Can Federal Courts Enforce Contracts in the Cannabis Industry?
By Amy Rubenstein & Brian Cohen
Amy Rubenstein
https://www.dentons.com/en/amy-rubenstein
Brian Cohen
https://www.dentons.com/en/brian-cohen
Although most states have some legal cannabis structure—38 for medical purposes and 21 for recreation, after Maryland and Missouri voted to legalize marijuana earlier this month—cannabis remains federally prohibited as an illegal Schedule 1 drug under the Controlled Substances Act.
As a general rule, contracts that violate the law or require a party to engage in illegal activity are void and unenforceable. Accordingly, among the many challenges that cannabis’s illegal status under federal law poses to businesses operating legally under state law is from parties who knowingly and voluntarily enter into transactions in the cannabis industry and later seek to avoid those contractual obligations by arguing that: (1) the agreements are unenforceable based on the federally-illegal subject matter, and (2) federal courts lack jurisdiction to resolve disputes arising from them. Surprisingly, cannabis businesses themselves have even made this argument, despite the patent inconsistency with their operations.
For example, cannabis dispensary MedMen Enterprises currently seeks to void a lease in a recently filed federal lawsuit in the Southern District of New York by claiming that the contract’s subject matter is illegal. MedMen admits in its pleading that, since August 2021, MedMen has not paid $1 million in rent for a dispensary located in Chicago’s Fulton Market neighborhood under its written lease with Thor Equities. But MedMen contends that Thor cannot collect because the lease’s only purpose was to provide MedMen retail space to sell and distribute cannabis.
Recent Cases that Have Overcome the “Illegal Subject Matter” Arguments
Several courts have disagreed with MedMen’s arguments, allowing cannabis-related disputes to proceed and holding that the mere fact that one party is in the cannabis business does not preclude enforcing the parties’ agreement:
- In Indian Hills Holdings v. Frye, the plaintiff entered into a contract with and paid the defendants to purchase modular cubes used to cultivate, grow and produce cannabis. After the defendants sold the cubes to someone else and refused to return IHH’s money, IHH sued for breach of contract. The defendants argued that the Southern District of California lacked jurisdiction to hear the case because doing so would require the federal government to adjudicate a case that could result in a violation of federal law. The court rejected that argument, emphasizing the relief IHH sought. Although the court agreed that it could not order a party to perform illegal conduct, IHH’s lawsuit only sought damages. The court concluded that awarding straightforward money damages—if IHH could prevail on its claim—would not violate federal law and, thus, that the court had jurisdiction.
- In Siva Enterprises v. Ott, the plaintiffs provided business and operational services to the cannabis industry and alleged that the defendants had misappropriated their trade secrets and infringed on their trademark rights. The defendants moved to dismiss and argued that the plaintiffs, as a cannabis-related business, lacked Article III standing. The court denied the motion, framing the defendants’ position as “essentially arguing that their alleged actions are immune from federal law because plaintiffs are engaged in an illegal enterprise under federal law.” The court noted that the plaintiffs were not seeking a remedy that would require a violation of federal law.
- In Green Earth Wellness v. Atain Specialty Insurance, the District Court of Colorado rejected the defendant insurance company’s argument that it did not need to perform under an insurance contract because the plaintiff’s marijuana business was illegal, characterizing federal law as only “nominally prohibit[ing] such a business.” The District Court emphasized that the insurer knew that the plaintiff operated a cannabis business before entering into the insurance contract, and had still decided to “enter[] into the [p]olicy of its own will, knowingly and intelligently.”
- In Finch v. Treto, aspiring cannabis dispensary owners sued an Illinois agency in federal court to challenge the constitutionality of the state’s criteria for issuing cannabis licenses. The court rejected the defendant’s argument that granting equitable relief would conflict with federal law because “enjoining the licenses awarded . . . would not compel any party to violate federal law, award any illegally derived profits, or entangle this court in the production, sale, or distribution of cannabis.” The court did, however, note that the illegality issue is “unsettled in federal courts across the country.”
Recent Cases Declining to Hear Cannabis Disputes
However, other district court opinions support MedMen’s position that agreements related to cannabis are unenforceable and that federal courts lack jurisdiction to hear disputes related to them. For example:
- In Shelton v. Liquor & Cannabis Board, a Washington District Court dismissed the plaintiffs’ claims and held that it could not enter a declaratory judgment concerning the plaintiffs’ state-issued cannabis-related business licenses because it could not “order activity that remains federally illegal.”
- In Sensoria v. Kaweske, the Colorado District Court held that it could not remedy many of the plaintiff’s alleged injuries because they were related to the defendants’ misconduct involving cannabis-related assets.
- In Shulman v. Kaplan, a California District Court dismissed a RICO action because it “seem[ed] implausible that RICO—a federal statute—was designed to provide redress for engaging in activities that are illegal under federal law.”
- In Polk v. Gontmakher, a Washington District Court dismissed the plaintiff’s lawsuit because it sought to enforce a contract under which it was purportedly entitled to receive future profits from cannabis production.
- In J. Lilly v. Clearspan Fabric Structures, the Oregon District Court granted the defendant summary judgment holding that it could not award the plaintiff lost profits that were generated from a cannabis business.
Other courts have declined to exercise jurisdiction over a dispute because of a party’s involvement in the cannabis industry. For example, a California District Court exercised its seldom-used ability to abstain from hearing a case between members of a cannabis cultivation business. The plaintiff-member filed the suit in state court, but a defendant removed based on diversity jurisdiction. The court granted the plaintiff’s motion to remand on abstention grounds, finding that it could disrupt state’s interest in interpreting its own laws to “create regulatory channels for cannabis . . . .” The case returned to the state court.
Conclusion
So, how can parties predict whether illegality arguments will succeed or fail? District Courts seem to be drawing the line set forth in Indian Hills Holdings—while they remain reluctant to order performance that would violate federal law, simply awarding monetary damages seems more palatable. However, given the conflicting decisions that have come out of the various District Courts, a Federal Court of Appeals may ultimately weigh in. Or Congress could resolve the issue by legalizing cannabis or otherwise changing its legal status.
Even without clarity from the courts, cannabis companies should be reticent to deploy these arguments in public court filings. Companies that argue that their contracts are not enforceable risk not only undermining their own credibility, but also negatively impacting the credibility of a nascent industry whose reputation and profile they presumably have been trying to build. The unsettled and conflicting district court decisions put cannabis operators and the parties with whom they do business in the awkward position of not knowing whether or where their agreements will be enforceable, adding yet another layer of risk to an industry that has many other reputational, operational, and legal challenges to overcome.
But until there is more clarity, and with the benefit of developing case law, cannabis companies or companies contracting with cannabis companies should require contract provisions that will help protect them from later enforceability challenges. In particular, parties should include: (1) venue-selection clauses that require the parties to litigate their disputes in state court or arbitration; and (2) clauses that prohibit the contracting parties from raising illegality arguments in court.
