SPACE TO GROW Part 2:  Cannabis Lease Considerations

The legalization of marijuana presents significant opportunities for property owners looking to cash in on California’s budding cannabis industry. But what do people really know? 

Connect Media turned to a pair of panelists at our recent Connect Los Angeles conference, Cox, Castle & Nicholson’s Amir Sadr and David Wensley, for a deep dive into a burgeoning CRE sector. The lawyers shared insights into what’s taking place, how it impacts landlords, lease considerations, rent, security deposit, and collateral issues and what commercial real estate industry players need to know now.

This is our second installment of our special three-part report on cannabis and CRE in the coming weeks. The first part explored regulatory framework and local jurisdiction licensing. In this week’s installment, Sadr and Wensley cover lease provisions and considerations.

By Amir Sadr and David Wensley

To operate a cannabis business, a prospective tenant must first overcome three major hurdles: 1) whether the type of cannabis operation being considered for the property is permissible by the locality, 2) whether the property is properly zoned for the specific type of operation or whether the requisite land use permits and/or approvals may be obtained, and 3) whether the prospective tenant qualifies for applicable state and local cannabis business licenses.

License Contingency or Condition Subsequent Clause. Once the cannabis operator has overcome the aforementioned hurdles, in order to apply for a California state license, the prospective tenant/operator must obtain a signed lease or alternative form of authorization from a property owner granting permission to operate a cannabis business on the subject premises. However, possession of a valid license by the state is a prerequisite for the cannabis business to operate from the subject premises in compliance with applicable law. This condition creates a dilemma for landowners because the landowner must enter into a signed lease with a prospective cannabis operator who is not yet, and may never be, authorized to operate its cannabis operation. This circumstance mandates that the lease or other agreement between the landowner and cannabis operator contain a license contingency or condition subsequent provision, which provides for a unilateral (in favor of the landlord) or a mutual (in favor of both the landlord and tenant) right to terminate the lease should the cannabis operator ultimately fail to obtain the requisite state and local licenses within a specified time.

As in any commercial lease, landowners should also consider security or collateral for the tenant’s surrender and restoration obligations of the leased premises. Many prospective cannabis businesses will likely require possession of the landlord’s property prior to obtaining the necessary state and local licenses to plan construction, security, and business operations. Therefore, the license contingency or condition subsequent provision should incorporate appropriate surrender and restoration terms so the landlord may recover possession of its property in an acceptable condition if the operator fails to obtain the applicable business licenses necessary to operate in compliance with state law. The landlord should also endeavor to defer payment of any broker commissions, tenant improvement allowances, or performance of any other landlord obligations until all licensing requirements are satisfied.

Compliance with Applicable Laws. Most boilerplate lease agreements require the landlord and tenant to act and comply in accordance with all applicable laws. While cannabis operations may be legal under California state and local laws, the federal government has not legalized cannabis use. The possession, cultivation and distribution of medical or recreational cannabis remains illegal under the federal Controlled Substances Act (CSA) and cannabis remains categorized as a Schedule I drug.  As a Schedule I drug, cannabis is treated as a substance that has a “high potential for abuse” and “no currently accepted medical use in treatment in the United States.”

The U.S. Department of Justice (DOJ) maintains authority to prosecute state legal cannabis businesses under various federal laws, including federal drug and money laundering statutes. Moreover, related businesses and professionals working in or with the cannabis industry may also be prosecuted as co-conspirators or aiders and abettors under the federal statute. As discussed in the Los Angeles Lawyer article, “High Time,” federal enforcement of cannabis laws is currently uncertain. During the Obama administration, the DOJ adopted a set of guidelines commonly referred to as the Cole Memo on “Guidance Regarding Marijuana Enforcement,” which set recommendations on enforcement policies and practices related to cannabis operations. However, on January 4, 2018, Attorney General Jeff Sessions rescinded the Obama-era Cole Memo guidelines and instead granted federal prosecutors with the authority to decide how to enforce federal laws prohibiting cannabis operations in states where its use has been legalized.

Yet, pursuant to an amendment to the omnibus spending bill commonly referred to as the Rohrabacher-Blumenauer Amendment (originally the Rohrabacher-Farr Amendment), the U.S. Court of Appeals for the Ninth Circuit ruled that DOJ is prohibited from spending funds to prosecute individuals engaged in conduct that strictly complies with state medical marijuana laws. It is not clear if this ruling extends to recreational use of cannabis or whether the DOJ will be granted funding to implement Attorney General Session’s enforcement policy.

Regardless, the Ninth Circuit’s ruling coupled with the Attorney General’s latest position creates a quandary for property owners and cannabis operators. Property used to facilitate the cultivation, distribution, and manufacturing of cannabis may still be subject to federal asset forfeiture laws, and there is a risk that the federal government could seize such property. Property owners can also be charged with aiding and abetting a violation of the CSA.

Simultaneously, however, as noted, under MAURCSA, the authorization of a property owner by lease, license, or other arrangement is a prerequisite to obtain a license and comply with state law. This creates a significant legal issue for property owners because by signing a lease with a cannabis operator, a commercial landlord cannot claim ignorance as to the cannabis operation on their property and avail themselves of the so-called “innocent owner defense” under federal law. Consequently, the applicable law provision in any lease for a cannabis operation should be modified to include a carve-out for the CSA and its underlying regulations.

For comments, questions or concerns, please contact Dennis Kaiser