Arbitration Versus Litigation
We’ve written previously on arbitration and why it so often makes sense for cannabis business contracts, primarily because of enforceability issues stemming from cannabis being illegal under federal law. But in the realm of commercial real estate leasing, cannabis uses can present other unique challenges that require thoughtful solutions to disputes, and, more importantly, thoughtful planning to prepare for potential disputes down the road.
Below are some of the issues our California cannabis lawyers typically consider when anticipating how to draft dispute resolution clauses for commercial cannabis leases.
Enforceability of the lease and the arbitration award
Federal illegality of cannabis impacts all cannabis business transactions. Though the Federal Department of Justice has issued cannabis enforcement guidelines in the Cole Memo (and every cannabis-touching lease agreement should include language mandating compliance with these guidelines), this does not guarantee against federal civil asset forfeiture or other federal enforcement actions. Another consequence of federal illegality is that cannabis companies must consider what recourse they will have in enforcing their contracts and account for federal district courts being unwilling to enforce any such contract. For this reason alone, it will nearly almost always be better for you to have your disputes resolved in a California state court that will be far more likely to apply and enforce California state cannabis laws. California state courts can also apply federal law, but because there is often a risk of your case being removed to federal court you should always consider putting an arbitration clause in your cannabis commercial leases, specifying the arbitral body, limiting how the lease and the arbitration award can be enforced (confining it to state courts, perhaps) and limiting potential appeals.
Choice of law
We’ve written about how California commercial cannabis landlords (and tenants) should consider beefing up their lease’s indemnity provisions, allowing for early termination in the event of enforcement actions, disallowing federal illegality as a grounds for invalidating the lease, and generally requiring strict compliance with California state law for the specific proposed cannabis use. For similar reasons, arbitration clauses can include a mandate that the arbitral body apply state law and the California Arbitration Act, and not, for example, the Federal Arbitration Act, which allows an award to be vacated where the arbitrator “manifestly disregards the law.” It is not difficult to imagine a scenario where a federal court vacates an arbitral award for an arbitrators having failed to apply the Controlled Substances Act or void the cannabis lease ab initio. California arbitration clauses should, at minimum, specifically outline 1) the method for choosing the arbitrator, 2) the laws the arbitrator must apply in resolving the dispute, and 3) the standard of review any reviewing court must apply. For many California real estate transactions, the arbitration clause should also include specific statutory notice language.
Carve-outs for Unlawful Detainer, Nonpayment, and other Early Termination Causes
Though arbitration can be a highly useful tool, landlords will also want to maintain their ability to seek remedies for nonpayment of rent and unlawful detainer (eviction) without having to go through the arbitration process. Similarly, if a tenant faces a state or federal enforcement action, the landlord (and even the tenant for that matter) will likely want to maintain its ability to terminate the lease quickly and without arbitration. The parties to a California commercial cannabis lease should always consider carving out exceptions to arbitration to keep options open and to encourage timely performance of the lease.
Arbitrator’s industry expertise
California arbitrators tend to be retired California state court judges and the changes of this sort of arbitrator having deep knowledge about the cannabis industry or cannabis laws are not good. But spelling out the arbitrator selection process in your commercial lease agreement (or even naming the specific arbitrator ocan allow you to make certain your arbitrator has sufficient cannabis industry knowledge to understand any eventual dispute.
Consider making mediation the first step
Arbitrations can be expensive and their outcomes uncertain. So instead of drafting a commercial lease agreement that requires you to jump right into that process whenever a dispute arises, consider making private mediation a mandatory first step before a demand for arbitration can be made.
Though every commercial lease dispute is unique (even more so for cannabis commercial leases), there are common themes and one is that private dispute resolution tends to work best for disputes between cannabis businesses.
Will Courts Enforce Them?
A contract isn’t worth much without your being able to enforce it, and the same goes for commercial leases. We’ve written about unique problems in cannabis contracts due to the state-vs-federal illegality problem (see here, here, here) and of how courts have navigated that inconsistency in the context of contract enforcement. But when it comes to commercial cannabis leases in California, landlords and cannabis companies alike want to know how likely it is a court will enforce their lease. The short answer: it’s much likelier now than five years ago.
The main challenge with California commercial cannabis leases, as with all cannabis contracts, goes back to the problem of federal illegality. Because cannabis is still federally prohibited under the Federal Controlled Substances Act, it is federally illegal to cultivate, manufacture, or sell cannabis for any purpose. This means cannabis contracts trigger the doctrine of illegality in contract law, which holds that contracts without a lawful object are void and unenforceable as against public policy. Though enforcement of contracts is generally governed by state law, state law includes federal law under the U.S. Constitution’s Supremacy Clause.
Courts have struggled with how to reconcile the different laws, but a consistent theme emerges in California court decisions: commercial cannabis lease agreements will generally be enforced so long as the dispute before the court is purely contractual and so long as the landlord and tenant are in an arms-length transaction for payment of rent. One infamous example of this is the Harborside case, where a U.S. District Court declined to void a commercial lease for a cannabis dispensary on grounds of illegality, where the dispensary was in compliance with California law.
Another more recent example is Mann v. Gullickson, a November 2016 Northern District of California decision involving a dispute between a creditor plaintiff who sold shares in two cannabis businesses to the defendant in exchange for a promissory note. When the creditor sued for nonpayment under the promissory note, the defendant argued federal illegality rendered the contract (the promissory note) unenforceable. Though the court acknowledged it could void a contract if it required a party to violate the CSA by, for example, requiring it to cultivate or sell cannabis, for several reasons, the court declined to do so in this case.
First, the fact that the court could order payment on the note without requiring any cannabis-related actions meant that enforcing the contract would not necessarily further an illegal purpose. Second, even if an illegal purpose were to be furthered, the court found it would be inequitable for the defendant to be unjustly enriched by not having to pay on the promissory note. Third, the court noted that many states, including California, had recently changed their laws to encourage state-legal cannabis business activities, thereby undercutting the defendant’s public policy argument. Fourth, and most interestingly, the court called out the observed effect of changing state laws on federal enforcement: “The federal government’s concern over the CSA’s medical marijuana prohibition has waned in recent years, and the underlying policy purporting to support this prohibition has been undermined.” The court also noted that under the McIntosh case, the Rohrabacher-Farr amendment prohibits CSA enforcement against medical marijuana in the Ninth Circuit (the federal appellate circuit that encompasses California).
The lesson to be drawn from these cases for California commercial cannabis leases is that cannabis leases should be written to keep the landlord-tenant relationship as an arms-length transaction. This means no profit-sharing arrangements, no payments in cannabis product, and no equity shares changing hands; just payment of rent. Ultimately, the best way to avoid enforcement problems for your California commercial cannabis lease may be to include a well-drafted arbitration clause that specifies choice of California state law, among other things, as that can to a large extent side-step the issue of court enforcement, at least until you need to get your arbitration award enforced by a court.
Residential Farm Purchase
With California’s cannabis real estate market red hot right now, many cannabis businesses are looking at buying rural farms with family farmhouses as sites for their marijuana business. This though can be a risky approach. Businesses hoping to become legitimate licensed operators under California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) should consider the following before signing on the dotted line on this sort of real estate deal:
Government approval contingencies.
One of the most important differences between a residential and a commercial Purchase and Sale Agreement is that well-crafted commercial agreements (especially in the cannabis industry) usually contain business-specific contingencies, including a contingency for local and state government approval that the buyer will be able to confirm that it can legally use the property for its intended use. Residential real estate Purchase and Sale Agreements (even those with an agricultural addendum) rarely include these specific contingencies, leaving the buyer to investigate and bear the risk. Because local law is king under MAUCRSA, you need a contingency in your real estate Purchase and Sale Agreement that will allow you to stop the deal if your local government is not going to let you conduct cannabis business on the property.
If a seller is using a residential Purchase and Sale Agreement because a house is included with the land purchase, chances are good that the property being bought is zoned residential. This sort of zoning increases the likelihood commercial uses will be disallowed altogether or restricted by local ordinance — many of which will roll out in the months and years to come as MAUCRSA licensing tees up. Even rural properties that look suitable for farming must be closely scrutinized for land use restrictions of all kinds, including zoning. A buyer cannot simply rely on the appearance of the property or on general knowledge about a past use.
California’s Right-to-Farm laws generally work against neighbors seeking to bring nuisance claims against farming uses abutting a residential development. But those laws do not (at least as of yet) make cannabis an explicit agricultural product that landowners have a right to farm. Add that to probably the most common complaint about cannabis — odor — and you can see why that family farm could end up creating a NIMBY problem that would not be there with your typical cornfield. See California Cannabis NIMBYs and Land Use Disputes.
Civil asset forfeiture
Even state-legal cannabis businesses are at risk of federal civil asset forfeiture actions and that sort of action could be even harsher for cannabis operators living in a house on their cannabis farm — the federal government could take their house as well as their land.
California’s Williamson Act allows localities to enter contracts with landowners that restrict the use of their property to only agricultural purposes and not build any improvements on the land in return for local tax breaks. Some California localities (even those with medical cannabis licensing ordinances) will often decline to waive prohibitions on federal illegality in agricultural conservation easements to allow cannabis operations on those parcels, because federal funding is directly tied to these conservation programs, and it is much easier for the federal government to turn off a locality’s funding spigot than to pursue a civil asset forfeiture against individuals and their land. This means you should carefully examine all land use restrictions on any parcel you are considering buying.
California’s water rights laws are complex and contentious (see, e.g., Chinatown). A California landowner’s right to use a nearby water source can flow from a number of different legal sources, such as riparian rights (land is adjacent to water source), appropriative rights (first in time, first in right), prescriptive rights (akin to adverse possession), overlaying groundwater rights, adjudicated rights, contractual rights, statutory rights, etc., etc., etc. What’s more, these various rights frequently compete with each other in priority for finite water sources, particularly during droughts. A potential buyer of a residential farm will need to look closely not only at the existing water rights associated with the property, but also at the potential for those rights to be augmented, especially if the intended use is cannabis cultivation, which is water-intensive. Commercial properties, especially those with past manufacturing or large scale agricultural uses, usually have greater established water rights than a small family farm. Furthermore, though the California Department of Food and Agriculture has not yet issued its final cannabis cultivation rules (those will come in November), MAUCRSA will require government approval of any water diversion for cultivation purposes (and water board approval by certain fast-approaching dates for some water sources), which is something that can be included in a government approval contingency but that would not typically be included in a residential Purchase and Sale Agreement, so amend accordingly.
The above list highlights just some of the key land use issues you should consider before you do any residential land deal involving cannabis.
Land Purchases Due Diligence
Due diligence on a real estate purchase is always important, but the unique characteristics and legal status of cannabis make it even more important for commercial cannabis businesses.
An easement is generally a right to access or travel across real property that belongs to someone else. Cannabis businesses need to look out for easements that benefit the purchasing owner’s dominant estate by allowing access to a neighboring property but are subject to express conditions such as “compliance with all laws” (which would include federal law). If the purchased parcel includes an express easement for parking on a neighboring property subject to “compliance with all laws,” the neighbor could seek to prevent access to the easement as long as the cannabis use remains federally illegal, which could jeopardize the business’s operations. A title analysis during the buyer’s due diligence phase should include not just the usual searches for recorded and non-recorded easements, but it also should also account for the implications on these property rights that a cannabis use might present, which would not necessarily present with a routine property due diligence.
Though covenants, conditions, and restrictions are normally associated with residential property (think homeowner associations), they are also common in the commercial real estate industry. CC&Rs typically are binding on future purchasers. Restrictions that might not normally be thorny or even applicable to typical business uses can present unique problems when it comes to cannabis. Common examples of this are restrictions on odor and waste emissions, use/manufacture/trafficking of “illegal drugs,” and the pervasive “compliance with all laws” mandate. Because cannabis is still illegal under federal law (notwithstanding its legal status in California and other states), a beneficiary of a “compliance with all laws” restriction could seek to enforce the CC&Rs against a cannabis operator. Consequently, due diligence for cannabis land purchases should include both a thorough review of CC&Rs and creative thinking on how those restrictions could potentially be interpreted against a cannabis use.
Zoning and local cannabis ordinances
A buyer looking for land for commercial cannabis operations has usually narrowed the search to jurisdictions with some form of commercial cannabis ordinance (See our California Cannabis Countdown series, which tracks updates in cannabis legalization by locality). Though many California cities and counties have passed legislation to accommodate new zoning requirements for cannabis uses, the burden is on the buyer to confirm that the parcel it seeks to buy will be suitable for its intended use, and, ideally, that it will stay that way. This means conducting due diligence on the local cannabis ordinance and on other related zoning laws and local land use restrictions. This also often means working with the locality to put in place a development agreement (sometimes required by the local ordinance anyway) to make sure the zoning laws won’t change.
Geographical vicinity and state regulatory requirements
In addition to local zoning requirements, cannabis operators must consider state laws when deciding where to locate. California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) requires cannabis businesses maintain at least a 600-foot distance from schools and other youth gathering places. Local cannabis ordinances commonly include geographical buffer requirements that mirror current state requirements, but they can (and they sometimes are) be stricter than MAUCRSA’s. This means that your search for land suitable for your cannabis operation should include an analysis of local and state geographical buffers and any other local restrictions.
The importance of maintaining good neighbor relations cannot be overstated in the commercial cannabis industry. You should assume any neighboring landowner who opposes your business operation would have no trouble finding a legal basis to challenge it. They can (and often do) seek to enforce land use restrictions or lobby to change local zoning laws to the detriment of cannabis businesses. Or they might just bring an old-fashioned nuisance lawsuit against you, claiming the smell from your property or the number of people who visit it are damaging them. Your due diligence should, therefore, include gauging the potential risks coming from your future neighbors, particularly if the land you are considering is close to residential zoning or urban areas, where NIMBYism is likely to be more acute.
Real Estate and the New MAUCRSA Rules
California just released nearly 300 pages of new regulations for medicinal and adult-use commercial cannabis businesses. These long-awaited rules follow months of public comment, a substantial environmental impact report on cultivation, and a report from the state Water Resources Control Board on diversion and discharge relating to cannabis cultivation. Though the new regulations do not include wholly unanticipated changes, they do include the following that will impact cannabis businesses when it comes to real estate and land use:
Cultivation aggregate size limits
Though there remains a 5-year prohibition on large (type 5) cultivation licenses for grows of more than 1 acre, and a 5-year limit of one medium grow license (10,001-22,000 sq ft) per person, there is no 1-acre aggregate limit on cultivation, which had been recommended in the environmental report. In other words, there is effectively no limit, other than a company’s monetary resources for license fees, that would prevent a large cultivator from converting an existing mega-farm into a cannabis farm by simply aggregating an unlimited amount of specialty (0-5,000 sq ft) and/or small grow (5,001-10,000 sq ft) licenses. This is a troubling development for small and medium-sized operators, as they had lobbied hard for an aggregate grow limit of one acre.
Subletting and Storage
Though we already knew from MAURCSA that California would require each “premises” to be contiguous and occupied by only one licensee, the new rules go slightly further by forbidding a licensee from subletting any portion of its licensed premises and by requiring each location where cannabis goods are stored be separately licensed. This means any licensee subletting a portion of their space must plan out a proper demarcation of their premises and think carefully about using that old garage next door to store product without an additional license.
Concurrent adult-use and medicinal operations
Under the new rules, one licensee can concurrently operate under both an “M” license and an “A” license on the same premises, if certain conditions are met—mainly that there is one licensee that conducts a single type of operation on the premises but keeps labeling and records separate for medicinal and adult-use. Though this seems like a common-sense regulation (why would someone need two licenses to make the same product in the same place?), it was not clear until issuance of the new rules how adult-use and medicinal licenses would interact, and whether they would be treated as truly separate licenses requiring separate premises.
Renewable energy requirements
The prior proposed MCRSA (medicinal) regulations had required 42% of the energy used by indoor or mixed-light grow licensees come from renewable sources. The new cultivation rules require only that the licensee meet the “average electricity greenhouse gas emissions intensity required of their local utility provider” under California’s existing Renewables Portfolio Standard Program. This means that rather than having indoor grows become leaders in renewable energy standards, licensees now only need to fit in with existing requirements, and even if they don’t, they can purchase allowances and offsets under California’s cap-and-trade programs. There had even been talk of increasing the percentage requirement for renewable energy, but that seems to have fizzled out.
I’m a commercial landlord, what are my risks if I decide to rent to a cannabis tenant?
In a federal law enforcement scenario, the consequences could be serious. Marijuana is still (as of this writing) a Schedule I controlled substance, meaning that on the books, the federal government views cannabis as being on par with fentanyl-laced heroin. That may sound absurd—and it is—but in terms of federal drug enforcement it means that civil asset forfeiture actions are a real risk for landlords that knowingly rent to cannabis tenants. Making matters worse, the Department of Justice rescinded Obama-era enforcement guidance that deprioritized prosecution of state-legal cannabis businesses that comply with state law and don’t involve themselves with things that the federal government really cares about, like organized crime, growing on federal land, advertising to minors, or exporting to non-legal states.
So that was the scary part. The good news is that with each passing day, the federal government is getting closer to adjusting federal law to align with public opinion on legalization, whether it’s the administration apparently abandoning the federal crackdown on cannabis, or the Senate minority leader introducing a bill to decriminalize, or the former Republican Speaker of the House joining the board of a cannabis investment fund and saying his views on cannabis have “evolved.” While the Department of Justice is still prosecuting cannabis operations and filing asset forfeiture actions, in the last few years it has continued to follow the Cole Memo priorities, even post-rescission, a fact that may actually prove to help California establish and enforce its regulatory regime.
The key to this equation for commercial landlords is requiring a tenant’s strict compliance with state law as an affirmative obligation of the lease agreement, and building in termination contingencies for changes in law or federal enforcement actions.
My prospective tenant says she needs a signed lease before she can get a permit to operate, but I don’t want her in without a permit. How do I protect myself?
In most jurisdictions, both the local permit and the state license are tied to the property, and are non-transferable, so both parties almost always run into this chicken-and-egg problem. A common solution is to build in a licensing timeline and contingencies for failure of permits to issue. A bit like a tenant improvements build-out plan but with fingerprint scans and background checks, cannabis permits and licenses are no sure thing. But the uncertainty of getting government approvals can be built into the lease, sometimes with abated rent in the meantime.
My property insurance seems like it might increase, should I pass that cost onto the tenant?
Trick question: You need to start shopping for new insurance. You will likely lose your existing building insurance coverage when your carrier finds out you’re bringing on a cannabis tenant, and if you wait until you have to submit a claim to let them know, you could have a rude awakening when the carrier declines to pay on the policy due to breach of the insurance contract. While landlords can charge a premium for rent to cannabis tenants, so too can insurance companies charge a premium for premiums on commercial cannabis tenancies.
I have a mortgage on my building, will that be affected if I take on a cannabis tenant?
It depends on the contract, but probably. And that also applies if you want to refinance down the road. Most loan agreements and deeds of trust securing a loan with real property contain some sort of language requiring compliance with “all laws” regarding use of the property for the duration of the loan. Absent a smart carve-out for federal law inconsistent with state cannabis laws, such phrasing presents a problem for potential cannabis uses. Any decision to take on a cannabis tenant must consider existing security interests on the property and compliance with the terms of the contracts. That may mean shopping for hard-loans, but it’s certainly a problem better dealt with prior to the new tenancy rather than midway through when you find out your lender is calling your loan due for violation of contract terms.
My potential cannabis tenant wants to sublease to other operators. Is that a problem?
It depends what kind of subleasing we’re talking about. The general rule is that the state prohibits a tenant from subleasing all or part of a licensed premises. But as of last month, the state is now allowing manufacturers, under certain circumstances, to operate in shared spaces under a sort of timeshare arrangement. Depending on the nature of the space and the terms of the proposed subtenancies, a landlord may want to prohibit subleasing in the lease terms and work backwards from there.
The California Department of Public Health—the agency charged with regulating commercial cannabis manufacturing—issued new emergency rules to allow certain types of manufacturers to operate in shared-use facilities and on shared equipment, under essentially a sort of timeshare sublease arrangement. The move is a win for small, medium, and artisan manufacturers that don’t have the budget to buy commercial property or take on an expensive lease, and who have the ability to run a lean operation without large space requirements.
The new rules require an existing “primary licensee” with a Type 6 (nonvolatile extraction), Type 7 (volatile extraction), or Type N (infusion) license that either owns or leases suitable manufacturing space. If the locality approves of the arrangement and issues the appropriate permits, the primary licensee can then enter into a use agreement with multiple “Type S” licensees— manufacturers that can engage in packaging and labeling, food infusion, and some butter and oil extraction operations required for the infusion process, all in the same space, as long as they have less than $500,000 in annual revenue.
Each Type S licensee must have their own designated space to store their cannabis and cannabis products, and the shared-use facility must have a security plan as with any other licensee. Under this new arrangement, however, Type S licensees can have exclusive access to the shared-use facility and equipment at their own designated times, like a time share. The California Bureau of Cannabis Control’s existing rules prohibit licensees from subletting all or part of a licensed premises. But under the new Type S rules, the use agreement creating the shared-use arrangement satisfies the requirement of lessees to demonstrate the legal right to occupy a space and obtain landlord approval for the proposed cannabis activity, implying that the relationship is akin to a sublease and thus seemingly creating a limited exception to the prohibition.
What this means for manufacturers looking to break into the market is that even in high-priced areas, there is an opportunity to cut costs by sharing rent and equipment—two of the largest recurring expenses for manufacturing operations. Companies with shared space can also potentially take advantage of group savings on expenses like insurance, maintenance and service contracts, utilities, security services, and distribution. On the other side of the equation, the new rules also present an upside for landlords and master tenant “primary licensees,” whose owned or leased space will now be able to command more overall rent, much like a dated 3-bedroom apartment in San Francisco can command $6,000: more tenants to spread the cost.
The next question will be what other actions the state might take to benefit small and medium commercial cannabis operations, as it faces challenges claiming that it has benefitted large-scale operators at the expense of the still-growing artisan industry.