Owner – Financial Interest – Trap Advisors
Owner – Financial Interest – Trap Advisors California Regulators Definitions of Ownership Interest [“Owners”] and “Financial Interest Holder [“FI”] – A Trap for The Unware
We have spent the past three years as a very active and aggressive participant in the creation and evolution of the commercial cannabis industry in California.
The market went from a lightly regulated experiment with medical cannabis beginning in 1996 to a highly regulated market which continues in transition and involves twenty-three state level agencies, three with primary regulatory responsibility, and second tier, land-use regulation by 539 counties and cities.
We have witnessed the
- Creation of a structure for legal medical cannabis beginning with Prop. 215 back in 1996, and the evolution of law regarding legislative limits on the modification of a Proposition passed by the vote of the citizens of California.
- Creation of a legal adult use cannabis framework with the passage of Prop. 64, and the
- Creation and development of the triumvirate of cannabis industry regulatory agencies which include the Bureau of Cannabis Control [“BCC”], the California Dept. of Public Health [“CDPH”] Medical Cannabis Safety Board [“MCSB”], and the California Dept. of Food and Agriculture [“CDFA”] CalCannabis Cultivation Unit, [collectively the “Regulators”]. We have written about the regulatory framework in greater detail here, and detail the classification of cannabis cultivation as agricultural activity under local law here.
The complexity of the system has created the “absolute necessity of” and “engagement by” myriad attorneys, certified public accountants, consultants and professional managers to guide cannabis businesses It is quite ironic that the very system of regulation has created a serious “hoisted by one’s own petard” trap for the wary among that exact group of advisors.
With the “re-adoption” of the Emergency Regulations, all three California agencies tasked with regulating cannabis are now finally on the same page about the disclosure and vetting of “Owners” versus FI’s. The melding of the traditional advisor roles of lawyer, accountant, financial advisor and, consultant with the evolving “fintech” roles of lender, mezzanine lender, landlord and other types of financial recompense in the cannabis industry have created an entirely new set of issues [“cannabis regulatory disclosures” or “CRD’s” for short]
These issues broadly encompass:
- Inclusion in or exclusion from license applications with the Regulators as well as the second-tier regulators of land0-use the 538 counties and cities that comprise the State of California.
- Vetting and disclosure of the entirety of these relationships in such filings, and an entirely indirect set of issues related to the interface of the CRD’s with the California Rules of Professional Conduct for Attorneys, Rules of the California Board of Accountancy, Treasury Circular 230, numerous other sets of rules of professional conduct that govern other professions and trades.
- The situation is further complicated by the consequences of anyone covered by these rules that continues to operate on a daily basis in violation of such rules. As a simple example, is an attorney who is in violation of the CRD’s guilty of wire fraud every time they send an email when the requisite conditions are met? Could a overzealous Dept. of Justice prosecutor [thankfully, the cannabis industry never encounters that situation] pursue a firm under the criminal RICO statutes based solely on these issues?
- Before we dismiss the latter two points as “impossible” or “pipe dream” consider the current going’s on at the US-Canadian border” where it appears that agents of ICE [the Federal Immigration and Custom’s Enforcement agency are preventing Canadian’s that are employed or invest in businesses that “benefit illegal drug trade “whether directly or indirectly from entering the United States. This appears to be official policy that applies to both “touch the plant” and non-plant touching businesses.
It can be difficult to ascertain the actual extent and nature of the entirety of an individual’s involvement with an entity, particularly in the case of an advisor. One obviously starts their evaluation with the usual sources:
- Secretary of State’s Office Filings, Certificates of Organization and Incorporation,
- Operating and Shareholder Agreements, By-Laws, Board and Shareholder Meeting Minutes, Agreements, Loan Documents and Security Agreements and Contracts which have been approved.
- For advisors, we extend to Engagement and Termination Letters and modifications thereof, Side Letters, Stop-Loss Agreements, and literally any document that has a financial compensation or incentive component. Depending on the exact nature of an ownership interest, involvement in management and control of a company, there may be filing requirements with the Regulators with respect to a “Financial Interest”, or possibly an “Ownership Interest”
The Regulators require that FI’s be disclosed to and vetted upon application for annual cannabis licenses and the license applicants must provide a list of all financing it receives. Specifically, the license application mandates applicants include the name, birthdate, and government-issued identification type and number (i.e., driver’s license) for any individual with a financial interest in a commercial cannabis business. FI’s are not required to submit to criminal background checks, but they will still undergo some vetting by state regulators.
Even with these new rules, most institutional investment in the cannabis space is still concentrated in those ancillary services that support cannabis businesses but do not “touch the plant” such as attorneys, CPA’s compliance consultants, technology consultants, and the myriad of other supporting services. Many of these consultants not directly involved in cannabis don’t appreciate the idea of being listed in a state database as being Owner or FI’s
.However, given California’s wide-reaching definition of owner and FI, even these companies and their investors can be deemed by the state to have this direct cannabis business interest. To avoid being considered owners or FIHs in California, ancillary service providers will need to avoid directly providing financing, using profit-sharing or similar performance-based payment schemes with cannabis businesses, and they will also need to avoid managing, directing, or controlling the licensed entity.
Attorneys and CPA’s have an additional level of concern, due to the potential for “stacking” violations of the cannabis Regulator’s rules on to top of their own Codes of Professional Conduct. The details of those provisions are beyond the scope of this article.
The California Rules of Professional Conduct, specifically Rule 8.4 Misconduct can easily be construed to include an attorney’s violation of the CRD’s.
Finally, though the linkage ought to be rare and remote, the linkage of Federal criminal sanction should not be overlooked. We briefly highlighted concerns with respect to mail and wire fraud statutes. The US Attorney’s Manual definition of the elements of wire fraud raise their own concerns. We have additional concerns as we track the evolution of FINCEN FIN-2014-G001 that deals with the cannabis industry and banking, and developments with respect to Suspicious Activity Reports [“SAR’s”] and assertion of violations of the “structuring provisions and other Title 31 violation.
Owner – Financial Interest – Trap Advisors
 California Proposition 215, also known as the Medical Use of Cannabis Initiative or the Compassionate Use Act, was on the November 5, 1996 general election ballot in California as an initiated state statute where it was approved.
The passage of Proposition 215 is considered a significant victory for medical cannabis. It exempts patients and defined caregivers who possess or cultivate cannabis for medical treatment recommended by a physician from criminal laws which otherwise prohibit possession or cultivation of cannabis.
In May 2009, the U.S. Supreme Court declined to hear an appeal of a California state appellate ruling from 2008 that upheld Proposition 215 and concluded that California can decide whether to eliminate its own criminal penalties for medical cannabis regardless of federal law. The appellate ruling came about because of a lawsuit against Proposition 215 filed by San Diego and San Bernardino counties.
These counties objected to Proposition 215 on the grounds that it requires them, in their view, to condone drug use that is illegal under federal law. They also challenged a law that requires counties to issue identification cards to medical cannabis patients, so these patients can identify themselves to law enforcement officials as legally entitled to possess small amounts of cannabis. [ San Francisco Chronicle, “Solano to allow medical cannabis ID cards,” June 24, 2009]
Proposition 215 also led to the lawsuit, People v. Kelly This case was decided in January 2010 by the California Supreme Court, which ruled that the state of California cannot, through the legislative process, impose a state limit on medical cannabis that is more restrictive than what is allowed under Proposition 215. People v Kelly helps define laws governing the initiative process in California especially as it relates to legislative tampering.
The language that appeared on the ballot stated:
- Exempts patients and defined caregivers who possess or cultivate cannabis for medical treatment recommended by a physician from criminal laws which otherwise prohibit possession or cultivation of cannabis.
- Provides physicians who recommend use of cannabis for medical treatment shall not be punished or denied any right or privilege.
- Declares that measure not be construed to supersede prohibitions of conduct endangering others or to condone diversion of cannabis for non-medical purposes.
- Contains severability clause.
In 2004, the California State Legislature passed the Medical Cannabis Program Act (MMPA). The MMPA was intended to clarify which specific practices with regard to medical cannabis were to be considered lawful in the state. The MMPA:
- Established a voluntary statewide identification card system;
- Set limits on the amount of medical cannabis each cardholder could possess;
- Laid out rules for the cultivation of medical cannabis by collectives and cooperatives.
In 2007, the California Fourth Appellate District ruled against the City of Garden Grove, and in favor of a medical cannabis patient (Felix Kha), saying that “it is not the job of the local police to enforce the federal drug laws.”
The case resulted from the seizure of medical cannabis from Kha by the Garden Grove police force in June 2005.
Kha was pulled over by the Garden Grove Police Department on June 10, 2005, and cited for possession of cannabis, despite Kha showing the officers proper documentation of his status as a medical cannabis patient.
The charge against Kha was subsequently dismissed, with the Superior Court of Orange County issuing an order to Garden Grove that the city must return to Kha 8 grams of medical cannabis that was seized from him by the police. The police, backed by the city of Garden Grove, refused to return Kha’s medicine and the city appealed.
In the 2007 state court decision, the court ruled that the federal Controlled Substance Act of 1970, enacted to combat recreational drug abuse and trafficking, did not intend to regulate the practice of medicine, “a task that falls within the traditional powers of the states.”
Before the California Fourth District Court of Appeal issued its decision, California Attorney General Jerry Brown filed a “friend of the court” brief on behalf of Kha’s right to possess his medicine. The justices noted they were convinced by Brown’s arguments that local agencies are bound by state laws in approaching medical cannabis.
The California Supreme Court denied a case review in March 2008, and Garden Grove then went to the United States Supreme Court, which turned the case down in late November 2008.
Medical cannabis advocates called the decision a huge victory in clarifying law enforcement’s obligation to uphold state law – in this case, Proposition 215.
 MMRSA was followed by clean up legislation and Proposition 64 [“Prop. 64”] was passed California became a state that permitted adult use cannabis. Following Prop. 64, the California legislature passed the Medical and Adult-Use Cannabis Regulation and Safety Act [“MARUCRSA”]. MAUCRSA was the foundation for multiple agencies to write of regulations for oversight of the cannabis industry in California.
The Medical Cannabis Regulation and Safety Act [“MMRSA”], which went into effect in 2016, included a multitude of regulatory procedures involving many agencies, but much of the regulation of cannabis growing will now fall under the CDFA on both state and local levels. Regulations will include not only compliance with environmental requirements such as the regional water board cultivation permits, but with regulations concerning pesticide use, testing, sales, distribution, and a host of other standards akin to those faced by commercial agricultural producers around the state.
California Governor Jerry Brown signed the MMRSA into law on October 09, 2015, and it became effective on January 01, 2016. The Act, composed of 3 bills (AB 266, AB 243, and SB 643) established a licensing and regulatory framework for the cultivation, manufacture, transportation, storage, distribution, and sale of medical cannabis in the State of California. The MMRSA established the Medical Cannabis Cultivation Program within the California Department of Food and Agriculture [“CDFA”] to license cultivators, establish conditions under which indoor and outdoor cultivation may occur, establish a track and trace program for reporting the movement of medical cannabis items through the distribution chain, and assist other state agencies in protecting the environment and public health.
Subsequently, California voters passed the Adult Use of Cannabis Act (Proposition 64), which also designated responsibilities for oversight of commercial cannabis to multiple state agencies
 Interestingly, the issue for representation of applicants and licensees before the Regulators continues unanswered, see California Cannabis Applicants and Licensees Should Be Entitled To Representation here.
 18 USC 1343 –
“Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises, transmits or causes to be transmitted by means of wire, radio, or television communication in interstate or foreign commerce, any writings, signs, signals, pictures, or sounds for the purpose of executing such scheme or artifice, shall be fined under this title or imprisoned not more than 20 years, or both. If the violation occurs in relation to, or involving any benefit authorized, transported, transmitted, transferred, disbursed, or paid in connection with, a presidentially declared major disaster or emergency (as those terms are defined in section 102 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act (42 U.S.C. 5122)), or affects a financial institution, such person shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.
 18 USC 1961 including
“(1)“racketeering activity” means
(A) any act or threat involving murder, kidnapping, gambling, arson, robbery, bribery, extortion, dealing in obscene matter, or dealing in a controlled substance or listed chemical (as defined in section 102 of the Controlled Substances Act), which is chargeable under State law and punishable by imprisonment for more than one year;
(B) any act which is indictable under any of the following provisions of title 18, United States Code: section 1341 (relating to mail fraud), section 1343 (relating to wire fraud)…”
 § 5004. Financial Interest in a Commercial Cannabis Business
“(a) A financial interest means an investment into a commercial cannabis business, a loan provided to a commercial cannabis business, or any other equity interest in a commercial cannabis business.
(b) The license application shall include the name, birthdate, and government-issued identification type and number for all individuals that have a financial interest in a commercial cannabis business but are not owners as defined in Business and Professions Code section 26001 (al), however, they shall not be required to submit the information required of owners under section 5002(c)(20).
(c) Notwithstanding subsection (b), the following individuals are not required to be listed on an application for licensure under section 5002(c)(19):
- A bank or financial institution whose interest constitutes a loan;
- Individuals whose only financial interest in the commercial cannabis business is through an interest in a diversified mutual fund, blind trust, or similar instrument,
- Individuals whose only financial interest is a security interest, lien, or encumbrance on property that will be used by the commercial cannabis business; and
(4) Individuals who hold a share of stock that is less than 5 percent of the total shares in a publicly traded company.”
 § 5003. Designation of Owner
- All applicants for a commercial cannabis license shall have at a minimum one individual that meets the definition of “owner” under Business and Professions Code section 26001(al) and who will submit the information required of owners under section 5002.
- “Owner” means any of the following:
(1) A person with an aggregate ownership interest of 20 percent or more in the person
applying for a license or a licensee, unless the interest is solely a security, lien, encumbrance.
(2) The chief executive officer of a nonprofit or other entity
(3) A member of the board of directors of a nonprofit.
(4) An individual who will be participating in the direction, control, or management of the person applying for a license. An owner who is an individual participating in the direction, control, or management of the commercial cannabis business includes any of the following
- A partner of a commercial cannabis business that is organized as a partnership.
- A member of a limited liability company of a commercial cannabis business that is organized as a limited liability company.
(C) An officer or director of a commercial cannabis business that is organized as a corporation.
 “(Rule Approved by the Supreme Court, Effective November 1, 2018)
It is professional misconduct for a lawyer to:
- violate these rules or the State Bar Act, knowingly* assist, solicit, or induce another to do so, or do so through the acts of another;
- commit a criminal act that reflects adversely on the lawyer’s honesty, trustworthiness, or fitness as a lawyer in other respects;
- engage in conduct involving dishonesty, fraud,* deceit, or reckless or intentional misrepresentation;
- engage in conduct that is prejudicial to the administration of justice;
- state or imply an ability to influence improperly a government agency or official, or to achieve results by means that violate these rules, the State Bar Act, or other law; or
- knowingly* assist, solicit, or induce a judge or judicial officer in conduct that is a violation of an applicable code of judicial ethics or code of judicial conduct, or other law. For purposes of this rule, “judge” and “judicial officer” have the same meaning as in rule 3.5(c).”
Comment: Paragraph (c) incorporates the language of Model Rule 8.4(c) but adds the words “reckless or intentional” to modify “misrepresentation.” The conduct prohibited in this provision – dishonesty, fraud, deceit and reckless or intentional misrepresentation – are central concepts of conduct in which lawyers must not engage if respect for the legal profession and the proper administration of justice is to be maintained. The addition of “reckless or intentional” is intended to clarify that negligent misrepresentation is not regarded as dishonesty that should result in discipline under this rule.2 In addition, as initially circulated for 90-day public comment, paragraph (c) included an express reference to “moral turpitude.
 USAM 9-43.100 – The elements of wire fraud under Section 1343 directly parallel those of the mail fraud statute but require the use of an interstate telephone call or electronic communication made in furtherance of the scheme. United States v. Briscoe, 65 F.3d 576, 583 (7th Cir. 1995) (citing United States v. Ames Sintering Co., 927 F.2d 232, 234 (6th Cir. 1990) (per curium)); United States v. Frey, 42 F.3d 795, 797 (3d Cir. 1994) (wire fraud is identical to mail fraud statute except that it speaks of communications transmitted by wire); see also, e.g., United States v. Profit, 49 F.3d 404, 406 n. 1 (8th Cir.)
The four essential elements of the crime of wire fraud are:
- that the defendant voluntarily and intentionally devised or participated in a scheme to defraud another out of money;
- that the defendant did so with the intent to defraud
- that it was reasonably foreseeable that interstate wire communications would be used; and
(4) that interstate wire communications were in fact used) (citing Manual of Model Criminal Jury Instructions for the District Courts of the Eighth Circuit 6.18.1341 (West 1994)), cert. denied, 115 S.Ct. 2289 (1995); United States v. Hanson, 41 F.3d 580, 583 (10th Cir. 1994)
Two elements comprise the crime of wire fraud: (1) a scheme or artifice to defraud; and (2) use of interstate wire communication to facilitate that scheme); United States v. Faulkner, 17 F.3d 745, 771 (5th Cir. 1994) (essential elements of wire fraud are:
- a scheme to defraud and
- the use of, or causing the use of, interstate wire communications to execute the scheme), denied, 115 S.Ct. 193 (1995); United States v. Cassiere, 4 F.3d 1006 (1st Cir. 1993)
To prove wire fraud government must show
- scheme to defraud by means of false pretenses,
- defendant’s knowing and willful participation in the scheme with intent to defraud, and
(3) use of interstate wire communications in furtherance of scheme); United States v. Maxwell, 920 F.2d 1028, 1035 (D.C. Cir. 1990)
Wire fraud requires proof of
- a scheme to defraud; and
(2) the use of an interstate wire communication to further the scheme.”).