Medical Marijuana Partnership Risks: Not Just Blowing Smoke

Public sentiment regarding the use of marijuana has shifted dramatically over the past several years. As of April 2015, medical marijuana is legal in 25 U.S. states and the District of Columbia. Additionally, nine states have pending legislation, and 12 states have legalized the limited use of low-THC marijuana for medical purposes. Recreational use is legal in four states. Despite the fact this “black” market has become “white” in many states, those involved in the industry still find themselves at significant risk of criminal prosecution and reputational ruin.

The sale, possession, production and distribution of medical marijuana remain illegal under federal law.States that have legalized marijuana have seen hundreds of raids on dispensaries, particularly in Colorado and California, many of which were operating in compliance with state law. The states that have legalized marijuana have only been able to do so because of federal guidance urging prosecutors to refrain from targeting state-legal marijuana operations. Some of this guidance explicitly discusses the possibility for fraud and notes the obligation for those involved in the industry to undertake appropriate due diligence. This level of due diligence must be more than just a perfunctory check to see if there are any criminal activities in a local jurisdiction.

The risks of fraud in the medical marijuana industry are clear and pervasive.

The call for appropriate due diligence is grounded in the fact that the industry has been rife with fraud.In 2012, a registered caregiver under the Rhode Island Medical Marijuana Program was sentenced to prison for illegally cultivating marijuana plants. In May 2013, a grower registered under the Oregon Medical Marijuana Program was sentenced to 15 years in prison after a jury found he was using his license to “create the appearance” that he was complying with the Oregon law while actually selling most of the marijuana illegally. In May 2014, federal prosecutors in Denver levied international money laundering charges against a local attorney and three others, claiming that the group had wired and laundered hundreds of thousands of dollars from Colombia to buy a Denver grow house.

As the limited history of the industry has shown, not all growers and dispensary owners adhere to the ethical standards required by the states, and fraud is endemic. In February 2015, in the first case of its kind in California, prosecutors alleged organized crime was running a chain of northern California medical marijuana clinics. Federal agents arrested the alleged owner of the chain and accused him of money laundering and generating millions of dollars for the Ukrainian mob.

With this as a backdrop, more sophisticated investor groups are looking at medical marijuana licenses as a potential revenue stream. Private equity funds, international consortiums, hedge funds and the like are looking to secure these licenses to partner with state governments. Because investors behind the license bidders can come and go, the risk for states and applicants will be an evolving problem. State entities will be under the microscope by cities, media and other stakeholders to ensure they are partnering with reputable investors. It will be important to know that the money behind these groups is not tainted. Money laundering will be a real concern. In our experience, the source of funds and the backgrounds of the primary individuals are better learned before a contract is signed. The legal and public scrutiny afterwards can cause tremendous problems.

Probity and due diligence are critical to the sustainability of this market sector. States issuing licenses, private equity funds investing in the businesses, insurance companies, and financial institutions accepting funds are among those who must take appropriate care to ensure these businesses are operating aboveboard and to the highest standards of integrity.

In part, organized crime has found a place in this industry because of the conflict between federal and state laws and, thus, the reluctance of banks to provide financial services to medical marijuana growers and dispensers. To banks, the pre-eminence of federal law has been a powerful deterrent to allowing pot businesses to set up accounts. The Financial Crimes Enforcement Network (FinCEN) issued guidance in February 2014 that tacitly acknowledged the legality of banking marijuana businesses.

The guidelines were widely touted as a way to get money into the banking system where it could be more easily tracked and less likely to be controlled by organized crime. As part of this guidance, FinCEN called for due diligence by financial institutions in monitoring their marijuana customers. This diligence includes reviewing the accuracy of information disclosed in their state license applications and understanding their “normal and expected activity.” Even so, in March 2015, federal prosecutors in Washington brought drug conspiracy and related charges against several family members. The defendants were convicted of growing marijuana but acquitted of the remaining four counts. The defendants argued they were growing the marijuana for their own medical use.

Despite the federal guidelines, banks have been reluctant to take on the risks associated with the industry. For many growers and distributors, finding a bank to provide services is still a “pipe dream” according to a 2014 article in the Wall Street Journal. Because financial transactions of a marijuana business are illegal under federal law, banks must still file suspicious activity reports (SARs) when a new pot business opens or closes an account or when such businesses exhibit activities that violate the guidelines.

These SARs provide some insight into the rapid growth of this industry. In August 2014, FinCEN director Jennifer Shasky Calvery stated almost half of the SARs (43 percent) FinCEN received between February 14, 2014, and August 8, 2014, were termination SARs, indicating the bank deemed it necessary to terminate its relationship with these entities in order to maintain an effective anti-money laundering compliance program. In other words, almost the same number of institutions severed ties to marijuana businesses within the period analyzed as those that provided services. In April 2015, Dynamic Securities Analytics, which provides quantitative transaction analysis, reported that the percentage of non-suspicious marijuana-related SARs — filed solely because of the illegality of marijuana production, distribution and sales at the federal level — increased by 146 percent between August 9, 2014, and January 26, 2015, while reports of termination decreased to 36 percent. The more than doubling of these non-suspicious SARs indicates financial institutions want to capitalize on this burgeoning industry, but still need more information about their potential business partners.

Although federal guidelines and state laws provide some protection to those considering entering the market, they are only a starting point. Before issuing licenses and serving these operations, states, financial institutions and others must fully understand the backgrounds of the individuals applying for the licenses as well as their partners. They must also have a clear understanding of the sources of funding both within and outside of the United States. It is critical to investigate all dispensaries and growers before licensing to avoid any financial misconduct and to identify any criminal history or ties to organized crime, fraud or other corruption. Watchdog groups, citizens, media, law enforcement and other stakeholders will be carefully observing to ensure those involved in this business are beyond reproach.

The risks of fraud in the medical marijuana industry are clear and pervasive. States, banks, private equity firms, insurance companies and others could unknowingly enter into a financial relationship that could prove disastrous without thorough domestic and international due diligence investigations being completed on the dispensaries, growers and their sources of funds. Growers and dispensary owners could have significant financial or legal problems, ties to U.S. or international organized crime, or a host of other issues. Those doing business with such entities could face criminal prosecution, financial ruin, and public embarrassment leaving nothing but pipe dreams behind.