“Looooooooove is a long, long road”

Tom Petty

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Well, the (initial) moment is finally here. The largest federal catalyst in 75+ years in cannabis (but maybe not the most needed; more on that later). The Department of Justice, which contains the DEA, on April 30^th signaled approval of HHS’s recommendation that cannabis be rescheduled from Schedule I to Schedule III of the Controlled Substances Act (CSA).

By signaled, we mean the Associated Press reported the DOJ would do it based on 5 anonymous sources, some of whom were senior DOJ representatives, and when reporters asked those representatives for comment on the article, those representatives confirmed the accuracy of the reporting.

There’s a lot to unpack here: What it means for the cannabis industry, what it means for the insurance industry, what the process could look like from here (including timing), and how this may or may not affect other federal legislation in the near term.

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What Does Rescheduling Mean for the Cannabis Industry?

This part is very simple: Moving cannabis from Schedule I to Schedule III of the CSA means that plant-touching cannabis businesses, which of course make up almost the entire cannabis industry, are not subject to Section 280E of the IRS Code. Skip over this next part if you know what that means. For those who don’t, prior to this rescheduling, cannabis businesses were prohibited from deducting any operating expenses (rent, insurance costs, employment costs, anything below the Cost of Goods Sold line) from taxable income – really the only business category in the country subject to this arcane tax treatment. These businesses are taxed on Gross Margin, not Operating Income. That has translated into effective tax rates of well above 50% for many operators, with some paying 75%+ effective tax rates and, in a few edge cases, 200%+ tax rates. It’s obviously hard to do things like reinvest free cash flow into your business in order to grow it if virtually all of your money is going to the IRS. Any business trafficking in a Schedule I or Schedule II substance is subject to this tax treatment, which is why there was some chatter that as a half-measure, the DOJ could have moved to Schedule II for a minor optics improvement without solving the core problem at hand – and of course everyone was relieved when it seemed we would get all the way down to Schedule III.

If and when rescheduling is completed, cannabis businesses will be taxed normally, which has enormous positive effects for the cannabis (and broader) economy. More reinvesting free cash flows into cannabis businesses, more job creation, an inherently lighter cost structure translating into lower prices at the checkout counter for consumers, etc. We would also make the argument that rescheduling does, incrementally, help badly needed institutional capital come into a sector that is driven almost 100% by retail investors. Reason being, we’ve talked to enough institutional platforms, whether hedge funds or private equity firms (or other multi-strategy managers) who have essentially said “look, we can get around the stigma, we can maybe get around some of the bank custody issues to actually hold public equities, but it doesn’t make sense to invest as long as 280E tax treatment is around – it just stifles the growth profiles we want to see too much.” Again, more on this later, but our view is that rescheduling won’t hold a candle to what SAFER Banking (or something like it) will do for institutional capital inflows.

The impact of rescheduling for the cannabis industry can’t be overstated; the industry has literally been starving for capital to grow, whether that capital comes from its own revenue or from larger investors. We believe that somewhere between $10B and $20B in free cash flow amongst the top 100 operators over the next 5 years that was otherwise going to the IRS is now unlocked and free to be reinvested (or, maybe in some distant future, paid out in dividends to shareholders…). That’s a huge amount and a serious catalyst for growth in the space.

There are other administrative effects of rescheduling: criminal penalties for being caught possessing or trafficking Schedule III substances are marginally lighter than those for Schedule I substances – we do need to remember that the economic side of this discussion is not the most important one, despite it getting a footnote-like reference here.

What Does Rescheduling Mean for Cannabis Insurance?

Generally, we believe that rescheduling will help drive insurance prices for cannabis coverages lower, given more capacity should emerge. Carriers and reinsurers that have long sat on the sidelines may now have the legal air cover they need to invest in the space, and more capacity supply generally translates into more competition and lower prices, all else equal. Cannabis will remain federally illegal, however, and so we’re cautious to say that dozens of new capacity providers will dive in head long. It will be a gradual process, with teams at some carriers and reinsurers now just starting to investigate how to price risk in cannabis if they sense that the stigma has been removed just enough for them to spend resources against trying their hand in the space.

Rescheduling doesn’t automatically make a cannabis operation (in any part of the value chain) less risky. We would argue, though, that if operators are sending less of their profits to the IRS, there’s a chance that some of the money they will get to reinvest in their own businesses will flow to areas like security, compliance, cyber infrastructure, workplace safety and training, etc. Investing in these areas is good for business and good for shareholders, so we hope operators use this chance to do what they’ve always wanted to do, which is make their operations fundamentally stronger.

Some have asked us specific questions around management liability topics in the context of restructuring, such as “as a Director or Officer of a cannabis company, does rescheduling mean that I’m less likely to be litigated against or otherwise prosecuted by the federal government, and if that’s the case, will my D&O policy premiums go down?” Technically and practically speaking, probably not. Here’s why: A) the federal government wasn’t likely to come after you anyway given other priorities and the fact that the DOJ is legally prohibited from doing this to state-licensed cannabis businesses as part of each year’s appropriations bill (legally prohibited from spending budgeted dollars to prosecute these cases), and B) cannabis is still federally illegal, and most good D&O policies already accounted for this by making it clear the policy would still apply if a D or O was sued for something related to participating in a federally illegal but state legal activity (if your policy doesn’t say that, get in touch with us to get one that does).

Cannabis Hasn’t Been Fully Rescheduled Yet Despite This Announcement – Where Does the Process Go from Here?

The process from here is relatively well-documented; the timing at which the process moves is much less clear, which is already frustrating some. With that said, and we’ve said this before, while overdue, most of this is driven by election year politics, and the timing of the announcement was likely deliberate in order to have this whole thing wrapped up prior to the election (an aggressive but achievable timeline).

We’re going to show a highly abridged list of steps here, but this is the general flow:

1. The DEA will recommend, via Attorney General Merrick Garland, to the White House Office of Management and Budget (OMB), that rescheduling should occur. Note: As of press time, this hasn’t happened yet, technically.
2. The OMB will review the DEA’s proposal (which is a bit circular given the HHS was the executive branch group that drew up the proposal in the first place), and they will approve it, sending it back to the DOJ.
3. The DOJ, with this OMB review now in hand, will publish a proposed rule in the Federal Register, which will detail the rescheduling. This opens up a public comment period, where you can be sure stakeholders on all sides of the table will chime in (by chime in, we mean sue the federal government over the issue). Noise will be made.
4. At various points during the public comment period, an administrative judge may hold hearings. These hearings would likely be aimed less at the merits of scientific arguments made by the HHS and now DEA as well, but more at whether or not the proper process was followed A) during the HHS’s scientific evaluation and evidence-gathering process, and B) whether all the aforementioned agencies followed proper administrative procedures in moving this item through the various cogs in the government machine. You can be sure that litigation against rescheduling will focus heavily on both A and B, and rely almost entirely on scrutinizing administrative law.
5. At some point following the public comment period, what was a proposed rule will become a final rule at the DOJ – and then we are done. That is, until litigation continues long after the final rule is published – but to what effect, no one knows.

Most of the above steps don’t have a set timeframe in which they need to be completed according to administrative law, and even if they did, you can expect that for such a contentious issue, all bets are off according to how things should go or be timed. With that said, there is no reason this entire process can’t be done in the next 7 months, wrapping right before Election Day as a final rule. Two other timing considerations: A) early voting matters to Biden, and that starts well before election day, and B) final rules need to be submitted, technically speaking, to Congress and to the Government Accountability Office (GAO) with ample lead time (60 days). Skipping over quite a bit here, but this means that if Biden’s administration can get this done prior to or right at the beginning of September, it makes it much harder for Trump to undo the rule if Trump gets elected (although to the surprise of some we would argue Trump not only doesn’t care about this issue, but in certain respects, is better on cannabis than Biden because of Jared and Ivanka – a story for another day).

Plan for a major legal battle. There are industries with multiple hundred billion dollar balance sheets that have lobbied against rescheduling and will use cracks and windows in the above next steps to pour tens of millions into litigation. With that said, we are confident this still gets done, as it would appear all agencies involved so far took their time to follow the correct administrative processes, reviews, evidence gathering, and so on. Not to mention, the science is sound.

This Is Great, but It’s Not Legalization. Will This Help Other Federal Legislation in Support of Cannabis?

Probably not, but if so, only marginally. It may hurt current legislative initiatives in Congress such as SAFER Banking more than it helps. We tend to believe that Congressional support for vehicles like SAFER Banking and other flavors of that bill have far less support than the media reports, especially when priorities get tested and omnipresent legislative gridlock boils over. It’s the same story every time, over seven times, in fact, now, with SAFER Banking – there appears to be broad support, there may actually be broad support, but the House runs out of time, other things that are legitimately higher priorities take precedent, and this gets kicked down the road. And that was before (mostly) the House was in disarray. Let’s not forget that certain Representatives are about to call, yet again, a motion to vacate the Speaker of the House.

Similarly, we feel that Republican forces will tend to view rescheduling as a “vote-buying trick” by Biden, or, at a minimum, another in a list of executive actions that they feel are executive overreach, particularly when paired with student loan forgiveness. The average Republican Representative or Senator probably takes a step back, looks at all of these things together, and thinks that the Biden administration has been “forcing things through outside the proper channels”, meaning through Congress (and in the case of student loan forgiveness, against the orders of the Supreme Court).

The counterargument here is that legislators who were on the fence because of stigma may now look at this and feel that bona fide federal agencies in charge of scientific and legal oversight have said this is not as bad of a substance as some have made it out to be – and finally jump in to support.

Intentions are great, timing and other priorities are what matter in the political machine.

There is a lot of misconception in the market that rescheduling allows large institutional investors (and banks) to participate in the space. That isn’t true, at all. We would need to see SAFER Banking or something similar for that to take place. Cannabis equities move up and down today in a nearly 100% retail investor-driven environment that is dominated by automated, arbitrage-programmed algorithmic trading bots (say that five times fast) and trading volume is beyond anemic. This is a bank custody issue. When the banks can’t take custody of the stocks, large institutions can’t buy the stocks. There are no real institutional buyers right now because of this issue, and while some may trickle in through creative methods, we won’t see the massive capital inflows the industry needs until the custodian issue is solved.

Conclusion

Once again, rescheduling is a massive win for the industry and its importance can’t be overstated. As Tom Petty sings, “love is a long, long road”. Consider rescheduling leaving the on-ramp and merging on to the highway. It feels so good to finally be on this trip, but we’re still several exits away.

Can your insurance broker write pieces like this and debate the issues at this level? If they can’t, can they properly look around risk corners for you? Get in touch with us today to save money on your insurance program and be served by the best client service team in the country.