As anticipated, the U.S. Court of Appeals for the Sixth Circuit’s recent decision in K.V.G. Properties, Inc. v. Westfield Insurance Company, No. 17-2421 (Aug. 21, 2018), is unlikely to negatively affect the legitimate U.S. cannabis industry. Although, the Sixth Circuit held that the "Dishonest or Criminal Acts Exclusion" in “a standard first-party commercial insurance contract” precluded coverage for damage to a policyholder’s property caused by tenants “growing marijuana in their rental units,” the court’s conclusion was premised on the fact that the tenants’ acts were illegal under both federal and state law. In other words, the tenants were not authorized by the state (in this case, Michigan) to grow marijuana.

At the same time, though, the Sixth Circuit also indicated that its holding might have been different had the tenants been acting in compliance with state law. “Under different circumstances,” the federal appellate court stated, the policyholder/landlord “might have a strong federalism argument in favor of coverage.” Although the court’s discussion in this regard may be considered dicta, it is still noteworthy. Analytically sound, it suggests that an insurance policy’s “Dishonest or Criminal Acts Exclusion” may not preclude insurance coverage for losses experienced by cannabis-related businesses acting in compliance with applicable state law. For the cannabis industry, this analysis is the most important takeaway from the Sixth Circuit’s recent decision.

At issue in K.V.G. was a landlord’s claim for insurance coverage for damage caused to its rental property by its tenants. As the Sixth Circuit explained, “a commercial landlord leased several pieces of real property to a group of commercial tenants. [The landlord] authorized the tenants to use the property for general office or light industrial business.” Unbeknown to the landlord, however, the tenants used the property to grow marijuana. The tenants’ operations caused extensive damage to the units. “To accommodate their ‘business,’” the Sixth Circuit explained, “the tenants removed walls, cut holes in the roof, altered ductwork, and severely damaged the HVAC systems.”

The landlord, in turn, “filed a claim with [its insurer] for insurance coverage.” The insurer denied the claim, relying, in relevant part, on the "Dishonest or Criminal Acts Exclusion" in the landlord’s Building and Personal Property Coverage Form. That exclusion states that the insurer “‘will not pay for loss or damage caused by or resulting from’ any ‘[d]ishonest or criminal act by you, any of your partners, members, officers, managers, employees …, directors, trustees, authorized representatives or anyone to whom your entrust the property for any purpose’.”

On the basis of that exclusion as well as other policy language, the U.S. District Court for the Eastern District of Michigan found that the landlord was not entitled to coverage and granted the insurer summary judgment.

The Sixth Circuit affirmed. After finding that the relevant insuring agreements provided coverage, that court considered “whether the risks here are not covered because an exclusion takes them off the table.” Here, the appellate court focused on the "Dishonest or Criminal Acts Exclusion." “Under this exception,” it explained, “the core issue is whether the tenants committed a ‘criminal act’ within the meaning of the policy.” It had little trouble concluding that the tenants had in fact committed such an act. Indeed, the Sixth Circuit concluded that “no reasonable jury could find that [the] tenants complied with Michigan law.” The court even observed that, during eviction proceedings, the landlord “itself claimed, in Michigan court, that its tenants violated the law.” In other words, even though Michigan had legalized medical marijuana, the tenants were not in compliance with the Michigan Medical Marihuana Act. Accordingly the appellate court concluded that “[t]he policy’s insuring agreements cover the damage here, but … the Dishonest or Criminal Acts Exclusion applies.” As such, the policyholder was not entitled to insurance coverage for the damage done to its rental units.

The Sixth Circuit’s holding clearly turned on the fact that the tenants were not acting in compliance with state law. Had they been, the outcome in K.V.G. could have been different. In identifying the key question before it – “whether the tenants committed a ‘criminal act’ within the meaning of the policy” – the appellate court was quick to observe that: “In the abstract, this is an interesting question.” The court continued: “Cultivating marijuana is a crime under federal law … but it is protected by Michigan law under certain conditions” (internal citations omitted). As such, the court observed that: “Under different circumstances, [the policyholder] might have a strong federalism argument in favor of coverage.” 

Notably, the Sixth Circuit then stated:

In diversity cases, we act as faithful agents of the state courts and the state legislature … Since the [Michigan Medical Marihuana Act] was passed by ballot initiative, we would exercise even more care, lest we (as unelected judges) tread directly on the will of the People of the State of Michigan, who cannot easily correct any error we commit. Exercising the Michigan courts’ common-law power to interpret public initiatives, we would hesitate before reading a Michigan insurance policy to bar coverage for a “criminal act” when Michigan law confers criminal and civil immunity for the conduct at issue … But we need not face that difficult issue today, because no reasonable jury could find that [the] tenants complied with Michigan law (internal citations omitted).

Although the Sixth Circuit did not reach the question of whether the "Dishonest or Criminal Acts Exclusion" would have barred coverage had the tenants been acting in compliance with state law, the court at least suggests that the outcome could have been different in those circumstances. And, for good reason. The court observed that, in such circumstances, the policyholder “might have a strong federalism argument in favor of coverage” and that the court “would hesitate before reading [an] insurance policy to bar coverage for a ‘criminal act’ when [applicable state] law confers criminal and civil immunity for the conduct at issue.” It offered these observations even after acknowledging that “[c]ultivating marijuana is a crime under federal law.” In other words, the court indicated an uneasiness in labelling an act authorized by state law to be criminal, regardless of a federal prohibition on the act.

These same arguments and concerns would exist if the policyholder was the cannabis-related business itself (as opposed to, for example, a general commercial landlord renting space to a cannabis-related business). As such, the Sixth Circuit’s decision in K.V.G. can be read at least to suggest that an insurer should not be able to invoke the "Dishonest or Criminal Acts Exclusion" to deny insurance coverage to a cannabis-related business compliant with state law just because cannabis is still illegal under federal law. While the Sixth Circuit or another court ultimately will need to squarely address that issue, the Sixth Circuit’s analysis in K.V.G. is certainly persuasive and hopefully a harbinger of good decisions to come.

Client Alert 2018-178