Key Points
- The Department of Health and Human Services (HHS) released details of its recommendation to re-schedule cannabis from schedule I to III; Drug Enforcement Agency (DEA) approval is pending but opposition and court proceedings could still delay re-scheduling.
- Many complexities and unknowns but for now, its likely that individual state rights will remain status quo while still operating under the shadow of federal law. Active and unrestricted capital markets access is needed to maximize potential economic (and social) benefits.
- Safe Harbor provisions for banks and SEC regulated activities (investment banking, custody, stock exchanges etc.) remain in question. With a re-scheduling, updated FinCen (U.S. Treasury Department) that includes such protections may suffice in the absence of specific legislation (such as SAFER Banking).
- Inevitable reclassification will eliminate the 280E tax burden which materially improves cash flows and unlocks shareholder value in short order. Re-scheduling also eliminates a key element of risk and uncertainty that has kept many institutional investors on the sidelines.
- Legalization at the Federal level could take years. In the meantime, Schedule III designation will expand permissions for research, likely fostering the bringing to market of new cannabinoid-based products, presumably under the umbrella of FDA oversight.
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Background
In October, 2022, President Biden directed the Department of Health and Human Services (HHS) and U.S. Attorney General to initiate “the administrative process to review expeditiously how marijuana is scheduled under federal law.”
The announcement came nearly 25 years since California became the first state to legalize medical cannabis (1996) and arguably the impetus for the gradual easing of federal policy, more than a decade since Colorado passed Proposition 64 (2012) establishing the first state to end cannabis prohibition.
Cannabis has remained on the Controlled Substances Act (CSA) as a Schedule 1 narcotic for over 50 years. Today, 38 states (plus D.C.) have legalized medical marijuana 24 of which (plus D.C.) allow for recreational use. Several more are expected to follow suit this year.
In August, 2023 the HHS completed its study and made its determination for re-scheduling. It was not until earlier this year, that the 254 page report (un-redacted) was made publicly available by request under the Freedom of Information Act (credited by attorney Matt Zorn). Unsurprisingly to most, the recommendation affirms that Cannabis meets the criteria for Schedule III classification (has medicinal use and is not deemed as harmful as Schedule I or II).
This move is significant and underscores the notion that we are indeed on the cusp of meaningful federal policy change which eliminates a key element of risk and uncertainty that has kept many institutional investors on the sidelines.
Importantly, with a Schedule III listing, the 280E tax burden is eliminated which immediately accelerates the free cash flow profiles of plant touching businesses. Many operators in effect, have historically had to raise capital to pay taxes.
Best case scenarios, effective date could come 90 days after the DEA’s initial ruling. In general, after the DEA reviews and opines on the HHS recommendation, a proposed ruling is filed in the Federal Register. This is followed by a 60-day comment period during which time the opposition can seek a hearing in front of an Administrative Law Judge (ALJ). After an ALJ review, the DEA makes its final ruling which again is filed in the Federal Register. Schedule III becomes effective 30 days thereafter. Again, the opposition can appeal the decision and seek judicial review (which is expected). Accordingly, this process can go on for quite some time, or best-case scenario, the effective date could come 90 days after the DEA’s initial decision (before an appeal, if applicable). It is at this point when 280E would become irrelevant for cannabis companies.
What happens once moved from Schedule III? Schedule III drugs require DEA registration and are typically sold at a licensed pharmacy with a doctor’s prescription but can be “dispensed directly by a practitioner”.
Attorney Shane Pennington points out, that when drafting the CSA, it granted authority for the AG to waive the requirement for registration of “certain manufacturers, distributors, or dispensers if he finds it consistent with the public health and safety”. His view is quite clear: (1) Rohrbacher-Farr protects medical marijuana businesses (2) HHS has “authoritatively recognized” that marijuana has a currently accepted medical use to patients.
With such a waiver (or language specified in a Garland Memo), it stands to reason that state regulated “medical” and recreational use will be viewed with no differentiation in the eyes of the federal government and state oversight will likely remain status quo. After all, it wouldn’t seem practical for an operator to pay 280E on its recreational use business and at the same time, avoid the tax on medical sales.
A bifurcated market may be the choice for some states while others may opt to combine programs to achieve operational efficiencies (more cost effective to regulate one market than two). Also, medical sales continue to decline as new recreational use markets are implemented, which calls to question why two separate markets are necessary.
As we predicted in 2014 (inaugural GreenWave Report), “The medical and adult use marijuana segments will likely merge into one substantially larger market” and “Since “chronic pain” (loosely defined), is the most common ailment among medical marijuana users, it is likely that a number of recreational users are already purchasing marijuana without great difficulty in states where medicinal use is legal. Accordingly, it can be argued that a merged market already exists in medical marijuana states.”
Schedule III will also expand the ability to conduct research for the development of pharmaceutical drugs, pills, topicals, sublinguals and any number of forms that are cannabis-derived – this is the first step in the recalibration of Medical Marijuana which we suggested in 2014.
These products will likely be regulated by the Food and Drug Administration (FDA) with classification into specific categories, such as drug, food and dietary supplements, or cosmetics. FDA oversight would ensure products meet the standards for contaminant testing, manufacturing expectations, and marketing practices and this is when Big Pharma could be expected to step in.
What about de-scheduling (federal legalization)? This will come in due time as other important issues (social justice for one) are addressed. The day before the HHS recommendation was made public, a House Resolution was filed that calls for, among other provisions the de-scheduling of cannabis.
Until now, when was there any gradual easing of fed policy?
“It is the sense of the House of Representatives that the President should direct the U.S. Mission to the United Nations and the Commission on Narcotic Drugs to seek to de-schedule cannabis from the international drug control treaties, expunge and forgive legal penalties relating to certain low-level marijuana offenses, and treat cannabis as a legal commodity.”
When Federal legalization does occur, a further unlock in shareholder value is likely because the remaining costs of prohibition that have historically reduced operating cash flow and margins will be eliminated (cost of capital, accounting/compliance costs, insurance etc.). Additionally, de-scheduling will enable interstate commerce that will enable most operators to achieve economies of scale thus driving margin expansion.
Updated Department of Justice Guidance: Cannabis remains federally illegal with Schedule III. Unless legislation is passed, operators would still experience difficulty in obtaining financial services, and would still be subject to criminal penalties and civil forfeiture.
In years past, the DoJ has established parameters for law enforcement:
- “Ogden Memo” – Oct 2009 (updated June 2011) clarifies enforcement with respect to Medical Marijuana.
- “Cole Memo” – August 29th 2013 (updated Feb 2014) addresses recreational use cannabis (which anecdotally, exactly 10 years later August 29th 2023”, the HHS made its recommendation to the DEA).
- “Garland Memo” – TBD guidance on re-scheduling.
Upon implementation of Colorado’s recreational use market in 2014, The Department of Treasury issued guidance as it relates to banking and marijuana businesses. This past November, in a letter to Treasury Secretary Yellen and FinCen Director Gacki, members of Congress requested “that the Financial Crimes Enforcement Network (FinCEN) update its out-of-date guidance on marijuana-related businesses.” Even with the progression of state regulated cannabis markets and an overwhelming majority of Americans supporting cannabis legalization, sources of capital remain limited and difficult to access.
While The SAFER Banking Act (introduced in 2021) opens up commercial banking to state legal cannabis businesses and addresses public safety concerns, it excludes Safe Harbor provisions for SEC regulated businesses (i.e. investment banking, custody of securities, listings on U.S. stock exchanges). As such, these exchanges remain reluctant to list U.S. cannabis companies without protections within the context of The SAFER Banking Act (or other legislation). DoJ guidance (i.e. Cole Memo) does not provide such protections because it can be rescinded (i.e. AG Sessions in 2018). With a re-scheduling, updated FinCen (U.S. Treasury Department) that includes such protections may suffice in the absence of specific legislation (such as SAFER Banking). SAFER Banking has stalled in Congress and it is not clear if OR when the bill will move forward.
Capital Markets Reform The industry has hit an inflection point but active and unrestricted capital markets access is needed to maximize the potential economic (and social) benefits. U.S. cannabis companies remain disadvantaged relative to their Canadian counterparts that are able to list on major U.S. exchanges in light of the fact that:
- More states have legalized cannabis without prosecution.
- A few of the U.S. cannabis operators have moved to the TSX and more could follow. With the TSX listing, some banks, have lifted a longstanding ban on custodial services making it easier for institutions to trade these stocks.
- A listing on a major exchange provides more liquidity and would be a first step towards institutional ownership.
- Up-listing will spur more M&A activity (economic benefits).
Furthermore, American based tobacco, alcohol and pharma concerns remain unable to deploy capital into U.S. Cannabis (or risk de-listing) thus sector investment is restricted to outside U.S. borders.
These factors alone could entice lawmakers and regulators to facilitate change.