Today, cannabis remains a Schedule I controlled substance under the Controlled Substances Act, and states that permit the cultivation, production, and sale of cannabis do not allow the transport of products across state lines.
Until federal legalization occurs, there is no interstate commerce in cannabis. If and when cannabis is descheduled, interstate sales of cannabis could begin and how interstate distribution will be regulated remains to be seen.
To date, state laws permitting the intrastate cultivation, manufacturing, and distribution of cannabis have not allowed for the export of cannabis into other states, or the import of cannabis into the state. Presumably this is in deference to the federal ban, as well as to protect local companies trying to create a brand-new industry.
The U.S. Constitution’s Commerce Clause prohibits state laws that unduly restrict interstate commerce under the court-developed doctrine known as the “dormant Commerce Clause.” It would appear then that the current state cannabis permitting rules limiting export generally run afoul of the dormant Commerce Clause. However, given that cannabis is illegal under federal law, it is unlikely a federal court would entertain a constitutional law claim challenging these state rules. As such, until legalization, the intrastate limitations are likely to remain.
The Implications of Tennessee Wine
The dormant Commerce Clause was most recently and relevantly tested in the U.S. Supreme Court decision, Tennessee Wine and Spirits Retailers Assn. v. Thomas, which declared Tennessee’s durational-residency requirement for a liquor license unconstitutional.
Although the bulk of the case relied on an interpretation of Section 2 of the 21st Amendment, which repealed Prohibition and granted states the authority to regulate alcohol, the court found overall found that “it would be hard to avoid the conclusion that [the] overall purpose and effect is protectionist,” and that the state’s two-year residency requirement to obtain a liquor permit is not needed to “enable the State to maintain oversight over liquor store operations” or to “promote responsible alcohol consumption.”
The Court’s finding reiterated a long line of case law rejecting states’ efforts to enact protectionist policies when it comes to the interstate commerce of alcohol.
Tennessee Wine does not have any current implications for cannabis, since state laws do not currently allow for export to other states. However, if and when the federal government removes cannabis completely from Schedule I, the decision does raise a number of observations about post-legalization interstate commerce.
- Presumably, attempts by states to generally prohibit or otherwise frustrate the import of cannabis products from other states would be unconstitutional, given the strong history of dormant Commerce Clause precedent. So, if states cannot block or limit out-of-state actors, what happens to the value of existing intrastate cannabis licenses?
- If state licenses do decrease in value, does the license holder have a regulatory takings argument?
- How do smaller cannabis companies, which may not have the scale to export into other states, compete against a national influx of products?
- One approach states could take is to only permit the import of cannabis for medical purposes, but not for adult-use. However, the Court in Tennessee Wines rejected the argument that durational-residency requirements for retail liquor sales permitting promoted public health and safety. Would retail sales of cannabis—which, for adult-use, is a similar consumer product to alcohol —be viewed through the same lens, or be treated by a court with a higher level of public health and safety consideration?
Alcohol’s Three-Tier System as Analogue?
The alcohol industry provides a historical corollary for an adult-use, recreational product that went from underground sales in violation of a federal ban to countrywide legal sales with the stroke of a pen. Post-Prohibition, rules were developed subject to a “three-tier” system and “tied-house laws.”
The “three-tier” system deals with the three different parts of the sale of alcohol: production, wholesale distribution, and retail, while limits to cross-ownership are the “tied-house laws.”
Would a three-tier system, similar to that in the alcohol industry, necessarily follow for cannabis? The cannabis industry today is highly fragmented, with few companies having deep multistate presence, and where national brand recognition is almost non-existent. At the same time, much of the cannabis industry is vertically-integrated, with companies owning their own production, manufacturing, and distribution, due to the evolution of state permitting schemes.
The arguments underpinning alcohol’s tied-house rules are similar to those in cannabis; however, with many companies having developed as vertically-integrated, pulling apart that structure could be difficult and destabilizing.
What Does It Mean?
Post-legalization, we could see large companies making significant investments and acquisitions in the US cannabis industry, similar to what they have done cross-border up into Canada (including market-leading US alcohol distributors).
National and global consumer products companies could presumably assume vertically-integrated cannabis production into existing distribution networks, with or without the necessity for separate, legally-required wholesale channels. However, that risks squeezing small, local and regional cannabis companies out of a national market.
What then can cannabis companies do to prepare for an unknown future post-legalization?
- Consider today what role locally, regionally, nationally, and globally your company will play in a marketplace without borders – there could be room for high-volume, widely-distributed products as well as low-production niche products with a limited market.
- Consider what makes your product (not just your brand) different in a sea of competitors, and whether and how you could distinguish yourself in a national market.
- Over time, as valuations continue to rise, and multi-state operators continue to expand their national footprints and brands, it will be more challenging and more expensive for a regional company to scale nationally. Consolidation, licensing arrangements, and partnerships can be effective tools to gain that scale, but those require finding the right counterparty, which takes diligence and time.
- Keep an eye on the capital markets. Access to equity capital has shifted over the past year, with investors becoming more discerning. As you develop your plan, particularly one targeting a national market requiring significant capital, consider where that capital will come from. In the event of an economic downturn, those equity sources could quickly dry up (although that also could create an opportunity for those with access to cash).
- Get involved with trade groups and your government representatives so that you have a voice in crafting the laws that will affect post-legalization distribution.
It remains to be seen how federal legalization will shake up distribution in the cannabis industry. Companies need to monitor not just regulation, but also market activity, to strategize and be prepared when that disruption arrives.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Marc Hauser is counsel and vice-chair of the Cannabis Practice Team at Reed Smith LLP. Hauser has been a deal and capital markets lawyer for over 20 years, with extensive experience working with distressed companies and special situations. His current practice is entirely focused on the cannabis and industrial hemp industries, providing strategic advice to industry participants throughout the U.S.