California limited liability company disputes | Courtroom war stories and lessons learned

Cannabis LLCs Are Not All “Peace and Love”

Limited liability companies (LLCs) are a popular modern form of business entity celebrated for their ease of implementation and informality.  Despite the enactment of uniform legislation providing the “default” rules for LLC governance and operation, the law is still evolving rapidly and in many respects LLCs are the “wild west.”

Cannabis is one of the world’s most well-known recreational substances, basking in the glow of newfound decriminalization in many states.  As the “green rush” of cannabis entrepreneurial activity evolves, LLCs have become a popular choice of cannabis business entity.  Given the unsettled legal aspects of cannabis regulation, which include permitting “equity programs” in several local jurisdictions (including San Francisco, Oakland, and Los Angeles) pursuant to the Cannabis Equity Act, cannabis LLCs are the “wild west on steroids.”

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Cannabis LLCs are not all “peace and love”

Cannabis LLCs are subject to all of the same problems as LLCs focused on other industries, with an additional layer of cannabis-specific unpredictability.  The author’s “LLC Jungle” litigation practice has seen robust participation by cannabis LLC combatants.

Here is a brief list of “red-flag” issues for cannabis LLCs to be mindful of, which is by no means exhaustive:

Operating Agreement

If your LLC does not have a written Operating Agreement detailing the parties’ respective rights and duties, then start over, “do not pass Go; do not collect $200.”

LLCs are flexible entities and a written agreement is not necessarily required, but the lack of a written Operating Agreement is almost a guarantee of future litigation between the stakeholders, and will not impress regulatory authorities or potential lenders.

“Purpose” provisions

Cannabis LLC Operating Agreements should take care to specify the purpose of the entity.  Is the entity intended to exist only to own and operate a cannabis facility on a specific piece of property?  Or is the purpose more flexible and able to morph over time to a “Plan B?”

What is typically thought of as “boilerplate” in the Operating Agreement can have a big impact down the road.  What happens if a permit is not granted for the specific use that is defined as the “purpose” of the entity?  If an entity’s purpose fails, it can be readily dissolved, which might not be the founders’ intent.  See prior LLC Jungle post: Dissolving an LLC when its Purpose Fails.

Conditions precedent and regulatory approval

Conditions precedent can be used in any contract to make a party’s duties “contingent” on something else happening, such as a regulatory body issuing a permit.  If the condition fails, the party doesn’t need to perform the conditional duty.

Since the activities of most cannabis LLCs are highly subject to discretionary conduct by regulators and other third parties, the Operating Agreement should specify what duties are subject to conditions precedent, and how those conditions should be deemed satisfied.

Ownership, managerial control, and local “equity programs”

The local cannabis permitting “equity programs” require various degrees of ongoing ownership and/or managerial control by the “equity applicant” — typically a person who has previously suffered at the hands of the enforcement of “war on drugs” era criminal cannabis laws.

Most standard Operating Agreement provisions allow for the removal of managers and potentially shifting ownership interests.  Local regulators might find such provisions offensive to the underlying purposes of the equity programs.  To keep the local regulators happy and ensure the success of permit applications, cannabis LLCs might need to tighten up these provisions to ensure that the equity applicant can’t be easily sacked from his/her position, or targeted by “kickback” schemes by unscrupulous operators looking to use the equity applicant as a mere puppet.

And, as with any LLC, cannabis LLCs should specify in their Operating Agreements what types of decisions can be made by the manager in his/her sole discretion, as opposed to issues requiring unanimous or majority member approval.

Alternative Dispute Resolution

An effective Alternative Dispute Resolution (ADR) provision within an Operating Agreement aims to ensure that any disputes between stakeholders are addressed in the private forum of arbitration and mediation instead of in the publicly visible court system.

While there are many pros and cons to ADR (too many to cover here), the confidentiality aspect of ADR is often highly desirable for fledgling cannabis companies who are trying their best to not “turn off” the local regulators or potential capital partners.

Fiduciary duties and the covenant of good faith and fair dealing

As informal as LLCs might be, the playground still has some basic rules.  LLC managers owe fiduciary duties to the LLC and its members, and a manager’s conduct is governed by the covenant of good faith and fair dealing implied into every contract under California law.

This means that despite the “wild west” vibe of LLCs in general and cannabis LLCs in particular, the LLC manager’s conduct is not unconstrained.  While the internal controls of an LLC might resemble a dictatorship, there are still lines in the sand that the manager cannot overstep without incurring liability to the members.

Providing the statutorily-required access to books and records is one example.  See prior LLC Jungle post: Why LLC Managers Should Take Member Books and Records Requests Seriously.

Acting in bad faith to deprive a member of the anticipated benefits of the LLC is another example.  See prior LLC Jungle post: Does an LLC Manager’s ‘Sole Discretion’ Eliminate the Implied Covenant of Good Faith and Fair Dealing?”

.     .     .

The issues flagged above are just a starting point.  For a recap of a laundry list of other issues, see the prior LLC Jungle post: Top LLC Articles and Wisdom from the Money and Dirt Blog.

Paying mind to those issues at the outset will help cannabis LLCs stay out of the “jungle” and away from expensive LLC-related litigation.

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