. Title and risk of loss likely would already have transferred to the retailer, but upon rejection, the goods will be returned to the manufacturer.

As you can imagine, there are endless possibilities of ways to allocate risks and liabilities in the context of risk of loss and title. Inspection and rejection adds far more criteria. Cannabis contracts that are silent on these provisions are just begging to wind up in litigation.

#4 Indemnification

I explained indemnification in an earlier post, which I’ll quote here:

If you’re not familiar with indemnification, let’s go back to the purchase example. Say a retailer purchases edibles from a manufacturer, and customers get sick when they eat the edibles. And say those customers sue the retailer. The retailer didn’t make the edibles, so it would want the manufacturer to foot the bill for its defense and any damages that are awarded. This is called “indemnification.”

Here’s another example: Party A licenses its trademarks to Party B, a manufacturer and distributor, to make and sell branded goods. Party C decides that it is the real owner of these trademarks and sues Party B. Party B is going to be upset because it did not intend to infringe Party C’s trademarks and was probably promised in the cannabis contract that Party A actually owned the goods. With a good IP indemnification clause, Party B can force Party A to engage defense counsel and pay any costs associated with Party B’s defense.

Nobody wants to get hauled into court because the other party to a cannabis contract did something wrong. Indemnification is the gold standard for dealing with risks caused by a contracting party.

#5 Limitations of Liability

I also explained these clauses in my earlier post:

If you’ve ever looked at a written contract, you’ve probably seen a provision about halfway through in all caps with a heading that reads, “LIMITATION OF LIABILITY.” As the name suggests, these provisions are intended to narrow or eliminate liabilities of one or both parties. They generally include provisions that carve out things like consequential and incidental damages (i.e., damages that are not a direct result of a breach) and punitive damages (i.e., damages that are intended to punish a wrongdoer). But limitations of liability may also place caps on one or both parties’ damages, which can be a big advantage in a dispute.

Generally speaking, contract disputes do not lead to punitive damages, which are damages that are intended to punish a wrongdoer. These are usually reserved for certain “torts” like battery, interference with a third-party contract, etc. Some cases may involve both contract and tort claims where punitive damages may be on the table. A carefully crafted limitation of liability clause in a cannabis contract may be able to touch on both (depending on applicable state law).

That said, even if punitive damages are not available in contract disputes, incidental and consequential damages may be on the table, though they are often hard to get. Imagine that a cannabis company has a water leak and hires a plumber to fix it. The plumber does not perform work in accordance with the contract and the business floods overnight. The business is forced to shut down for a week and loses tens of thousands of revenues. The direct damages in the dispute will be fixing the negligent repair and maybe even some of the damage to the premises. The incidental and consequential damages may be the loss of revenue. While again, this can be hard to prove, it is very easy to disclaim those types of damages in a written contract so as to never need to worry about complex battles over damages.

#6 Caps

Caps are also a great way to shift risks. Caps can be used in all sorts of contexts. Limitation of liability clauses may have caps on damages in addition to damage carve outs. For example, a distribution contract may provide that except for certain cases of willful misconduct, the distributor’s maximum liability to the manufacturer may be the amounts paid by the manufacturer to the distributor in X period of time.

Indemnification provisions also often have caps. This comes up a lot when buying and selling businesses or business assets – and it’s usually the seller that pushes for them. Imagine selling a business for $750,000. If indemnification clauses are unlimited, and a dispute arises that requires seller-side indemnification, the seller may end up paying the buyer more than it was paid for the business. So as you can imagine, sellers will often push to cap indemnification at some percentage of the purchase price. In my experience in non-cannabis deals, the percentage is often relatively low. In cannabis deals, I often see a much higher percentage. That tends to be due to the fact that there are often (not always) many more potential issues for buying a cannabis business than most other kinds of businesses.

As an aside, M&A transactions sometimes also include deductibles as well. In those cases, a party seeking indemnification won’t be entitled to indemnification unless it has some minimum threshold of losses. If that number is $50,000, and the buyer seeking indemnification only had $40,000 in damages, it won’t be indemnified. Once it hits that $50,000 mark, it can either (depending on the cannabis contract’s terms) be indemnified for the entire basket of damages, or only for what’s over the $50,000 mark.

Parties to cannabis contracts have myriad tools at their disposal when it comes to shifting risks and liabilities. Of course, this can really only be done well in a written contract.