California Cannabis Regulators Seek Control Over White Labeling Practices
February 25th, 2019
The California Bureau of Cannabis Control (“BCC”) recently adopted Final Rules that will greatly impact the legal marijuana industry in the Golden State. While not as disruptive as initially proposed, the final regulations will require marijuana license holders that sell products under a brand owned by a non-licensee to report that brand owner as either having a “financial interest” or report the brand owner as an “owner”. While the California cannabis industry is a buzz as to what this means to cannabis operators, investors in California cannabis companies need to understand how it impacts them.
Before we go into details on the new regulations, it will be helpful to apply a few labels to the different players in this discussion. For clarity, I will refer to operators that hold a license to conduct commercial cannabis operations under the Medicinal Adult Use Cannabis Regulation and Safety Act (“MAUCRSA”) as “Operators”, I will refer to the owner of the brand or other intellectual property as the “IP Owner”, and I will refer to the arrangement by which the IP Owner allows the Operator to use the brand or other intellectual property as the “Authorization”. With that in mind, let’s turn to the Final Rules.
As a quick review, under Section 5032(b) of the Final Rules, an Operator is prohibited from conducting “commercial cannabis activities on behalf of, at the request of, or pursuant to a contract with any person that is not licensed under the Act.” On its face, this broad prohibition makes illegal many white label arrangements common in the California cannabis industry. Luckily, the Statement of Final Reasons published in connection with the Final Rules states that “if [an Operator] includes as one of their owners a brand‐owner, the [Operator] can produce the branded product because in this case the [Operator] is not engaged in commercial cannabis activities on behalf an unlicensed person. Because the owner of the brand is an owner of the license, there is no unlicensed person involved.”
How, you may reasonably ask, does the IP Owners become an “owner” simply by granting a trademark license to the Operator? Under the MAUCRSA, an “owner” is any person that participates “in the direction, control, or management” of the Operator. Because trademark licenses and white label arrangements (should) include quality control provisions such as approval rights and recall rights whereby the IP Owner can ensure its valuable brands are not tarnished by poor operating practices of the Operator, the IP Owner is participating in the “direction, control, or management” of the Operator. Under the MAUCRSA’s expansive definition of “owner,” actual ownership or equity is not required.
By promulgating 5032(b), the BCC made it explicitly clear that customary quality control features present in virtually every trademark license or white label arrangement triggers reporting the IP Owner as an “owner” of the Operator. So what impact does this reporting have on Operators, IP Owners and their investors?
Importantly, Operators must ensure that IP Owners (and their respective “owners”) that it conducts business have not experienced any type of disqualifying event that will jeopardize the Operator’s cannabis license. For IP Owners, they need to conduct diligence on their investors to ensure that there are no ineligible persons in their cap table that will cause Operators to terminate the Authorization or risk losing their cannabis license. Additionally, IP Owners need to understand that they will be subject to additional regulatory scrutiny and prepare for it or avoid the California market.
Investors should take immediate steps to ensure their existing portfolio companies have conducted a review of how 5032(b) impacts them. To the extent the portfolio company is not compliant, it needs to develop and implement a plan to become compliant quickly. With respect to new investments, 5032(b) compliance must be included when conducting diligence, which may now require background checks into IP Owners that the Operator conducts business with.
Expect more on this topic in the coming months as it ripples through the California cannabis market.
Edward R. Culhane is an experienced cannabis lawyer focused primarily in the areas of venture capital, private equity, securities and mergers and acquisitions. Mr. Culhane has been representing investors deploying capital to the cannabis since early 2016 and is licensed to practice law in the states of California, Colorado and Minnesota.
 Final Statement of Reasons Appendix C ‐ Bureau Summary and Response to 15‐Day Comments ‐ Page 28