Illicit to Essential: Cannabis Issues in a COVID-19 World

An Essential Industry

Cannabis has now been deemed an essential industry in most states that have legalized medical or recreational access.

It is amazing how quickly an industry that has struggled for over a decade to get out of the shadows of illicit activities has been embraced as an essential service and product in most markets where state and local access are allowed. The list of states that have loosened access restrictions due to the COVID-19 impact includes California, Colorado, Connecticut, Illinois, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New Mexico, New York, Ohio, Oregon, and Washington.

There continues to be a bit of a “buzz” over just how essential this access is, but with so many individuals out of work and being asked to shelter in place, it seems appropriate to allow individual choice when it comes to cannabis, arguably no different than access to alcohol. At one point in late March, the mayor of Denver ordered all nonessential businesses, including liquor stores and cannabis dispensaries, to close within city limits. Within two hours on the same day, he had to retract that order as it applied to liquor and dispensaries due to the chaos and long lines that quickly ensued. New rules were subsequently instituted in Colorado to allow customers back inside of dispensaries as long as they practice what is now being referred to as “extreme social distancing.”

As we write this, it is April 20, the annual 420 holiday that has been described as the holiday for cannabis aficionados—what St. Patrick’s Day is to the Irish. Many in the industry annually plan for April 20 to be the biggest sales day of the year, like Black Friday after Thanksgiving is to traditional retailers. As in prior years, months of planning and investment went into building up inventories within the cultivation and processing pipelines in 2020. However, 420 in 2020 was a different sort of event because the big outdoor gatherings and parties were not held, or were not in evidence. Kudos to ArcView for hosting a well-attended, festive virtual 420 rally on Zoom with input from many of the top industry leaders.

Some people are now predicting a glut of product this year as a result of not only a curtailed 420 holiday but also, and likely far more important, the continued contraction of the industry due to the prospect of greatly diminished social gatherings, coupled with the impact of a contracting economy generally. Cannabis demand will be impacted by how long large numbers of people are out of work, together with the duration of stay-in-place protocols restricting concerts and other group activities. Although the phased reopening of the economy has begun to be implemented, some jurisdictions, like California, are considering the prospect of no college or professional sports fan gatherings until 2021. When many individuals will need to make difficult choices between payments for rent or mortgage, cars, and cell phones and dropping dollars on a few prerolled joints or their favorite edibles, we think that the choice, while difficult, will lead to lower sales in the cannabis sector.

Nonetheless, initial reports subsequent to the COVID-19 impact on the loss of jobs and folks staying in place show that cannabis sales are substantially up in many jurisdictions. Furthermore, cannabis retailers are attributing a recent uptick in sales to the receipt of $1,200 stimulus checks last week by many customers. (We don’t think this is the type of “stimulus” the government intended when formulating this part of the economic response to the COVID-19 crisis.)

Cannabis, the CARES Act, and Viability of the Industry

While many small businesses have rushed to apply for Paycheck Protection Program (PPP) loans during the COVID-19 crisis, as authorized under the federal Coronavirus Aid, Relief, and Economic Security Act (CARES Act), operators within the legal, regulated cannabis industry cannot take advantage of the program due to their illegal status at the federal level under the 1970 Controlled Substances Act (CSA). The PPP, signed into law March 27 and administered by the U.S. Small Business Administration, provides what amounts to a tax-free loan to small businesses to help them weather the pandemic and retain their employees. The new law specifically prohibits businesses, including ancillary companies that get revenue from such businesses, that are illegal at the federal level from accessing CARES Act money. That means that both plant-touching and ancillary companies are excluded. The specific rules applicable to the PPP loan program, including what funds can be used for and what will qualify as tax-free forgiveness of debt, are complex. Consult with qualified professional advisers.

The lack of access to CARES Act money is just one more way in which it has become much more difficult for the smaller players to remain viable, particularly in the more established legal, regulated markets. Prior to COVID-19, consolidation within the cannabis industry had already begun, and what we are presently experiencing will only accelerate those changes. As the cannabis industry has continued to mature, more sophisticated operators are either expanding to be truly well-run, integrated seed-to-sale enterprises or focused on being exceptionally good at specific subsectors like cultivation, processing, or retailing. In 2019, we witnessed the significant drop in enterprise value of some of the industry leaders, including MedMen, Canopy, and Aurora, to name just a few recognizable publicly traded names. For many of these companies, the focus shifted in 2019 from growth and expansion to shoring up profit margins and conserving capital.

Nonethess, the impact of the COVID-19 pandemic has brought about changes that may transform the industry in positive ways. Where access has been mandated as essential, concepts like curbside delivery and online ordering, which would have been off-limits a year ago, have emerged as a means to serve customers—in much the same way that the COVID-19 crisis has accelerated the utility of curbside delivery of take-out food. (Of course, this comes with the added compliance hurdles in regulated cannabis of videotaping all curbside sales: proper identification is still required with sales staff wearing appropriate PPE so that the customer never has to leave their vehicle.) Another positive change is that debit cards are being accepted more routinely to minimize the handling of cash. These practices may expedite the way an increasing amount of cannabis retail sales take place prospectively, well beyond the end of the COVID-19 crisis.

Legislative, Tax,  and Regulatory Issues

Let’s move beyond the COVID-19 related challenges and opportunities to identify some of the other emerging trends that the industry will see in the near future in terms of legislation, tax law, and regulation.

As of this date, the SAFE Banking legislation that passed the U.S. House of Representatives in September 2019 by a 321 to 103 margin remains pigeonholed on the desk of Senator Mike Crapo (R-ID), who is chair of the Senate Banking Committee. Crapo has indicated that he has significant reservations about allowing the legislation, which addresses the cannabis industry’s lack of access to financial institutions, to get to the Senate floor due to potency and financing issues.

With respect to potency, Crapo has expressed interest in limiting the strength of legal cannabis because the products produced today are not the same as what folks experienced in the 1960s and 1970s. Given the advancements in seed and strain genetics and the entire cultivation process, including light/dark regimens, and trimming and curing techniques, the product routinely marketed today is three to 10 times the strength of what was commonly available only 20 years ago before the legalization of cannabis first began with medical access in California.

Furthermore, Crapo is concerned about how to address the accountability of “legacy cash” that has built up within the illicit side of the industry over decades. How this cash will be accounted for as it potentially makes its way into the banking system is a big unanswered question. In part, it will depend on how the cash gets recognized for income tax purposes given that this is revenue that, for the most part, has escaped taxation for generations.

Senator Rand Paul (R-KY) stated at a small gathering of the members of the National Cannabis Industry Association in Denver on March 25 that he believes that if the SAFE Banking bill gets to the Senate floor for a vote, it will easily pass. Assuming the White House would sign this legislation into law, this would allow banking at the federal level for the cannabis industry; and once institutions like Wells Fargo, Chase, and Citibank are cleared to bank the industry, one can only imagine the significant shifts that could result for the industry overall. This change alone could be the catalyst to overturn the illegal status of cannabis under the CSA.

In addition to the legislature, the Internal Revenue Service (IRS) is also focusing some attention on the cannabis industry. The IRS just issued a 47-page position paper, on March 30, 2020, titled The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance, which covers a broad range of issues of great concern to the IRS and the U.S. Department of the Treasury. The “Highlights” section of this paper states thus:

Marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act. Businesses in this industry have limited banking access and are subject to Internal Revenue Code Section 280E, which prohibits the deduction of expenses incurred in trafficking Schedule I controlled substances. The IRS risks diminished taxpayer compliance when marijuana businesses fail to report all income as required under IRC Section 61, regardless of source, and deduct expenses not allowed under IRC Section 280E.

The findings in this paper parallel recent rulings in court cases, including the April 7, 2020, published ruling by the U.S. Court of Appeals for the Tenth Circuit in Standing Akimbo v. United States. No. 19-1049 (Apr. 7, 2020).

In addition to trends in legislation and tax law, regulation is an area of emerging change. In particular, testing of cannabis is evolving. Using Colorado as an example of a reasonable industry standard, huge advancements continue to happen in the testing segment. The facilities that do the testing must be fully independent from investment, direct or indirect, in the industry. This assures that objective assessments are being made in accordance with the mandate of the regulations established in each jurisdiction. In the past, the main focus in many regulated markets was to ensure the purity and potency of products. New testing requirements have recently been instituted to ensure that all marijuana, marijuana concentrates, and marijuana products are also tested in accordance with ISO protocols for heavy metals and mycotoxins. The industry routinely tests for four heavy metals: lead, arsenic, mercury, and cadmium. The California Bureau of Cannabis Control has mandated heavy metals testing since December 31, 2018, for all three categories of cannabis products that it regulates, i.e., inhalable cannabis, inhalable cannabis products, and other cannabis and cannabis products.

Home Delivery

Things are evolving quickly on the home-delivery front. Home delivery has been allowed in some parts of California for some time. Other jurisdictions, like Colorado, have passed legislation at the state level that allows for home delivery, but the legislation is subject to acceptance and implementation at the local municipal level. In late March, Governor Steve Sisolak of Nevada ordered all regulated cannabis sales in the state to shift to delivery only, closing in-store retail sales until further notice.

As more Americans across the country are sheltering at home during the COVID-19 pandemic, cannabis retailers around the country are seeing more flexibility to meet the needs of consumers, particularly on the medical front. Below is a sampling of recent activity.

Nevada. Nevada—in particular, Las Vegas, the state’s largest urban market—has seen a huge increase in cannabis delivery sales. Customers preorder online, and deliveries are made 24/7 in vehicles inspected and authorized by the Nevada Department of Taxation, which oversees all Nevada-regulated cannabis activities.

Planet 13, a publicly traded company (PLNHF), operates a 112,000-square-foot facility a block off of the Las Vegas strip and has just announced expansion into Santa Ana, California, by acquiring a 55,000-square-foot facility in close proximity to Disneyland, the largest shopping mall in California, and the nearby beaches. At its flagship Las Vegas store, Planet 13 has transitioned from using third-party delivery vendors to now having a fleet of 29 vehicles and 77 drivers as of April 20, with plans to add more drivers and vehicles. It reports doing 700 to 800 deliveries per day, with sales of $80,000 to $100,000 per day and a targeted goal of $200,000 daily sales using 100 drivers delivering at all hours of the day. Planet 13 is just one of almost 60 licensed Nevada dispensaries that have launched delivery services.

Colorado. Boulder-based medical cannabis dispensary The Dandelion, which is owned and operated by the retail chain Native Roots, obtained Colorado’s first state-issued delivery license in March; it started delivery services within Boulder city limits on March 27 following strict protocols mandated by the Colorado Marijuana Enforcement Division and the City and County of Boulder. The Dandelion, which first opened in 2009, initially only offered the service on Friday through Sunday but quickly expanded to daily deliveries. Parent Native Roots has implemented a remote phone-in registration portal so that new patients do not have to physically come into the store.

Michigan. As an example of what is evolving in a less-established market like Michigan, Freddie’s, located in Clio, Michigan, between Flint and Saginaw, now provides both curbside and home delivery. Delivery orders must be for $200 or more, and there is no delivery charge. State-mandated limits of no more than 2.5 ounces of marijuana or equivalent product per day, per customer remain in place. The customer placing the order must be the one receiving the order when the delivery is made. Orders need to be placed two days in advance using the company website, and deliveries are made between 10:00 a.m. and 8:00 p.m.

To ensure that their delivery drivers and customers stay healthy, the retailers being allowed to expand how they transact business are putting into place unprecedented measures, ranging from taking employees’ temperatures and limiting access to in-store sales with extreme social distancing protocols to providing all staff with appropriate personal protective equipment (PPE), including masks, latex gloves, and alcohol-based disinfectants.

Other states, including Massachusetts, New York, and Illinois are also taking steps to encourage home delivery of cannabis products as well as to give customers the option of curbside pickup.

California. In California, where home delivery has been allowed in some jurisdictions for some time, retailers are petitioning the Bureau of Cannabis Control to lift the requirement that customers who have cannabis delivered must sign to verify that they received their orders, said Elizabeth Ashford, senior director of corporate communications at California-based cannabis delivery company Eaze. Eaze, specializing in cannabis delivery, has seen a 34 percent increase in the number of customers signing up for its service, as well as a surge in the size of orders, according to Ashford, who noted that the consumer preference has shifted toward edibles.

Also in California, Driven Deliveries has seen a nearly 20 percent increase in transactions and a 10 percent rise in order value since the coronavirus was discovered in the state, according to CEO Christian Schenk.

Famed retailer Harborside, based in Oakland, California, has recently added two more vehicles to its fleet to keep up with demand for cannabis delivery, according to Pedro Fonseca, Harborside general manager. Harborside plans to hire up to three new delivery drivers and shift some workers from its sales staff into the delivery role. Harborside is providing all employees with masks, hand sanitizer, and gloves. The company also is monitoring the number of people in the store.

Massachusetts. In Massachusetts, medical marijuana treatment centers have at least temporarily been permitted to expand their delivery service whereby patients are allowed to acquire up to a 60-day supply of medical-grade marijuana.

Michigan. In Michigan, Governor Gretchen Whitmer signed an executive order on March 16 that permits all licensed Michigan marijuana retailers to provide home delivery and curbside pickup of products. Before Whitmer signed the order, retailers had to be licensed for delivery, and sales had to be conducted inside the store.

New York. The New York Department of Health has instituted rules that permit registered organizations that had previous approval to deliver medical marijuana to the homes of registered patients and designated caregivers to deliver without written approval.

Ownership: Social Equity

Social equity is of growing relevance within the cannabis industry as jurisdictions struggle with how best to award licenses to operate. To highlight this aspect, we will compare and contrast the stated requirements in Illinois, which is the most recent state to authorize recreational, adult-use access, and the recently adopted rules by the City of Los Angeles for expanding access to cannabis in disadvantaged communities within the city.

Illinois, under the Illinois Department for Commerce and Economic Opportunity, has created the Illinois Adult-Use Cannabis Social Equity Program to assist in awarding licenses for cannabis dispensaries using a 250-point application framework with points awarded for minority status and for prior convictions of lesser cannabis offenses, among other criteria. Pursuant to the Cannabis Regulation & Tax Act (Act), cannabis is now legal for adult use in Illinois, effective on January 1, 2020. As part of the act, the State of Illinois has a stated commitment to ensure that communities historically impacted by the criminalization of cannabis have an increased opportunity to participate in the legal cannabis industry.
In order to address the impact on those communities, the act established a program for social equity applicants who meet the following criteria:

• Has at least 51% ownership and control by one or more individuals who:
  • Have lived in a Disproportionately Impacted Area in 5 of the past 10 years [as defined in the Act].
  • Have been arrested for, convicted of, or adjudicated delinquent for cannabis-related offenses eligible for expungement, including cannabis possession up to 500 grams or intent to deliver up to 30 grams.
  • Have a parent, child, or spouse that has been arrested for, convicted of, or adjudicated delinquent for cannabis-related offenses eligible for expungement, including possession up to 500 grams or intent to deliver up to 30 grams.
• Has more than 10 full-time employees, and more than half of those employees:
  • Currently reside in a Disproportionately Impacted Area.
  • Have been arrested for, convicted of, or adjudicated delinquent for cannabis-related offenses eligible for expungement, including cannabis possession up to 500 grams or intent to deliver up to 30 grams.
  • Have a parent, child, or spouse that has been arrested for, convicted of, or adjudicated delinquent for cannabis-related offenses eligible for expungement, including possession up to 500 grams or intent to deliver up to 30 grams.

Ill. Dep’t of Commerce & Econ. Opportunity, Illinois Adult Use Cannabis Dispensary Licenses (accessed May 2020).

Los Angeles, on the other hand, has just announced a new social equity program to be used in granting up to 150 new dispensary licenses and 60 new nonstorefront delivery licenses in economically depressed parts of the city. There are three distinct tiers, each with specific qualifications under which a prospective cannabis business owner might qualify for the Los Angeles social equity program:

• Tier 1. The candidate is considered “low income,” with earnings of less than $41,230 annually, as well as either (a) a cannabis conviction prior to November 8, 2016 (the date when Prop 64 was enacted), which now would be prosecuted as a misdemeanor or citation; or (b) five years of cumulative residency in a qualifying zip code.
  • Qualifying zip codes include 90001, 90002, 90003, 90008, 90011, 90013, 90014, 90016, 90021, 90027, 90033, 90037, 90043, 90044, 90057, 90058, 90059, 90061, 90062.
• Tier 2. The candidate is considered “low income,” with five years of cumulative residency in a qualifying zip code; or has 10 years of cumulative residency in a qualifying zip code.
• Tier 3. The candidate is a landlord entering into a Social Equity Agreement with the city to provide capital and/or leased space, as well as business, licensing, and compliance assistance to Tier 1 and Tier 2 applicants. The landlord agrees to provide access to real estate property for Tier 1 applicants rent free and with prorated utilities for a minimum of two years, provided that the property meets certain requirements.

Under the program, which is still being developed, qualifying applicants are expected to be eligible for benefits such as priority processing or applications, business, licensing, and compliance assistance; training via an incubator; fee waivers; and access to an industry investment fund, if such is established. To be eligible for the benefits of the social equity program, a person must own at least one-third (for Tier 1, 51 percent) of the business applying for the license.

Conclusion

The emerging and evolving issues outlined above are just a part of how dynamic the cannabis sector is today as the American and global economies begin to sort out what the future will hold post-COVID-19. The future is bright for some, but it will be a supreme struggle for others to redefine a path to success. The fact that the industry has been deemed essential in most corners—given that just a decade ago it was, for the most part, totally illegal at all levels—is a testament to where we are headed. However, there will be major challenges and significant continued disruption to get to the appropriate higher ground (no pun intended).

Ron Seigneur is managing partner and Ryan Cram is a senior financial analyst of Seigneur Gustafson LLP, located in Lakewood, Colorado. 

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