California Cannabis: What’s in YOUR Distributor Services Contract?

Even though the Medicinal and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA“) stripped distributors of massive amounts of power, they are still relevant and 100% necessary if cultivators and manufacturers want to get their products to retailers. Why? There are three primary reasons:

1. Distributors are the only license type that can transport marijuana products and they’re also the only licensees that can coordinate the required third-party testing of licensees’ products.
2. Prior to any retail sale, licensees must ensure that a distributor undertakes quality assurance packaging and labeling reviews of their products.
3. Perhaps most importantly, distributors are almost exclusively in charge of collection and remittance of the cultivation and excise taxes to the California Department of Tax and Fee Administration (“CDTFA”).

Given the responsibilities placed on distributors by the MAUCRSA and the corresponding Bureau of Cannabis Control (“BCC”) emergency regulations, multiple distributors, as well as cultivators and manufacturers working with distributors, have asked us to draft their distribution service contracts. Gone are the days where cannabis goods and services are traded amongst wholesalers and retailers based on handshakes–at this point, it would be a huge mistake not to have your distribution contracts in writing to ensure enforceability and good behavior in the marketplace.

So what should go into your cannabis distribution contract? Excluding all of the normal and necessary contract concerns like performance deadlines, term, termination standards, material breaches, waiver, assignment, disputes, etc., here’s a list of considerations that should be specific to the average California distribution agreement:

1. Don’t think of it like alcohol . This is not an alcohol distribution contract, so forget googling some boilerplate alcohol or beer distribution agreement. Unlike California alcohol distributors, marijuana distributors don’t have to push brands or make any representation or warranties that they have the authority or power to do that for the benefit of the manufacturer or cultivator in any kind of exclusive way or setting. Distributors don’t have to sweat product promotion, marketing, or even sales: in California, they don’t have to take title to the products they distribute (taking title is strictly optional). Even if a distributor were going to take on such a role, the alcohol distribution contract model still likely wouldn’t fit given the BCC rules in play regarding “ownership” and “financial interests,” and because of the MAUCRSA’s anti-competitive behavior standards.
2. The white label option . Consider white labeling for flower. Distributors may re-label, re-package, label, and/or package cannabis flower for retail sale under the BCC rules. Notably, distributors are not allowed to white label any manufactured products unless they also hold a manufacturing license and are re-labeling/re-packaging their own manufactured products. If you’re going to white-label flower as a distributor, you need to consider a whole host of issues ranging from the creation of intellectual property, to product specifications, product warranties, applications of branding, risk and retention of title over the product, quality control, and liabilities and/or product recalls due to faulty packaging and labeling.
3. Core services . Determine what lines of business you want to be in as a distributor, as you can charge licensees for performance of these services. Your options are: 1) storage only services, 2) transportation or transportation-only, 3) coordination of third party testing, and 4) quality assurance reviews of packaging and labeling. If you coordinate testing, you must also do the final quality assurance review.
   • Storage only . Note that distributors can’t store (or distribute) non-cannabis goods on their premises. There are also significant regulatory obligations that should be recorded in any distribution service contract to ensure that distributors meet these mandatory performance standards (like separate and distinct storing of various batches and that the informational content of batch labels lines up with BCC rules). If dealing with storage-only services, distributors and other licensees will want to analyze in their service contracts who bears the risk of loss of any product and what the consequences under the contract will be for any storage rule violations by the distributor.
   • Transportation or transportation-only . Movement of the product across the marketplace is going to be a critical revenue driver. There are all kinds of BCC rules governing transportation of product which, again, should be recorded in any service contract between a distributor and any other licensee including, but not limited to, performance standards for the generation of correct and accurate shipping manifests as well as ensuring that the distributor follows the rules for the state’s designated transportation routes. In addition, if you’re dealing with a transportation-only distributor, that distributor can’t transport any product to retailers except for transporting immature plants and seeds from a nursery licensee, and these kinds of distributors can’t take title to any product unless they hold some other type of commercial cannabis license. Again, who bears the risk of loss of product and performance regarding transportation schedules is going to be paramount when dealing with transportation services.
   • Coordinating third party testing . Essentially, the distributor is responsible for lining up third party lab testing of all products made or manufactured after January 1, 2018, and distributors must video record the lab’s retrieval of any given batch sample for testing as well as ensure that the lab takes a representative sample of the batch for testing (both the lab and the distributor are obligated to execute a chain of custody form to substantiate their interactions over the batch). The labs used by distributors for this service should be subject to negotiation between the cultivator/manufacturer and the distributor, and we anticipate that to be a large point of contention between the parties based on cost of the tests and reputation of the labs. The question has also arisen regarding with whom the lab should contract, with the distributor or with the licensee whose product is being tested (or both). Again, this is likely subject to negotiation between the parties.
   • Quality assurance review . Once the distributor receives a passing certificate of analysis from the lab for a test batch, the distributor cannot just transport the products to a retailer. Instead, the distributor has to do a quality assurance review of the product’s labeling and packaging to make sure that it meets the BCC rules. Basically, the distributor is the last stop to ensuring that all product packaging and labeling meet the rules in play. Such a role will of course play into the distributor’s liability for any bad, defective, or faulty packaging/labeling that hits the marketplace and those scenarios need to be handled through solid indemnification clauses in the distribution service agreements.
4. Testing contingencies . Make sure you sort out who is responsible for what and when in the event a batch doesn’t pass testing since the state has a mandatory protocol in place for this. If the distributor is in possession of a failed batch that can be “remediated,” the distributor may “transport the batch to a cultivator or manufacturer for remediation.” Notably, the distributor doesn’t have to return the batch to the licensee who sourced it, which is another point of negotiation for the distribution services contract. Finally, a distributor can’t destroy a batch that failed laboratory testing and that can’t be remediated, so don’t include that in your agreements for products that fail testing: it won’t be an enforceable performance standard.
5. Inventory Tracking . Account for any discrepancies in inventory in the contract. Distributors are obligated to audit their inventory every 14 days. If there’s any difference between actual inventory and the state’s track and trace system, the distributor must immediately undertake an audit. In turn, this inventory accounting should be a distributor performance standard in any service contract, especially if you’re looking at storage or transportation-only services, to ensure that there’s no confusion about which party is responsible for maintaining track and trace standards on the products while they’re in storage or while they await transportation or testing.
6. State tax reporting . Be sure to address the distributor’s collection and remittance of taxes to CDTFA. This is going to be a big issue between licensees as CDTFA continues to change its MAUCRSA tax policies and standards. For cultivators and manufacturers, distributors will likely want to collect the cultivation tax upon transfer of the product or upon the issuance by the lab of a passing certificate of analysis. In addition, the timing of remittance of the tax should also be addressed in the contract and abide by CDTFA regulations. Ultimately tough, CDTFA may ignore tax agreements between parties, and will first look to the distributor for any unpaid tax. A distributor should therefore address in the contract the parties’ responsibility for bad math on the tax owed, falsified financial data and other failures to comply with CDTFA regulations or policy.
7. Licensing issues . Don’t forget to negotiate what happens to the agreement in the event a party loses their state license or local approval to operate. It’s highly unlikely that the parties will want to keep doing business together if one of them loses their ability to conduct commercial cannabis activity under state or local law, so be sure to include that worst case scenario in the distribution agreement.
8. Regulatory changes . The rules will continue to change indefinitely and they may (and likely will) affect your distribution agreement as a result. After enough time goes by and the market stabilizes, regulatory will often begin to make rules around licensees’ abilities to contract with each other to ensure that there’s no anti-competitive behavior or practices taking place. As a result, make sure that you reserve the right to amend the contract to comply with the rules in the event they affect material terms in the agreement.

The Canna Law Blog is a forum for discussing the practical aspects of cannabis law and its impacts on the cannabis industry. We provide insight into how cannabis businesspeople can use the law to their advantage and in plain language we tell you what works and what does not. We aim to help you strategize how to wield the law as both a shield and a sword.

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The Canna Law Blog™ is a forum for discussion about the practical aspects of cannabis law and how it impacts those involved in this growing industry. Our goal is to provide insight into how cannabis businesses and stakeholders can use the law to their advantage.

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