By Steve Schain
Envision managing the risk of a volatile, staggeringly lucrative, 100-percent federally legal enterprise? Toss in ridiculously inconsistent federal, state and local regulations, insanely evolving technologies and efficiencies and an industry-wide disinclination to ever “play by the rules.”
However, when armed with decent risk management fundamentals, a marijuana-related business can diminish most horrible outcomes, fortify the enterprise’s sustained growth and maybe even get rich along the way.
Risk management is the identification, evaluation and prioritization of risks followed by coordinated and economic resources applications that minimize, monitor and control unfortunate events’ probability or impact.
Although denied many standard “risk management tools” (like credit cards, bankruptcy law protection and federal patents and trademarks), assembling a “risk management insurance, accounting and legal advisory team” could prevent an insufficiently prepared marijuana-related businesses from foundering.
Indentifying Loss Exposure
With Corona brewer and Robert Mondavi wine producer Constellation Brands Inc. investing $3.88 billion in grower Canopy Growth Corp., the Wall Street Journal valuing 2018′s U.S. legal marijuana sales at $10.2 billion, and marijuana stocks trading on Canadian exchanges, cannabis is officially big business and in dire need of risk management.
However, due to marijuana’s 100-percent federal illegality, even more is at risk and fewer, and less effective, risk management tools are available. The Comprehensive Drug Abuse Prevention and Control Act of 1970 prohibits marijuana’s manufacture, distribution, dispensation and possession and lists it next to heroin as a Schedule I controlled substance having “a high potential for abuse,” 21 U.S.C. Sections 801, Et. Seq (1970) (Controlled Substance Act). Thus, claims may be brought against anyone in the marijuana industry’s supply chain touching the item prior to sale to the consumer; i.e., anyone planting, cultivating, harvesting, processing/extracting, testing, packaging, disposing, transporting and dispensing marijuana (hereafter, collectively referred to as marijuana-related businesses or MRBs). Due to this federal illegality, many standard risk management tools are denied to MRBs—like credit cards, bankruptcy law protection and federal patents and trademarks.
Risk management is the process of anticipating losses and developing a plan to survive them through: identifying each loss exposure (such as being sued for a defective product); evaluating each loss exposure’s frequency and severity; weighing, then selecting, each exposure-managing technique; deploying exposure-managing techniques; and reviewing evaluating and improving a risk-management plan.
A marijuana-related business’ “loss-causing-events universe” encompasses: people (owners, investors, employees, customers and vendors); property (buildings, equipment, crops, inventory, vehicles, data, cash, intellectual property); and profits.
Although people are a marijuana-related business’ most valuable asset, and their welfare is the first priority, even the most safety-conscious businesses experience job-related injuries costing thousands in medical expenses and lost productivity. Through enacting safety plans and rigorous employee training, accidents’ frequency and severity can be minimized, employee health and welfare can be protected and workers’ compensation insurance coverage premiums can be stabilized. Similarly, to prevent a dying investor’s ownership transferring to a less than cooperative relative, MRBs could obligate owners to execute buy-sell agreements requiring their survivors to sell the decedent’s portion to the surviving partners.
Unlike people, damaged or destroyed property can be repaired and replaced and its “useful life” can be accurately anticipated and amortized. Unfortunately, due to federal prohibition, MRBs are denied many standard insurances (like crop or cash exceeding $25,000), federal trademark and patent protection, and banking and credit card services.
Marijuana-related businesses’ profits and valuation create the greatest vulnerability and regulatory fines and penalties, business interruption and lawsuits impose the most perilous risk. Because they endure federal, state and local regulations, MRBs are vulnerable to fines and penalties from federal agencies (including the Drug Enforcement Administration, U.S Department of Agriculture and Food and Drug Administration), state agencies (Pennsylvania Department of Health’s Office of Medical Marijuana), and each municipality and borough in which they operate.
“Business interruption loss” is where an event halts an MRB’s operations like a wildfire’s soot and ash wiping out a grower’s crops immediately prior to harvest. Before the ensuing revenue-generating grow cycle is completed, employees, utilities and rent still require payment and, unless it has six months of cash to survive a revenue less 180-day period, a marijuana-related businesses could get crushed.
Lawsuits range from a single plaintiff seeking damages to class actions in which an entire group of claimants seek compensation. Each year defective, faulty or misused products cause serious injuries and property damage. Although primarily seeking remuneration for personal injury, property damage, or economic harm, products liability claims may also seek punitive relief to punish the defendant and redress harms allegedly done to society. Defending litigation or settling claims can materially drain a company’s resources requiring additional regulatory requirement compliance, developing/disseminating product warnings, instituting a product recall, deploying employee time to investigate/mitigate claims, investigating/testing products and assessing risk and hiring expert consultants.
Assembling a Risk Management Team
Because even the most standard loss could crash insufficiently prepared MRBs, assembling a “risk management insurance, accounting and legal advisory team” is critical.
First, before the business launches, choosing an industry-appropriate insurer and coverage is mandatory and, due to the specificity of the regulations governing cannabis production cycles, extraction and infusion, waste disposal, and finished products, managing a marijuana-related business’ insurance needs requires understanding the most precarious exposures.
Specialized coverage is needed for growing operations (indoor, outdoor, greenhouse), extractors, product infusers and manufactures, dispensaries (HIPPA compliance and cash management), transporters (product and cash), testing labs, commercial landlords and property managers and security providers. Additionally, because critical differences exist between the provided coverage (much of which contain troubling exclusions), specialized coverage is required for standard areas like general liability, property, workers’ compensation, professional liability, directors and officers, employment practices liability, crop, cybersecurity and data breach, motor truck cargo, stock throughput and crime and employee dishonesty
Second, choosing a certified public accountant (CPA) familiar with the cannabis industry, the thousands of pages of Internal Revenue Service’s (IRS) regulations and, most importantly, Section 280E of the U.S. Internal Revenue Code of 1986 is a game changer.
Pursuant to Section 280E, the IRS forbids MRBs from deducting otherwise ordinary business expenses from gross income associated with “trafficking” Controlled Substance Act’s Schedule 1 substances like marijuana, see 21 U.S.C. Sections 801, Et. Seq (1970); 26 U.S.C. Section 280E (“No deduction … shall be allowed for any amount paid … in carrying on any trade or business if such business … consists of trafficking in controlled substances …”).
Thus, because it prohibits claiming any tax deduction other than costs of goods sold (i.e., direct expenses attributable to the production of products sold by a company), Section 280E denies a marijuana-related business from claiming typical retail business deductions like rent, utilities and maintenance.
A seasoned industry CPA can offer profitability protecting and 280(e) shielding strategies like: using primary accounting system as the general ledger only for sales, cost of sales and inventory; using primary accounting system’s department classification functionality within a single accounting file and use separate files for each legal entity without commingling a management company or other entities with a dispensary; using the same chart of accounts in each company’s accounting file (making it easier to prepare and confirm financial information); keeping sales, cost of sales and inventory details in the tracking and point-of-sale systems and archive monthly; documenting services and transactions between all dispensary-related entities; following all intercompany contracts and pay/record the intercompany bills monthly; ensuring all inventory is on the balance sheet at the end of each reporting period; and developing, documenting and strictly following a process to determine total cost of goods sold.
Third, because even the most standard claim could derail an insufficiently prepared MRB, having a lawyer on board to avoid, mitigate and defend against liability and claims is essential.
Successfully defending against litigation requires treating all failures as potential claims and quickly reacting to liability issues when they arise. A seasoned cannabis attorney will help launch a risk transfer program shielding from claim and damages caused or contributed by third parties’ acts and omissions by documenting these decisions in writing and at a business relationship’s inception. Risk transferring documents include “hold harmless agreements” (ensuring that third parties are contractually responsible for own negligence, errors and omissions) and “statements of financial responsibility” like certificates of insurance which confirm both that third parties have sufficient insurance and list marijuana-related businesses as an “additional insured.”
Reprinted with permission from the March 25, 2019 edition of the Legal Intelligencer ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or [email protected].