The challenges of getting social equity right in the state-legal cannabis industry

6 minute read

REUTERS/Shannon Stapleton

Register now for FREE unlimited access to Reuters.com

July 22, 2021 - We previously wrote about the federal-state divide on cannabis legalization, and the special challenges it creates for businesses trying to operate in the burgeoning state-legal cannabis industry. Those challenges are especially pronounced for members of minority populations that have been the focus of the war on drugs since the 1970s.

While many states, including New York, have made righting the wrongs of those policies a central feature of their recent legalization efforts, it remains to be seen whether they can succeed where earlier efforts have failed. We will cover some of those legal and practical challenges here.

By all accounts, 2020 and 2021 have been banner years for the cannabis industry in the United States. Despite federal prohibition, the state-legal cannabis industry is now estimated to be worth over $18 billion, supporting over 300,000 full-time jobs, and several states, including New York, New Jersey and Connecticut, passed laws legalizing adult-use cannabis in the first half of 2021. But the very same minority populations most harshly impacted by the war on drugs are largely excluded from this industry. For example, according to Leafly's Jobs Report 2021, African Americans represent roughly 13% of the U.S. population, but only 1.2% to 1.7% of business owners in the industry.

Register now for FREE unlimited access to Reuters.com

Recent legalization efforts try to address these disparities head on through social and economic equity requirements baked into the laws. A number of states, including California, Illinois, New York, and Connecticut, offer priority licensing for social and economic equity applicants.

Though definitions vary by state, generally these include applicants who are from communities that have been disproportionately impacted by cannabis prohibition, women-owned businesses, minority-owned businesses, distressed farmers, and service-disabled veterans. The goal of these programs is to allow those impacted by the war on drugs — as well as certain other underrepresented groups — to participate in the burgeoning cannabis industry.

New York's recently enacted Marihuana Regulation and Taxation Act (MRTA) aims to do this by planning to award 50% of all adult-use dispensary licenses to social and economic equity applicants, while also granting preference to licensees that set out a plan for benefiting communities and people disproportionately impacted by the enforcement of cannabis laws in the past. It also waives some requirements at the application stage. Connecticut's new law goes further by including a requirement to reserve 50% of all licenses for social equity applicants. However, as discussed below, these good intentions may not be enough.

Many social equity laws have a residency component, which can be expressed either as a requirement or a preference. Advocates of such policies argue that they are necessary to ensure that residents — rather than out-of-state investors or multistate operators (MSOs) — reap the economic benefits of legalization. For instance, Detroit attempted to set aside 50% of its licenses to so-called "Detroit Legacy" applicants, a definition that combined a lengthy residency requirement with certain social equity components (like being impacted by the war on drugs).

Such regulations have been challenged on constitutional grounds, with the Detroit regulation being found to likely violate the Dormant Commerce Clause of the U.S. Constitution, which prevents states from discriminating against interstate commerce. See Lowe v. City of Detroit (E.D. Mich. 2021).

Similar challenges were successful in Missouri and Maine. See Toigov. Dep't of Health & Senior Servs. (W.D. Mo. 2021); NPG, LLC v. Portland (D. Me. 2020). But at least one court sidestepped this question by refusing to use "its equitable power to facilitate [federally] illegal conduct" (in this case the award of medical marijuana licenses). Original Invs., LLC v. Oklahoma (W.D. Okla. 2021).

Other aspects of social equity preference programs have also been challenged in court. Illinois, for example, faced lawsuits challenging the state's preference for veteran-owned businesses, which allegedly unfairly disadvantaged other applicants. See, e.g., Avalon Smoke Shop v. Ill. Dep't of Fin.& Prof'l Regulation (N.D. Ill. 2020); WAH Grp. LLC v. Ill. Dep't of Fin.& Prof'l Regulation (Ill. Cir. Ct. Cook County 2020). And Los Angeles has faced challenges to its decision to reserve cannabis delivery licenses for applicants from communities disproportionately impacted by the war on drugs for the next five years on due process grounds. S. Cal. Coal. v. City of L.A. (Cal. Super. Ct. L.A. County 2020).

Given the potentially enormous amounts of money at stake, it should not be surprising that such challenges have been lodged.

Even if social equity programs survive legal challenge, it remains to be seen whether such programs will ultimately succeed in fostering a more diverse industry. A license is merely a ticket for admission into a highly competitive industry, with no guarantee of success.

For one thing, so long as cannabis remains federally illegal, access to banking will remain constrained. While certain banks, and credit unions, provide banking services to the cannabis industry, they come with hefty monitoring fees that increase the closer one gets to the plant. For dispensaries, that can mean thousands of dollars a month in monitoring fees just for the privilege of having a checking account for the business.

Many banks are also unwilling to provide financing for the industry, requiring business owners to turn to more expensive alternative finance solutions, or sales of equity, to raise operating capital. Those very same businesses will be unable to take many ordinary business deductions due to Section 280E of the Internal Revenue Code, and its state-level analogues, which prohibit such deductions for federally illegal industries.

In the past, social equity applicants were able to partner up with well-financed investor groups (or in some cases MSOs) in applying for licenses by forming an operating company in which they both had a stake. In exchange for financial backing, those applicants gave up significant control. More recent legalization efforts, like New York's, have tried to combat this arrangement by requiring the social equity applicant to retain a controlling majority of any such company both financially and in terms of legal control. NY CLS Cannabis § 87(5). New York also limits the number of licenses in which any "person" can have a "direct or indirect financial or controlling interest." NY CLS Cannabis § 72(2).

The effect of these provisions may be that such arrangements will simply become unavailable for social equity dispensary operators, requiring them to shoulder the financial burden of operating a highly regulated business alone.

States trying to right the wrongs of the war on cannabis have touted increasingly progressive social equity components in their recent legalization efforts. However, it remains to be seen whether New York and its neighboring states will find solutions for the real-world problems facing small players in an industry dominated by players who have reached a scale that allows them to absorb costs that new entrants simply may be unable to absorb.

Hopefully states are already beginning to think about how to provide training and low-cost financing for the social equity applicants they are trying to prioritize. If they don't, they may just be setting up social equity applicants for financial failure a few months or years down the road.

Register now for FREE unlimited access to Reuters.com
Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Alex Malyshev is a partner at Carter Ledyard & Milburn LLP, and the chair of its Cannabis, Hemp & CBD Industry Group. He contributed the chapter, “Banking and Investment Considerations for Cannabis Businesses” in “Health Care and the Business of Cannabis: Legal Questions and Answers,” (American Health Law Association 2021). He is based in New York and can be reached at malyshev@clm.com.

Sarah Ganley is an associate in the Litigation Department of Carter Ledyard & Milburn LLP and can be reached at ganley@clm.com. She is based in New York.