White Labeling, Contract Manufacturing, and IP Licensing Under the Final Cannabis Regulations

by Omar Figueroa, December 10, 2018

On Friday, December 7, 2018, the Bureau of Cannabis Control (the “BCC”) — along with California’s two other cannabis licensing agencies, CalCannabis Cultivation Licensing within the California Department of Food & Agriculture (“CDFA”) and the Manufactured Cannabis Safety Branch within the Department of Public Health (“DPH”) — released their respective final versions of the regulations that will soon govern the state’s cannabis industry.

The three sets of regulations which have been submitted to the Office of Administrative Law (OAL) for review will not go into effect until the OAL completes its review.  The proposed permanent regulations can be found here: BCC, CDFA, and DPH. It is anticipated that the official OAL-approved versions will be unveiled at some point in January.  

According to the OAL web site, the OAL Deadline to complete the review of the regulations submitted is January 16, 2019.

The OAL’s review is mainly procedural. OAL is limited to the record of rulemaking, and is not allowed to substitute its judgment for that of the rulemaking agency with regard to the substantive content of the regulation.  

The OAL review is intended to be an independent check on the exercise of rulemaking powers by executive branch agencies.  The goal is to ensure that every regulation is legally valid, supported by an adequate record, and easy to understand. Government Code § 11349.1 sets forth the criteria for OAL review:

These standards are explained in further detail in the OAL’s own regulations, which can be found at Title 1, Division 1, Chapter 1, Article 2 of the Code of California Regulations, “Criteria Applied in the Review of Proposed Regulations.”

 

Occasionally, the OAL disapproves of proposed regulations, and it explains its reasoning in a written “Decision of Disapproval of Regulatory Action.” These Disapproval Decisions are published on the OAL site, and provide examples of the various ways in which OAL could in theory disapprove of deficient cannabis regulations.

One of the most controversial proposals in BCC’s October 2018 proposed permanent regulations was an apparent prohibition on “white labeling,” contract manufacturing, and branding agreements, between a licensee and an unlicensed person. This prohibition was set forth in § 5032 of the proposed regulations, at subdivision (b).  In response to strenuous objections from many stakeholders in the cannabis industry, the language of the latest version of § 5032 was partly modified.

The October 2018 version of § 5032 reads as follows:

The latest (and likely final) version of §5032 reads:

Let’s look more closely at the changes in subdivision (b).  The October 2018 version of § 5032(b) sets forth a broad prohibition followed by examples:

The December 2018 version of § 5032(b) sets forth a broad prohibition without any illustrative examples:

To the disappointment of many who submitted comments in opposition, § 5032(b) remains essentially unchanged.  The only change is that the non-exhaustive list enumerating four types of prohibited commercial cannabis activities has been deleted.  

The Final Statement of Reasons explains the changes to subdivision (b) of § 5032.  In brief, the Bureau decided that the “inclusion of the clarifying example transactions is causing more confusion” and therefore withdrew the list of examples of specific commercial cannabis transactions which are prohibited.

Although the non-exhaustive list of prohibited commercial cannabis transactions has been withdrawn, the broad language which generated the outcry in the first place remains:

“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.” § 5032(b).   

The question, then, becomes, who is considered a “person who is not licensed under the Act.”  The Act refers to the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA), which is codified, in large part but not entirely, in Division 10 of the Business & Professions Code.

By way of background, MAUCRSA is the regulatory framework underlying the proposed permanent regulations.  Any regulations have to be consistent with MAUCRSA, and the definition of “owner” in MAUCRSA is extremely broad:

“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, or 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.

Business & Professions Code § 26001(al) (Emphasis added).  

Thus, under MAUCRSA, an “owner” need not have an aggregate ownership interest of 20 percent or more.  Indeed, an individual can have no ownership interest whatsoever (0% ownership interest) and still be considered an “owner” if the individual “will be participating in the direction, control or management” of the licensed entity.

The BCC, in the Final Statement of Reasons, makes clear that the “owner” of a licensee would not be considered an unlicensed person.  (This is a welcome relief to disclosed “owners”, who strictly speaking, could  technically have been considered non-licensees under the plain language of MAUCRSA.)

In response to a request for clarification on whether a licensee is allowed to produce branded products on behalf of a brand-owner disclosed as an “owner” of the licensee without thereby conducting commercial cannabis activity on behalf of an unlicensed person, the BCC replied that the licensee can produce the branded products (and is not engaged in commercial cannabis activity on behalf of an unlicensed person) because the owner of the brand is an “owner” of the licensee. The  BCC concluded that, under these circumstances, there is no unlicensed person involved.

The BCC did indicate its willingness to assist applicants which such questions and to help applicants and licensees determine, based on their business plans, which persons need to be listed as “owners.”

Similarly, the BCC indicated that brand licensing arrangements between a licensee and the licensee’s “financial interest” holders would accomplish the BCC’s objective of ensuring that anyone who exercises control over a licensee should be registered as an owner or financial interest holder in accordance with Sections 5003 and 5004 of the regulations.

In response to a comment indicating “that language should be added to clarify that any person or entity that is disclosed as an owner or as having a financial interest is part of the licensee’s operation and therefore authorized under the Act,” the BCC replied that the suggested language would be duplicative and unnecessary as “sections 5003 and 5004 of the Bureau’s emergency regulations and regulations already allow certain individuals to engage in commercial cannabis business under a Bureau license if they were disclosed as an owner or financial interest holder.”

Elsewhere in the Final Statement of Reasons, the BCC made clear that, “Generally, where a brand-owner may be dictating the standards and specifications of a product (ie. providing direction or control), they would likely be considered an owner that would need to be disclosed under section 5003.  Where ownership is properly disclosed, such persons would not be considered non-licensees, and would be able to conduct business under their license.”

Thus, the final permanent regulations submitted by BCC, and the accompanying Final Statement of Reasons, make clear that a brand-owner who is dictating the standards and specifications of a product would ordinarily be considered an “owner” whose ownership (for BCC purposes) would need to be properly disclosed.  

Because trademark law greatly disfavors “naked licenses,” trademark owners generally maintain control over the trademark in order to avoid loss of trademark rights.  Given the direction and control required by a trademark owner who wants to avoid granting a naked license, such a trademark owner would probably be required to register with the BCC as an “owner” of the licensee  regardless of the brand-owner’s actual ownership interest in the licensee.

So, what can licensees and brand-owners do to ensure compliance with the December 2018 version of § 5032(b), which prohibits commercial cannabis activities with unlicensed persons?

There appear to be three possible “workarounds,” which are not really workarounds but ways of complying with the language and intent of the proposed permanent regulations.  

The first “workaround” is for a brand-owner who exercises direction or control over the licensee (in order to avoid granting a “naked license”) to be properly disclosed as an “owner” of the licensee pursuant to § 5003.  Alternatively, if the brand-owner does not qualify as an “owner” (because the brand-owner has inadvertently abdicated direction and control over the product by granting a naked license, for example) but the brand-owner qualifies as a person having a financial interest in the commercial cannabis business because the brand-owner will receive a modest percentage of the profits under an intellectual property licensing agreement, the brand-owner should be disclosed pursuant to § 5004. (If the percentage of the profits is 20% or greater, then the brand-owner would be considered an “owner” who would have to be disclosed under proposed § 5003(b)(5).)

Another “workaround” is for the licensee or for someone disclosed to the BCC pursuant to § 5003 or § 5004, to outright buy (not rent) the rights to the intellectual property before the regulations take effect, so that the brand-owner is also one of the following when the regulations take effect: a licensee, an “owner” of the licensee, or a person with a financial interest in the licensee.

A third “workaround” is for the brand-owner to become a BCC licensee. For example, assume that the brand-owner is genuinely interested in exploring the possibility of organizing a temporary cannabis event, knowing that such events (“brand activations”) can exponentially increase a brand’s exposure to desirable consumers.  Since the Cannabis Event Organizer license does not require local approval, the brand-owner in good faith obtains a Cannabis Event Organizer license from the BCC without much difficulty. (The brand-owner is happy to learn that temporary Cannabis Event Organizer licenses can be obtained for free for the time being, while the readopted emergency regulations remain in effect.)  Once the brand-owner obtains a Cannabis Event Organizer license, the brand-owner is a BCC licensee, and should no longer be considered an unlicensed person.

UPDATE: On March 19, 2019 the BCC released Guidance on Commercial Cannabis Activity which clarifies that a cannabis event organizer license cannot be used as a “workaround.”

Nevertheless, to the extent that a brand-owner with a license exerts direction or control over another licensee, the brand-owner should be disclosed under § 5003 as an “owner” of the other licensee, meaning the licensed entity which has licensed the brand from the brand-owner. Similarly, to the extent that the brand-owner obtains a commission or percentage of sales profits under 20%, the brand-owner should be disclosed under § 5004 as a person with a financial interest in the licensed entity which has licensed the brand.  (If the percentage of the profits is 20% or greater, then the brand-owner would be considered an “owner” who would have to be disclosed under proposed § 5003(b)(5).)

The BCC’s emphasis on encouraging disclosure portends a regulatory focus on individuals who participate in the direction, control, or management of licensed entities but who have not been disclosed under § 5003 or § 5004. Such individuals are considered unlicensed persons with whom commercial cannabis activities are prohibited.   With the upcoming “sunset” of the collective and cooperative defense on January 9, 2019, and BCC’s recent focus on augmenting its enforcement staff, it is anticipated that enforcement will target unlicensed operators, with an emphasis on licensed entities that are directed, controlled, or managed by individuals who have not been disclosed to the regulatory agencies.

 

The information contained herein is provided for educational and informational purposes only, and should not be construed as legal advice or as an offer to perform legal services. The content of this blog contains general information and may not reflect the most current legal developments or information. The information is not guaranteed to be correct, complete or current. The Law Offices of Omar Figueroa makes no warranty, expressed or implied, about the accuracy or reliability of the information in this blog. Recipients of content from this blog should not act or refrain from acting on the basis of any information included in the blog without seeking appropriate legal advice on the particular facts and circumstances at issue from an attorney licensed in California. The Law Offices of Omar Figueroa expressly disclaims all liability with respect to actions taken or not taken by the recipient based on any or all of the information or other contents of this blog. The transmission of this blog, in whole or in part, does not constitute or create an attorney-client relationship between any recipients. Nothing herein is intended to create an attorney-client relationship and shall not be construed as legal advice. This is not an offer to represent you, nor is it intended to create an attorney-client relationship. The only way to become a client of the Law Offices of Omar Figueroa is through a formal fee agreement.