Is Ensuring Compliance with Cannabis Rules and Regulations Important for Tamping Down on Illicit Markets?

The policies behind the rules and regulations that govern cannabis programs implemented at the state level often reflect past anti-cannabis biases and, perhaps erroneously, the belief that robust regulation is the only way to transition the industry from illicit-market activities to legitimate marketplace participation. Licensed cannabis operators want to believe that complying with state regulatory requirements will provide a competitive advantage over those operating illicitly. Unfortunately, in the short run, this may not be the case because the costs of complying for many still exceed the benefits of operating legally. Although well-designed regulations can protect the public, help avoid monopolies, and generate tax revenue, poorly written legislation can create government bureaucracies that stifle growth, increase costs, decrease competition, exclude smaller participants, and do more harm than good.

Today, in part because marijuana remains illegal federally, licensed operators face a patchwork of laws that vary by state. Ensuring compliance with each state’s regulations is time-consuming and expensive for businesses operating in multiple states, as well as those working in a single state. Cannabis regulatory expenses include direct compliance costs such as obtaining and maintaining licenses, locating and modifying operational spaces, and implementing enterprise-wide compliance programs that can be relied upon to demonstrate and prove compliance with relevant regulations. The costs of regulation are borne by the licensees that must comply with them and typically fall into two categories: operational costs and compliance risks.

Like in other highly regulated spaces, as the cannabis industry matures, compliance programs will become risk-based as more information becomes available to identify those areas that present the most significant risks and how such risks can be avoided and/or mitigated. Until then, licensed cannabis businesses must be prepared to demonstrate compliance with all rules and regulations in which they operate. Doing so is a burden that is often too onerous for many prospective applicants and current licensees to overcome, and it is one of the main reasons why so many illicit markets continue to thrive. Complying with rules and regulations is unnecessary if you run operations outside the regulated market.

As additional states legalize cannabis, new state markets have the opportunity to learn from those that have legalized before them so that regulators can avoid the pitfalls other states have experienced and create the efficiencies needed to incentivize legacy market participants to operate within the confines of the new regulations. California and New York provide good examples of the challenges that legislation can pose to encouraging legal participation – and an alternative that might smooth the path.

A brief history
The prohibition against cannabis in the U.S. began in the 20th century after the Mexican Revolution of 1919. Many states outlawed marijuana in response to the number of Mexican immigrants coming to the U.S. because residents of the U.S. associated the recreational use of marijuana with these immigrants. As unemployment rose during the Great Depression, so did the public’s fear and resentment toward newcomers. In response to this “Marijuana Menace,” by 1931, 29 states had outlawed marijuana. Shortly after, the federal government passed the Marihuana Tax Act of 1937 and effectively criminalized marijuana.

The U.S. paused its prohibition against marijuana during World War II when it launched the Hemp for Victory program to encourage hemp farming to assist with producing wartime supplies for U.S. troops. The federal government reversed course again when Congress set mandatory sentences for drug-related offenses, including marijuana with the passage of the Boggs Act in 1952 and the Narcotics Control Act in 1956. Then in 1970, mainly in response to the anti-Vietnam War counterculture movement of the 1960s, Congress passed the Controlled Substances Act (CSA), which lists marijuana as a Schedule I drug outlawing it for any use. Today, but for limited circumstances, the cultivation and sale of marijuana or marijuana-derived products remain illegal under federal law.

Nevertheless, after fighting a failed “war on drugs” for decades, the public’s perception of marijuana has shifted. A recent poll conducted by SICPA reported that 78% of Americans believe cannabis should be legalized federally. Currently, 37 states, three territories, and Washington D.C. have legalized marijuana in some form, while 19 of these states have also legalized marijuana for adult use. Today’s state-by-state patchwork of rules and regulations has emerged against the background of U.S. marijuana prohibition.

The approach California has taken to legalize cannabis is an example of how ineffective regulation adversely affects a new market and how over-regulation furthers the growth of an illicit market. When California launched its adult-use market in 2018, licensees were required to obtain approval from state and local regulators. Since the costs associated with successfully navigating the bureaucratic red tape were high and the process lengthy, most of the legacy market participants simply closed or relocated operations. Legal operators emerged but faced escalating operational costs and taxes, and the higher costs have been passed on to consumers. However, many California consumers stayed loyal to their illicit market suppliers, which do not have to worry about running afoul of new cannabis laws because the legal risks for doing so are limited and largely inconsequential. Some analysts believe that California’s illicit market is almost double the legal market, and license holders complying with the regulations have little hope that change is on the horizon.

Taking a different approach: New York
As New York prepares to launch its adult-use cannabis program, industry participants are watching to see if its regulatory structure, which requires the incorporation of the legacy market from the start, will make a meaningful difference. The Marijuana Regulation & Taxation Act (MRTA) legalized up to 3 ounces of cannabis and up to 24 grams of cannabis concentrate for personal use. The maximum fine for unlawful cannabis possession is $125.00.

The MRTA seeks to eliminate its illicit cannabis market, in part, by incentivizing participation in the new market by those disproportionately affected by cannabis prohibition, including those who have been cultivating and selling cannabis illegally. In support of reaching its goal of issuing 50% of new licenses to social equity applicants, legislators included provisions within the MRTA that mandated the establishment of the Cannabis Control Board (CCB). The CCB is tasked with overseeing a social and economic equity plan that, among other things, creates an incubator program to encourage legacy participants to apply for licensure.
Additionally, New York created a Social Equity Cannabis Investment Fund that is a public-private limited partnership aiming to help finance up to 150 conditional adult-use dispensaries in New York. This funding may help minimize the barriers to entry into the legal market and help illicit operators obtain licenses by connecting them with the necessary capital to obtain licensing and commence operations.

Despite its efforts, New York continues to have a robust legacy market. Like in California, consumers can easily obtain lower-priced cannabis from unlicensed retailers without either having consequences for doing so. And despite cannabis possession being decriminalized, selling it without a license remains illegal; however, until the legal market sales begin, unlicensed operators continue to take advantage of the transitional period. In response, regulators have hesitated to crack down on these businesses because New York wants illegal market participants to become legal operators. Instead, the Office of Cannabis Management has been sending cease and desist letters to organizations selling cannabis and cannabis-derived products illegally and warning offenders that they may be ineligible for a license to operate legally if they continue to sell unlicensed cannabis products.

In the meantime, New York does not anticipate that legal adult-use sales will begin until mid-2023, substantially later than initially anticipated. Only the Conditional Adult-Use Retail Dispensary Regulations have been issued, and without a comprehensive set of rules, prospective operators face difficulties finding investors and capital to begin and sustain operations.
Moreover, until the cannabis industry (illicit and license operators) can review the rules, it is difficult to assess whether the regulations will be effective in creating a system that encourages legal entrepreneurship while protecting the health and safety of consumers and the communities in which they live.

But hopefully, New York’s approach will make sense to those currently engaged in unlawful cannabis activities and provide the impetus needed to move from illegal operations to compliant businesses. This type of regulatory framework would cost less to comply with for all participants.

In conclusion
As with most aspects of the cannabis industry, finding the right balance of legislation and enforcement will take time. But with new markets coming online all the time, there will be increasing opportunities to learn from one another’s successes and challenges, and eventually best practices for enticing illicit operators (and their customers) into the legal market will be found.

In the meantime, licensed businesses should continue to watch their relevant jurisdictions closely, and implement automated compliance solutions like those created by Simplifya in order to reduce the burdens associated with complying with complex and changing cannabis regulations. Simplifya’s tools are a critical component of compliance plans built by trusted advisors and they make complying in today’s environment easier and more cost-effective.

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