Weeding out gray market cannabis operators presents special challenges for states

March 8, 2023 – Efforts to legalize adult-use and medical cannabis do not show sign of slowing up, with nearly 39 states having legalized cannabis in some capacity (and 21 states and the District of Columbia now allowing adult-use). Legalization efforts usually rely, at least in part, on the promise of tax revenue which (in many states) results in higher prices than what the black (or “gray”) market provides. The proliferation of that illicit market of unlicensed operators is also the result of decriminalization of many cannabis related offenses and, in states like New York, previous participants in that market are at the front of the line for social-equity related licenses.

This, unfortunately, sets up legal operators for failure in some states (as has been amply demonstrated in California, which allowed the illicit market to proliferate for over a decade). Understandably, most states are loath to engage in a “War on Drugs 2.0” by using the police to crack down on the operators of stores selling illicit (and untaxed) cannabis.

This dynamic is complicated by the fact that unregulated cannabis sales also pose significant concerns relating to consumer health and safety, as cannabis sold on the gray market is not subject to the same stringent testing requirements as cannabis sold under state laws and regulations. Indeed, cannabis sold on the gray market is not subject to any testing or regulatory requirements at all, raising the risk of contamination and other harmful side effects.

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States are therefore in the untenable position of trying to snuff out the gray market without re-incarcerating the very same individuals that their social equity initiatives are supposed to protect. In this article, we focus on some of the tactics that have been employed by states and regulators to weed out the gray market (with various degrees of success).

New York

Although New York legalized recreational cannabis nearly two years ago, regulators have been slow to issue dispensary licenses in the state. This was part of a conscious choice to prioritize the issuance of Conditional Adult-Use Retail Dispensary (“CUARD”) licenses to justice involved individuals impacted by the war on drugs. The first of those licenses was not issued until November of 2022 and, as it stands, the Empire State has approved a total of 66 retail dispensary licenses, but only three are currently open for business (and are all located in Manhattan).

The delayed launch of New York’s legal cannabis market, during a period when enforcement of existing laws relating to cannabis was relaxed, provided ample opportunity for gray market operators to proliferate throughout the state, eating up valuable market share. In New York City, for example, unlicensed cannabis shops have popped up all over the city, operating openly to serve the multibillion-dollar cannabis economy, in the form of both trucks and storefronts (often masquerading as “vape” shops).

Initially, New York’s response to unlicensed retailers focused primarily on issuing fines and impounding weed trucks for parking tickets or food vending violations. In first few months of 2022, the Office of Cannabis Management, the regulator established under state law, sent out cease-and-desist letters to dozens of unlicensed sellers, warning that they were not operating within the law.

The letters also warned sellers that failure to cease operations could render them ineligible to obtain licenses in the future and result in substantial fines as well as criminal penalties. When this did not have the desired effect, the state began to crack down more forcefully, impounding a fleet of trucks in September and raiding several unlicensed shops. The efforts intensified as New York prepared to open its first legal dispensaries.

Then, in February of this year, New York City announced that it would be taking a new approach. On Feb. 7, 2023, the Manhattan District Attorney’s Office sent more than 400 letters to known gray market sellers warning that the city was prepared to use New York’s Real Property Actions and Proceedings Law (RPAPL) to force their landlords to evict them.

In the coming months, the DA’s office will join efforts with the Mayor’s office to continue the crackdown on the city’s gray market sellers by identifying evidence of unlicensed cannabis sales and then notifying landlords of their requirement, under RPAPL, to begin eviction proceedings. If a landlord fails to commence an application for eviction within five days of receiving written notice or if, after making the application, the landlord fails to diligently prosecute the eviction, then the DA’s office will have full authority to directly intervene and bring its own proceeding against the tenant.

In addition, New York City has recently initiated public nuisance lawsuits against the landlords of four Manhattan properties where it is alleged unlicensed sales of cannabis to underage customers have taken place. Officials, invoking a New York City law that declares any property where unlicensed business is taking place to be a public nuisance, are seeking penalties of $1,000 per day that the landlords allowed the unlicensed sale of marijuana to take place.

California and Canada

New York, like other jurisdictions, made a judgment that it is more palatable to go after landlords, as opposed to operators (many of whom would be eligible to obtain CUARD licenses under different circumstances). New York City was not the first to try this tactic.

In 2019, California’s Bureau of Cannabis Control (BCC) sent hundreds of letters to landlords in the state notifying them that the BCC had reason to believe their property was being used for illegal cannabis activity. The letters warned that landlords may be subject to criminal and civil penalties, including the imposition of fines of up to $30,000 per day, for allowing such activities to occur on their properties.

Similarly, the city of Sacramento has gone after property owners for illegal cannabis cultivation on their properties by tenants. According to one report, from a National Public Radio affiliate, between August 2017 and September 2019, the city charged property owners roughly $94 million in administrative penalties for their tenant’s illegal cannabis cultivation. Sacramento’s approach resulted in a flurry of legal challenges, ultimately pushing the city to make a series of changes to its cannabis enforcement program.

In late 2019, it softened a controversial ordinance holding landlords liable for illegal cannabis grows, even if they had no knowledge of the illegal activity. Sacramento made further concessions in a recent settlement with a property owner who sued the city after being charged $137,000 for a tenant’s illegal cannabis cultivation. The city agreed, among other things, to make substantial changes to its enforcement program, including requiring the city to give a warning before issuing a fine, allowing property owners 30 days to correct any violations. Wang v. City of Sacramento Police Department (Court of Appeal, Third District, Calif. 2021).

Similar tactics are also being tested outside the United States. In news from Canada, for example, a landlord was recently convicted on provincial charges for leasing space to a chain of unlicensed cannabis dispensaries, called CAFE, that have been operating openly across the city of Toronto for six years. “CAFÉ landlord convicted on appeal in Toronto illegal pot-shop case,” CBC News, Canada, Jan. 25, 2023.

Regulators are expected to continue to refine their approaches and test new strategies to clamp down on unregulated cannabis sales in their states. And while regulators and state officials are still figuring out the most effective strategies for weeding out gray market operators, at least one thing is clear: States are serious about reining in this market.

Alex Malyshev and Sarah Ganley are regular, joint contributing columnists on legal issues in the cannabis industry for Reuters Legal News and Westlaw Today.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Alex Malyshev

Alex Malyshev is a partner at Carter Ledyard & Milburn LLP and the chair of its cannabis, hemp and CBD industry group. He contributed the chapter, “Banking and Investment Considerations for Cannabis Businesses” in “Health Care and the Business of Cannabis: Legal Questions and Answers” (American Health Law Association 2021). He can be reached at malyshev@clm.com.

Sarah Ganley

Sarah Ganley is an associate in the Litigation Department of the Carter Ledyard & Milburn LLP. She is based in New York and can be reached at ganley@clm.com.

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