Dentons: Cannabis Cos. Must Heed Growing Federal Investigatory Risks

Authors

Alicia Corona and Amy Rubenstein (March 30, 2023)

Alicia Corona

Amy Rubenstein

 

 

As state-regulated cannabis markets expand rapidly, so too does  government oversight. 

The dynamic between a largely new state-by-state legal industry and well established federal investigatory regimes has left industry participants  exposed to substantial liability risks.

Many times, when cannabis companies think about compliance, they focus  on their local jurisdiction’s regulatory scheme, especially the regulations to get the business set up and operating.

But cannabis companies — and ancillary businesses providing services to  them — do not always appreciate the federal investigatory risks associated  with the industry.

Despite cannabis remaining federally prohibited, federal regulators have  not ignored areas where cannabis companies must comply,  including Occupational Safety and Health Administration standards,  Internal Revenue Code requirements, the U.S. Securities and Exchange  Commission’s regulations and rules, and the Foreign Corrupt Practices Act.

Cannabis companies should keep these additional regulatory schemes in  mind as they continue to grow, both in the U.S. and abroad.

 

OSHA Investigations 

Failure to comply with federal workplace health and safety requirements can pose significant  legal challenges for cannabis companies, especially those with growing, cultivation and  manufacturing operations that involve workplace exposure to ultraviolet light, pesticides,  other chemicals and gases, and dust from the grinding process.

Some of the most common OSHA citations against cannabis companies stem from  inadequate personal protection equipment for employees.

In particular, respiratory-related violations appear to have OSHA’s attention, and the  National Institute for Occupational Safety and Health issued two Health Hazard Evaluation  Reports — one revised in August 2019[1] and another from February 2022[2] — that  analyzed potential hazards during cannabis cultivation.

These and other reports put the cannabis industry on notice, and OSHA citations to cannabis  companies can be expected to increase as employees and the government point to a  connection between occupational cannabis exposure and respiratory illnesses.[3]

One August 2022 case study conducted by the Washington State Department of Labor and  Industries reported a notable increase in new onset and work-aggravated asthma by  industry workers directly after legalization of recreational use cannabis.[4]

Other cannabis-related workplace exposures, including potential dermal hazards, have   garnered regulatory attention as well.

For instance, in December 2018, the California Division of Occupational Safety and Health — California’s OSHA-approved state plan — issued over $50,000 in penalties to Future2 Labs  Health Services Inc. after a worker suffered serious burns while extracting oil from cannabis  with propane.[5]

The serious accident-related citations included failing to protect workers around flammable  vapors and failing to provide them with protective gear.

These types of enforcement responses at both the state and federal level signal that such  hazards are taken seriously, and that agencies will continue to take a close look at potential  hazards affecting workers at cannabis cultivators and processors nationwide.

To avoid OSHA issues, as well as the potentially steep financial and reputational costs  associated with any allegations of wrongdoing, cannabis companies should take appropriate  steps to identify potential hazards with respect to each position in their workforce and  conduct a thorough risk assessment.

Once the risks are known they must bring their facilities and policies into compliance with  state and federal safety standards, including educating workers about potential hazards.

Additionally, companies should ensure that their employees know how to report any  illnesses, accidents or workplace safety concerns to OSHA.

 

Section 280E of Internal Revenue Code 

Because of an unusual rule limiting permissible deductions for taxpayers illegally trafficking  in a Schedule I or II controlled substance, even state-legal cannabis companies face  adverse tax treatment and IRS scrutiny.

Section 162(a) of the IRC allows a taxpayer to deduct ordinary and necessary expenses paid  or incurred during the tax year in carrying on any trade or business.

Under Section 280E, however, “[n]o deduction or credit shall be allowed for any amount  paid or incurred during the taxable year in carrying on any trade or business if such trade or  business … consists of trafficking in controlled substances” prohibited by federal law, which  includes cannabis.

Accordingly, Section 280E prevents cannabis companies from claiming tax deductions other  than the cost of goods sold.

Section 280E presents a significant financial hurdle for cannabis companies, an existential  threat for competing against the illegal market,[6] and fertile ground for IRS investigations.

Normalizing the federal tax treatment of cannabis could be as simple as repealing the  application of Section 280E to otherwise lawful cannabis dispensaries. But that would  amount to a $5 billion federal tax cut for cannabis businesses from 2018 to 2027, according  to a 2017 estimate from the U.S. Congress’ Joint Committee on Taxation.[7]

Multiple cannabis operators have discussed how Section 280E has inflated their tax bills by  hundreds of millions.[8] More oppressive still is the enormous tax bill that can be levied  against cannabis companies operating at a net loss.[9]

Accordingly, it is important for cannabis companies to identify whether deductions can be  categorized as cost of goods sold to help minimize the tax impact of Section 280E on their  business.

Given what the IRS has to gain, cannabis companies could be easy audit targets. Research  suggests that cannabis companies are five times more likely to be audited than other  companies.[10]

In addition to ordinary financial hygiene and proper accounting practices, cannabis  companies should keep detailed and careful records so that if they are audited, the process  will be less burdensome.

In the event that the IRS does engage in any sort of inquiry, cannabis companies can  minimize the disruption to business operations with advanced preparation and proper tax  planning.

 

SEC Investigations 

Like any other public company, publicly listed cannabis companies must take care to ensure  strict compliance with the SEC’s regulatory requirements.

Some of the most common legal violations pursued by the SEC include misrepresentation or  omission of material information about securities, selling unregistered securities and insider  trading.[11]

While the SEC’s interest in these violations is not new, public interest in the cannabis space  may increasingly draw the SEC’s attention.

For example, in September 2022, the SEC sued two companies and its associated officers  and directors for their alleged involvement in a scheme to conceal paid promotion for  securities offerings.

The complaint in SEC v. Mikula alleges that the individuals involved received millions of  dollars for promoting the securities in a newsletter called Palm Beach Venture, but failed to  publicly disclose these payments.

One promotion recommended investing in one of the defendant companies, Sway Energy  Corp., formerly known as Elegance Brands Inc., based on allegedly false and misleading  statements about the prospects of the company’s CBD product, Gorilla Hemp.

In addition to the allegedly false and misleading statements, the newsletter article also  allegedly falsely claimed that the publishers received no financial compensation for the  promotion, and instead made their recommendation “based on our own analysis.”[12]

In reality, the complaint alleges, one individual received “more than $80,000 in  entertainment, including meals, nightclubs, and first class airfare, in exchange for  [promoting] Elegance.”[13]

In another matter, the U.S. District Court for the Central District of California granted a  default judgment in November 2022 against C3 International Inc., the maker of the  cannabis pill Idrasil, arising from a suit brought by the SEC in September 2021.[14]

The court awarded $3.1 million in civil penalties and disgorgement of $1.9 million after C3  failed to respond to allegations that it made misrepresentations between 2014 and 2019  about Idrasil’s patent status, the probability that health insurance companies would  reimburse for Idrasil, and the use of investor funds for business purposes.

The SEC’s recent enforcement action against C3 highlights the risks involved for ancillary  businesses and professionals, too, especially under an aiding and abetting theory of liability  for securities laws violations.[15]

This means that those who knowingly or recklessly provide substantial assistance to primary  violators in the achievement of the primary violation — including by disseminating false  statements — could face liability.

In a related complaint involving C3’s Idrasil business, the SEC alleged that an unregistered  broker hired by C3 knowingly disseminated misrepresentations about the company and its  financial projections for revenue, profits and cash flow.[16]

The complaint, SEC v. Arkells, charges the defendant with, among other things, aiding and  abetting violations of Section 17(a) of the Securities Act, and Section 10(b) of the Exchange  Act and Rule 10b-5 thereunder.

In addition, the SEC’s consistent attention to financial reporting underscores the need to  ensure comprehensive, accurate and reliable reporting.

In October 2022, the SEC charged Cronos Group Inc., a Nasdaq-listed cannabis company  from Toronto, and its former chief commercial officer, with improper accounting and other  accounting misconduct during multiple reporting periods.

Mark Cave, associate director of the SEC’s Enforcement Division, warned in the press  release that “[i]t is critically important for issuers to have adequate controls in place before  they take on the reporting obligations required of public companies.”[17]

Most recently, the SEC filed a complaint on March 16 alleging that American Patriot Brands  Inc. — a cannabis cultivation and distribution company incorporated in Nevada — defrauded  investors of $30 million by promoting itself as “one of the largest cannabis farms in the  country,” despite only producing a small amount of sellable cannabis, and by making “wildly  inflated” claims about its revenue.[18]

For example, the SEC alleges that one presentation emailed to an investor falsely stated  that in 2016 revenue exceeded $3.3 million and earnings exceeded $1 million, when the  company’s gross revenue was $330,905, and it had negative earnings of over $9.6 million.

The SEC also alleges that offering materials suggested to investors that the company was  imminently poised to trade on a securities exchange when in fact the SEC registration it  needed for widespread public trading was in jeopardy and was eventually revoked.

As the cannabis industry continues to rapidly expand, there is reason to expect that these  types of enforcement actions by the SEC will become more commonplace.

Cannabis companies will need to implement robust internal financial controls to ensure strict  SEC compliance.

 

Foreign Corrupt Practices Act Compliance

Major growth in the international cannabis market has created new opportunities for  companies to expand their global footprint.

Germany — one of the most profitable markets for medical cannabis in Europe[19] — recently moved to decriminalize possession of cannabis by adults and permit its sale in  licensed stores.[20]

Following Germany’s lead, the Czech Republic also announced its intent to legalize adult-use  cannabis, with a bill expected to be presented this month and potential legalization by  January 2024.[21]

Last year, Thailand became the first country in Asia to decriminalize cannabis cultivation  and consumption, potentially opening the door for other nations in the region to do the  same.[22]

Indeed, the day the Thai legislation took effect, the country’s Food and Drug  Administration received over 100,000 applications to cultivate cannabis.[23]

Other countries that have also recently legalized or decriminalized recreational cannabis use  include Malta in 2021; Canada in 2018; the Republic of Georgia in 2018; and South Africa in  2018.

As with any other industry looking to expand into international markets, particularly one  that is newly legal and heavily regulated, cannabis companies likely will have contact with  foreign officials that may subject them to scrutiny under anti-corruption laws like the FCPA.

In general, the FCPA imposes liability on companies for bribes paid to win business, which is  broadly defined as any payment, offer to pay or authorization to pay a foreign official  anything of value.

This is especially true in license-centered industries like cannabis, where foreign officials  make licensing decisions, and in countries where the corruption risk is especially acute.

Mexico, for instance, is poised to become a new center for cannabis industry expansion  given its close proximity to the U.S., favorable growing conditions, and the Mexican  Supreme Court’s 2021 decision invalidating a long-standing law that criminalized the  possession of cannabis for recreational use.

Although Mexico has yet to pass a full legalization law providing the means to grow, possess  and sell cannabis, some of the world’s largest cannabis companies are keeping an eye on  the market to capitalize quickly on legalization when it happens.[24]

However, Mexico ranks in the bottom third on Transparency International’s Corruption  Perceptions Index,[25] making it a challenging business climate for any company operating  within the country, but especially those affiliated with the cannabis industry.[26]

Notably, CEND, a global provider of technological infrastructure and certification platforms  for the cannabis industry and other regulated industries, facilitated its first large-scale  shipment of low-THC legal cannabis — i.e., hemp — from Uruguay to the U.S last  month.[27]

As cannabis companies engage in cross-border transactions, contact with foreign officials

should be carefully monitored and controlled. This includes, for instance, liasing with border  officials to fast-track the exportation and importation process.[28]

But these types of contacts with government officials abroad are precisely the type to draw  scrutiny from the U.S. Department of Justice, which investigates potential bribes and other  FCPA violations.

Unlike established multinational companies used to complying with anti-corruption laws,  many cannabis companies may be unfamiliar with these laws and how to navigate the risks  of doing business abroad.

FCPA compliance for these rapidly burgeoning companies in the global market will be  increasingly important as government entities place a magnifying glass on operations.

Compliance best practices include implementing a stand-alone FCPA compliance policy with  firm guidelines regarding foreign payments; providing robust employee training; and  conducting third-party due diligence.

Conclusion 

As the legal cannabis industry grows, companies should expect investigatory scrutiny at all  levels to increase. To avoid any unintended liability, planning is key.

Companies should recognize these risks as a business reality, and one for which they must  prepare. Developing robust controls, thoughtful documentation and significant preventative  measures may not only avoid liability but also unnecessary scrutiny from any investigatory  agency with which the business intends to be compliant.

Alicia Corona is an associate and Amy Rubenstein is a partner at Dentons. 

The opinions expressed are those of the author(s) and do not necessarily reflect the views  of their employer, its clients, or Portfolio Media Inc., or any of its or their respective  affiliates. This article is for general information purposes and is not intended to be and  should not be taken as legal advice. 

 

SOURCES

[1] James Couch et al., Evaluation of a Medicinal Cannabis Manufacturing Facility with an  Indoor and Outdoor Grow Operation, HHE Report No. 2016-0090-3317 (June 2018, rev’d  Aug. 2019).

[2] Michael P. Grant et al., Evaluation of Potential Hazards During Harvesting and Trimming  Cannabis at an Indoor Cultivation Facility, HHE Report No. 2091-0152-3381 (Feb. 2022).

[3] Carolyn Reeb-Whitaker, Claire R. LaSee & David K. Bonauto, Surveillance of Work Related Asthma Including the Emergence of a Cannabis-Associated Case Series in  Washington State, 59 J. of Asthma 1537, 1544 (2022).

[4] Id. at 1542.

[5] FY 2019 Comprehensive Federal Annual Monitoring Evaluation (FAME) Report, Cal. Dep’t  of Indus. Relations, https://www.osha.gov/sites/default/files/2020-07/california_2019.pdf.

[6] Stefan Sykes, Marijuana’s Black Market Is Undercutting Legal Businesses, cnbc (Dec.  23, 2022 12:13 PM), https://www.cnbc.com/2022/12/23/marijuana-black-market undercuts-legal-business.html.

[7] Letter from Robert P. Harvey to Senator Cory Gardner (Dec. 1,

2017), https://newtax.files.wordpress.com/2018/12/370531229-Senator-Gardner-280E Score-12-04-2017.pdf.

[8] Alan Brochstein, Here is Who’s Killing It in Cannabis, New Cannabis Ventures (Apr. 3,  2022, 10:50 AM), https://www.newcannabisventures.com/here-is-whos-killing-it-in cannabis/.

[9] Joseph E. Thomas, Puff, Puff, Tax: Internal Revenue Code Section 280E Penalizes State Sanctioned Marijuana Companies and Undermines the Ability-to-Pay Principle, 66 Villanova  L. Rev. 451, 476 n.181 (2021).

[10] Id. at 474.

[11] How Investigations Work, SEC (last modified Jan. 27,

2017), https://www.sec.gov/enforcement/how-investigations-work.

[12] SEC v. Jonathan William Mikula et al., No. 2:22-cv-07096-SB-PLA, (C.D. Cal. filed  Sept. 30, 2022).

[13] Id.

[14] SEC v. C3 International, Inc. et al., No. 8:21-cv-01586-CAS-PD, (C.D. Cal. filed Sept.  28, 2021).

[15] 15 U.S.C. § 78t(e).

[16] SEC v. Nicolas Arkells, No. 2:22-cv-05991-CAS-PD, (C.D. Cal. filed Aug. 24, 2022).

[17] Press Release, SEC, SEC Charges Canadian Cannabis Company and Former Senior  Executive with Accounting Fraud (Oct. 24, 2022), https://www.sec.gov/news/press release/2022-191.

[18] SEC v. American Patriot Brands, Inc., et al., No. 3:23-cv-01124, (D.P.R. filed Mar. 16,  2023).

[19] Dario Sabaghi, How Big is Germany’s Medical Cannabis Market, Forbes (Aug. 9, 2021,  8:00 AM), https://www.forbes.com/sites/dariosabaghi/2021/08/09/how-big-is-germanys medical-cannabis-market/?sh=231413fb40f4.

[20] Wilhelmine Preussen, You May Inhale: German Cabinet Backs Plan to Legalize  Cannabis, Politico (Oct. 26, 2022, 2:51 PM), https://www.politico.eu/article/germany cabinet-propose-legal-framework-legalize-cannabis-health-minister-karl-lauterbach/.

[21] Dario Sabaghi, Czech Republic Plans to Legalize Cannabis In Coordination With  Germany, Forbes (Nov. 4, 2022, 7:00

AM), https://www.forbes.com/sites/dariosabaghi/2022/11/04/the-czech-republic-plans-to legalize-cannabis-in-coordination-with-germany/?sh=6cc09d7c77e4.

[22] Chayut Setboonsarng & Jiraporn Kuhakan, Thailand Legalises Growing, Consumption of  Marijuana, Reuters (June 14, 2022, 1:51 AM), https://www.reuters.com/world/asia pacific/thailand-legalises-growing-consumption-marijuana-2022-06-09/.

[23] Over 100,000 People Register to Grow Cannabis, Bangkok Post (June 9,  2022), https://www.bangkokpost.com/thailand/general/2323174/over-100-000-people register-to-grow-cannabis.

[24] Oscar Lopez, A Green Wave? Mexico’s Marijuana Market May Be Middling, N.Y. Times  (Mar. 12, 2021, 12:54 AM), https://www.nytimes.com/2021/03/12/world/americas/mexico marijuana-legalization.html.

[25] Corruption Perceptions Index: Mexico, Transparency

International, https://www.transparency.org/en/cpi/2021/index/mex.

[26] Roberto Martinez B. Kukutschka, Integrity Risks for International Businesses in Mexico,  Chr. Michelsen Institute (2018), https://www.u4.no/publications/integrity-risks-for international-businesses-in-mexico.

[27] Javier Hasse, Uruguay Ships 1,000+ Pounds of Cannabis to the U.S.: Country’s  Ambassador Weighs In, Forbes (Feb. 6, 2023, 09:15

AM), https://www.forbes.com/sites/javierhasse/2023/02/06/in-bold-move-uruguay-ships 1000-pounds-of-legal-cannabis-to-the-us-countrys-ambassador-weighs-in/.

[28] Id.

 

Originally published on Law360

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