California struggles to launch its new distribution model

Barriers to entry are allowing the black market to thrive

“Everyone has a plan until they get punched in the mouth.” — Mike Tyson

 

California’s plan for recreational cannabis, as pitched to the voters who legalized it through Proposition 64, was for a huge, regulated marketplace that would supplant underworld operators, ensure high-quality products and fill the state’s coffers with a billion dollars of new tax revenue.

Now, more than six months into legalization, California’s experience has been checkered with unintended consequences and frustrated expectations as the brave new world launched by voters has run into an incumbent black market that refuses to evaporate according to plan.

Proposition 64 and its regulations did away with the old “closed circuit” of medical marijuana and its nonprofit collectives. Instead, it forged a new, seed-to-sale supply chain of state-licensed businesses. At its center, between the familiar cultivators, manufacturers and dispensaries, was a brand-new type of licensee: the distributor.

Today, all cannabis must flow through a licensed distributor on its way to market. Only a distributor can transport cannabis. Distributors are responsible for quality assurance and laboratory testing of product and packaging. They also collect information on every cannabis shipment moving in the state. The distributor must calculate and collect cultivation tax from growers and excise tax from retailers — and distributors must face liability for late remittances.

While new to cannabis, the distributor model is familiar in other regulated industries. Indeed, when first proposed, it was castigated as a throwback to alcohol’s post-prohibition model — the one that created the multinational behemoths still with us today. Fears of “Big Weed” were allayed by allowing producers to contract with — rather than sell to — distributors and by allowing distribution licenses to be held along with other license types — a “self-distribution” option.

Barriers to entry arose nonetheless. The state has issued only 200 distributor licenses, as opposed to more than 1,000 licenses for cultivators and 400 to retailers. Most of the distributor licenses issued have been to self-distributing manufacturers and retailers transporting their own product, leaving as few as 60 distributors to service the open market.

The limited number of distribution options is exacerbated by transportation regulations that require significant investment in vehicles and facilities; by the concentration of distributors in the few local jurisdictions that will issue them permits; and by the inaccessible locations of so many “off-the-grid” California cultivators.

The flow-through hourglass model has become a bottleneck with costs and delays that have quickly directed the attention of industry participants back to an irresistible alternative.

Nowhere was the gulf between expectation and reality more starkly evident than when California recently announced its tax revenue from the first full quarter of legalization. The state expected more than $90 million from cannabis cultivation and excise taxes but collected just $36 million — $34 million of which came from excise tax payments collected from retailers by distributors, most of whom now work on a cash-on-delivery basis, given their exposure for late payment penalties.

On the other hand, the cultivation tax accounted for only $1.6 million of Q1 tax revenue. Since its inception, the cultivation tax, a flat rate per ounce of product, has been criticized as regressive, onerous and difficult to calculate. Unlike a downstream excise tax, it is practically impossible for distributors to accurately calculate how much to collect, especially on product that has passed through multiple hands before reaching them.

Faced with destructive taxes and compliance costs, many cultivators have already voted with their feet on California’s legal market and headed straight back into the shady arms of the black market. No rational actor would do differently — unlicensed transactions offer higher margins and lower barriers to entry with no cost to switch and (so far) practically no enforcement risk. For those that remain legitimate, it is simply not possible to compete with those who bear none of the costs or inconvenience of compliance.

Supply and demand therefore ensures regulated, legal cannabis will never succeed in California as long as a black market remains easily accessible. California already produces many times more cannabis than it can consume. And those 400 licensed retailers pale in comparison to the more than 12,000 options available only a click away on cannabis consumer websites.

Keeping cannabis producers in the mainstream requires incentives that work for them — not just a tax bill.

Simultaneously, enforcement must make opting out altogether much less of a no-brainer. In an industry as large as California’s, government can only do so much. Unfair competition waged from the shadows must also face a legal challenge by the licensed businesses it harms.

The industry drove legalization at the ballot box and won; it must now stand its ground.

Anthony Phillips is a San Francisco-based business lawyer. He represents and advises cannabis industry clients, including distributors, throughout California. He can be reached at adphillipsesq@gmail.com.

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