Addressing the Ramifications of Federal Legalization for the U.S. Cannabis Industry

AUTHOR

Christian Foote

+1 415.984.8552

cfoote@clarkhill.com

 

The cannabis industry rang in 2021 with high hopes of federal legalization, leading to a massive run-up in cannabis equity values. Eighteen months later, however, proposals for federal legalization continue to stagnate and the industry remains beset with the unfair tax burdens, transactions costs and regulatory nightmares created by prohibition. The high hopes of the early Biden administration have given way to disappointment and plummeting equity values. Many wonder, what is taking Congress so long to pass a bill de-scheduling cannabis? Why can’t the federal government just legalize cannabis already? 

While understandable, these industry frustrations fail to fully consider the upheaval that will result from federal legalization. While prohibition is a bane of the industry in many ways, it nonetheless is responsible for the very existence of the legal U.S. cannabis industry in its current form. Federal legalization therefore cannot be viewed as a flick of a switch that will automatically cure the ills of the cannabis business. Rather, federal legalization must be viewed as a seminal event that will fundamentally alter the U.S. cannabis business by introducing interstate commerce to an industry that is defined by the singular absence of it. If this shift is forced to take place without sufficient preparation, the result will be chaos for both the new national market as well as the existing state-by-state regime that it will ultimately replace.  

What is needed is a viable plan to create a national market in cannabis, but without destroying the intra-state markets that currently comprise the industry.  

In its current form, legal cannabis in the U.S. consists of a network of insular markets that exist only at the state level. Each state that has legalized cannabis is effectively a Walled Garden in which cannabis can be cultivated, processed, and distributed only under a highly regulated regime under creation of state law. Importing out of state cannabis into these Walled Gardens is strictly prohibited. Cannabis must be grown and processed in-state. Only residents of that state may grow and sell cannabis in the state. In each state, sundry other rules and regulations discriminate against out-of-state producers for the protection and benefit of in-state businesses.  

This purely intra-state economy is almost unheard in other areas of the U.S. economy – an engine that derives much of its power from the inability of the states to restrict trade. Normally, state laws which discriminate against out of state producers are quickly struck down under the Dormant Commerce Clause. The Dormant Commerce Clause refers to a Constitutional law principle by which a state may not unduly interfere with interstate commerce because, under the Constitution, regulation of interstate commerce is Congress’s job. It is only by virtue of federal prohibition that interstate commerce of cannabis is banned, thereby holding the Dormant Commerce Clause at bay. It is this freedom from the Dormant Commerce Clause (joined with the federal government’s non-enforcement policy) that has led to the development of the cannabis Walled Gardens, that is, the insular, protected cannabis industry within each state that is walled off from interstate competition.  

With the advent of federal legalization, however, the lynch pin upholding this entire state-by-state industry will be removed, and interstate competition will come crashing down on these nubile, Walled Garden industries. 

Against this backdrop, Congressional inaction appears more logical. Indeed, many powerful stakeholders have vested interests in the Walled Gardens. These players are highly incentivized to continue the federal prohibition of cannabis and thus the continued protection of Walled Gardens. Hundreds of millions if not billions of dollars of capital have been invested in the Walled Gardens in reliance on the rules and regulations which created these insular markets – rules which would otherwise fail to pass constitutional muster in the absence of prohibition. To take just one example, licenses to cultivate and sell cannabis in Arizona are currently selling for $8 million to $10 million. These are mere paper licenses which with no real assets or business operations attached to them. They derive their value to a considerable extent from the right to be free from competition from producers in larger, more mature markets like Northern California.  

Further, each Walled Garden relies on a cadre of government employees with expertise and responsibility for overseeing the state market. In many of these states, cannabis sales have proven to be a lucrative source of tax revenue. Thus, both private business and state governments share strong motivations to continue the status quo. This harm to intra-state investment in legal cannabis regimes may explain the delay in Congress passing legislation to legalize cannabis. Simply put: those who have invested capital, time, and expertise into a new walled garden market are highly incentivized to protect that investment from the ravages of interstate commerce.  

A regulatory chasm could also result if Congress were to suddenly repeal prohibition. Virtually every single law that protects the Walled Gardens from outside competition would be challenged – and likely stricken – under the Dormant Commerce Clause. Litigation would overwhelm the Walled Garden states. As there is obviously no regulatory structure or expertise in place at the federal level, the removal of state cannabis laws would result in uncertainty and potential chaos. 

What is to be done? The state-by-state balkanized cannabis industry cannot last forever, despite the current motivations of its participants. At some point cannabis will become a national market and interstate commerce in cannabis ultimately is necessary to meet the promises of the industry. It thus behooves Congress to find a way to bridge the gap: to protect capital invested in state markets, ensure regulatory continuity, and on-ramp cannabis to the national (and international) market.  

One solution proposed by Professors Scott Bloomberg of the University of Maine School of Law and Robert A. Mikos of Vanderbilt Law School is to simply suspend the Dormant Commerce Clause for a sufficient period to allow these nascent state cannabis businesses to prepare for interstate commerce. Bloomberg and Mikos analogize federal legalization of cannabis to the landmark 1944 case of United States v. The South-Eastern Underwriters Association, in which the Supreme Court reversed long-standing precedent and concluded that insurance is interstate commerce. In the aftermath of the South-Eastern Underwriters case, litigation challenging insular state laws – which, like cannabis, had given rise to a state-by-state industry – proliferated to the point where Congress had to get involved. Its solution was simply to suspend application of the Dormant Commerce Clause in the insurance industry with the passage of the McCarran‐Ferguson Act in 1945.  

Bloomberg and Mikos posit that Congress should do the exact same thing with cannabis: legalize it at the federal level but allow the states to maintain their current regulations and restrictions against interstate commerce – at least for a period of several years with a built-in sunset provision. This framework would allow for producers and investors to recoup a return on their investment, while also allowing smaller scale cannabis producers to prepare for interstate commerce. With the built-in sunset provision to the abeyance on interstate commerce, these industry players would be forced to prepare for the ultimate reality that cannabis will be a highly competitive multi-billion-dollar national market.  

Creating a viable, predicable path to federal legalization will help assuage opposition at the state level and make federal legalization a reality. A temporary suspension of interstate commerce could help break the log jam and facilitate federal legalization.  

The views and opinions expressed in the article represent the view of the authors and not necessarily the official view of Clark Hill PLC. Nothing in this article constitutes professional legal advice nor is intended to be a substitute for professional legal advice.

 

Primary Sponsor

Top Marijuana Blog