Unique Issues in Leasing to a Cannabis-Related Business
On January 1, 2018, properly licensed businesses in the State of California became able to cultivate, manufacture, distribute and sell marijuana products derived from marijuana or its active ingredients subject to compliance with State and local laws and ordinances. Those businesses considering entering into the cannabis business at this time see the legalization of marijuana products in various states as the “next gold rush” with fortunes to be made. Cannabis businesses have been known for paying premium rental rates for the real estate they use in the various aspects of their operations. The premium rents present a potential enormous upside for landlords. However, having a cannabis business as a tenant and conducting business in the marijuana industry also comes with a wide variety of risks, and the parties should carefully analyze and understand the underlying legal issues and complexities.
Before entering into any lease, landlords and tenants should each be aware of common pitfalls in cannabis real property leases and risk management strategies specific to the marijuana industry. An off-the-shelf pre-printed AIR Commercial Real Estate Form lease is entirely inadequate (without significant modification) to properly document any lease involving a cannabis business. Savvy landlord and tenants and their respective lawyers should be aware that leasing to a cannabis business poses unique issues not ordinarily encountered by commercial landlords or typically addressed in the commercial lease forms currently in wide circulation. “Boilerplate” lease provisions, such as alterations, utilities and other services, compliance with all laws, default and remedies, insurance, and venue all must be reevaluated in the context of leases for marijuana cultivation and distribution facilities. A thorough discussion of each and every lease provision is beyond the scope of this article but this article does highlight some of the ways in which a traditional lease form is inadequate when leasing to a cannabis-related business.
1. Permitted Use Provisions. The permitted use provision should specifically identify the activities allowed within the lease premises. If the tenant is a cannabis retailer, the permitted use should explicitly permit “retail sale of marijuana”. Leaving the permitted use vague will likely mean the tenant runs the risk of breaching the lease by conducting an activity not specifically permitted on the property or under the terms of the licensing authorization. It is also important to consider if any other leases owned by the landlord in the vicinity of the proposed lease premises contain a “prohibited use” provision. This is an important due diligence item that is often forgotten on both sides of a leasing transaction. For example, in a retail context, it is not uncommon for a lease to include a list of prohibited uses in the vicinity of that tenant’s lease premises. These prohibited uses frequently include the sale of liquor, the sale of adult materials, a gym or fitness facility, and any business which regularly conducts auctions.
2. Compliance-With-Law Provisions. Commercial leases usually contain a “compliance-with-laws” provision. These provisions usually provide that the tenant, at its sole cost and expense, shall comply with all federal, state, county, municipal, and other governmental statutes, laws, rules, orders, and regulations affecting the tenant’s use of the premises. In the context of leasing to a cannabis business for cultivation or distribution, the tenant’s use will not comply with federal law and the parties will want to modify the requirement to comply with federal law, or the tenant will find itself in a default situation from the date it signs the lease. The lease should provide that the tenant’s use of the premises must comply with state law regarding marijuana licensing, use, and operation. A landlord may also wish to require the tenant to demonstrate to it all evidence that the tenant is in compliance with applicable law.
Until January 4, 2018, the industry widely viewed the 2013 Memorandum for All United States Attorneys: Guidance Regarding Marijuana Enforcement (August 23, 2013) commonly referred to as the “Cole Memo” as mitigating the risk for entering into the cannabis business. The Cole Memo acknowledged the limited resources of U.S. attorneys and said that federal prosecutors ought not devote scarce resources to the prosecution of [medical marijuana] participants. On January 4, 2018, Attorney General Jeff Sessions signaled a shift in priorities when he rescinded the Cole Memo and left discretion on how or whether to enforce marijuana laws in the hands of each United States Attorney. Therefore you should monitor any policy statements made by the U.S. Attorney in the specific district where you are doing business and monitor that policy on an ongoing basis as that policy may change. It should be noted that the actions of the U.S. Attorneys are limited by the Rohrabacher-Blumenauer amendment which prohibits the Department of Justice from spending money enforcing federal marijuana laws against state-compliant medical marijuana businesses. However, this amendment applies only to medical marijuana businesses and expires on January 19, 2018 unless Congress acts to preserve it.
3. Operational Issues. The customary operational provisions in a commercial lease with respect to hours of operation, avoiding a nuisance and quiet enjoyment may need to be spelled out more specifically in a lease to a cannabis business. For example, in a multi-tenant building, the off-the-shelf building “rules and regulations” will need significant revision to address issues such as odors emitting from the lease premises, hours of operation, avoiding a nuisance to other tenants and surrounding properties, and ensuring the other tenant’s quiet enjoyment of their lease premises.
4. Licensing Issues/ “Chicken and Egg”. In order for any cannabis business to apply for a license from the California Bureau of Cannabis Control, and from most local authorities, the business must already have lined up its proposed premises (such licenses are generally tied to the location of the business). This means for any operator that does not own its property, it will need to have the commercial lease in place. The obvious risk for both the landlord and the tenant is if the planned business is never granted a license from either the state or local authorities.
Smart cannabis business tenants will insist on assurances in the lease that the landlord will assist with the licensing application process and with regulators, such as if new regulations impose new requirements on the tenant that require alterations to the property during the lease, and will want a simple path to terminate the lease in the event they are denied a license to operate their planned business. Because the landlord will have a hard time collecting rent from an unlicensed cannabis business, it may be in both parties best interests to allow for termination if the tenant fails to obtain or comply with its required licenses subject, in many cases, to a requirement that the tenant pay a termination fee to the landlord funded out of a hefty security deposit.
5. Structuring the Rent Obligation. Many retail leases contain some type of profit-sharing provision (usually called “percentage rent”), where the tenant is obligated to pay a fixed base rent and then additional rent/percentage rent (using an agreed-upon formula) based on the revenues generated by the tenant. When structuring the rent obligation where the tenant is a cannabis business, these profit-sharing arrangements should be avoided. Taking a portion of the business profits or, even more problematic, accepting an outright ownership interest or the cannabis product itself in lieu of rent puts both the landlord and the tenant at risk. Regulators will be looking closely at all owners of cannabis businesses for purposes of granting licenses as well as other parties conducting business with them. It is likely that regulators will view any transaction that is beyond an ordinary arms-length deal as de facto license ownership, which will make the landlord subject to disclosure to the state regulators and their vetting process as a cannabis business owner and could cause the tenant’s license to be delayed or denied.
6. Insurance Provisions. A typical lease will require the tenant to “keep in force fire and extended coverage insurance for the full replacement value of tenant’s improvements and tenant’s property, including, but not limited to, inventory, trade fixtures, furnishings, and other personal property.” Without modification, a tenant in the cannabis business may find itself immediately in default if it is not able to obtain insurance for its marijuana inventory, which is an illegal controlled substance under federal law. The tenant may either ensure its inventory under a self-insurance program or carry the risk of loss.
The tenant may not be the only party struggling with insurance issues in these types of leases, however. The landlord should inquire with its insurance company in advance to ascertain whether the proposed use will adversely affect the property insurance for the building, either through increased insurance premiums or cancellation of the insurance policy.
7. Venue. Another risk of entering into a contract with a business that is illegal under federal law is that, in the event of a dispute, the entire contract could be voided for illegality, leaving the landlord with no legal recourse if the tenant breaches. State courts in California have struggled with determining the question of legality when the contract is legal under state law but illegal under federal law and there have been mixed results. For this reason, the parties may want to consider arbitration as the preferred dispute resolution mechanism, and as a second choice, a state court in California (and not a federal court). Arbitrators are less likely to void a contract as illegal, and selecting arbitration also protects against the risk of a dispute being removed to federal court.
While the passage of Proposition 64 in California has created great demand and opportunities in the cannabis industry, there is still substantial risk under Federal law and special business risks particular to tenants engaged in the cultivation and sale of marijuana. While all of the risks cannot be eliminated, by including certain provisions in their leases, the parties can at least mitigate many of those risks. The issues laid out above are not a comprehensive list of what should be considered in a real estate lease for a cannabis business. Numerous other issues that are unique to the nature of the specific cannabis business need to be carefully thought through in crafting a suitable lease.
The opinions expressed are those of the author, Linda Koffman, and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.