How To Sue a Cannabis Company and Never Lose

That's a pretty big boast, isn't' it? As a lawyer in the cannabis industry, I spend every day writing dispensary/processing/cultivation applications, incorporating businesses, setting up efficient corporate tax structures to minimize IRS 280E, writing and editing operating agreements, management agreements, contracts, leases, etc. Additionally, there are edits of other lawyer's work to conform to state and federal requirements, and to insure they work for the cannabis industry since most are adapted from general commercial purposes.

Adapting documents, using online legal document production or working with a lawyer who is a general practice attorney, is a silver lined hand delivered invitation to bankruptcy, prosecution, and a host of other painful resolutions. Why? Because as I keep learning in this industry, most attorneys consistently make the same mistakes on clients' documents, which create vulnerabilities that litigators, trolls and others find too attractive to let go. Let's start with legal issues that you need to insure you fix, and then move to tax issues (next chapter, in a few days hopefully).

So, you're starting a cannabis company, applying for a dispensary/processing/cultivation license, or buying into one. Straight shot to the moon, right? Cash everywhere, big distributions, then finally a roll up with other like minded business people and a final check with a whole lot of zeroes. Not so fast, moneybags, you may not get out of here with your shirt on.

Where are the dangers? Let's go over a few of the legal ones:

Incorporation. So simple I don't need a lawyer, right? Or my lawyer incorporated my business as an LLC and I've never had any issues, so why worry now? Because there's always someone who may have an issue, a creditor who feels stiffed, partners or investors who feel you shortchanged them, so they come to top shelf litigators who smell blood in the water because you're attorney screwed up big time. How? Let's start with an easy example.

a. You started a cannabis company, incorporated as an LLC, had your supposedly very competent lawyer put together subscription agreements, offering documents, etc. and a powerpoint deck showing you have the special sauce to make this thing fly off the shelf. PERFECT! Now it's time for some smart litigator to come in an make sushi out of you. How? Well, you had all the documents, incorporated first, then sold shares using a meticulously crafted offering memorandum that seemed bullet proof. Guess what? If you sold more than 50% of the shares in the LLC to raise money, you're in serious trouble. Guess what? You don't have a valid LLC anymore, you terminated it. If there is a sale or exchange of 50% or more of the total interests in the LLC's capital and profits within a 12-month period (Sec. 708(b)(1)(B)) then you terminated the LLC, so the documents aren't going to protect you. So, now that the LLC is terminated, its assets are considered contributed tax free to a new LLC (under Sec. 721), and the interests in the new LLC are then deemed distributed to the members of the old LLC (Regs. Sec. 1.708-1(b)(4)). Now, let's move in for the kill. The old LLC is technically dead, the documents are worthless or possibly evidence of fraud, and the IRS deems the old assets are being moved into a new LLC (which you don't even have), but you are required to make a Sec. 754 election so the IRS sees the post termination exchange of LLC interests. Oh, so you didn't think about doing that? I'm coming after you for fraud, breach of fiduciary duty, potential tax penalties, breach of contract, and whatever else I can think of. Think you have a defense? Rather than go into court and litigate it, it would be smarter to call Floyd Merryweather, Jr. a washed up clown. At least the beating will be over in less than a minute.

b. Offering documents. Man, they are all over the web, every legal site has templates for them, and why not go to the SEC and simply download a prospectus from a cannabis company that has registered an offering and use their disclosures. My response? :)))). Payday!! Do you think because they talk about the lack of banking, financing, government regulation, the potential of crop failure, and not being able to follow the business plan due to circumstances beyond your control that you've covered every possible contingency? Nope. Wrong. Not even close. Let's name a few that are probably not mentioned: a. How about environmental impact risks? Where do you dump your waste water, in the storm drain? You better hope the EPA doesn't show up - the first fine is $500,000 and each additional is $2,000,000. b. Investment risk. Of course there is investment risk. But did you mention that if the venue is forced into federal court, the judge could rule that the documents are invalid because it involves the sale of a scheduled substance? Oops.

c. Piercing the corporate veil. Hey, I incorporated, have a separate checking account, pay taxes, withhold the right taxes from paychecks and make sure it gets deposited, so I have nothing to worry about, right? Oh yes you do. If I have a client ready to sue you and willing to pay for it, I'm starting with the low hanging fruit first. I'm going to do discovery and ask for your corporate resolution book. Oh, you don't have one? Pity. Guess what, you just violated one of the cardinal rules of protecting the corporate veil - observing formalities. Oh, you have one? Send it over. I promise you I'll find something you didn't enter but your company did. Maybe you didn't authorize the sale of stock. Maybe you didn't authorize the purchase of assets over a certain amount, despite the requirement in your operating agreement. Believe me, I'll find it.

Scared? Good. Fear is what keeps animals alive, and companies in compliance so their owners and investors can sleep at nite. Pay attention to the formalities, and ask the right questions.