For much of 2018, Canada was the focal point of the global cannabis industry due mainly to Canada’s federal legalization of cannabis for recreational purposes, which occurred on October 17, 2018. Fueled by optimism surrounding both Canadian and global prospects, we saw a significant uptick in capital raising in the cannabis industry, with nearly US$13.8 billion raised in 2018, up from US$3.5 billion in 2017. Much of this capital raising activity was a result of U.S. cannabis companies that looked north of the border for access to capital markets.
Despite being only 6 months removed from legalization, Canadian licensed producers (LPs) appear to have shifted their focus to (i) developing “next generation” products, such as edibles and “vapes,” which are set to become legalized in Canada in October 2019, but which have been legal for some time in certain U.S. states, such as Colorado, California and Washington, and (ii) implementing a rest-of-world strategy that includes exposure to the U.S. cannabis market—both resulting in an increasing number of transactions reaching across the border. As U.S. clients are requiring more and more guidance from counsel, U.S. law firms are grappling with how to advise with respect to both the Canadian and U.S. cannabis industries.
With respect to the development of next generation products, significant investments from major U.S. alcohol and tobacco companies have given credibility to the Canadian cannabis industry and provided certain players with an experienced partner for the next phase of legalization (both domestically and abroad). Constellation Brands (Constellation), a leading international producer of wine, beer and spirits, made a US$4 billion investment in Canopy Growth Corporation (Canopy). The investment closed in November 2018 and brought Constellation’s ownership stake in Canopy to approximately 37%. In December 2018, Altria Group Inc. (Altria), parent company of Philip Morris USA, announced a US$1.8 billion investment in Cronos Group Inc. (Cronos), representing a 45% ownership interest in Cronos.
With respect to exposure to the U.S. market, the enactment of the 2018 Farm Bill in the U.S., which created a federally legal environment for the cultivation, distribution and sale of industrial hemp, has provided an opportunity for Canadian LPs to establish a toe-hold in the U.S. market after having previously been denied access due to the restrictions of the major Canadian and U.S. stock exchanges against operations which are offside U.S. federal law. The significance of the Farm Bill stems from the presence of the non-psychoactive cannabinoid, cannabidiol (CBD), which is found in industrial hemp and for which the Brightfield Group has estimated a potential market of US$22 billion by 2022 in the U.S. alone.
Canadian LPs, including Canopy and Tilray Inc. (Tilray), have already taken advantage of the liberalized U.S. hemp laws to establish a presence south of the border. On October 15, 2018 Canopy announced that it had entered into an agreement to acquire the assets of Ebbu, Inc., a Colorado-based hemp research leader. Canopy has also taken a step toward establishing a cultivation presence in the U.S. by announcing on January 14, 2019 that it had been granted a licence by New York State to process and produce hemp. Canopy stated that it intends to invest between US$100 million and US$150 million toward the establishment of large-scale production capabilities focused on hemp extraction and product manufacturing within the U.S. Tilray, meanwhile, announced the acquisition of Manitoba Harvest, a Canadian hemp-based food processor with products currently sold in grocery store chains throughout Canada and the U.S. The company has been developing products containing hemp-derived CBD and plans to enter the U.S. CBD market once approved by the FDA.
CONSIDERATIONS FOR US LAW FIRMS
Cannabis continues to be a Schedule I narcotic under the federal Controlled Substances Act in the US. We have found little evidence of enforcement of federal law against cannabis companies operating within states that have established a legal framework, but, despite this, U.S. law firms have understandably been hesitant to provide legal services to companies that operate in the cannabis space. However, as was the case in Canada, the volume of activity in the space and the involvement of well-established, “traditional” clients have necessitated that major U.S. law firms become familiar with both the U.S. and Canadian cannabis industries.
The primary consideration from a U.S. legal perspective is that providing advice to a company that operates in violation of U.S. federal law, regardless of compliance with state cannabis laws, could be seen as aiding and abetting in the commission of a federal crime. Furthermore, a firm that accepts payment for such services could be in receipt of proceeds of crime under applicable anti-money laundering statutes. However, to advise a cannabis company that operates exclusively in Canada, or any other jurisdiction which has a legal framework regulating cannabis, does not appear to be a violation of U.S. law. As a result, many U.S. law firms have gotten comfortable advising cannabis companies that do not have U.S. cannabis operations, such as Canopy and Tilray. Similarly, U.S. law firms have gotten comfortable advising U.S. companies who do business with cannabis companies that operate solely outside of the U.S., such as Constellation, Altria and other U.S. investors.
U.S. law firms should take comfort from the policies of major stock exchanges (the TSX and TSX-V in Canada, and the NYSE and NASDAQ in the U.S.), which prohibit the listing of cannabis companies that operate in violation of U.S. federal law. Although such issuers are subject to continuous monitoring by the exchanges, law firms are best advised to conduct their own diligence prior to agreeing to act on behalf of any cannabis company.
Another consideration that has provided some comfort for U.S. law firms with respect to aiding and abetting in the commission of a federal crime is the degree to which a prospective client “touches the plant.” Any company that cultivates, processes, or sells cannabis would be said to “touch the plant”—these are the clients that U.S. law firms have been most hesitant to advise. However, as the degree of contact with the plant decreases, the comfort with providing legal services increases. For example, a client that is providing security systems or hydroponic lights to in the cannabis industry is generally viewed as a much less risky client than one that directly touches the plant.
Even still, some U.S. law firms have gotten comfortable advising clients that touch the plant with the reasoning that general corporate, securities and transactional advice is not aiding and abetting the commission of a crime, as they are not advising on any matter that is a violation of federal law.
One final concern expressed by some U.S. law firms is that of reputational risk. There remains a degree of stigma associated with cannabis use, and that is considered by the general counsel and ethics committees of law firms when deciding whether to accept a cannabis-related mandate. Furthermore, as a relatively nascent sector, the cannabis industry has experienced some growing pains in both Canada and the U.S. in the form of questionable dealings by executives and directors. Many firms fear the prospect of seeing their name alongside their client’s in a news story regarding unscrupulous behaviour.
Ultimately, the level of comfort a law firm has with working in the cannabis space exists on a spectrum. Many large firms simply won’t advise on cannabis-related matters. Others have taken a cautious approach, working exclusively on deals that do not involve U.S. cannabis operations or with companies that are several steps removed from touching the plant. At the opposite end, there are those that have leapt headfirst into the industry, advising U.S.-focused clients that do in fact touch the plant, with an eye toward establishing a first-mover advantage in the industry and “being on the right side of history.”
Even for firms that have avoided the cannabis industry to date, the reality in the U.S., as it was in Canada, is that traditional firm clients, whether it be investment banks, retailers, pharmaceutical or consumer packaged goods companies, will get involved in the cannabis space and firms will need to get smart in a hurry.
Federal legalization of cannabis in the U.S. appears to be on the horizon, whether it be as part of a 2020 election campaign or sometime prior. We expect that there will continue to be interest in U.S. hemp and cannabis assets from Canadian LPs in the interim and expect that there will be an explosion of activity in the form of capital raising and domestic M&A upon federal legalization in the U.S. At that time, firms that have developed experience, expertise and relationships in the cannabis industry will be well positioned to capitalize on the opportunity.