Cannabis and Banks: What Qualifies as Illegal Activity?

May 23, 2018Articles The Legal Intelligencer

Many legal issues arise out of financing cannabis activities, not the least of which is whether a target property for a cannabis venture is mortgaged by a bank. The standard institutional mortgage contains language that allows the mortgagee to “call” the loan if the property is being used to conduct “illegal activity.” This language relates to federal lending guidelines and is usually nonnegotiable. The question thus becomes: what qualifies as “illegal activity”?

As a general matter, a contract for an illegal purpose is unenforceable. And while 29 states have passed some form of marijuana legislation, marijuana remains a controlled substance under federal law. The interplay between state and federal law has left the status of the marijuana industry—and the rights of involved lenders and borrowers—unclear. Several recent cases highlight this ambiguity.

In Green Cross Medical v. Gally, a landlord sought to revoke a lease because the tenant—who had not yet received the appropriate license—intended to operate a dispensary on the property under the Arizona Medical Marijuana Act (AMMA). 395 P.3d 302 (Az, Ct. App. 2017). The tenant responded by filing an action for a temporary restraining order and a preliminary injunction. Pointing to the Controlled Substances Act (CSA), the landlord argued that the lease was void for illegality. The trial court ultimately held that the lease violated both state and federal law and was therefore void.

The appellate court disagreed. The court held that interpreting the AMMA to allow state prosecution of the landlord would lead to absurd results and frustrate the purposes of the AMMA—particularly because the AMMA expressly protected the tenant and its customers. The court also found that a landlord should not be entitled to breach an otherwise enforceable contract simply because the lease could violate the CSA. To this end, the court noted that contracts for an illegal purpose are not always unenforceable, and that where the contract can be enforced in a way that does not require illegal conduct, the court may provide relief. According to the court, granting damages for breach would not require the landlord to violate the CSA.

The Arizona appellate court in Green Cross Medical also noted that the federal policy on medical marijuana has been in flux for years, and that since 2009, the Justice Department has instructed U.S. Attorneys not to prosecute individuals in compliance with state medical marijuana law: “We recognize there is a tension between the CSA and the AMMA because the CSA still criminalizes the sale, use, or possession of medical marijuana whereas the AMMA offers immunity and protection for those persons operating in compliance with the AMMA. Nevertheless, refusing to enforce such contracts would undermine the medical marijuana program the voters approved. Enforcing such contracts leaves the federal government in the same position it has chosen with respect to medical marijuana in Arizona. If the federal government wishes to end such programs by enforcing the CSA, it has the power to do so provided Congress permits use of federal funds to prosecution and the Department of Justice desires to bring such action.”

Using a similar approach, the U.S. District Court for the Northern District of California recently held that a promissory note was enforceable despite the borrower using those funds to operate a marijuana-related business in Mann v. Gullickson, 2016 WL 6473215 (N.D.Cal. 2016). In Mann v. Gullickson, the plaintiff sold two businesses to the defendant: Dispensary (DP), a consulting business for state-regulated marijuana dispensary or cultivation licenses; and weGrow Enterprises, Inc. (weGrow), a franchise hydroponic retail operation. In exchange, the defendant forgave a $10,000 loan to the plaintiff and executed a promissory note agreeing to pay the plaintiff another $400,000.

After defaulting on the promissory note, the plaintiff sued the defendant for breach of contract. The defendant then moved for summary judgment contending that the parties’ agreement was void for illegality because it relates to medical marijuana—a prohibited substance under the CSA. To support this argument, the defendant proposed a bright-line rule: “California law includes federal law and thus, a violation of federal law is a violation of law for purposes of determining whether or not a contract is unenforceable …” The plaintiff advocated for a more nuanced approach that focused on the legality of the remedy, not the legality of the subject matter.

Indeed, the court sided with the plaintiff and denied the defendant’s motion. Although the court recognized the “continued erosion of any clear and consistent federal public policy in this area,” the court ultimately couched its opinion on the nature of the businesses and held that requiring the defendant to satisfy the note’s obligation did not force the defendant to “possess, cultivate, or distribute marijuana, or to in any other way require her to violate the CSA.” The court emphasized, “there is no indication in the record the companies directly grew or sold marijuana.” Thus, the note was not void for illegality.

On the other hand, some courts continue to hold that any agreements related to marijuana are void for illegality. For example, in Tracy v. USAA Casualty Insurance, the plaintiff tried to seek coverage for loss to “trees, shrubs and other plants” after thieves stole her marijuana plants. 2012 WL 928186 (D. Haw. Mar. 16, 2012). The U.S. District Court for the District of Hawaii held that “to require the defendant to pay insurance proceeds for the replacement of medical marijuana plants would be contrary to federal law and public policy, as reflected in the CSA … .” That said, federal policy has only become less clear since Tracy.

At bottom, there are no black and white answers when it comes to the enforceability of marijuana-related agreements—only gray. For this reason, most lenders outright refuse to enter into such agreements. This is particularly true for mortgage loan originators who underwrite a new loan with the intention of immediately selling it to investors like FHA, Fannie Mae or Freddie Mac. As government entities, such investors will not accept marijuana-related contracts.

Other lenders, often called “portfolio lenders,” keep a certain number of loans in their portfolio instead of selling to investors. Portfolio lenders thus assume the risks associated with lending to marijuana-related business. And, because portfolio lenders assume the risk, they have greater discretion in deciding whether to extend credit to a cannabis-related entity. Depending on the jurisdiction, sophisticated borrowers may have better luck in persuading these lenders to do just that.

Reprinted with permission from the May 23 issue of The Legal Intelligencer. (c) 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.