Tenant’s Use – Illegal or Not?

by K&L Gates LLP
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Impact on lease provisions of state laws allowing marijuana cultivation and distribution.

The State of California was a pioneer in legalizing the use, distribution, and cultivation of marijuana in varying forms. In recent years, 20 states have followed suit. As of the date of this alert, Colorado and Washington have legalized marijuana use, while 18 other states permit the use of marijuana for medicinal purposes. However, the growing, distribution, or possession of marijuana is a federal crime throughout the United States regardless of state laws.

Until recently, there was little guidance on how the conflict between state and federal law would play out. A memorandum from James M. Cole, Deputy Attorney General of the United States, dated August 29, 2013 (the “Memorandum”), offers some guidance on this issue. The Memorandum clarifies prosecutorial priorities by stating that the federal government will rely on state and local law enforcement to “address marijuana activity through enforcement of their own narcotics laws.”[1] One thing remains clear – the cultivation, distribution and possession of marijuana remains illegal under federal law regardless of state law provisions.

So, what happens if an entity or person, permitted under applicable state law to engage in the cultivation, distribution, or possession of marijuana, is leasing space in a building for such purposes? This scenario sheds a completely different light on some “boiler plate” lease provisions, which are usually very modestly negotiated, such as compliance with all laws, insurance, and subordination provisions. In this alert, we will flesh out some of the issues presented by these otherwise standard, non-controversial provisions in the context of leases for marijuana cultivation and distribution facilities.

A. Compliance with Law Provisions

Commercial leases almost uniformly contain a “compliance with laws” provision similar to the one quoted below with little or no resistance or negotiation from either party:/.

Tenant, at its sole cost and expense, shall comply with all federal, state, county, municipal, and other governmental statutes, laws, rules, orders, and regulations affecting Tenant’s use of the Premises.

Clearly, in the context of a lease of a facility for marijuana cultivation or distribution, the tenant’s use will not comply with federal law. The tenant should insist on removing the federal law compliance covenant completely, or otherwise it will find itself in a precarious default situation from the date it takes possession of the premises.

Should the landlord comfortably rely on the Memorandum and other memoranda issued by U.S. Attorneys, which state that federal prosecutors “ought not devote scarce resources to the prosecution of [medical marijuana] program participants”?[2] What happens if the U.S. Department of Justice at any time in the future changes its position on enforcement or a regional U.S. Attorney exercises his or her discretion more aggressively than contemplated in such memoranda? At a minimum, the landlord needs to be assured that the tenant’s use will comply with state law regarding medical marijuana licensing, use, and operation, especially since the Department of Justice’s no-enforcement statement is qualified by the fact that the program participant has to demonstrate a “clear and unambiguous compliance” with state law.[3] Additionally, if the Department of Justice subsequently changes its policy and pursues criminal prosecution of medical marijuana tenants, the landlord needs to make sure that it can terminate the lease. 

Accordingly, neither the landlord nor the tenant should overlook the federal law compliance language in the lease. Both the landlord and the tenant need sufficient remedies in the lease to safeguard their respective interests against a future federal policy change. In such case, the landlord needs to protect itself against criminal prosecution and extricate itself from the tenant’s operations to avoid incurring accomplice liability; and the tenant needs to avoid incurring indemnity and damage obligations vis-à-vis the landlord while defending itself against potential criminal prosecution.

B. Insurance Provisions

Tenants often are asked to agree to the following insurance requirement:

Tenant shall keep in force fire and extended coverage insurance for the full replacement value of Tenant’s improvements and Tenant’s property, including, but not limited to, inventory, trade fixtures, furnishings, and other personal property.”

A tenant under a marijuana facility lease who agrees to the above provision without any modification will likely find itself in default under the lease if it is not able to obtain insurance for its marijuana inventory, which is an illegal controlled substance under federal law. Accordingly, appropriate changes need to be made to the lease, and the tenant may either insure its inventory under a self-insurance program or carry the risk of loss. The tenant may not be the only party struggling with insurance issues in these types of leases, however. The landlord should inquire with its insurance company in advance to ascertain whether the proposed use will adversely affect the property insurance for the building, either through increased insurance premiums or cancellation of the insurance policy.

C. Subordination and Non-Disturbance Provision

As any sophisticated tenant knows, it is critical to obtain a non-disturbance assurance from the landlord’s existing lender and from any future lender to the landlord. No tenant wants to be evicted from its premises if the landlord’s lender forecloses on the property without the necessary non-disturbance assurances in place for the tenant’s benefit. However, this sound practice becomes substantially more challenging and complicated when the lease contemplates a use that is illegal under federal law, such as the cultivation, distribution or possession of marijuana. A request for a subordination and non-disturbance agreement (SNDA) is likely to become a significant obstacle for the lease transaction and may potentially kill the deal, as a federally insured and regulated lender may object to a use of the property that is illegal under federal law.  A tenant in such circumstances needs to assess the potential risks of losing the lease transaction up front or losing the facility in the future as a result of a foreclosure of the property.

From the landlord’s perspective, even if the tenant does not ask for an SNDA, it would be prudent for the landlord to inquire with its lender before entering into a lease that permits the tenant to cultivate, distribute, or possess marijuana on the property. Additionally, the loan documents should be reviewed carefully for potential prohibition against such lease transactions. Typically, loan documents will contain provisions such as “Borrower shall cause the property to comply with all laws” or “Borrower shall not permit any violation of laws on the property.” Breach of such covenants usually means a material breach under the loan documents and a possible loan acceleration.

A tenant that cultivates, distributes, or possesses marijuana as part of its business operations also may face practical operating issues (which may or may not have an impact on the lease and the tenant’s relationship with the landlord), such as an inability to open bank accounts in the name of the tenant entity operating the business.

Tenants and landlords who are contemplating entering into leases that permit the tenants to cultivate, distribute, or possess marijuana on the leased property should carefully analyze the underlying legal issues and complexities. We expect that, with time, lease provisions will continue to be tested in light of such tenants’ uses, unless federal law and policy is changed.  Anticipating the various lease issues and drafting carefully to address the intended outcomes and consequences will be extremely important in this context.

[1] See Memorandum for All United States Attorney, dated August 29, 2013, from James M. Cole, Deputy Attorney General of the United States, titled “Guidance Regarding Marijuana Enforcement.

[2] Memorandum for Selected United Stated Attorney Re: Investigations and Prosecutions in States Authorizing the Medical Use of Marijuana, dated October 19, 2009.

[3] Id.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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