Never ending story: sudden changes to California's proposed cannabis regulations

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With only two months until the January 1 implementation of the final State Cannabis Regulations, the California agencies given licensing authority under the Medicinal and Adult-use Cannabis Regulation and Safety Act posted last minute changes that are causing quite a buzz in the cannabis community.

The announcement was made by the Bureau of Cannabis Control (BCC) on their California Cannabis Portal webpage. While many of the changes are simple clarifications, there is one particular proposed change that is getting a lot of attention, which we will discuss in more detail below.

No More Co-Packing/Licensing Arrangements

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From the feedback within the industry, it is safe to say that this is one of the most significant proposed changes. Section 5032 of Title 16 Section 42 of the CA Code of Regulations would be amended adding a new section (b) that states:

“(b) Licensees shall not conduct commercial cannabis activities on behalf of, at the request of, or pursuant to a contract with any person that is not licensed under the Act. Such prohibited commercial cannabis activities include, but are not limited to, the following:

  1. Procuring or purchasing cannabis goods from a licensed cultivator or licensed manufacturer.
  2. Manufacturing cannabis goods according to the specifications of a non-licensee.
  3. Packaging and labeling cannabis goods under a non-licensee’s brand or according to the specifications of a non-licensee.
  4. Distributing cannabis goods for a non-licensee.”

Currently there are quite a few cannabis brands in the California marketplace that do not operate as a licensed cannabis business, but provide specifications to licensed cannabis businesses to develop and sell their products. These companies were set up to be intellectual property companies that develop formulas and brands, and use a licensed manufacturer or grower to act as an entry into the marketplace. Most of the contract terms were structured as royalty payments or revenue sharing agreements. Some of the largest brands in the state operate under this model and replicate the concept as a means to enter multiple states that have commercial or medical cannabis markets in place. All they need is a contact within the supply chain and their brands can grow on a national scale without having to own a license in any state.

So what does the change mean in practical terms?

If approved, almost all licensing deals and other co-packing or co-manufacturing relationships would come to an end. This shift could signal a huge disruption in the marketplace as unlicensed brands scramble to secure licenses (which can be very difficult and take many months), merge with existing license holders or sell their intellectual property. The biggest impact will be seen in the edibles market due to the lack of licensed commercial kitchens that are capable of manufacturing edible cannabis products. A manufacturing license can be obtained within the state, but finding a building that is both licensed and a functional kitchen can be difficult in California. And, the cost to build the type of kitchen necessary can be significant and not within the plans of many licensed businesses.

It is unclear why this change was suggest, especially considering how much investment and activity has taken place over the last 10 months under the presumption that the “co-manufacturing” model would be permissible. If transparency is a concern, it could be address through other methods, like the proposed change to require persons who share in revenues (but are not actual owners) share in revenues to be disclosed and subject to background checks.

It also isn’t clear how this change would impact general corporate planning, as many cannabis operators have intellectual property held in separate IP holding companies and license the IP back to their subsidiaries that are licensed cannabis business. The regulations did not clarify what ownership levels or connection through corporate organization would qualify an IP holder as being a licensee, and significant reorganization may be necessary to address these changes.

Links to the amended text and summaries of the regulations proposed by the BCC are included in the announcement.

For now the BCC will accept comments on the proposed changes until November 5, and will release the final draft later this year. As with our announcement around this time last year when the proposed regulations were first proposed, we expect another hectic holiday season as these emergency regulations go through the formal adoption process.

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