Medical Marijuana Franchising:
A Half-Baked or Fully Baked Plan?

Vol. 15, No. 3

By

W. Michael Garner, P.A.

I. Introduction

Over twenty years ago the federal government nearly transferred marijuana from Schedule I to Schedule II, which would have made it legal under federal law for doctors to prescribe marijuana for various medical purposes. In the Matter of Marijuana Rescheduling Petition, Docket No. 86-22, U.S. Department of Justice, Drug Enforcement Administration (1988). However, the Administrator of the DEA did not follow Administrative Law Judge Young’s recommendation in the rescheduling case to transfer marijuana from Schedule I to Schedule II, meaning that, under federal law, it is still illegal for doctors to prescribe marijuana and for individuals (even patients with prescriptions) to manufacture, distribute, dispense, or possess it. See Seeley v. State, 132 Wash. 2d 776, 797 (Wash. 1997) (providing a historical analysis of the issue). Nonetheless, many states have legalized medical marijuana, leading to the formation of a new industry that has caught the attention of even some people in the franchising community. But is franchising such a concept a good idea or even feasible? This article will address some of the business and legal risks present in this unique industry.

II. Marijuana-Based Franchising Thus Far

Estimates of the marijuana industry’s value range between $10 billion and $120 billion a year. Ariel Nelson, How Big is the Marijuana Market?, CNBC: Marijuana & Money: A CNBC Special Report (April 20, 2010), http://www.cnbc.com/id/36179677. With such a large amount of money at stake, it was only a matter of time before businesses began considering the use of franchise business models in the industry.

Some franchisors have entered the market very indirectly, using the idea of marijuana as a marketing tool. Cheba Hut, for example, has established a sub shop franchise that sells subs named after marijuana-related products, including a 12-inch sub, known as a “blunt” size sub.

Other franchises, however, are entering the marijuana market more directly. WeGrow, for example, does not dispense marijuana but, instead, offers a hydroponics business concept in which franchisees sell equipment that others can use to grow marijuana. Hydroponics stores themselves are not uncommon, but weGrow’s version is: “As more individuals decide to join collectives, become caretakers or grow their own medicine, they all need to purchase their grow equipment from a hydroponics store, and that’s why medical marijuana cultivators represent a significant revenue source for our business. We’re just the first to admit it.” weGrow Enterprises, Inc., Franchise Information Packet at 8, http://www.myvirtualpaper.com/doc/vretail_demo/wegrow/2011051701/8.html#1 (emphasis added). WeGrow hydroponics stores will not hide the fact that their customers are looking for equipment to grow medical marijuana. As weGrow’s first franchisee in Arizona stated, “We’re not talking tomatoes.” Marijuana Hydroponics Superstore, weGrow, Opens First Franchise in Arizona on June 1, PRWeb (May 31, 2011), http://www.prweb.com/releases/2011/5/prweb8504866.htm. WeGrow has since opened a store in Washington, D.C., on March 30, 2012. Given the tension between federal law and D.C. law, this is something of an ironic location for a weGrow store, but the franchisee sees a business opportunity and a way to “lend a hand in this [medical marijuana] movement.” Ryan Sullivan, “Walmart of Weed” Opens First Store in Washington, DC, MyFox8.com (March 30, 2012), http://myfox8.com/2012/03/30/walmart-of-weed-opening-first-store-in-washington-dc/.

Finally, and most directly, Cannabis Medical Technology appears to be the first franchisor to venture into dispensing marijuana through franchised outlets. Cannabis Medical Technology offers more than 27 organic cannabis strains, including Jilly Bean, Purple Avalanche, and Rocky Mountain High. Sean Kelly, Growing Franchises: Pipe Dreams and Organic Sleep Sites, Franchise Times, Aug. 2011, at 61-62. Cannabis Medical Technology was in the process of selling its first franchise in August 2011. Id.

III. Potential for Franchising in the Medical Marijuana Industry

Before considering the legal issues and business risks associated with a medical marijuana-related business, a franchise lawyer when conferring with a client should ask if this is an industry that is amenable to a franchising model. The medical marijuana industry may be ripe for franchising for the following reasons:

  • A franchisor’s potential ability to guide a franchisee through the extensive laws and regulations may incentivize franchising by alleviating a franchisee’s concerns about navigating the barriers to entry.
  • The fact that the industry is sparking media interest may provide extensive publicity for franchisors trying to sell prospective franchisees on the business concept.
  • The physical effects of medicinal marijuana and its, at least perceived, importance for some patients suggests that customers/patients may be more comfortable going to a franchised business with a recognized name rather than to an independent store.
  • Patients themselves have to worry about laws and regulations and may trust a store to guide them through federal, state, and local laws and rules if that store is backed by a larger entity.
  • The industry is growing. While it may be a risky industry, franchisors can pass some of that risk to franchisees.

While the medical marijuana industry is potentially ripe for franchising, this type of franchise business is fraught with numerous business and legal perils, as discussed below.

IV. Legal and Business Risks for Lawyers, Franchisors, and Franchisees

A. Federal Laws and Regulations

The notion of a medical marijuana-based franchise poses a variety of legal questions that franchisee and franchisor attorneys must consider when advising clients. First and foremost, as mentioned above, marijuana is a Schedule I controlled substance under federal law and, therefore, people may not manufacture, distribute, dispense, or possess it. 28 U.S.C.A. § 841; 21 U.S.C.A. §§ 802, 812.

This federal prohibition on manufacturing, distributing, dispensing, or possessing marijuana is inconsistent with many state laws. In Vermont, for example, a person who has a valid registration card issued by the state is exempt from arrest or prosecution for possession or cultivation of marijuana under 18 V.S.A. § 4230. 18 V.S.A. § 4474b. The problem is, of course, that these state laws conflict with federal law. In an attempt to resolve or clarify this conflict, in State of Arizona v. United States of America, Case No. 2:11-cv-01072-SRB (D. Ariz. 2011), Arizona sought a declaration as to whether the Arizona Medical Marijuana Act (“AMMA”) complied with federal law and could be implemented without fear of federal prosecution or whether the state law was preempted because of an irreconcilable conflict with federal law. The court dismissed the state’s claim without prejudice for lack of ripeness (the complaint did not establish a genuine threat of imminent prosecution) and provided Arizona with 30 days to file an amended complaint. Arizona failed to file an amended complaint and the court entered judgment against Arizona on February 6, 2012. On February 16, 2012, however, the U.S. Attorney in Arizona sent a letter to Arizona Governor Jan Brewer, stating that the U.S. Attorneys’ Office would “vigorously enforce” federal laws against those operating and facilitating large marijuana production facilities, including state employees who participate in the AMMA. Feds Warn Arizona Over Medical Marijuana, ABC15.com (March 20, 2012), http://www.abc15.com/dpp/news/state/feds-warn-arizona-over-medical-marijuana. This leaves Arizona and its state employees in a difficult position: (1) work to implement the AMMA and face potential prosecution from the federal government; or (2) decline to implement the AMMA even though it has been enacted by Arizona’s legislature.

The impact of federal anti-marijuana laws has, in fact, become more pronounced. A June 2011 memorandum from the Department of Justice not only threatens cultivators, sellers, and distributors of medical marijuana, but also those that “knowingly facilitate such activities.” Memorandum from the U.S. Department of Justice, Guidance Regarding the Ogden Memo in Jurisdictions Seeking to Authorize Marijuana for Medical Use (June 29, 2011), http://www.docstoc.com/docs/83985744/us-Department-of-Justice-Office-of-the-Deputy-Attorney-General-. The memorandum suggests that even landlords, banks, and perhaps government officials that “facilitate” the business could face federal prosecution. Id. In October 2011, four U.S. attorneys in California announced a crackdown aimed at landlords in California who own buildings housing dispensaries. Highs and Laws, The Economist (Dec. 3. 2011), http://www.economist.com/node/21541065. In fact, U.S. attorneys have begun to file asset-forfeiture lawsuits against buildings housing medical marijuana stores. Under 21 U.S.C. § 881(a)(7), all real property, "including any right, title, and interest (including any leasehold interest),” is subject to forfeiture to the United States where controlled substances are manufactured or distributed from the property. In two cases filed on June 5, 2012, the United States sought forfeiture of property at which medical marijuana dispensaries operated in California, but it should be noted that the United States has also alleged that one of these dispensaries was operating in violation of the city’s zoning laws and the other lacked a valid seller’s permit. U.S.A. v. Real Property Located at Telegraph Road, Santa Fe Springs, California, No. CV12-4897 (C.D. Cal. June 5, 2012); U.S.A. v. Real Property Located at 13840 Rosecrans Avenue, Santa Fe Springs, California, No. CV12-4896 (C.D. Cal. June 5, 2012). These asset forfeiture civil lawsuits may be a way for the United States to avoid more costly and time-consuming criminal prosecutions while still enforcing anti-marijuana laws. The tension between federal laws and state laws will likely continue for the foreseeable future.

This prohibition against knowingly facilitating such activities has significant implications for franchise lawyers. In advising a franchisor or franchisee seeking to enter the medical marijuana business, would a franchise attorney be “facilitating” such activities subjecting him or her to prosecution? Additionally, some attorneys may not be comfortable advising a client in navigating this business given federal anti-marijuana laws. Even if it were legal under federal law, some lawyers may still need to address moral or ethical concerns about representing a client in this business.

Moreover, if a franchise attorney provides advice to a client regarding the medical marijuana business that, by its nature, violates federal law, to what extent do attorney-client communications and work product lose the attorney-client privilege or work product doctrine protections? Generally, if communications between an attorney and client are made in order to perpetrate a crime (or fraud), those communications are not privileged. 1 Kenneth S. Broun et al., McCormick on Evidence § 95, at 380 (John W. Strong ed., 5th ed. 1999). An attorney’s work product also loses protection under the crime-fraud exception. Wachtel v. Guardian Life Ins. Co., 239 F.R.D. 376 (D. N.J. 2006) (holding that the crime-fraud exception allows for disclosure of otherwise privileged communications and work product). Because of federal anti-marijuana laws, the business itself may be criminal. Accordingly, do the privilege and work product protections lose all effect? See U.S. v. Loften, 507 F. Supp. 108 (S.D. N.Y. 1981) (holding that where conversations between lawyer and client were in furtherance of criminal enterprise, privilege was lost). If an attorney communicates with his or her client about what to disclose in an FDD, for example, do those communications become available to an adversarial party? Attorneys must be aware of and advise clients of these possible risks.

If, after considering some of these questions, a franchise attorney chooses to proceed with representation, he or she must first ask a franchisor or prospective franchisee client to consider whether federal laws pose a substantial risk to the sustainability of the industry. How much risk is associated with a change in the executive branch’s approach to enforcing federal marijuana laws? From a franchisor lawyer’s perspective, how much should a franchisor disclose about this risk in its FDD? From a prospective franchisee lawyer’s perspective, if a dispensary faces the threat of closure from the federal government, how much should a prospective franchisee of a dispensary be willing to invest in the business? And, if “facilitating” activities subjects people to prosecution, are those entrepreneurs that only indirectly service the medical marijuana industry putting themselves at risk?

Federal tax law and the IRS also play an important role in this industry. IRS officials recently told one group that sells medical marijuana that it cannot deduct any business expenses from its income. Azmat Khan, A “Crushing Blow” to Medical Marijuana Dispensaries?, Frontline (Oct. 6, 2011), http://www.pbs.org/wgbh/pages/frontline/social-issues/the-pot-republic-social-issues/a-crushing-blow-to-medical-marijuana-dispensaries/. The IRS’s position stems from a section of the federal tax code forbidding the deduction of any business cost related to trafficking in controlled substances. 26 U.S.C.A. § 280E. In 2007, the United States Tax Court addressed this issue in Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R., 128 T.C. 173 (2007). The court in this case held that while expenses attributable to the provision of medical marijuana could not be deducted, expenses attributable to the business’ provision of counseling and other caregiving services were deductible. Id. at 185-186.

An important development came about on July 17, 2012 when a bipartisan group in Congress proposed legislation that would make compliance with state medical marijuana laws an affirmative defense to federal prosecution or proceedings: "It is an affirmative defense to a prosecution or proceeding under any Federal law for marijuana-related activities, which the proponent must establish by a preponderance of the evidence, that those activities comply with State law regarding the medical use of marijuana . . . ." H.R. Res. 6134, 112th Cong. (2d Sess. 2012). Passage of a federal law like this could create a substantial opportunity for growth in the medical marijuana business by addressing, at least in part, the conflict between federal and state marijuana laws. It still, however, does not resolve all of the issues discussed above. For example, the attorney-client privilege issue would still be problematic because the proposed legislation does not alter federal law's criminal prohibition of the use, growth, or distribution of marijuana.

B. State and Local Laws, Regulations, and Ordinances

Medical marijuana businesses also have to worry about complex state and local laws. For example, one producer of marijuana-infused beverages was caught off guard when it learned its product could not be sold in Denver unless the beverage was produced in a Denver kitchen. If a dispensary had been selling marijuana-based beverages in Denver that were not produced in Denver, it would have been running afoul of local regulations. David Segal, When Capitalism Meets Cannabis, The New York Times (June 26, 2010), http://www.nytimes.com/2010/06/27/business/27pot.html?pagewanted=all.

Additionally, all states allowing for the use of medical marijuana require that patients have a recommendation from a physician. The laws surrounding what conditions a patient would have to suffer from to use medical marijuana, however, are often listed in statutes and administrative rules and are not uniform. Compare A.R.S. § 36-2801.01, § 36-2803 (requiring the department of health services to adopt rules governing the manner in which the department shall consider petitions from the public to add debilitating medical conditions or treatments to the list of debilitating medical conditions in § 36-2801), with 18 V.S.A. § 4472 (setting forth the conditions that make a patient eligible to register for the legal use of medicinal marijuana). Moreover, some states require sellers to prove nonprofit status – often as a collective or cooperative. See 18 V.S.A. § 4474e(b)(1); 22 M.R.S.A. § 2428.6.A. These dispensary laws and regulations are changing so rapidly that it may prove difficult for franchisors and franchisees, as well as their lawyers, to stay up to date.

If an attorney helps a client engage in this business but fails to keep up with state laws, he or she may face the same issue related to the crime-fraud exception to the attorney-client privilege and work product protections discussed above.

Additionally, franchisor lawyers will have to help clients grapple with difficult questions. Should a franchisor undertake to help its franchisees comply with these laws? If not, should it disclose to prospective franchisees the difficulties in keeping up with changes in the law? If franchisors choose to assist their franchisees in complying with these changing laws, will the franchisor be able to institute system-wide changes as rapidly as necessary to keep up with the changing laws and regulations? Will the franchisor be obligated to constantly update its operations manual to ensure that nothing in the manual conflicts with the wide array of state and local laws? Will the franchisor need to adopt state- and city-specific operations manuals?

From the franchisee lawyer’s perspective, what happens if the operations manual conflicts with a law? Will the franchisee be allowed to deviate from the operations manual or will the franchisee have to choose between breaching the franchise agreement by not complying with the operations manual, thereby facing termination, or violating a law, thereby facing prosecution and termination? It is something of a Hobson’s choice, an apparently free choice that offers no real alternative, and prospective franchisees need to be aware of such dangers.

Another concern is that states may repeal laws allowing the use of medical marijuana or significantly curtailing patients’ ability to use it. For example, the Montana legislature passed a law in April 2011 outlawing medical marijuana that was vetoed by the governor. If a state repeals its laws authorizing the use or the dispensation of medical marijuana, what happens to medical marijuana franchise relationships in that state? Generally, if the object or performance of a contract is rendered illegal by statute after the contract is entered into, the contract is considered to be discharged by law. Roger LeRoy Miller & Gaylord A. Jentz, Fundamentals of Business Law: Excerpted Cases 198, 246 (2010). If the franchise agreement is “discharged by law,” is the franchisee still obligated to pay under the terms of its lease? Further, if the contract is already illegal under federal law, what is to stop a franchisor or franchisee from simply arguing that the contract is discharged whenever it suits either party’s interests?

Even if states do not repeal medical marijuana laws, courts may step in and limit the ability to sell marijuana. In State v. McQueen, for example, the Michigan Court of Appeals held that medical marijuana cannot be sold through certain private shops. State v. McQueen, 2011 WL 3685642 (Mich. Ct. App. 2011). The holding could be read as prohibiting all sales of medical marijuana:

The question becomes whether the “medical use” of marihuana permits the “sale” of marihuana. We hold that it does not because the “sale” of marihuana is not the equivalent to the “delivery” or “transfer” of marihuana.

Id. The Michigan Medical Marihuana Act provides that “delivery” and “transfer” of medical marijuana are allowed, but this does not encompass the “sale” of medical marijuana. Mich. Comp. Laws § 333.26423(e). This recent decision would leave a franchisee that sells marijuana in a very precarious position because, not only may that franchisee be forced to close, it may be liable for lease payments, other costs, and perhaps lost future royalties -- something of which franchisee counsel should make his or her clients aware. The McQueen defendant’s application for leave to appeal, however, was granted on March 28, 2012, by the Supreme Court of Michigan. As such, whether the sale of medical marijuana is permitted in Michigan is still an open question.

This type of uncertainty may also make it difficult to find a lender willing to finance the upfront costs of a franchise purchase and build out. “There are unresolved issues with regulations, law enforcement and other agencies that need to get resolved before the industry can progress and become bankable.” Bank Shutting Out Marijuana Dispensaries, United Press International (Aug. 24, 2011), http://www.upi.com/Top_News/US/2011/08/24/Bank-shutting-out-marijuana-dispensaries/UPI-58961314215938/. This could effectively stop the growth of the industry in franchising regardless of the legal issues.

Franchisees in this industry also must be aware of a franchise agreement’s termination provisions. Franchisors provide themselves with the contractual right to terminate, usually on minimal notice, if the franchisee violates or fails to comply with any law, rule, regulation, ordinance, or order. Given the idiosyncrasies and the relatively novel nature of state and local medical marijuana laws, this is a dangerous provision for franchisees because conflicting statues and regulations could make strict compliance impossible.

V. Dealing with Business Risks

One way that franchisors are likely to deal with some of these risks is to contractually put the burden on the franchisee to comply with laws and regulations. In fact, weGrow Enterprises, Inc., in its FDD, did just this. It requires franchisees to operate the franchised business in compliance with all laws and regulations.

WeGrow’s FDD also includes professional fees in Item 7 of its FDD, ranging from $2,500 to $7,500. The corresponding note in Item 7 states, “These fees are representative of the costs for engagement of professionals for the start-up of a franchised business. We also strongly recommend that you seek the assistance of attorneys and accountants for the initial review and resulting advisories concerning this franchise opportunity . . . .” In addition to initial attorneys’ fees for reviewing the franchise opportunity, franchisees should include ongoing attorneys’ fees in their business plans to stay up to date on this fluid area of law.

Franchisor lawyers would do well to advise franchisor clients to outsource some disclosure to lawyers. While franchise salespersons and franchisors often advise prospective franchisees to seek counsel prior to signing a franchise agreement, this advice is sometimes, if not often, given half-heartedly at best. Franchisor lawyers would best serve their franchisor clients’ interests by encouraging them to protect their investment by pushing prospective franchisees to review the business model, disclosure documents, and agreements with a knowledgeable franchise attorney prior to purchasing.

VI. Conclusion

Despite the risks, investors and franchisees may see an opportunity for growth. WeGrow announced that it sold out the franchise rights to open all stores in Arizona, New Mexico, Washington D.C., and Delaware, and it has discussed plans for an IPO. Elizabeth Brennon, weGrow Medical Marjiuana Superstore Reveals Plans for IPO, News Junky Journal (July 20, 2011), http://www.newsjunkyjournal.com/weGrow-medical-marijuana-superstore-reveals-plans-for-ipo/2512969/. While the great amount of risk involved needs to be acknowledged, there is perhaps the potential for great return, especially for the first franchisors and franchisees to enter the business. Whether franchised medical marijuana-related businesses are half-baked or fully baked remains an open issue, but this industry should give franchise lawyers plenty to think about and discuss with their clients.

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