Few industries promise rapid growth equal to that of the cannabis industry, with one study projecting the industry could reach $30 billion in annual sales by 2025. This growth continues to accelerate as more states legalize cannabis for medical or adult use. But until federal cannabis laws are reformed, the illegality of cannabis at the federal level could render all contracts associated with cannabis – whether they govern insurance, banking, consulting, leasing, etc. – unenforceable.

It is a basic tenet of contract law that a contract that requires a party to perform an illegal activity is unenforceable. After experiencing buyer’s remorse, some cannabis companies and their vendors have used this “illegality” defense as a sword to avoid the enforcement of cannabis-related contracts. Whether cannabis’s federal illegality renders a particular cannabis contract unenforceable turns on several factors: state law differences in the illegality defense, the language of the specific state statute providing for legalization, or whether the conduct was illegal at the time of contract formation even if that conduct has since been legalized under state law. Although the answer may not always be clear cut, anticipating these issues on the front end can prevent serious heartburn down the road.

This article analyzes how several courts have addressed the illegality defense as applied to cannabis contracts and provides key considerations for cannabis industry participants to help ensure their contracts are enforceable.

Insurance Coverage

We have previously discussed how the illegality of cannabis on the federal level resulted in denial of commercial insurance coverage to the tune of $500,000 even though medicinal cannabis was legal in the state where the conduct occurred (Michigan). To recap, the Sixth Circuit held that an insurance company properly denied coverage because the insured sought to recover for property damage caused by a cannabis tenant and the insurance policy specifically excluded “loss or damage caused by [any] [d]ishonest or criminal act” of the insured or its agents.

Similarly, in Tracy v. USAA Cas. Ins. Co., an insurance company denied a homeowner’s claim for stolen marijuana plants, even though Hawaii law allowed individuals to grow marijuana for medical purposes. The federal district court in Hawaii held the insurance company did not breach the insurance contract by denying the homeowner’s claim. While the loss of the plants was a “covered loss” under the policy, the court explained that the policy provision was unenforceable because “requir[ing] the [insurer] to pay insurance proceeds for the replacement of medical marijuana plants would be contrary to federal law and public policy.”

Loan Agreements

In Bart St. III v. ACC Enterprises, LLC, Bart Street III loaned $4.7 million to ACC Enterprises to fund its cannabis business. ACC Enterprises defaulted on the loan, and Bart Street III filed suit for unjust enrichment and breach of contract. Although the contract specifically stated that it was governed by Nevada law, under which cannabis is legal, the court held that portions of the loan agreement were unenforceable because cannabis was illegal under federal law. While the court did not decide whether the illegal sections of the contract made the entire contract illegal, it did hold that Bart Street III could not recover for unjust enrichment because the contract involved “moral turpitude.” In a grim warning to cannabis lenders and investors, the court held that any lender or investor who seeks to profit from the “cultivation, possession, and sale of marijuana” is part of a “conspiracy to cultivate marijuana.”

Lease Agreements

J. Lilly, LLC v. Clearspan Fabric Structures involved a contractual dispute between Clearspan, a lessor of commercial greenhouse equipment, and J. Lilly, a licensed cannabis company in Oregon. After Clearspan failed to correct numerous defects that J. Lilly claimed hindered its ability to cultivate cannabis, J. Lilly filed suit and sought $5.4 million in lost profits. Although neither party asserted an illegality defense to enforcement of the contract, the court raised the argument on its own and ultimately held that it could not award damages to J. Lilly because doing so would be akin to ordering Clearspan to violate federal law.

Considerations

These cases should serve as a cautionary tale to cannabis industry participants who, like all sophisticated businesses, enter into a contract in reliance on the contract’s enforceability should a dispute arise. Fortunately, there are steps contracting parties can take to reduce the risk that the non-performing party under a cannabis contract can successfully assert the illegality defense to avoid its contractual obligations:

  • Monitor State Law Dictating Public Policy Preferences on Cannabis. A handful of states have enacted legislation in an attempt to protect commercial contracts from the issues discussed above.
  • Choice of Law Provisions. Contracting parties can include a choice of law provision stating that the contract is governed by the law of a state with favorable cannabis laws, like California. For such a provision to be enforceable, there must be some nexus between the contracting parties and the chosen state. To create such a nexus, one of the parties might consider incorporating the contracting entity in the chosen state.
  • Contractual Provisions Preventing Removal. Contracting parties can include a forum selection clause to keep any disputes arising under the contract in state courts, rather than federal courts, which have been more inclined to refuse to enforce cannabis contracts on the basis of illegality. Such forum selection clauses should identify a specific state court that will hear any dispute arising under the contract, state that the parties consent to personal jurisdiction in that court, and state that the parties waive their right to remove to federal court litigation filed in the chosen state court.
  • Alternative Dispute Resolution. Contracting parties can consider avoiding courts altogether by requiring that contractual disputes be resolved in arbitration. Because there is generally no appellate review of arbitration decisions absent evidence of fraud, partiality, or material misconduct, arbitrators may be more likely to consider equitable principles in enforcing the parties’ agreement, as opposed to strictly applying federal preemption or illegality principles that could produce harsh results.
  • Status of State Law on Date of Contract Formation. In some states, the enforceability of cannabis contracts could be dependent on the status of state law on the date the contract becomes effective. For example, in Metsch v. Heinowitz, the parties entered into various contracts to produce edibles for the medical marijuana industry. After the relationship began to deteriorate, litigation ensued. The trial court entered summary judgment in favor of the defendants on grounds of illegality, and the California Court of Appeals affirmed. In its order of affirmance, the appellate court noted that courts in California should look to the legality of the contract at the time of the formation; if the underlying substance of the contract was illegal when formed, it is invalid even if the conduct becomes legal when the parties seek to enforce their rights under the contract.

Although the prospects of federal cannabis reform have increased, with Vice President Kamala Harris outright promising that the Biden-Harris administration “will decriminalize marijuana,” meaningful reform could take some time. Until then, cannabis companies and the vendors that serve them must remain vigilant to decrease the risk that their contractual counterparties can avoid their obligations through the illegality defense.