California’s cannabis entrepreneurs and investors have circled Jan. 1, 2018 on their calendar. It marks the official opening of California’s fully-legal, state-licensed, medicinal and recreational cannabis market.
Heralded by analysts’ predictions of sustained double-digit growth and $6.5 billion in annual revenue, expectations are high that the new market in California will generate enormous profits for those well-positioned to participate in it.
Yet, California already has a $2.8 billion medicinal cannabis market — one built around a closed circuit of nonprofit collectives developed before cannabis entered the mainstream. Transforming that model into the golden goose anticipated by new investors will prove much more difficult than turning the calendar page.
In 2004, to provide a more robust legal framework for widespread medicinal use, the state Legislature passed the Medical Marijuana Program Act (MMPA), which may have raised more questions than it answered.
The MMPA allowed medical marijuana cardholders to form cooperatives and “collectives” to grow, distribute and dispense cannabis. The act also imposed a strict prohibition on any for-profit cultivation or distribution, which remains California law today.
In 2008, California’s attorney general issued guidelines that became the roadmap for the state’s burgeoning medical marijuana industry, noting that the MMPA’s collectives have no actual legal definition in state law. Nevertheless, cardholders could form business entities to act as collectives conducting medicinal marijuana activities. All participants in such activities had to be members of the collective and all cultivation, distribution and consumption had to take place within a “closed circuit” of members.
The risk of noncompliance with these guidelines was criminal prosecution. In this uncertain environment, California’s medicinal marijuana pioneers stepped from the market shadows and into the cold light of corporate law. Corporations have been formed since medieval times to raise capital, mitigate risk and limit liability for business ventures. Shareholders receive a saleable interest in the corporation, a vote on corporation affairs and the right to sue if it is not run properly.
California’s Corporations Code establishes various corporate forms for new ventures. Each offers degrees of flexibility in, for example, writing and amending bylaws; establishing ownership classes with different voting rights; and determining taxation.
One form is the nonprofit mutual benefit corporation (NMBC). The NMBC, most common among homeowners’ associations and professional organizations, became prevalent for California’s medical marijuana collectives. For early adopters, its attraction was simply having the word “nonprofit” in its name — all the better to satisfy MMPA compliance. The NMBC also lends itself to a membership model and, by statute, cannot distribute profits. Therefore, it most closely resembles the collective chimera invoked by the MMPA.
With NMBCs proliferating, the market grew exponentially and cannabis moved inexorably toward legalization. Today, NMBCs often hold precious local permits, own the strongest brands and will receive priority in the 2018 state-licensing application process. They are consequently prime targets for investors eying the potentially lucrative future.
But the nature of the NMBC entity and the concerns that motivated their founders do not necessarily lend themselves to a quick sale or an injection of capital from a profit-motivated investor.
NMBCs can neither issue shares nor distribute profits. While they can sell assets or merge with another entity (including for-profit entities), such transactions may require a vote of the members. Considering a collective’s membership may include every patient, provider, vendor and employee that has participated in its activities, such votes may be difficult, expensive and uncertain.
Moreover, a right that NMBC members have in common with shareholders of for-profit corporations is the right to sue. So-called derivative lawsuits allege claims on a corporation’s own behalf, usually against its own managers. In merger and acquisition cases, derivative suits often allege that managers have engaged in self-dealing, made inadequate or deceptive disclosures, circumvented shareholder approval, or offered unfair value in exchange for corporate assets or to shareholders losing their stakes.
Sometimes they are right. Often though, these are meritless “strike suits” brought by enterprising lawyers to extract legal fees by obstructing legitimate deals. Certainly, this is the view of commentators who bemoan that more than 90% of all mergers and acquisitions involving public companies in the U.S. now face a derivative lawsuit. Litigating and resolving derivative suits has become a cost of doing business.
The difficulties of any deal aiming to transform an NMBC into a for-profit entity will depend largely on the bylaws, membership and voting structure of the nonprofit in question — and those vary widely. With so many NMBC members as potential plaintiffs, the risk of derivative litigation is high, irrespective of how well thought-out the transaction may be.
Investors and managers looking for profits in 2018 should prepare accordingly.
Anthony Phillips is a founding member of the cannabis law practice at Archer Norris, which provides transactional and litigation services and legal advice to businesses in California’s legal cannabis industry. Archer Norris has more than 75 attorneys and four offices throughout California. He can be reach via email at aphillips@archernorris.com.
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