Franklin C. McRoberts: A Bumper Crop: Cannabis Meets Business Divorce

Unless you’ve been living under a rock, you’ve probably heard that a little over two months ago, New York State Governor Andrew M. Cuomo signed legislation reform advocates and stoners alike have dreamt of for decades, finally legalizing the recreational possession and use of marijuana in New York. Though recreational sale of marijuana will not be legal until at least 2022, the legislation’s passage sets the stage for rapid development of a brand new, multi-billion-dollar, legal cannabis industry in the state.

With big business comes big business divorce. Even before Governor Cuomo signed the new law, legal disputes among marijuana industry entrepreneurs were percolating through the lower courts of the New York State Unified Court System. In this week’s New York Business Divorce, we’re excited to write about what seems to be the very first New York appellate court decision in a marijuana industry business divorce dispute.

The new decision, CIP GP 2018 v Koplewicz, 194 AD3d 639 [1st Dept 2021], addresses a subject we’ve addressed on this blog many times: enforceability under New York law of oral partnership or joint venture agreements. With marijuana investors suddenly flocking to New York in droves – and I suspect often entering into deals with co-owners without adequate documentation to back it up – many similar disputes in the coming years seem likely. New York’s nascent legal marijuana industry may be a bumper crop for business divorce litigators.

The Alleged Partnership

CIP is a fascinating case study in the Wall Street-ization of the marijuana industry. This was not your average mom and pop pot shop. According to the highly-detailed amended complaint, the plaintiff, CIP GP 2018 d/b/a Crimson Investment Partners (“CIP”), is a private equity investment firm formed by three Harvard Business School classmates focusing on “investments in small and medium sized founder-led businesses that benefit from the significant experience of the CIP operators corporatizing their operations and digitizing their processes.” In June 2018, Crimson allegedly entered into an oral “three-way Partnership” with two other investment firms, Thayer Street Partners Management, LLC (“Thayer Street”), a “$400 million private investment firm” headquartered in New York, and Eastmore Management, LLC (“Eastmore”), a “$3 billion private investment firm” also headquartered in New York.

“The Partnership’s business,” according to the amended complaint, “centered on the acquisition and management of cannabis safety testing laboratories across the country (and integrated technologies including software and robotics) – a substantial growth sector of the legal cannabis industry as determined after extensive research and analysis by the Partners.”

CIP alleged that each of the three partners “agreed to contribute its own unique skills as entrepreneurs and investment professionals in exchange for a one-third ownership interest in the Partnership that would generate revenue through investment distributions and management fees.” Eastmore’s role as partner “would be to originate investors through its substantial network of fellow high-net-worth individuals and to help identify potential acquisition targets for the Partnership.” Thayer Street’s role as partner “would be to negotiate acquisitions, perform due diligence and execute the investments.” CIP’s role as partner “would be to execute investments and to have an operating team ready to drop in post-acquisition to corporatize and integrate acquisitions.” According to CIP, one of the highest priorities of the partnership’s business model – which CIP alleged to have brought to the partnership – was to acquire, expand, and ultimately sell two of the largest marijuana testing laboratories in California, including one called “Cannalysis.”

The Alleged Squeeze Out

CIP alleged a scenario we often hear from clients: a startup venture showing initial glimmers of success, only for one or more founders to attempt to force out one or more of the others to take 100% of the pie for themselves. CIP alleged that when it “became clear after more than a year of research, negotiations, complex financial modeling, and due diligence, that the investment opportunities generated almost exclusively by [CIP]’s efforts would be enormously valuable,” Eastmore and Thayer Street “disavowed the Partnership Agreement, took [CIP]’s investment and the venture’s corporate opportunities for themselves, and drove [CIP] out of the business venture.”

“As the opportunity went from a multi-million dollar venture to potentially a billion dollar business,” CIP alleged, Eastmore and Thayer Street “took action to usurp the entire opportunity for themselves by circumventing the Partnership Agreement and undercutting the agreed upon equity structure to carve CIP out of the Partnership entirely.” Eastmore and Thayer Street allegedly “excluded [CIP] from the business, illegally withheld funds invested by [CIP], stole tens of millions of dollars in assets and services, and now stand to gain hundreds of millions of dollars in ill-gotten profits from the investment venture built by [CIP] under the agreement of an equal partnership.”

The freeze out reached a crescendo when, “[o]n the night before [certain] investors were set to fund the Cannalysis transaction,” Eastmore and Thayer Street “stated that they would not comply with the Partners’ original Partnership Agreement, and would cut CIP out entirely unless it agreed to an unconscionable share of the equity interests in the business venture with no managerial or voting rights.” The freeze out, CIP alleged, constituted breach of the alleged oral partnership agreement, which CIP pled as count two of a fourteen count pleading.

The Letter of Intent

Eastmore and Thayer Street moved to dismiss the amended complaint. In support of dismissal of second cause of action for breach of oral partnership agreement, they relied heavily upon a draft, unsigned “Letter of Intent” prepared by none other than CIP itself. The Letter of Intent – dated “June ___, 2019,” one year after formation of the oral partnership – was loaded with language Eastmore and Thayer Street argued was utterly inconsistent with the existence of an oral partnership, including:

  • “The parties to this Letter of Intent will endeavor to finalize and execute one or more definitive agreements (collectively, the ‘Definitive Agreement’) defining (i) the structure and operation of the Business; (ii) the ownership thereof; (iii) the respective rights and obligations of the parties hereto in respect of same; and (iv) such other provisions as may be mutually agreed upon.”
  • “This Letter of Intent is intended to be a statement of the mutual interest of the parties with respect to a possible transaction and is subject to execution and delivery of a mutually satisfactory Definitive Agreement. Nothing herein shall constitute a binding commitment of either party . . . The parties will become legally obligated with respect to the transaction only in accordance with the terms contained in the Definitive Agreement relating thereto if, as and when such document is executed and delivered by the parties.”

Eastmore and Thayer Street also relied upon a letter from Crimson’s counsel sent around the same time as the Letter of Intent referring to the “oral agreement” as having been “voided” by Eastmore and Thayer Street’s alleged breach of the oral agreement.

The Dismissal Decision and Appeal

In a short Decision and Order, Manhattan Commercial Division Justice Barry R. Ostrager dismissed most of CIP’s pleading, but denied dismissal of the second cause of action for breach of oral partnership agreement, ruling: “Neither the Letter of Intent . . . nor the letter from Crimson’s counsel, conclusively establishes a defense to the asserted claims as a matter of law at the pre-answer stage of this litigation” (citations and quotations omitted).

Eastmore and Thayer Street cross-appealed denial of dismissal. You can read the cross-appeal briefs herehere, and here. Though a bevy of issues were raised in CIP’s appeal and defendants’ cross-appeal, we’ll focus only on the oral partnership claim.

The Issue of Partnership Formation

The first issue the appeals court considered was whether CIP sufficiently alleged the existence of a general partnership.

Under New York law, “[w]hen there is no written partnership agreement between the parties [the] [f]actors to be considered in determining the existence of a partnership include (1) sharing of profits, (2) sharing of losses, (3) ownership of partnership assets, (4) joint management and control, (5) joint liability to creditors, (6) intention of the parties, (7) compensation, (8) contribution of capital, and (9) loans to the organization” (Czernicki v Lawniczak, 74 AD3d 1121 [2d Dept 2010]).

The CIP Court chose not to conduct a full-blown analysis of the nine general partnership factors. Instead, relying upon a strand of case law we have written about here and here addressing the subject of so-called “preliminary agreements” that may be enforceable despite the need to “hammer out details subsequently,” the Court ruled that CIP amply alleged the existence of an oral partnership because “[CIP], Thayer Street, and Eastmore had an ‘essential understanding of what each party’s contribution and potential exposure would be’ in the partnership and agreed on equal equity distribution and to share profits and losses” (quoting Richbell Info. Servs., Inc. v Jupiter Partners, L.P., 309 AD2d 288 [1st Dept 2003]).

The Issue of Partnership Disclaimer

The second issue the appeals court considered was whether the Letter of Intent’s language that it would not “constitute a binding commitment of either party” and that the parties will not “become legally obligated with respect to the transaction only in accordance with the terms contained in the Definitive Agreement” when “executed and delivered by the parties” effectively disclaimed the existence of an oral partnership agreement.

In Kalaj v 21 Fountain Place, LLC, 169 AD3d 657 [2d Dept 2019], the Court considered a similar issue, ruling that “while a letter of intent can, in the appropriate case, constitute documentary evidence” for purposes of a pre-answer dismissal motion, “the nonbinding nature of the letter of intent d[id] not, in and of itself, utterly refute the plaintiff’s allegations that a meeting of the minds on the essential terms of the transaction occurred at some point between the defendants and the prospective purchaser, either within or outside the bounds of the letter of intent.”

Relying upon Kalaj, the CIP Court ruled, “Under the circumstances here, the draft letter of intent written a year later” than the alleged the oral partnership agreement “does not conclusively show that the oral partnership agreement was not binding.”

The Issue of Partnership Dissolvability

The third issue the appeals court considered was whether the amended complaint sufficiently alleged that the oral partnership was for a “particular undertaking.” Under Section 62 of the New York Partnership Law, an individual partner can dissolve a general partnership at any time, for any reason, or for no reason at all, without causing a breach of the partnership agreement (an arrangement commonly referred to as a partnership at-will), unless the partnership is for a “definite term” or a “particular undertaking,” in which case a partner’s dissolution results in breach of the partners’ agreement and subjects the dissolving partner to a claim of damages.

According to the amended complaint, the Partnership had a “particular undertaking” (thus allegedly rendering it not dissolvable or terminable at-will): “The particular undertaking or specific objective of the Partnership,” CIP alleged, “was to create a holding company for all acquisitions throughout the country and then to take the holding company to an initial public offering of its stock.”

The most recent cases from New York’s highest court, the Court of Appeals, addressing New York’s law governing partnerships for a “definite term” or “particular undertaking” are Congel v Malfitano, 31 NY3d 272 [2018] and Gehlman v Buehler, 20 NY3d 534 [2013].

Relying upon Gehlman, the CIP Court ruled, “Nor is the partnership agreement, as alleged, dissolvable at will, since the complaint alleges a particular undertaking to acquire cannabis testing facilities, including one specifically identified by plaintiff, that could be accomplished at a future time.”

In short, according to the appeals court, the amended complaint alleged sufficient factual detail at the pleadings’ about the parties’ intent to form a partnership and for the partnership to continue until achievement of a defined goal to survive dismissal.

Lessons from CIP

For marijuana entrepreneurs, the overriding lesson, which we’ve written about many times, is that it’s comparatively easy under New York law to allege the existence of an oral partnership agreement, including oral partnerships that morph into an agreement to operate in another business form, such as a corporation or LLC. For that reason, alleged oral partnerships are the go-to entity form for spurned co-venturers forced out of an enterprise before the deal gets documented in a more formal manner. So if you’re concerned about out-of-the-woodwork claims of an oral partnership, document your business relationship from the get-go, or as soon as possible thereafter.

If it’s your intent not to form a partnership, document that understanding as well. Under New York law governing the kinds of “documentary evidence” that courts can consider on a pre-answer dismissal motion, “emails . . . are not considered ‘documentary evidence’” (Benjamin v Yeroushalmi, 178 AD3d 650 [2d Dept 2019]). So don’t rely upon emails. If you imagine yourself in the position of Eastmore and Thayer Street opposing the existence of an oral partnership, the smart thing to do is have some sort of formal, signed memoranda from the very beginning stating that the parties have not yet entered into a business relationship, including a general partnership, and could only do so in a formal writing, signed by all parties.

In CIP, I suspect the outcome might have been different if three facts were altered. The Letter of Intent in CIP might have sufficed to defeat plaintiff’s claim at the pre-answer dismissal stage if it had been done at the very inception of the relationship. The Letter of Intent might also have sufficed if it had included a broadly-worded merger clause, explicitly referring to all prior oral negotiations and understandings, and stating that the Letter of Intent superseded those understandings. And of course, the Letter of Intent would have been more reliable if it had been signed.

The bottom line for marijuana entrepreneurs: document your business relationships, and if you haven’t done it already, it’s never too late.

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