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These days in cannabis, we see lots of toll processing
agreements between licensees. And that’s for good reason–
not every licensee wants to be vertically integrated, which is
expensive and significantly complex. Most licensees simply want the
benefits of being able to offer a variety of products that they
can’t otherwise directly make themselves. How do they
accomplish that? In a variety of ways, including
intellectual property licensing and
contract manufacturing; but today I focus on the specific
basics of toll processing agreements.
What is a toll processing agreement? It’s a contract between
two parties in which a „toller” agrees to manufacture a
customer’s product (usually derived from raw materials supplied
by the customer) for an agreed upon fee (i.e., the „toll”). Toll processing agreements are different than
contract manufacturing where, with contract manufacturing, the
manufacturer usually supplies the raw materials, itself, and also
has the most say over processes, third party vendors, and quality
conditions.
Toll processing agreements should be mutually beneficial between
the parties:
- The customer receives a customized product (potentially with
on-demand services) without the headache and capital outlay of
having to make the product itself. The customer also gets say over
product integrity and customization, quality assurance, vendors,
etc. - The toller/processor/manufacturer gets a (typically) long term
contract getting to do what it does well, making/finishing third
party products on auto-pilot using its existing labor force,
facilities, equipment, and expertise.
Toll processing agreements are used across many industries that
involve any kind of outsourcing of manufacturing or product
processing, and they of course can (and often do) include packaging
and labeling, too. So what are the big ticket items to be covered
in a cannabis toll processing agreement?
Regulatory compliance regarding control and compensation
No matter what cannabis-friendly state you’re in, you need
to make sure that toll processing does not violate any applicable
cannabis regulation or statute. At this point, all states address
issues of ownership (which usually means any kind of direction,
management, or control over licensees), as well as „true
party” or „financial interests” (which hinges on
what parties are receiving any form or net or gross profit from a
licensee). In a toll processing relationship, the customer company
will have lots of say regarding source material and also regarding
exactly what the toll processor does with those source materials to
render the final product for retail sale/distribution.
The big question here is whether the terms of a toll processing
agreement will amount to „control” under cannabis
regulations. And the answer is: It completely depends on your
state’s cannabis laws. If the „toll” amounts to a
percentage of sales of final product ultimately sold–rather
than, let’s say, volume of product produced–you also need
to check your state’s cannabis regulations to see whether or
not that compensation structure triggers any disclosure
requirements (some of which will have specific timing requirements
depending on the state).
Product specifications and quality standards
Even though the toll processor is doing the manual labor, the
customer company should provide all product specifications and
quality standards. (Note that those specifications and standards
must also comply with applicable cannabis laws and rules, including
around permissible product types). Specifications and quality
standards are typically listed on an exhibit to the toll processing
agreement, and the parties will need to negotiate over how and when
product specifications or quality standards can change. Other
points of consideration are: what happens if there’s any kind
of production cost change that materially affects the agreement
regarding processing expenses; what happens when there are
production delays; and which party will bear the costs for any of
that. Good toll processing agreements will also ensure that any
such change will not be effective unless agreed to by both parties
in writing.
Packaging and labeling
Typically, the toll processor is going to handle packaging and
labeling, but that should be done in accordance with applicable
product specifications. Packaging and labeling must also comply
with the litany of cannabis rules and laws set out by state
agencies. The customer company will want to make sure that they
shift the burden of compliance in this department on to the toll
processor, but the toll processor will want to ensure that all
product specifications (including packaging and labeling) comply
with all cannabis laws and rules from the outset.
Intellectual property license
If the toll processor is going to engage in packaging and
labeling of the customer company products–which entails
putting the customer company’s intellectual property on that
packaging and labeling–the customer company is going to need
to grant to the toll processor
a limited intellectual property license. The
license will typically be royalty-free, as the toll processor
won’t be selling the products and is compensated based on toll
processing services rendered. If you’re the customer company,
make sure that the IP license terminates when the toll processing
agreement terminates.
Exclusivity and confidentiality
Lots of
trade secrets exist in cannabis markets, and if you’re
outsourcing your manufacturing or cultivation processing, you need
to make sure that your toll processing agreement addresses
exclusivity and confidentiality. This is especially true where more
and more cannabis companies are undertaking limited (if any)
commercial activity outside of toll processing ventures. If those
toll processors are manufacturing/processing for many other
licensees, you’re very unlikely to net any kind of exclusivity,
but you’ll need to ensure that any confidential product
specifications given over to the toll processor remain
confidential.
Acceptance, rejection, title, and risk of loss
The parties will need to negotiate over what constitutes final
product acceptance or rejection (including any timing and
inspection rights). In a toll processing agreement, the toll
processor doesn’t usually take title to the resulting product,
even though it might retain possession for some time depending on
delivery schedule. Further, risk of loss should be negotiated
between the parties. Recognize also that, in cannabis, acceptance
and rejection of products can have all kinds of regulatory
consequences, and any cure of any rejected product is also
typically controlled by cannabis quality assurance and testing
regulations.
Product recalls
This is always a tricky area, but a cannabis toll processing
agreement must absolutely address product recalls. Specifically,
the agreement should address who has what obligation in the event
of a recall and who will bear the costs. Usually, the customer
company will have the power to declare a recall and will also bear
the costs of such recall, unless the toll processor engaged in some
kind of gross negligence or intentional misconduct in the
manufacturing process.
There are additional considerations for parties to cannabis toll
processing agreements including: purchase order protocols,
representations and warranties, indemnification, and the ability to
terminate the agreement– especially if there’s a change
to cannabis laws or regulations that bar or cost-prohibitively
alter the relationship. The above merely make up the highlights of
what any reliable cannabis toll processing agreement should
cover.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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