Known Unknowns In LA’s Cannabis Social Equity Amendment

This summer, the LA Municipal Code was changed decisively (the “Amendment”); shifting power power in a cannabis social equity company to the equity-shareholder (“Equity Individual”). These changes will have a significant impact on LA’s social equity licensing, and they also raise new question. So it’s important applicants and operators understand what has changed, what’s the same, and what we still don’t know.

A social equity company is defined as one in which an Equity Individual – someone who satisfies several technical criteria for experiencing material harm from the criminalization of cannabis – owns 51%, or 33.3%, of its equity (the “Equity Share”). Until 2025, only social equity companies will be issued new dispensary licenses by the Los Angeles Department of Cannabis Regulation (“DCR”). Previously, the Equity Individual was entitled to its pro rata of profits/dividends, sale proceeds, and votes. But the previous framework was silent about voting proxies, transfer restrictions, priority returns of capital, vesting/forfeiture and a long list of techniques companies could use to soften – or in some cases, reverse – the Equity Individual’s majority power. This silence spawned variation among deals and great variation in responses: with hundreds of companies participating in the program, and predatory deals, cookie-cutter deals, and everything in between emerged as a result. Intending to eliminate predatory agreements with Equity Individuals, the Amendment changed the rules and raised new questions.

Here, we’ve summarized its most important components: 

Economics 104(2)(ii)(1). The Amendment requires the Equity Individual’s “unconditional ownership” of its “Equity Share” of securities, and we take that to mean no involuntary transfers. The Amendment prohibits anything “potentially causing…ownership benefits” to escape the Equity Individual. Examples of forbidden terms include vesting, conditions precedent/subsequent, restrictions on assignment and executory agreements. We take this to prohibit a company linking an Equity Individual’s securities to outside events (e.g., occurrence of  financing; award of a conditional use permit) and performance or non-performance of ancillary obligations (continuous service status; confidentiality). Before the Amendment, many companies negotiated the right to acquire up to all of the Equity Individual’s securities on certain events. This could be used as an incentive (e.g., vesting for services performed) or to exclude the Equity Individual from an exit. Pricing could be fair or ferocious. Until more guidance arrives from DCR, all these terms are prohibited. 

Be Creative. We know the DCR will not require Equity Individuals hold securities forever. Likewise, we know the holding period will not be brief. But, without a defined holding period, neither companies nor Equity Individuals can exit, which eliminates significant value. Someday, DCR will identify a holding period after which securities could be sold to a non-Equity Individual and the company keeps its licenses. We are counseling clients to consider including a buy-out provision, priced at fair market value by an independent professional), effective thirty (30)-days after DCR’s holding period expires (whenever that may be). 

Illogical Consequences. At face value,“unconditional ownership” prohibits transfer restrictions, but we are confident DCR will not. There’s no reason for DCR to prohibit prohibitions on transfers to competitors, or transfers to persons ineligible to hold cannabis company securities. Likewise, rights of first refusal in favor of the Company and other investors, we suspect, are permissible conditions on ownership, notwithstanding the Amendment’s text. There are multiple efforts seeking from DCR clarification on these points, or a general interpretive release on the Amendment.  

Governance 104(2)(ii)(3). The section titled, “Voting Rights and Control,” prohibits anything except majority-rules. The Amendment requires the Equity Individual wield its majority-power in every vote, whether trivial or momentous. Before the Amendment, investors controlling 49% of a business negotiated standard governance rights: without the consent of the (non-majority) investor, a company could not amend its certificate of incorporation, incur material debts, license intellectual property, etc. After the Amendment, it is clear that for every vote, the Equity Individual’s voting power must equal its ownership in the company: they must wield 51% of all votes. This means no decision is possible against the wishes of the Equity Individual; its consent is required for every decision. Voting agreements are prohibited. The simplest restatement of this section: the Equity Individual controls the company

Elevate the Threshold. The Amendment is silent about boards of directors and about supermajorities and we take these silences to imply DCR consents to the foregoing, or DCR’s de-prioritizing any prohibition of the foregoing. It is widely expected that DCR will not object to voting thresholds in excess of 51% as long as the Equity Individual always votes its 51%. Note that Section 104.20(2)(ii)(3)(B) gives the CEO position to the Equity Individual, whereas before the Amendment, selecting and compensating the CEO was an undisputed Board-prerogative. 

Profits, Dividends, Distributions 104(2)(ii)(2). This section of the Amendment blends the two previous points: unconditional ownership and power over 51% of a resource. Without adjustments, offsets, priority returns or other techniques that privilege one shareholder or member over the Equity Individual, the Equity Individual receives the same per-security dividend as its peers.  

Unsettled. DCR released guidance in 2019 capping fees an equity company could pay to a related party: 20%, in the context of a management services agreement. There is no statement in the Amendment or from DCR identifying if the old guidance is superseded. Presumably, even if its details were unsettled, the underlying mandate persists: payments leaving the company that impair the Equity Individual from receiving its Equity Share of profits, dividends and distributions, are prohibited. Within these unsettled details, however, investors, Equity Individuals and companies can negotiate MSAs, loans, and other bargains between the company and investors/lenders/service providers. Provided that all shareholders “pay” the expenses identically, DCR has not navigated this area. 

Disputes 104(2)(ii)(4). The Amendment adds text on disputes; there is concern the Amendment fertilizes disputes. First, parties are “entitled” to relief in Superior Court for violations of the Amendment, including declaratory relief for violations that have not yet occurred. Before the Amendment, no one lacked a right to relief for broken contracts, but a different idea is a private right of action if counterparty complies with a contract but the contract does not comply with the Amendment. Who is to “blame” if the contract strays from the Amendment? Equity Individuals are as heterogeneous as any group of entrepreneurs in Los Angeles and it would be foolish to assume a lack of sophistication. Who reforms the contract; or if the remedy is purely monetary, who is “at fault” for the contract “violating” the Amendment? In other words, the business deal is unenforceable without its compliance to the Amendment. Second, licenses may be suspended or revoked if, “it can be shown, by a preponderance of the evidence” that a deal’s terms violate Equity Share requirements. It is unclear to whom to show the evidence and what determines if there is a “violation.” Again, are we asking a Superior Court, or an administrator at DCR, to modify a private contract to satisfy the Amendment? As we’ve tried to argue, there are multiple reasonable interpretations of the Amendment and we struggle to predict how a judge would pick which is right, but we predict DCR will do its best to avoid adjudicating these disputes. Finally, the Amendment purports to nullify any agreement that “is or may be construed to be inconsistent” with the Equity Share requirements. Not identified is the person doing the construing, and unlike in the second dispute concept, the threshold for deciding what “is or may be construed as inconsistent” is unknown. 

Conclusion. Until DCR provides more guidance on Equity Share in practice, many companies, Equity Individuals and investors are holding their breaths. Addressing some of these Known Unknowns, either by trial and error, or from DCR guidance, will be a relief. 

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