Bear Market

Back-breaking taxes and competition from the illicit market threaten legal businesses in the Golden State

There’s a misconception that cannabis businesses are rolling in profits, but the truth, particularly in California, is that many in the market are struggling to survive.

In some ways, the obstacles faced by licensed businesses mirror those in other states that have launched regulated cannabis programs: the licensing process is too slow; the testing and traceability requirements are onerous; everything costs more for marijuana businesses, from goods and services to insurance and real estate; banking and financial services are largely unavailable; taxes are too high.

High taxes are pushing consumers into the illicit market.

But California is a different story in size, scope and monumental expectations. For more than two decades, California has been the undisputed epicenter of cannabis culture and entrepreneurship — as well as ground zero for the nation’s fruitless War on Drugs. But the Golden State has failed to live up to its potential for a multibillion-dollar legal market.

State-licensed businesses face a wide range of challenges, not the least of which is competition from the illicit market. In Los Angeles, there are fewer than 200 licensed cannabis retailers, but hundreds, if not thousands, of unlicensed dispensaries. The same can be said of cannabis farms in Northern California.

“On one hand, it’s not fundamentally fair that people who want licenses have not been able to get licenses,” says Ruben Honig, executive director of the United Cannabis Business Association, a trade group representing more than 160 dispensaries. “On the other hand, it’s not fundamentally fair for those businesses that have licenses, especially in the city of Los Angeles, that are laying off employees and suffering.”

The Taxman Cometh

Reducing or eliminating the illicit market is always one of the stated goals of cannabis legalization. Yet, when states and municipalities tack on crippling tax rates, the opposite happens. Higher prices in the legal market fuel the illicit market and send consumers — many of whom were once loyal dispensary shoppers — back to the street-corner dealer.

Chiah Rodrigues of Mendocino Generations says the taxes are affecting everybody in the supply chain from cultivators to the consumer. She says the tax rate is as high as 57% in some jurisdictions.

In Mendocino County it’s a relatively low 27% — but a flat-tax structure on small and medium-sized growers is “ridiculous.”

“We’re getting taxed in Mendocino County on product you don’t sell,” she says. “If you have a 10,000-square-foot cultivation space, you’ve got a $5,000 minimum tax rate. If you sell enough cannabis to go over that, you pay a 2.5% tax rate on top of the $5,000. On my farm, I paid $4,200 of the tax, based on my sales for last year. So I had to pay the $800 difference because I didn’t sell enough.”

Taxes, she says, should be structured just like every other business.

“Don’t get me wrong, I’m happy to pay taxes,” Rodrigues says. “But it needs to be a fair tax that is in line with the actual business you’re doing. What industry pays tax on something you don’t sell?”

Stopping a Second WarOver the past year and a half, Honig has watched members of the UCBA face extreme difficulties in keeping their doors open.

“2018 was really a year of survival,” he says.

But enforcement is a complicated subject in a state where the wounds of prohibition run so deep.

On one hand, legal operators cannot be successful if they’re competing against a thriving illicit market. But many people would rather avoid the militaristic enforcement actions of the past.

“The last thing that we want to see is the continued inflammation of the War on Drugs,” Honig says. “Los Angeles has been ground zero for that, and especially South Los Angeles.”

Mendocino Generations is a membership-based organization of about 50 farms.

Growers in Northern California have also been terrorized over the years by federal law enforcement. Mendocino Generations co-founder Chiah Rodrigues says her heart still races every time she hears a helicopter. Lately, the helicopters have returned to the skies over the Emerald Triangle, hovering over licensed and unlicensed farms alike.

“This is what we had to deal with during the Reagan era,” she says. “This is why I have PTSD and why I’m in the regulated market. It’s the worst feeling.”

The competition and growing mistrust between licensed and unlicensed growers have created a situation where neighbors are turning against each other, Rodrigues says. There are licensed farmers that are reporting unlicensed farms in the area. There are also illegal growers calling the authorities on their licensed neighbors to report compliance violations.

“It’s happening on both sides,” Rodrigues says.

Many believe the illicit market will continue to thrive until tracking and tracing is implemented from seed to sale.

In July, the Mendocino County Sheriff’s Office conducted a multi-agency raid on cannabis farms based on suspected involvement in water diversion or environmental degradation. “Operation Clean Sweep” resulted in the removal of more than 42,000 cannabis plants.

In Los Angeles, and other parts of the state, unlicensed retailers continue to outnumber their legal counterparts. Honig says the city needs to take civil action to enforce the rules and differentiate legal businesses.

“There’s a fine line between enforcement and reinvigorating the War on Drugs,” he says. “(But) we cannot sacrifice our existing licensees just because the market hasn’t shaken itself out.”

It’s even more complicated in the city of Los Angeles, Honig says, because he feels the authorities have been given more than enough tools to shut down unlicensed businesses. Yet, those efforts so far have not been successful.

Honig says a comment by Assemblyman Tom Lackey at a recent meeting struck him as poignant: “Regulations that are not enforced are merely suggestions.”

“We need to continue to hold Los Angeles to the fire to enforce their rules and regulations,” Honig says.

Technology Tug-of-War

Alkhemist co-founders James Chung and Conrad Jun.

One measure Honig says would help the regulated market is Assembly Bill 1417, which would punish technology platforms that advertise unlicensed marijuana businesses. The UCBA-sponsored bill would impose a $2,500-a-day fine per violation.

“We do not believe that technology platforms, especially cannabis-specific technology platforms, should be able to advertise for the illegal industry,” Honig says. “I don’t think they’re doing anybody a service and they’re confusing the consumer.”

Weedmaps, a California company, opposes the bill and continues to allow marijuana businesses to advertise on its site, with or without a license. Its Seattle-based rival, Leafly, supports it.

On March 1, 2018, “we made it official that the Leafly Dispensary Finder would no longer list any unlicensed California dispensaries or delivery services,” said Laura Morarity, Leafly’s vice president of corporate affairs, adding that the company worked to actively remove unlicensed marijuana retailers.

The company enacted a process within its sales team to ensure potential advertisers have the appropriate licensure. The Leafly policy extends to other states, as well as Canada, and allows for businesses that have either a permanent or temporary license in California.

“That’s just a philosophy we have,” Morarity says. “We believe in the power of a regulated, legal market and think that is important for consumer trust, so that is what we have focused our efforts on.”

Weedmaps submitted a letter to the Legislature through its lawyers that says AB 1417 would “fundamentally alter the advertising relationship of listing service providers and businesses who wish to use on-line platforms by requiring the listing service provider to police advertisements.”

According to the letter from George Miller of Lang Hansen O’Malley & Miller, as well as a white paper from lawyers at Davis Tremaine Wright, the new law would be in conflict with Section 230 of the federal Communications Decency Act, which protects online providers from state laws that impose liability on online providers based on content supplied by users and third parties.

“To be sure,” the white paper reads, “the State may impose and enforce these requirements on advertisers, but not websites that host advertisements.”

A Weedmaps spokesperson declined further comment.

Stronger Together

Mendocino Generations co-founders Chiah Rodrigues and Jamie Beatty.

In 2015, Chiah Rodrigues and her husband Jamie Beatty began discussing Prop 64 and looking at the future of cannabis farming in Mendocino County.

They realized that banding together with other farmers was the only way the local community could survive and maintain its lifestyle. The couple developed Mendocino Generations as a member-based alliance of farms with the motto “Stronger together.” It allows farmers to pool their resources and their talents.

At its peak, the organization had 60 member farms, but that number has been shrinking, somewhat due to natural attrition and somewhat due to farms being unable to maintain their licenses. The transition from a largely unregulated market to one with steep taxes and even steeper compliance standards was every bit as daunting people imagined — if not more so.

“The farming has almost become secondary to paperwork and compliance,” Rodrigues says.

But it’s not just regulatory hurdles that have affected cannabis growers.

“You almost feel like the regulators or the people who wrote these regulations had a secret meeting behind the curtain of, like, ‘We’re going to see how far we need to push all these people until they just disappear,” she says.

The next year will be make or break for a lot of farms.

“It’s not for lack of trying, but some people are not going to make the cut,” Rodrigues says. “I think if you can survive this moment, you can survive.”

 

Matters of State

At the state level, the California Bureau of Cannabis Control is floundering, according to a July audit by the state Department of Finance. According to the audit, as of January, the Bureau of Cannabis Control was understaffed and unable to keep up with the workload of overseeing what is expected to be the world’s largest legal cannabis market. Only 75 of 219 authorized positions had been filled — including a vacancy rate of 78% in the enforcement division — a level the audit called “not sustainable to provide effective and comprehensive oversight.”

Alkhemist CEO James Chung says his main gripe with the various state regulatory agencies is the pace with which they move.

“A lot of the folks who are in the application process right now are really going crazy because of the time lapse involved,” says Chung, whose company recently became the first state-licensed cultivator to be up and running in Los Angeles. “We’re businesspeople. Every day we’re not able to go, we’re spending thousands of dollars. We’re okay with requirements, but come on, speed it up. You can’t have six weeks with no response.”

Chung and his partner Conrad Jun had been preparing for adult-use regulations since 2015, so when Proposition 64 passed the following year, they were already in a good position to move forward and received licenses for cultivation, distribution and manufacturing in November 2018.

Chung described the process as a “cat-and-mouse game,” trying to stay one step ahead of the ever-changing regulations. As a lawyer, he felt he had an advantage when it came to interpreting the rules.

“We’ve got to be ahead of the curve,” he says.

The multitude of state agencies involved in cannabis regulation — all looking for their piece of the action — further muddies the waters.

“There are so many agencies working on this, but they seem to be silos; they don’t seem to be communicating with one another,” says Paul “Po” Kim, Alkhemist’s chief of cannabis. “You’re going to the same places two and three times because they’re not communicating.”

The Department of Finance report also found that while the Bureau of Cannabis Control had expenditures totaling more than $14.8 million in 2017-18, it only took in a little more than $1 million in revenue.

Many municipalities have continued to outlaw cannabis businesses, particularly in the public-facing retail sector, which has hampered the industry’s growth. Honig says there should be 6,000 retail licenses in California. Instead, there are about 700.

“I say this so many times that it’s become a cliché in my head: People say prohibition is over, but prohibition’s attitudes are rampant,” Honig says.

In Los Angeles, and other parts of the state, unlicensed retailers continue to outnumber their legal counterparts.

Moving Forward

As the cannabis industry moves forward, Honig says it’s vital for the industry to engage more communities and non-cannabis groups.

“We need to do a better job of moving the conversation forward on behalf of the industry,” he says.

Setting the industry up for stability is particularly crucial as cities like Los Angeles prepare to roll out social equity programs to provide better opportunities for the communities most impacted by the War on Drugs.

“The last thing we would want to see is social equity licensees coming into a market like this where it is such an uphill battle and they’re going to struggle to survive as a business owner,” Honig says. “We need diversity in this industry. I believe it’s fundamentally important for the success of the industry in California, and especially Los Angeles.”

In the past, Honig says he doesn’t feel cannabis has been a priority for lawmakers. For the industry to succeed and for sensible regulations to be implemented, it’s not enough for politicians to just say they’re “pro-cannabis.” The industry needs lawmakers and regulators to actively help the industry.

“We want champions,” Honig says.

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