Many young industries begin with a large number of small, local entrepreneurs. Over time the more successful ones sell their operations to larger, multi-state companies that consolidate operations. The consolidators are able to employ economies of scale to gain benefits from large, centralized purchasing and more efficient delivery of goods and services.
The cannabis industry will likely face the same arc from several small local outlets to nationwide businesses following consolidation. However, some current state licensing requirements, on their face, purport to prohibit interstate consolidation. Many states require that cannabis licensees be residents of the state in which they are licensed or require that cannabis products be sourced from within the state of licensing.
As the cannabis industry matures and more and more states license cannabis growers, distributors, and retailers, serious questions will arise as to whether those in-state-only restrictions are lawful. The restrictions will likely be challenged under the so-called “Dormant Commerce Clause” of the U.S. Constitution. If the challenges are successful those state and municipal restrictions will be overturned and become unenforceable.
Under the U.S. Constitution, the Commerce Clause gives the federal government the power “To regulate commerce … among the several states ….” The federal government alone has the authority to regulate interstate commerce. The Supreme Court has held that states cannot discriminate against out-of-state businesses, excessively burden interstate commerce or adopt protectionist state policies that favor state businesses or citizens at the expense of non-citizens conducting business in that state.
In the cannabis industry alone over the last two years, federal district courts in several states have considered the issue of whether a state or local government can discriminate against out-of-state businesses, business owners, or suppliers. All have indicated that the state or local regulations should be stricken as unconstitutional under the “Dormant Commerce Clause.” Federal Courts in Maine, California, Michigan, Missouri, and Illinois have all ruled on preliminary motions that they would likely hold the state or local regulation unconstitutional.
The Federal District Court in Chicago stated that the Illinois licensing lottery benefit to Illinois applicants likely violated the Dormant Commerce Clause even though the court denied a preliminary injunction against the state licensing procedures. The court denied the injunction because such an injunction would be overly disruptive to the licensees that had previously been awarded licenses and because the Illinois authorities were taking steps to alter the licensing procedures. Even though the court deferred to the state authorities, the court made it very clear that discrimination against out-of-state owners or businesses would not be permitted under the Dormant Commerce Clause. In fact, the court found that, on the merits, the out-of-state plaintiffs had a reasonable likelihood of ultimate success on the merits of their claim.
Similarly in Michigan, a federal court denied a preliminary injunction even though it found that there was a likelihood that the challenged local regulation unlawfully discriminated against an out-of-state competitor. There, the plaintiff could not show that it would have been awarded the license even if the residency requirement was not present and because the party that had been awarded the license had already made a substantial investment in its cannabis business.
In a California case, the court considered the argument that the effect of a local preference under the Los Angeles Municipal Code was to discriminate against out-of-state owners. Under the LAMC a preference was given, in the name of “social equity,” to residents who resided in certain Zip Codes which were identified as “Disproportionately Impacted Areas.” They were all within the City of Los Angeles. Thus, the Court stated that it would consider the validity of the municipal regulation, but, first, required that the plaintiffs satisfy the Court that they had standing. The plaintiffs claimed that, even though they were California residents, they were harmed because they could not bring in out-of-state investors.
The Dormant Commerce Clause will become a significant issue as the cannabis industry matures and becomes an interstate industry. State and local regulations designed to keep out-of-state residents or out-of-state companies from competing with local businesses will face significant constitutional challenges. Moreover, out-of-state companies seeking to buy local businesses will also challenge the state regulatory structure that favors, prohibits, or limits out-of-state ownership.
Like many other young industries, the cannabis industry will grow across municipal borders, state borders, and probably national borders. The current model of local retailers selling the product of local growers and processors to local customers will be subject to legal and constitutional challenges.
The views and opinions expressed in the article represent the view of the authors and not necessarily the official view of Clark Hill PLC. Nothing in this article constitutes professional legal advice nor is it intended to be a substitute for professional legal advice.