Being first is not always the best, especially if it is the first regulated marijuana regime in the world. When Colorado voters legalized recreational marijuana in 2012, Colorado regulators at both the state and local levels were tasked with creating a regulatory environment that provided for the cultivation, manufacturing and distribution of marijuana in a manner that protected public health and safety, even though such system would be in direct conflict with federal law.
This conflict resulted in atypical restrictions being placed on marijuana businesses, such as Colorado residency requirements, limitations on the number of out-of-state owners, arduous background checks for any and all owners and a blanket prohibition on public companies owning or financing marijuana businesses.
These restrictive provisions increased the burden on the Colorado regulators, inspired business arrangements that were doomed to fail and encouraged license-holders to create workarounds that led to enforcement actions.
Colorado went from the first and largest regulated marijuana system in the country to a relic as its regulatory structure restricted growth. Very quickly, other states enacted regulated systems that were less restrictive and fostered normal business activity. The marijuana industry shifted away from Colorado as businesses lost out on much-needed capital investment. Investors looked to burgeoning markets such as California, Massachusetts and Nevada, which have fewer regulatory burdens on ownership to overcome. Colorado was left behind and needed to fix its system.
The Colorado marijuana industry sprang into action and successfully passed legislation in 2018 that allowed for public company investment and relaxed ownership rules. This bill was ultimately vetoed by then-Governor John Hickenlooper, creating another setback for the state’s industry until spring of 2019, when a group of industry participants (including the authors of this article), the Marijuana Enforcement Division, local authorities and the governor’s office worked together to resolve the issue.
A Shift at the MED
Beginning on November 1, 2019, Colorado became the first state to enact robust legislation surrounding outside investment in marijuana businesses. This bipartisan legislation sought to address the need for investment dollars while maintaining strict regulations and oversight of the industry, thus opening the state’s marijuana market to outside investors and allowing marijuana businesses to offer their employees equity in the company.
The legislation removes the statutory requirement of background checks for owners of less than 10% of a marijuana business. In addition, the legislation removes the statutory restriction on public company ownership and outlines requirements for publicly traded companies to both invest in licensed marijuana businesses and to hold Colorado marijuana licenses.
The main goal of the legislation was to expand investment opportunities within the Colorado marijuana industry. This legislation represents a shift at the MED, which had previously reviewed all owners and all individuals with interest in a marijuana company, prior to those individuals obtaining legal title to such ownership or interest.
The regulations now focus on investigating those in control of the marijuana business, while still allowing the MED to investigate businesses and individuals if reasonable cause is shown. The main three changes to marijuana ownership requirements are (a) repeal of the requirement that owners of a marijuana business with less than 10% ownership interest must first go through an initial background check prior to becoming an owner; (b) repeal of the limit on out-of-state direct beneficial owners; and (c) allowing for publicly traded company ownership of marijuana businesses.
Why Colorado is Unique
While some states have used percentage of ownership as a baseline for who must be disclosed and background-checked, Colorado is unique in utilizing a definition that has been fleshed out for years in legislation, rules and case law. Colorado links its ownership disclosure requirements to the “control’ and “beneficial ownership” definitions found in the Securities Exchange Act of 1934. With the MED using this standard, the well-defined terms of “control” and “beneficial ownership” prevent confusion and provide clarity of disclosures for marijuana businesses with complex business structures.
As entities in the industry continue to become more complex, these businesses that have intricate financing, complex organizational structures, or varying management arrangements can stay compliant by knowing for certain who needs a background check and when they are required. Both the regulators and the industry participants can clearly determine disclosure requirements, which is helpful for each business to stay compliant. Given the industry’s high degree of regulation, this clarity aids in compliant operations and should be considered for other states going forward.
Another concept Colorado introduced in its rules was requiring each entity to have a “divestiture plan” that outlines how a marijuana business will divest a controlling beneficial owner within 90 days of being found to be, or becoming, prohibited or unsuitable. Some states, like Nevada, already have similar requirements for casinos and companies licensed for gambling. These regulations require entities to include provisions in their articles or bylaws that allow a casino business to divest an owner if that owner is found to be prohibited or unsuitable.
In Colorado, the concept was expanded to apply to both private and public companies and puts the onus on the marijuana business to determine how to contractually require an unsuitable owner to divest. This concept allows the MED to still control those receiving profits by being able to remove prohibited participants, while not over-regulating or providing hurdles in accessing to capital markets.
What does this Mean?
While the trend in the marijuana industry has generally been to go to Canada to access public markets and receive financing, there is a growing number of marijuana companies that want more access to the U.S. markets and are becoming SEC reporting companies. As such, the pressure will continue to grow on state legislatures to develop marijuana laws that work in concert with the SEC, including disclosures regarding “control” and “beneficial ownership.”
Colorado has taken a major step in ensuring public health and safety in the marijuana industry while allowing for normalized investment and access to U.S. markets. Colorado’s legislation provides a comprehensive outline for disclosure requirements for entities planning to go public, public companies entering or expanding in the marijuana industry and entities looking at various financing vehicles by utilizing legal concepts developed over decades by the SEC, which will likely be mirrored by many states as they begin to fine-tune their own regulations concerning investment in the marijuana industry.