21 Dec Vertical Integration: What It is & Why It Matters to Cannabis (Washington)
First posted in the Cannabis Law Journal
Vertical integration is a business strategy by which a company controls every stage of a single production path. For example, a cannabis company achieves vertical integration when it consolidates multiple steps in the cannabis production process by manufacturing (growing and processing) the product, and also distributing the product (either as a supplier to other businesses or retailer to individual consumers).
As a general business strategy in modern practice, vertical integration presents both advantages and drawbacks for the host company. The positive implications of vertical integration revolve around internal cost-savings and efficiency including lower transactional costs, strict control over quality, reliability with respect to supply, and increased market control. However, not without drawbacks, vertical integration often demands a large capital outlay due to the need to combine existing businesses or independently establish a second or third arm of an existing business in order to control every stage of the production path. Other disadvantages of a fully integrated business include reduction in corporate flexibility, increased costs and oversight required to run the expanded business, and possible loss of focus.
Washington State’s regulation of the cannabis industry demonstrates one of the most restrictive models of cannabis control, but neither the structure nor the content of its regulatory scheme is unique. When Washington voters passed Initiative 502 (I-502) in 2012, both the text and structure of the referendum mirrored post-prohibition laws enacted with the intent of making it difficult for alcoholic beverage market participants to comply with the law, and ultimately permit less product to flow to consumers. California and Illinois have some similar limitations with twilight clauses that will have to be interpreted as those respective markets develop.
Prior to alcohol prohibition, many producers of spirits, beer, and wine owned or had close ties with local retail storefronts and served only a small geographic area. Competition was fierce and, as a result, those who stood to make a profit had little concern for the integrity of their product or safety of their customers. These resulting business relationships – in which producers gained the upper hand by selling to favored retailers on exceptional credit terms, including charging little to no interest, furnishing storefronts with branded or promotional equipment ranging from coolers to signage, or paying so-called rebates for exclusive supplier agreements – were known as “tied houses,” referring to the enjoined interests of multiple entities at various stages throughout the supply chain. Lawmakers attributed the public’s overconsumption of alcohol prior to prohibition, at least partially, to these business practices.
Following the repeal of prohibition by the 21st Amendment in 1933, lawmakers concerned themselves with these “tied houses” and sought to enact various rules and regulations that would minimize problematic, inappropriate, or coercive business practices among the various sectors of the liquor industry, either through domination of one category of market participants (i.e. manufacturers, importers and distributors, or retailers) over another or through the unfair selective market exclusion of competitors. They also envisioned that strict regulations that were difficult to comply with would eliminate substandard or underfunded market participants (who could not afford the high cost of paying an attorney to review each transaction, or petitioning and waiting for a response from the applicable regulatory board for each new transaction or issue that arose, etc.) and result in less alcohol available for use by the public.
The three-tier statutory structure ultimately enacted, and still in force today, separates alcoholic beverage market participants into three categories and regulates their permissible business practices, as well as tax liabilities, respectively. Briefly, manufacturers (tier 1) such as wineries or breweries may only sell to licensed wholesalers, and pay federal excise tax on these transactions. Importers and distributors (tier 2), including distributors and control boards, may only sell to licensed outlets or retailers (tier 3), and must pay state excise tax. The final tier must sell exclusively to consumers, are charged with the duty of ensuring alcohol is sold only to those of legal age, and must also collect and pay state sales tax.
This three-tier structure seeks to prohibit enjoinment of business interests, and to regulate the cross-ownership, distribution schemes, and marketing practices of licensed operations. The cannabis industry, based on this model, adopted this three-tier structure as well as much of the legislative intent behind it. As it pertains to cannabis, proponents of vertical integration insist it helps avoid some federal tax problems that plague the industry because marijuana businesses cannot deduct regular business expenses under Section 280E of the Federal Income Tax Code. Vertical integration thus potentially offers businesses the opportunity to save costs, sell products at lower prices, and maximize profit margins. Opponents of vertical integration, however, argue vertically integrated cannabis businesses would be detrimental to both the industry and the consumer, presenting arguments that harken back to pre-prohibition alcohol regulation (or lack thereof): that vertically integrated cannabis businesses would create dangerous marijuana monopolies, stifle the market and decrease product quality, and pose significant obstacles for small business owners who would be unable to operate due to the immense capital or expertise required to enter the market and compete against cannabis conglomerates.
After weighing these advantages and drawbacks, legislators in states with active cannabis industries selected and enacted applicable statutory schemes. (As more states continue to legalize cannabis, they too will be faced with the decision of whether or not to permit vertical integration with respect to the industry in their state.) States fall into one of three categories with respect to vertical integration, each of which is discussed in further detail below: required, permitted, or prohibited.
In states where vertical integration is required – such as Massachusetts – only vertically integrated businesses may apply for a license from the state to legally operate their cannabis manufacturing, processing, and distribution activities. These states categorically disallow the third-party cultivation or manufacture of marijuana or marijuana-infused products. In these states requiring vertical integration, like Colorado, the law sets forth the minimum percentages required of particular business operations that must be performed by the host company in order to qualify as satisfactorily integrated. For example, Colorado enforces a 70/30 rule requiring Colorado retailers to grow at least seventy percent of the product they sell at retail. While rules requiring vertical integration were originally designed to prevent licensed retail stores from purchasing cheap product from illegal, black market sellers, these regulatory schemes largely present unnecessary, cumbersome challenges to the cannabis market including limiting small business growth in the industry (as small businesses may not be able to gather the tremendous necessary capital and expertise required to even enter the market).
Regulatory schemes permitting vertical integration – that is, rules that allow, but do not require, vertical integration – such as those adopted by Oregon and Nevada, offer the most economic freedom for the cannabis industry. In these states, producers or processors with appropriate licenses are legally permitted to sell their own products, or they can choose to wholesale their products to retailers. Likewise, retailers in these states are not bound by rules such as Colorado’s 70/30, and instead can exclusively operate a retail business without having to produce their own products. Additionally, this model allows for cannabis production businesses in sparsely populated areas to boost their profits by wholesaling to more lucrative urban and suburban markets.
States that prohibit or limit vertical integration include California, Washington, and Illinois. Under this model, states enforce various degrees of separation between the production and retail stages of the cannabis procurement process; this regulatory structure closely models traditional alcohol distribution models. In practice, marijuana businesses currently operating in such states are permitted to integrate vertically in very limited ways, but these states with express prohibitions against vertical integration are actively attempting to move away from any permissible vertical integration. For example, both Washington and also California allow for some licensees to hold two licenses types – such as a manufacturer or producer and processor licenses – but those licensees may not operate, or have any direct or indirect financial interest in, a retail license whatsoever. Additionally, California announced its intent to move toward a more blanket prohibition of vertical integration practices once the market has matured in its Medical Marijuana Regulation and Safety Act of 2015, declaring that all vertical integration would be prohibited after January 1, 2026.
Laws in states that prohibit or limit vertical integration in the cannabis industry echo – and sometimes repeat, verbatim – the language and tone of regulations applicable to the alcoholic beverage industry. For example, with respect to alcohol businesses, Washington’s cornerstone tied house rules are codified in RCW 66.28.010 , which prohibits alcohol manufacturers, importers, distributors, and authorized representatives from owning or having a financial interest in a retail license or owning property on which a retailer operates, and from providing things of value to retailers. Similarly, with respect to marijuana businesses, Washington law codified in RCW 60.50.328 prohibits licensed marijuana producers and processors from having a direct or indirect financial interest in a licensed marijuana retailer. As clarified by the Washington State Liquor and Cannabis Board (WSLCB), there should be no personal, financial or contractual relationship between a processor/producer and a retailer. Further, the Washington State Legislature amended its Administrative Code throughout 2015 and 2016 to include section 314-55-018 which broadens these traditional regulations and further prohibits any marijuana “industry member” – a far-reaching category of persons, ranging from producers, processors, and retailers, to their representatives, affiliates, officers, partners, financiers, agents, employees, and representatives – not only from receiving anything of value, including money, gifts, discounts, loans, premiums, rebates, free product of any kind, or treats or services, but also from entering into any agreement which causes “undue influence” over another industry member.
Under this highly regulated and participant-inclusive model of cannabis regulation, sometimes it can be difficult to discern whether anything of value has wrongfully changed hands between parties contemplated by statutes in states that prohibit or strictly regulate vertical integration, and also whether a particular statement or action can be determined to constitute undue influence under the applicable laws. This past summer 2017, in an effort to clarify these regulations and define the boundaries of acceptable business practices, the WSLCB highlighted recurring violations of tied house rules the board encounters:
- Discounts: Processors giving discounts to individual retailers – specifically one or two retailers – that are not uniform across all of their contracts, constituting a “money’s worth” violation.
- Giveaways: Generally, it is a violation of Washington law to give anything of value to a licensee or any of their employees under the broad definition of any “industry member.” Two narrow exceptions presently exist: (1) promotional items under RCW 69.50.585 and WAC 314-55-096 and (2) educational samples under WAC 314-55-096
- Labeling: It is a violation of Washington law for a processor to include a retailer’s tradename on the package of a product, because it both constitutes a prohibited written or unwritten agreement between separate tiers, and also creates undue influence as retailers will be reluctant to purchase a product that displays another, potential competitor’s, brand name regardless of the price.
- Leasing: The leasing of land, a building, equipment, or raw product is prohibited; neither property nor tangible items may be “rented” or “leased.” This includes items intended to display or house the processor’s product in retail outlets, such as shelves and coolers. Items can be sold outright among the tiers and industry members, but only at true market value and without causing, or being the result of, undue influence.
Penalties for violations of tied house laws include financial liability and may go as far as license cancellation.
While the goals of applying tied house laws to the burgeoning cannabis industry are to prohibit vertical integration, discourage predatory business practices, as well as decrease the potential for public harm or overconsumption, these laws often function by presenting onerous legal and business obstacles. All business models come with advantages and risks, but it is important for cannabis business owners, operators, and investors to understand the strengths and weaknesses that vertical integration poses in their respective state. It will take years before sufficient evidence can be gathered to reveal insight into how well vertical integration promotes protection and predictability in the regulated cannabis industry, as well as the ways in which it positively and negatively impacts market growth. In the meantime, cannabis industry members and potential market entrants must seek to stay abreast of these developing issues and enforcement trends, garner support and lobby for favorable laws in their state, and adapt their business practices accordingly. Contact an attorney to ensure your current activities or future plans are in compliance with applicable law.