Griffen Thorne, Author at Harris Sliwoski LLP Tough Markets, Bold Lawyers Wed, 27 Mar 2024 19:35:26 +0000 en-US hourly 1 https://wordpress.org/?v=6.4.3 https://harris-sliwoski.com/wp-content/uploads/cropped-Harris-Sliwoski-Logo-FinalIcon-White-1-32x32.png Griffen Thorne, Author at Harris Sliwoski LLP 32 32 The Top Four Questions You Should Answer Before Using an AI Chatbot on Your Website https://harris-sliwoski.com/blog/the-top-four-questions-you-should-answer-before-using-an-ai-chatbot-on-your-website/ Tue, 26 Mar 2024 15:08:58 +0000 https://harris-sliwoski.com/?p=134990 Should I Be Using an AI Chatbot on My Website? AI chatbots incorporated into business websites can be tremendously helpful. But they can also lead to huge costs, headaches, and even lawsuits if not incorporated correctly. In this post, we’ll examine the top four questions you should answer before you put an AI chatbot on

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Should I Be Using an AI Chatbot on My Website?

AI chatbots incorporated into business websites can be tremendously helpful. But they can also lead to huge costs, headaches, and even lawsuits if not incorporated correctly. In this post, we’ll examine the top four questions you should answer before you put an AI chatbot on your website.

1. What Am I Telling My Customers?

A consistent part of our firm’s web3 practice is drafting website policies – everything from privacy policies, to terms of service, to AI chatbot policies and terms. In our experience, many businesses dive headfirst into a new technology without required policies, which can lead to massive and expensive problems.

Some businesses make matters even worse for themselves by pulling website policies off the internet, changing the name, and then reposting someone else’s website policy on their own website. I wish I were kidding about this, but it happens more often than you can imagine, and it can and often does lead to devastating consequences.

For example, what are the chances that your business has the exact same privacy practices as someone else? Five percent? Unless a policy reflects your actual business practices, using the website policy from some other business is just begging for a lawsuit. And believe me, there is a huge market of plaintiff attorneys who would be more than happy to bring one.

The first thing businesses that use AI chatbots – or have a website at all for that matter – need to do is to get a good policy or set of terms in place. And to do that competently you will need to do a few things first.

2. Will the AI Chatbot Land You in Hot Water?

You’ve probably read about the recent scandal with Google Gemini which reportedly caused Google’s stock to lose $70 billion in value. You may have even heard about things like Old Navy’s AI chatbot being accused of illegal wiretapping. Putting aside some of the more publicized cases and allegations, there are still plenty of ways AI chatbots can generate output that is problematic and can cause you harm. Examples include things like:

  • Making defamatory statements that could be imputed to the website operator.
  • Providing incorrect instructions for how to use a product or service.
  • Making things up. Apparently this happens a lot. Even lawyers apparently get fooled!

These kinds of things may seem trivial, but they can lead to some pretty bad outcomes. For example, OpenAI was reportedly sued for defamation when ChatGPT allegedly created a fake complaint accusing someone of embezzlement. Imagine what would happen if a user asked an AI chatbot for instructions on how to use your product, received incorrect or incomplete instructions, and was then injured or harmed as a result of this.

Even AI companies seem to acknowledge the possibility that AI-generated outputs may cause problems. Anthropic’s (Claude.ai) terms of service from February 2024 state the following:

Reliance on Outputs. Artificial intelligence and large language models are frontier technologies that are still improving in accuracy, reliability, and safety. When you use our Services, you acknowledge and agree:

    1. Outputs may not always be accurate and may contain material inaccuracies even if they appear accurate because of their level of detail or specificity.

    2. You should not rely on any Outputs without independently confirming their accuracy.

    3. The Services and any Outputs may not reflect correct, current, or complete information.

    4. Outputs may contain content that is inconsistent with Anthropic’s views.

The point here is that AI tools are far from perfect. Businesses that want to deploy AI chatbots need to be aware of the potential risks and think of ways to mitigate them. Some mitigation techniques may be technical, such as ensuring that the AI chatbot only provides limited responses. Other mitigation techniques might include comprehensive AI chatbot policies and disclaimers.

3. Who Owns the Output Generated by the AI Chatbot?

When someone provides a prompt to an AI program (“input”), they receive a response (“output”). Does the user own the output? What about the input? The answer may depend a lot on what kind of AI tool is used. And if a user owns it, who else can use it?

For example, OpenAI’s January 2024 terms of use state that “As between you and OpenAI, and to the extent permitted by applicable law, you (a) retain your ownership rights in Input and (b) own the Output. We hereby assign to you all our right, title, and interest, if any, in and to Output.” This sounds great – a user owns its input and is assigned ownership of the output. But wait – the policy goes on to state that “We may use Content to provide, maintain, develop, and improve our Services, comply with applicable law, enforce our terms and policies, and keep our Services safe.” In fact, a user who does not want its “Content” used to train AI models has to affirmatively opt out.

Let’s look at Anthropic’s terms of service cited above. Similar to OpenAI’s terms, Anthropic’s policy states: “As between you and Anthropic, and to the extent permitted by applicable law, you retain any right, title, and interest that you have in the Prompts you submit. Subject to your compliance with our Terms, we assign to you all of our right, title, and interest—if any—in Outputs.” But they go on to state:

Our use of Materials. We may use Materials to provide, maintain, and improve the Services and to develop other products and services. We will not train our models on any Materials that are not publicly available, except in two circumstances:

  1. If you provide Feedback to us (through the Services or otherwise) regarding any Materials, we may use that Feedback in accordance with Section 5 (Feedback).
  2. If your Materials are flagged for trust and safety review, we may use or analyze those Materials to improve our ability to detect and enforce Acceptable Use Policy violations, including training models for use by our trust and safety team, consistent with Anthropic’s safety mission.

What does it mean to “provide Feedback”? Well, the policy says (bold type added):

We appreciate feedback, including ideas and suggestions for improvement or rating an Output in response to a Prompt (“Feedback”). If you rate an Output in response to a Prompt—for example, by using the thumbs up/thumbs down icon—we will store the related conversation as part of your Feedback. You have no obligation to give us Feedback, but if you do, you agree that we may use the Feedback however we choose without any obligation or other payment to you.

By my read of this policy, simply giving a thumbs up or down could be considered “Feedback” and associated materials could be used by Anthropic.

Why is any of this important? Well, if someone is using AI to generate output that they want to commercialize, the AI company providing the program may have terms that limit or restrict that commercialization (putting aside complicated issues of copyright laws). And users may have agreed to an effective license of the output back to the company providing the AI program. There are also potential privacy concerns. If a user inputs confidential information or information protected by privacy laws, and suddenly finds that he or she has not given a third party a license to that information.

Companies deploying AI chatbots should think about risk mitigation strategies (see point 2 above), and closely study the associated terms of any AI company whose programs they intend to use or incorporate.

4. Should I Be Concerned About Data Privacy and Confidentiality Issues?

Yes, and for the same reasons discussed in paragraph 3 above. Here too, many of the same risk mitigation strategies could be employed. Even before the era of AI, many websites contained statements prohibiting users from providing confidential or privacy-law protected information via a website or email. But in the era of AI, these kinds of disclosures have become far more important.

Conclusion

AI chatbots still have a ways to go before they are sophisticated enough to deploy without major concerns. Businesses that want to integrate them into their websites should appreciate their risks and come up with risk mitigation tools. Otherwise, they may find themselves among the first round of defendants in the coming era of AI litigation.

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How LOIs Can Go Horribly Wrong https://harris-sliwoski.com/cannalawblog/how-lois-can-go-horribly-wrong/ Wed, 20 Mar 2024 14:00:27 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=135332 Cannabis businesses often use letters of intent (LOIs) to get agreed deal terms in writing before spending time and money negotiating the definitive written contract. LOIs can be a big help, especially with a complicated deal. But they are easy to botch, and can lead to some pretty devastating consequences if not done right. Be

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Cannabis businesses often use letters of intent (LOIs) to get agreed deal terms in writing before spending time and money negotiating the definitive written contract. LOIs can be a big help, especially with a complicated deal. But they are easy to botch, and can lead to some pretty devastating consequences if not done right.

Be careful for unintended binding LOIs

In the majority of situations, parties to an LOI want them to be fully or partially non-binding. These LOIs are intended only to be outlines of a deal that the parties can use in negotiating finer points. Some provisions may end up being binding, like confidentiality or exclusivity provisions. But the majority of terms are often left to be fleshed out.

The problem is that some LOIs do a pretty bad job of clarifying what is and is not binding. This leads to two pretty bad potential outcomes. First, a provision intended to be binding could be construed as non-binding. Imagine the buyer in a deal wanted the seller locked in to an exclusivity obligation for 60 days after signing, but the LOI didn’t clearly specify that this was a binding obligation (as opposed to just some kind of expectation). It’s possible that the seller could then shop the deal around without any recourse on the buyer’s part.

The second potential problem is possibly a lot worse – an LOI could be deemed binding where it was intended not to be binding. I’ll get into this in greater detail in the next part.

Binding LOIs can be a big problem

From time to time, people want fully binding LOIs. In almost all cases, I think these are a bad idea. Because binding LOIs are, by definition, binding, they must contain a LOT more detail than your average non-binding LOI which may be as short as a page or two. With more detail comes more negotiation, and more time. So in most cases, if parties want a binding document, it makes a lot more sense to just proceed to the definitive contract and not waste time on a binding LOI that will precede it.

As an aside, there are some limited contexts where a binding LOI makes sense despite these concerns. For example, imagine a deal with a lot of different contracts to be drafted and executed at different times over a long period of time, but where the parties are nevertheless willing to spend a bit of time up front negotiating terms. In that case, it may make sense to have a binding LOI, or some kind of other binding agreement to flesh out these contractual obligations.

In any event, where binding LOIs can be problematic is where the negotiating parties fail to include sufficient detail and basically treat them as binding versions of non-binding LOIs. And insufficiently detailed LOIs can lead to a host of issues. I’ve seen plenty of situations where one party would have wanted to include more protective provisions in a full-length definitive, but the other party knows that the LOI is binding and refuses to negotiate anything else. It can be a terrible outcome.

LOI fundraisers

A lot of businesses will issue press releases after inking LOIs, for marketing purposes but also to drum up investments – especially so for public cannabis companies. As you can imagine, there can be a lot of shenanigans here as well. Some cannabis companies will enter into a huge amount of LOIs with little intent to consummate the transactions. This is obviously bad news for their prospective business partner who may have not only wasted time and money on getting the LOI done, but also passed on other deals. And it can lead to even more problems for the company issuing the press release if they don’t represent the proposed deal’s context accurately.

There are some pretty easy solutions to these problems. For example, even a non-binding term sheet can contain restrictions on publicity that are binding (though careful wording is required!). Or one or both parties could carve out exclusivity obligations or allow for LOI termination in the event the other party isn’t taking the deal seriously or it becomes clear that the other side is trying to fundraise off the LOI.

Non-attorney drafted LOIs

People think that because LOIs are not binding and intended to serve as an outline, lawyers are unnecessary. The problem with this train of thought is that it could be incredibly easy for non-lawyers to write an LOI that was intended to be non-binding, but fail to actually make it non-binding. Or they could draft an intentionally binding LOI that fails to include sufficient detail. Or they could make a hundred other types of mistakes that could have been avoided.

As I wrote a few years ago, “Getting a lawyer involved in the term sheet process can be key. This is especially true on complicated or expensive deals, or where one party knows it has less leverage in a deal to request changes at a later date. It’s even more true where the other side or their lawyers are going to be tough negotiators.”

To flesh that out a bit more, as a deal outline, the LOI will be the one of the key things that lawyers look to when negotiating a contract for the life of the negotiation. I can’t tell you how many times I’ve heard lawyers complain that something was “not in the LOI” or “different from what’s in the LOI” during negotiations, even when the LOI was clearly not binding. And in a lot of cases, parties will simply agree to stick to what the original intent was.

All of this is to say that an LOI is an incredibly important investment. Good lawyers don’t need to charge an arm and a leg on them, and a good LOI can save a ton of headache down the road. This is especially the case in a highly regulated industry where one or both of the parties to a deal may be less familiar with regulatory intricacies when negotiating the LOI.

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California Allows Cannabis Cultivators to Reduce License Sizes https://harris-sliwoski.com/cannalawblog/california-allows-cannabis-cultivators-to-reduce-license-sizes/ Thu, 14 Mar 2024 14:00:19 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=135266 The California Department of Cannabis Control (DCC) just published some new guidelines for cannabis cultivators following the passage of SB-833. Among other things, California will let cannabis cultivators reduce their canopy size and thereby reduce license costs. This will be a huge benefit. I write a lot about the woes that California’s cannabis industry faces

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The California Department of Cannabis Control (DCC) just published some new guidelines for cannabis cultivators following the passage of SB-833. Among other things, California will let cannabis cultivators reduce their canopy size and thereby reduce license costs. This will be a huge benefit. I write a lot about the woes that California’s cannabis industry faces – often due to overly burdensome regulation – but in this case, I think the DCC’s guidelines will have a positive impact on certain cannabis cultivators in the Golden State.

California has about a zillion different types of licenses for cannabis cultivators. They are based on size (specialty cottage, specialty, small, medium, and the relatively new large) and type (indoor, outdoor, or mixed-light). And there are separate licenses for nurseries and processors (you might think processing is manufacturing, because that would make sense, but you’d be wrong!).

Having more than a dozen different types of licenses guaranteed problems. One of those problems is that the state did not create a mechanism to easily change between license size. With the opening of large licensing in 2023, the state made it possible to go “up” in size, but not down. This was a big problem for a lot of folks in the industry.

Here’s an example: imagine a cultivator got a medium indoor license (which allowed for between 10,001 and 22,000 square feet of canopy). At the time of licensure the cultivator had enough built-out capacity to have 7,500 square feet of canopy, but expected to build out another room a few months down the line. For whatever reason, the cultivator didn’t have the means to complete the buildout and was stuck paying the medium indoor fee of $77,905 as opposed to the small indoor fee of $35,410.

Until recently, the cultivator’s only option would be to continue to pay double the annual licensing fee, or to submit a completely new application for the smaller license. This could be a cumbersome and costly process, even if it would lead to a better cost savings over time.

According to DCC’s new guidelines, cannabis cultivators will be able to request a reduced-size cultivation license either upon renewal or if they make a one-time change to their expiration date outside the renewal process. While we don’t have much data on how many licensees this will affect, it will hopefully help affected cannabis cultivators and reduce regulatory red tape.

Need Help With California Cannabis Law?

Contact Us

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Common Pitfalls in Cannabis Brand License Agreements https://harris-sliwoski.com/cannalawblog/common-pitfalls-in-cannabis-brand-license-agreements/ Tue, 12 Mar 2024 14:00:31 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=135102 Cannabis companies and (depending on the state) brands often use license agreements to grow their brands. If done correctly, they can be a huge driver of revenue for the brands and licensees, and can grow the good will of the brand across a particular territory. However, they are notoriously easy to botch. A bad license

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Cannabis companies and (depending on the state) brands often use license agreements to grow their brands. If done correctly, they can be a huge driver of revenue for the brands and licensees, and can grow the good will of the brand across a particular territory. However, they are notoriously easy to botch. A bad license agreement can be devastating for a cannabis brand. In this post, I’ll examine some of the most common problems I’ve seen in license agreements across a host of different states.

It may help if I first explain what I mean by “license agreement.” I’m using the term loosely to refer to a situation where a company (a licensor) licenses its intellectual property (like its brand name) to a third party to use in a defined way. There are a million different ways license agreements can take shape.

One common example would be a license of IP to a cannabis company for purposes of manufacturing and selling the branded products. In general, this is the kind of license agreement I want to focus on in this post.

#1 Failure to consider regulatory impact

Cannabis is a highly regulated industry. So it should come as little surprise that regulators often care a lot about the types of people that licensed entities deal with. Intellectual property licensors are one such group. Many states put roadblocks in front of IP licensors, making it difficult or even impossible to do license agreements. Sometimes, regulations are so onerous that deals must be completely reformatted, at risk of great penalty to one or both parties.

I say this a lot here, but it’s really important to figure this out before paying an attorney to draft and negotiate a license agreement. Not only will parties potentially waste money by failing to do that, but they will also potentially put themselves at risk of regulatory penalties later down the road.

#2 Poorly defined payment terms

I’ve done more license agreements than I can count. Usually, they start with a client or opposing counsel relaying agreed-in-principle deal terms. And often, I hear something like “royalties will be X%.” My next question is always, “X% of what?” You’d probably be surprised how often I hear crickets in response.

It often takes a lot of handholding or wrangling to figure out the precise calculation of royalties. And that’s just one of myriad payment terms. Things like payment timing, expense payments, invoicing and fee disputes, credits, etc. all require additional thought and detail. Parties often don’t appreciate that a license agreement sets the state for a long-term, sometimes multi-year relationship, and so are very different from one-time purchase agreements. If parties execute license agreements with unclear or vague payment provisions, they should not be surprised when disputes inevitably arise.

#3 Unclear order process

While I spend a lot of time working my way through unclear payment terms, by far the most common issue I see in license agreements is an unclear order process. Sometimes, license agreements completely fail to say anything about the process for making and/or ordering goods. In an agreement where the whole purpose is the manufacture and sale of goods, this is… a problem. But it happens all the time.

To be fair, some license agreements may not require an order process to be spelled out in detail. If an unlicensed brand (in a state that permits it!) licenses IP to a cannabis company to make and sell products to whomever it can sell them, then that cannabis company may have discretion as to how and when to make products. But license agreements may not be as clear as that and you may see situations where both the licensor and licensee agree to market and sell products.

In these types of cases, the licensor will need some clarity about how it can order products, how much of a lead time there must be to do so, and so on. If it is not clear how the parties will dictate or request for these processes to happen, then things are bound to go south.

#4 Pricing problems

Let’s go back to the example of an unlicensed brand licensing its IP to a cannabis company for a full suite of manufacturing and distribution services. Chances are the brand will be paid a royalty that is some percentage of the sales price of each unit of product sold. So obviously, the brand will want the sales price to be as high as possible. There are a few potential things that brands can get really wrong here.

First, some license agreements may not say anything about sales prices. In an extreme case, the licensee could sell the products at such a low rate that the brand got little back. On the other hand, if a brand sets a minimum sales price too high, the licensee may not be able to sell any product and both parties are out of luck. I’ve seen companies on the verge of litigation over these issues. In my view, a lot of this is easily avoidable.

Savvy brands have a few options here. At the very least, they could include a contractual duty to use “best” or “commercially reasonable” efforts to sell the products for the highest possible price. But this is still pretty squishy and up for debate. Brands could also include “tiered” pricing options, setting a “target” price and a lower minimum price. That way the licensee would need to try for the target price, but could have wiggle room to lower it a bit. Or, the parties could agree on a price but opt to revisit it periodically depending on sales levels.

#5 Packaging and labeling fiascos

I’ve seen plenty of license agreements that give the licensor complete discretion over what goes on a product’s packaging or labeling. That may be fine for products that are not over-regulated, but it can be a problem for cannabis transactions. Cannabis label laws are notoriously complicated – so much so that I’ve had at least a few changes on 100 percent of the labels I’ve reviewed. For example, California has different sets of detailed requirements that apply to manufactured and non-manufactured products that are extremely technical and complicated down to things like font size and text placement.

Even putting regulations aside, a licensee probably wants at least some level of assurance that its licensor is not going to do something that brings an infringement case on the licensee (see here for some examples). So leaving a label up to a licensor, who may not even be a licensed company, is a major risk.

When I am representing the IP licensee, one of the first things I do is look at who makes the call on labeling content. I don’t see a ton of pushback when licensee clients ask for some approval rights over label content. In fact, we usually end up with a licensor creating the initial label and editing it based on inputs from the licensee. But as with anything else, it’s important to get this in the contract so that there are not disputes later down the road.

#6 No guardrails on marketing

Similarly, cannabis marketing laws are complicated. If a license agreement allows licensees to conduct marketing activities, the license agreement should at the very least obligate the licensee to comply with laws while doing so. But strong license agreements may take things further, and require the licensee to abide by certain standards or guidelines above and beyond what the rules require. After all, marketing materials can both comply with the law and cause harm to the reputation of the licensor or good will of the licensed brand.

#7 Failure to protect the licensor and brand

The final common problem I’ll address today is a license agreement’s failure to adequately protect the licensor or brand. With respect to brand protection, a good license agreement will include a laundry list of provisions restricting how the licensee can use, sublicense, or delegate the licensed IP, and will require the licensee to provide assistance in or participate in intellectual property disputes. Without locking a licensee’s use in place, the licensor could jeopardize legal protection for its brand. And this totally defeats the purpose of the license.

More broadly though, license agreements often fail to address potential harm to the licensor itself. In the example I’ve been using here – a brand licensed to a company for manufacture, distribution, and sales – the licensor would have no part in the manufacturing and distribution process. In that case, it would want to be shielded from liability to the maximum extent possible. There are several contractual provisions that the licensor could include to accomplish this, such as:

  • Contractual indemnity provisions, to require the licensee to cover the licensor’s costs should it be roped into a lawsuit as a result of the licensee’s conduct.
  • Requirements for the licensee to procure insurance with additional insured coverage for the licensor.
  • Liability limitations that would limit the licensee’s ability to recover from the licensor.
  • Covenants and other provisions that would make crystal clear that the licensee (and not the licensor) remained responsible for certain conduct.
  • Carveouts from indemnification or liability limitation provisions that benefit the licensee if the licensee engaged in prohibited conduct.

This last point bears a bit more explanation. License agreements often require the licensor to indemnify (i.e., cover costs) the licensee for certain things, like if the licensee gets sued by a third party because the licensor’s IP is allegedly infringing. But a licensor-friendly license agreement will often carve out obligations where the licensee itself did something wrong. So for example, if a licensee markets a licensor’s brand in a way that leads to a third-party infringement suit, then the licensee may not be entitled to indemnification.

Conclusion

The above issues are some of the more common ones I’ve seen crop up over the years I’ve reviewed, drafted, and negotiated license agreements. They are by no means exclusive and there can be many other problems, especially when you start getting into more “exotic” agreement types, like tri-party agreements.

If you’re interested in other important provision in license agreements or other kinds of B2B cannabis contracts, check out some of our other posts below:

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Investing in Cannabis: Five Due Diligence Red Flags https://harris-sliwoski.com/cannalawblog/investing-in-cannabis-five-due-diligence-red-flags/ Thu, 07 Mar 2024 15:00:36 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=135074 Our cannabis team has performed due diligence on countless business purchases, investments, loans, and just about every other kind of transaction you can imagine. As you can imagine, we’ve seen some pretty bad and even sketchy things over the years. With rescheduling on the horizon (see here and here), we expect to see an increase in loans, investments,

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Our cannabis team has performed due diligence on countless business purchases, investments, loans, and just about every other kind of transaction you can imagine. As you can imagine, we’ve seen some pretty bad and even sketchy things over the years. With rescheduling on the horizon (see here and here), we expect to see an increase in loans, investments, and other transactions. And so we thought it might be time to look at five of the biggest due diligence red flags.

#1 No cooperation in due diligence

Hands down, the biggest red flag in due diligence is when the seller, borrower, etc. refuses to participate in the process. I don’t mean getting fatigue when the buyer or investor’s lawyers ask too many questions – I mean refusing to participate in the basic process. We’ve seen people refuse to provide basic information. Or walk away from a deal when basic questions were asked. Or say that other people did similar deals without information, so you should too.

This is all incredibly suspect behavior. Someone who is selling a business or seeking a loan or investment needs to be completely open. Obviously, diligence periods can get off the rails and become too long, but failure to provide basic information is a red flag that something bad lurks beneath the surface.

#2 When the pitch doesn’t match reality

One of the next big red flags is when due diligence reveals facts that grossly contradict pitches or early disclosures. The due diligence process usually begins once a client decides a deal is worth pursuing enough to pay lawyers or financial advisors. That means that the client will expect that what was disclosed to them initially is true. But often, once attorneys start to look under the hood, things can change quickly. Imagine a company saying it has X amount of licenses, when really it has half of that and has simply applied for more – stuff like that.

I can’t tell you how upset clients can get when they figure this out. A deal can just die on the spot. If a buyer or investor fails to do proper diligence, it may not learn the truth until after the deal closes. While the buyer or investor could sue for fraud, that money could just disappear. It’s much better to know this up front, before wasting time and money.

#3 Bad or crazy business structures

Another big thing to look for in due diligence is the target’s business structure, plans, and organizational chart. In our experience, the more complicated an org chart or business structure is, the bigger the chance that things won’t work out (my colleague, Vince Sliwoski, wrote a pretty good post explaining some of the wackier business structures we’ve seen over the years). In some cases, over-complexity is used in a misguided attempt to reduce tax burdens or avoid other problems. But it can also be used to straight up confuse and defraud potential investors. Again, due diligence is critical.

It’s not just bad or crazy business structures that a buyer or investor should look out for. They also need to understand fundamentally what the target’s business plan is. We’ve seen more than a few cases where a target claimed to have found some hidden loophole in the law that meant its business would be able to corner the market. Sometimes, a target will even get a law or accounting firm to give an opinion letter in support. But these kinds of pie-in-the-sky promises rarely come to fruition.

#4 Byzantine governing documents

Investing in a cannabis company means getting stock (of a corporation) or membership interests (of an LLC) and becoming an owner of the company. An even moderately well-governed company will ask its investors to sign on to existing governing agreements. In cases with smaller companies, an investor may have the chance to negotiate new governing agreements, but that’s by no means a guarantee. So one of the most important thing an investor can do with respect to due diligence is to look at the target’s governing agreements.

This is something that can trip up lots of lawyers and almost any lay person. I’ve seen investment transactions with 80 or 90 or even more than 100 pages of corporate documents slipped into the deal. If you are not intimately familiar with corporate law, you may miss key provisions that dramatically affect you.

For example, I’ve seen transactions where an investor thought they were going to have the same rights as other owners, but the governing agreements gave them non-voting stock with no management rights and a lower place in the distribution waterfall. This kind of thing can be buried deep within an operating agreement and couched in language that is incredibly dense and tough to understand. This is just one area where working with good corporate counsel can pay dividends (no pun intended).

#5 Ownership disputes

One of the most important things to look for is ongoing or threatened litigation. It’s relatively easy to find out if a business is involved in active litigation (court records are public after all, even though they may not be easily searchable). But finding records of things like private arbitration, mediation, or demand letters may be impossible unless the sellers or target company discloses that information to the buyer’s representatives. A step beyond that, sometimes there may even be a potential for a dispute, for which no demand letter has been served. Again here, a buyer will need to rely on a seller to disclose those facts.

This is a bit of a digression, but the point is that it’s critical to perform due diligence on a target’s litigation profile. One area where litigation can lead to disasters involves ownership disputes in an M&A (business purchase) transaction. Imagine a person is trying to sell you their business while they are currently embroiled in a lawsuit with an ex-partner who says they were illegally forced out and own half the business (we’ve seen this!).

If a buyer fails to figure out that an ownership dispute has or is likely to arise, or does learn and proceeds with the deal anyway, it is virtually begging to be named in that lawsuit. If money was handed over to the seller, that money may be as good as gone.


Above are five of some of the biggest red flags we have seen in cannabis transactions when performing due diligence. This list is by no means exhaustive, and there are countless other things that could tank a deal or lead to litigation. We’ll continue to blog about all kinds of corporate law mishaps for the cannabis industry, so stay tuned.

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What is a Series LLC? https://harris-sliwoski.com/blog/what-is-a-series-llc/ Thu, 29 Feb 2024 15:44:30 +0000 https://harris-sliwoski.com/?p=134998 Series LLCs Series LLCs are a relatively new type of entity that more and more states are embracing. Still, many experienced businesspeople are unfamiliar with series LLCs. Below, I break down the concept of a series LLC, their benefits, and some potential issues. What Is a Series LLC? To understand what a series LLC is,

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Series LLCs

Series LLCs are a relatively new type of entity that more and more states are embracing. Still, many experienced businesspeople are unfamiliar with series LLCs.

Below, I break down the concept of a series LLC, their benefits, and some potential issues.

What Is a Series LLC?

To understand what a series LLC is, think of a standard org chart with a parent entity and multiple subsidiaries. The parent and its subsidiaries are each legally distinct entities that can sue or be sued in their own names, own their own assets, and so on. A series LLC collapses the org chart from multiple entities to just one LLC with different cells (called “series”). Each series is part of the same entity but has the features of a distinct entity. But the owners get to avoid the hassle of forming dozens of companies, paying filing fees, and so on.

Delaware was the first state to allow series LLCs in 1996. Since then, a number of other states and U.S. territories authorized them, though the majority of states still do not. This could be a problem for reasons discussed below.

As with normal LLCs, corporations, partnerships, or other entities, states tend to have very different legal and operational requirements for series LLCs. Some states, for example, may require separate filings for individual series, where others may not. Some states, like California, do not allow formation of series LLCs, but will recognize series LLCs doing business within the state so long as they register with the California Secretary of State (this could require multiple registrations if multiple series “do business” in the Golden State).

The Problems with Series LLCs

Series LLCs come with a lot of baggage. First, they are very different from the “normal” entity types, and so can be difficult to manage for people unfamiliar with them. While series LLC laws aim for governance similar to traditional LLCs, things can become complicated when it comes to series with different functions and ownership. So, it’s important to consider whether a series LLC is better for an individual business than a traditional parent-subsidiary or affiliated entity structure.

Second, states do wildly different things when it comes to recognizing foreign (i.e., other state) series LLCs. For example, Arizona law states:

A foreign limited liability company, its members and managers and its foreign series, if any, have no greater rights and privileges than a domestic limited liability company and its members and managers with respect to transactions in this state and relationships with persons in this state that are not managers or members. A foreign series is liable for the debts, obligations, or other liabilities of the designating foreign company and of any other foreign series of that designating foreign company, arising out of transactions in this state or relationships with persons in this state and a designating foreign company is liable for such debts, obligations, or other liabilities of each foreign series of that designating foreign company.

In plain English, say a cell of a Delaware series LLC breaches a contract with an Arizona company and gets sued in Arizona – the assets of all cells of the series LLC would be on the table, not just the assets of the breaching cell. This completely undermines the point of a series LLC and actually would do much more harm than the other, traditional models discussed above where assets of affiliated entities would not be reached by the creditor absent veil piercing (which itself can be hard to prove).

Third, tax law is not necessarily a picture of clarity. The IRS has no official series LLC regulations, but did previously propose regulations that would treat each series as a separate entity. States may simply ignore the distinction between series, and tax the entire series LLC as a single entity.

Fourth, individual cells within a series LLC are not recognized as a “person” under the Bankruptcy Code. This is important because –as with states like Arizona — it’s certainly possible that bankruptcy proceedings for a specific cell could spill over into others.

The Benefits of Series LLCs

Now that we addressed some of the problems with series LLCs, let’s look at some of the benefits. First, series LLCs offer many of the same protections you’d see with the standard parent-subsidiary model. For example, real estate could be held by individual series, where in a parent-subsidiary model, it would be held by individual subsidiaries. This could save on filing fees, regulatory filings, and other red tape associated with more traditional entity models.

Second, series LLCs lend themselves well to fractionalization of assets. Take, for example, the company Masterworks, which allows regular folks like you and me to invest in specific pieces of art. What Masterworks appears to do is to form series LLCs, with individual cells that own individual pieces of art. It then appears to sell membership interests in those series (as opposed to ownership directly of the art).

Companies that offer these fractional interests often leverage Regulation A, a regulation I extensively outlined previously. This regulation harmonizes well with the structure of Series LLCs, opening a promising avenue for substantial growth in the realm of fractional ownership in the foreseeable future.

The Role of Series LLCs

As relatively recent additions to the array of legal business structures, series LLCs present a novel opportunity for innovation. Yet, for many traditional businesses operating across multiple states, the transition to series LLCs may still involve overcoming certain hurdles before they are the best option. Despite their drawbacks, series LLCs can provide significant benefits to certain business models, such as fractionalized asset sellers.

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California Cannabis Tax Collection and Penalty Nightmares https://harris-sliwoski.com/cannalawblog/california-cannabis-tax-collection-and-penalty-nightmares/ Wed, 28 Feb 2024 15:00:16 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=135037 California’s cannabis taxes are a disaster, with no end in sight. I’ve written about the state’s tax problems extensively, but today I want to talk about what the state can do when it comes to tax collection. Late cannabis taxes? Get used to hefty penalties If a licensed cannabis business fails to timely or fully

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California’s cannabis taxes are a disaster, with no end in sight. I’ve written about the state’s tax problems extensively, but today I want to talk about what the state can do when it comes to tax collection.

Late cannabis taxes? Get used to hefty penalties

If a licensed cannabis business fails to timely or fully pay its cannabis taxes, it will owe a substantial amount higher than the actual tax amount. Specifically, the state’s cannabis laws mandate a penalty of 50 percent of the unpaid amount, on top of the 10 percent general penalty payable for late tax payments. The same licensees will also be required to pay interest on the unpaid amounts. If you’ve ever seen a California Department of Tax and Fee Administration (CDTFA) statement of account, you may have noticed an additional charge listed as “other,” which allegedly includes miscellaneous collection fees.

Imagine a company owed $100,000 and failed to timely pay. Given the above, that same company would owe at least $160,000 (and probably closer to $170,000 or more) considering the penalties. Additionally, when I say “timely,” I mean it literally – we’ve seen the CDTFA impose penalties when a licensee was a day late.

Now you may point out that the CDTFA does entertain payment plans, and may even waive some of the penalties in some cases. But – and this is a big “but” – waivers are never guaranteed, payment plans take time and resources (i.e., money) to negotiate, and failing to follow a payment plan to the letter could result in it being revoked.

The bottom line is that if a licensee fails to pay the state’s absurdly high cannabis taxes by even a day, the licensee will be in a world of pain.

Threatening notices and demands

Now let’s say the oppressive tax penalties are not enough to get a licensee to pay. What next? The licensee can expect to receive a “notice of state tax lien” that is filed with the California Secretary of State. The notice will tell the license that the assessed liability constitutes a lien on all personal property of the licensee. This will make it very difficult for the licensee to secure financing, given that its assets are encumbered.

The CDTFA may also issue a “notice of possible disciplinary action” threatening to report the licensee to the Department of Cannabis Control (DCC – the licensing authority) which can discipline a licensee for failing to pay taxes. And of course that discipline can include license revocation.

Threats of individual liability are possible

Let’s say a cannabis business faced with these demands decides to close up shop and wind down. Are the taxes discharged? Nope. In fact, if a cannabis business dissolves, terminates, or is abandoned, the persons who were in control of the business can be personally liable for the cannabis taxes of the former business. I’ve seen the CDTFA even demand that owners of a cannabis business negotiating a payment plan acknowledge in writing that they can be liable for unpaid taxes if the business folds before the tax is paid.

This puts businesses owners and operators in a real bind. On one hand, these folks know that they cannot continue to operate — bankruptcy is not a viable option and receiverships and other non-bankruptcy processes don’t go nearly far enough. The DCC may prevent them from operating and making money to pay back taxes, to boot. On the other hand, these owners can’t simply walk away without being personally liable.

When the state comes to collect

Sometimes, all of the above things fail to work, and the state comes to collect. The issue is that there may not be a whole lot for the state to collect and sell off, and you may end up with absurd situations like the state auctioning off seized bongs and snow cone machines for a whopping $2,075 in proceeds. This is a true story!

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California’s cannabis taxes and penalties are way, way too high, and basically guaranty that the state will not be able to collect and will have to spend good money chasing licensees. Licensees and the state are essentially designed to be in an endless game of negotiations, with licensees hoping that the law will change or that some of their penalties will be forgiven.

None of this is tenable. If the state wanted to change things, it could. But it hasn’t, and it’s failure to act speaks volumes.

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Are Crypto Airdrops Legal? https://harris-sliwoski.com/blog/are-crypto-airdrops-legal/ Tue, 27 Feb 2024 16:58:16 +0000 https://harris-sliwoski.com/?p=134978 Over the last few years, airdrops have become much more common in the crypto space. Airdrops are often used to market or promote a crypto startup or platform. But like with so many other things in the space, their legal status remains murky. In this post, I do a deep dive on the legality of

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Over the last few years, airdrops have become much more common in the crypto space. Airdrops are often used to market or promote a crypto startup or platform. But like with so many other things in the space, their legal status remains murky. In this post, I do a deep dive on the legality of airdrops.

What are airdrops?

Airdrops involve sending tokens or coins to a wallet without receiving monetary payment. You might see a lot of terms thrown around, like standard airdrops (where anyone who registers is eligible to receive an airdrop), bounty airdrops (where a person who completes a task like posting on social media or joining a platform), or holder airdrops (where existing coin or token holders receive an airdrop).

At the end of the day, the common feature of each of these kinds of airdrops is that the recipient does not pay money to get them. This distinction is critical for determining whether airdrops are legal.

Are airdrops securities?

For issuers dropping tokens into the wallets of US persons, the most important legal question is whether their coin or token is a security. The test that the Securities and Exchange Commission (SEC) and courts use to make this determination is known as the Howey Test from the U.S. Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946). We did a deeper dive into the Howey Test in the context of SEC v. Ripple here, which I strongly suggest you read.

The Howey Test asks whether something is an investment contract, which is a type of security. To be an investment contract (and by extension a security), the following four prongs must be satisfied:

  1. An investment of money or other consideration
  2. In a common enterprise
  3. With the expectation of profits
  4. Derived solely from the efforts of others.

Now you may be thinking that free airdrops cannot possibly satisfy the first prong, so the analysis ends there. Well, in the eyes of the SEC, that’s wrong.

In 2018, the SEC issued an order in an administrative proceeding known as In re Tomahawk Exploration LLC, in which it concluded that a bounty program constituted an offer of securities. Critically, the SEC stated:

The lack of monetary consideration for “free” shares does not mean there was not a sale or offer for sale for purposes of Section 5 of the Securities Act. Rather, a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit.

In other words, if the issuer of a coin or token receives a non-monetary benefit, that could satisfy the “money or other consideration” prong of the Howey Test. And indeed, the SEC concluded that “Tomahawk received value in exchange for the bounty distributions, in the form of online marketing including the promotion of the ICO on blogs and other online forums. Tomahawk also received value in the creation of a public trading market for its securities.”

It seems pretty clear then that bounty airdrops would meet this prong. But what about standard or holder airdrops where the recipient does not have to do a specific task to get the token or coin? It seems, based on Tomahawk, that the SEC would still conclude that the issuer received a benefit, in that the issuance of the coin or token would create a secondary market and would likely cause more people to register (for standard airdrops) or purchase coins or tokens (for holder airdrops).

I won’t go through the other factors here, but if you’re interested in them, you can take a look at this Framework for “Investment Contract” Analysis of Digital Assets created by the Strategic Hub for Innovation and Financial Technology of the SEC. The framework goes through each element of the Howey Test and notes in a footnote (citing Tomahawk) that:

 Further, the lack of monetary consideration for digital assets, such as those distributed via a so-called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities.  In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation.

Can airdrops be legal?

Considering that the SEC will probably consider any airdrop to be a “security,” the question becomes whether they are legal. Under federal securities law, a security cannot be offered for sale unless it is registered or is subject to a registration exemption. I’m going to go out on a limb here and say that most airdrop tokens or coins are not registered.

For issuances that are not registered, the issuer must find a federal registration exemption. And, unless federal law preempts state law, the issuer must also comply with state laws. This is where things get complicated, and really depend on the facts of an airdrop issuance. There is not a clean, one-size-fits-all exemption here.

Crowdfunding exemptions require transactions to occur via an SEC-registered intermediary, which just isn’t the case with most airdrops. General solicitations are permitted, but only to accredited investors where an issuer takes reasonable steps to verify accredited investor status – which just isn’t going to happen with most airdrop issuances. Private placements can’t use general solicitation. Limited offering exemptions may be the closest applicable exemption, but they do not preempt state law so an issuer would have to conceivably comply with state law requirements (which vary substantially) in every state.

The point here is that most airdrop issuers are going to face a hurdle trying to find an exemption that fits. And without an exemption, the issuer would need to register their securities to avoid potentially serious penalties.

Are there any other considerations?

Let’s just assume that an airdrop issuer clears all the hurdles mentioned above. Are there other legal issues to consider? The answer is “yes,” of course.

First off, issuers of securities are restricted from a host of conduct. This includes a prohibition on fraud in connection with the purchase and sale of securities. This kind of fraud requires a showing of “scienter,” which is a fancy word for intentionality. If an individual affiliated with an issuer makes material misrepresentations, that “scienter” can be “imputed” to the issuer entity.

To see how seriously the SEC takes allegations of fraud, look no further than the Tomahawk order. The SEC focused a substantial portion of the order alleging that the issuer made false and misleading statements in connection with the issuance. The SEC concluded that there was evidence of scienter and imputed it to the entity.

Second, there will likely be some tax ramifications for recipients of airdrops – even though they are technically “free” of monetary consideration.

There are other factors that airdrop issuers must consider, but these are two of the bigger ones (in addition to clearing the registration v. exemption hurdle).


It seems like almost every day our web3 team fields questions about the legality of some kind of emerging technology or practice. This is an area of the law where the technology and business practices move much faster than the regulators. There is not always a clear answer, and sometimes the best answer is “maybe” or “it depends” or “we need to wait and see what the SEC does.”

Here though, it looks like the SEC has already made up its mind on airdrops. That said, things change quickly in this space, so stay tuned to our blog for more updates.

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California Cities: Prohibition Doesn’t Work https://harris-sliwoski.com/cannalawblog/california-cities-prohibition-doesnt-work/ Thu, 22 Feb 2024 15:00:32 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=134942 California has a population of nearly 40 million, six years of cannabis licensing, but only has about 1,200 licensed dispensaries. These stores are mostly spread out in highly populated areas like Los Angeles, San Francisco, and so on. The problem is that many California cities still prohibit cannabis licensing, even in places where a majority

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California has a population of nearly 40 million, six years of cannabis licensing, but only has about 1,200 licensed dispensaries. These stores are mostly spread out in highly populated areas like Los Angeles, San Francisco, and so on. The problem is that many California cities still prohibit cannabis licensing, even in places where a majority of the locals approved the state’s recreational cannabis program in 2016. This is a massive problem and is one of the key reasons the illegal market thrives. Let’s look at why that is the case and what these cities can do to change it.

Why prohibition doesn’t work

When the government prohibits something, there is an existing market for that thing, and a fear on the part of the government (justifiable or otherwise) that failure to prohibit it would lead to some kind of societal harm. Because there is an existing market for the thing, there is necessarily some kind of demand for it. If the government bans the thing, some people will realize that the potential cost (prison, fines, stigma, etc.) outweighs the benefit, and demand will go down.

But others will find that the benefit outweighs the potential cost, no matter how high it is — which is why people still roll the dice in countries like Singapore that will execute drug traffickers. So while prohibition may decrease demand, it won’t end it. And so long as there is some demand, again, some people will roll the dice.

This is exactly what has happened in the decades since cannabis was prohibited. If prohibition were an effective deterrent, then you would expect there not to be a high level of use or incarceration. But we’ve seen the opposite. There have been millions of people arrested and incarcerated for violating the Controlled Substances Act and state-law counterparts. It’s pretty clear then that these laws don’t have their intended effects, which brings me to the next point.

What problems are California cities creating?

When California voters passed the state’s flagship recreational licensing law in 2016, California cities were given an immense amount of control over the new industry. Perhaps realizing the initiative would face strong opposition if it took power away from cities, the drafters included provisions that allowed California cities to completely ban cannabis activities within their limits. These provisions led to local bans in vast swathes of the state.

While cities have slowly “come online” over the years, there are still vast swathes of the state without legal access to cannabis. In fact, many cities even sued the state when it tried to officially sanction statewide delivery rules. What this means is that there are still many California cities that prohibit cannabis.

If those cities are trying to eliminate local cannabis markets, I’ve got a bridge to sell them. Prohibition didn’t work before the state legalized cannabis, and it certainly won’t work when the state won’t lift a finger on enforcement. California cities that keep their bans alive are only bolstering their illegal markets and making it more difficult for the legal market to survive.

What California cities should be doing to combat the illegal market

I recently corresponded with Hirsh Jain of Ananda Strategy, who believes that the state needs 4,000 to 5,000 dispensaries to carry the legal market. And those dispensaries shouldn’t just be in Los Angeles or San Diego. They’d need to be dispersed across the state so that people have access and the legal dispensaries could compete with the illegal ones (and ideally put them out of business). If more California cities don’t end prohibition, illegal dispensaries and delivery services will continue to operate whether they like it or not.

That said, there are other things that California cities can do to combat the illegal market without allowing brick-and-mortar sales. One big one would be to allow outside delivery services to deliver into their borders. While the state did pass a law attempting to expand statewide access to medical cannabis deliveries, that fails to include the much larger recreational market. It also likely excludes potential medical cannabis purchasers who don’t want to or don’t have the resources to obtain a physician’s recommendation or medical marijuana ID card (MMIC).

Expanding retail deliveries would be a win-win for the legal market and cities alike. Yet for some reason, California cities fought it tooth and nail. While those cities may have thought they won, the real victory belonged to the illegal market, which continues to grow and grow.

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If the legal market is to survive, California cities are going to have to make compromises when it comes to cannabis prohibition. After all, cannabis is still being sold within their borders. For some of my thoughts on California’s problematic illegal market, check out these posts:

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Cannabis M&A: Will California Allow License Transfers? https://harris-sliwoski.com/cannalawblog/cannabis-ma-will-california-allow-license-transfers/ Thu, 15 Feb 2024 15:00:53 +0000 https://harris-sliwoski.com/?post_type=cannalawblog&p=134799 Cannabis M&A (short for mergers and acquisitions) in California is much more complicated and problematic than in other states. The biggest reason for this is that licenses are not transferrable, which all but eliminates the possibility of asset sales. In turn, this means that deals are much more complicated for both buyer and seller, and

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Cannabis M&A (short for mergers and acquisitions) in California is much more complicated and problematic than in other states. The biggest reason for this is that licenses are not transferrable, which all but eliminates the possibility of asset sales. In turn, this means that deals are much more complicated for both buyer and seller, and probably kills a lot of potential deals before they start. That might change soon, as the state is considering a bill that would allow license transfers.

Why are asset sales so important in cannabis M&A?

I recently wrote a post for one of our firm’s sister blogs on the top 5 issues buyers face when buying businesses in regulated industries. Here is what I wrote about the difference between “asset sales” and “business sales” in the M&A context:

[W]hen people talk about M&A, they often think of buying the entity (a “business sale”). However, it’s usually better practice to simply buy the assets of a business with a brand new entity (an “asset sale”). In an asset sale, the buyer will generally get all the assets, and not just the physical ones – IP, name, leases, etc. The advantage to doing it this way is that the buyer gets to continue operating the business but doesn’t inherit liabilities associated with the actual entity that sold the assets.

Let me flesh this out a little bit more. A business – say a corporation or LLC – has liabilities. Those liabilities may include taxes, debt, litigation, accounts payable, and so on. Those liabilities are “personal” to the business, meaning they are obligations of the business. If the business itself is purchased, the prior owner (seller) does not magically retain those liabilities and hand over the business free and clear. Even if the seller would agree to that, the buyer would have to get the creditors of the business to agree. And good luck with that.

There are some tools that business sale buyers have, such as making the sellers represent that there are no liabilities, requiring the seller to indemnify the buyer against disclosed or undisclosed liabilities, or even holding back some of the purchase price for a period of time after closing to deal with potential liabilities. To be clear though, these are not perfect solutions and we’ve seen cases where six- or even seven-figure liabilities come to light after the closing, with the seller nowhere to be found.

In asset sales, on the other hand, the buyer will buy some or all of the assets of the original business, including the license (more on that below). This means that the liabilities that are “personal” to the original business won’t follow it and the seller will have to deal with those on their own. This is hugely advantageous for buyers for obvious reasons.

Ok, asset sales are important…why not use them as a default?

The answer is pretty simple – regulation. Here’s what I wrote in that post linked above:

When it comes to regulated businesses, asset sales may not be an option. Regulated businesses may have licenses, permits, or other assets that cannot be sold to an unregulated entity. For example, in California’s cannabis industry, licenses are “personal” to the licensed business and can’t be sold. And the products that business owns can’t be transferred to an unlicensed buyer. In these kinds of regulated industries, asset sales are off the table.

In states like Oregon, where our corporate team has closed countless M&A deals, sales tend to be structured as asset sales. That’s because those states have processes in place to allow licenses to essentially move to different businesses and even possibly different locations.

California, on the other hand, doesn’t do that. For whatever reason, drafters of the state’s cannabis laws chose not to create processes for the transfer of licenses. And neither did state regulators at the Department of Cannabis Control (DCC). In fact, DCC regulations don’t even create an easy pathway for business sales – regulations regarding changes of ownership mandate that an original owner stay with the business for a time post-closing.

This same regulation makes clear that “Licenses are not transferrable or assignable to another person or owner” and, except in one very specific instance, “licensees may not be transferred from one premises to another.” This means that assets sales are off the table.

I should also mention here that California is a dual-licensing jurisdiction, which means that licensees must also have local licenses. Some (not many) localities have provisions in place to allow for license or location transfers, but doing so is difficult if not impossible given the DCC’s rules.

Will license transfers be allowed?

Earlier this week, California Assembly Member Phillip Chen proposed AB 2540. The proposed bill is very short, and the substantive change is to add the blue and italicized phrase to the following existing law:

“It being a matter of statewide concern, except as otherwise authorized in this division, the department shall have the sole authority to create, issue, deny, renew, discipline, condition, suspend, transfer, assign, reassign, or revoke licenses for commercial cannabis activity.”

This is literally all the bill in its current form states, and if the bill progresses through the legislature it is almost certain to be supplemented. While we don’t have a ton of information on AB 2540 just yet, we do have some information about what the purpose is from a 2023 effort by Chen to propose a substantially identical bill, AB 351, which died in committee. A committee analysis of the substantially identical bill from April 18, 2023 states:

Under existing law, DCC does not have explicit authorization to transfer, assign, or reassign a state-issued license. Currently, in order to acquire a license, one would have to acquire the entire company that holds the license (e.g., an LLC) and assume all of its liability. Subsequently, the owner of the company being bought would have to add the purchaser to the license. Once approved and added to the license, the purchaser could then offload the seller from the license. The author and sponsor contend that this process is overly burdensome and having the ability to transfer a license would improve continuity of operations.

I will just assume that this is the same logic behind AB 2540. If so, it hits the nail on the head. Business sales are problematic both because (1) they require the assumption of liabilities (many of which may be undisclosed by the seller or even unknown to the seller), and (2) the DCC has an irrational and unnecessarily complicated ownership change process, which requires at least one original owner to remain associated with a business for a length of time after it is sold.

What the future may hold

Given that Chen’s attempt to pass a similar bill failed last year, I think AB 2450 has a relatively rough ride going forward. That said, if the bill passes, it could open the state up for a host of cannabis M&A transactions that could completely change the industry. Cannabis M&A transactions will probably increase substantially if asset sales are permitted. This would be a huge relief for smaller business owners looking to offload licenses, retire, or just exit the industry.

As mentioned, the bill is in its infancy and has a long road ahead of it, during which time it could be modified or supplemented to the point where it is nearly a different bill. Whether or not that happens, if the bill passes, there is still the issue of local law, which the bill currently does not address. Unless cities or counties decided to follow suit, the state’s changes would be of minimal utility.

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No matter what happens with AB 2450, it’s clear that the legislature is beginning to wake up to the fact that the industry is clearly broken and in need of major regulatory overhauls. For just one example, a few days ago, I published a post on an effort to allow integration of the hemp and cannabis industries, which would be an immense change to the status quo. Stay tuned to the Canna Law Blog for more updates on changes to California’s cannabis industry.

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