The Philip DeFranco Show - MS 1.31 Why California’s Illegal Weed Business Is Bigger Than Ever; Regulations, Taxes, & More

Episode Date: January 31, 2019

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Hello, hello, welcome to your Extra Morning News Show. My name is Philip DeFranco, and I wanna ask you a question. When I say the word prohibition, what comes to mind? Probably alcohol, right? You think early 20th century America. But that word, prohibition, can easily refer to something else. Cannabis, marijuana, weed, pot,

or whatever you wanna call it. Marijuana in the United States is still federally illegal, but if you've been paying attention, states have been taking charge and allowing both recreational and medicinal usage. And in addition to that, we've been seeing more and more big names putting their voice out there in support of it too. And there's a variety here. I mean, you have people like Olivia Wilde, who is

a vocal proponent of the movement. Also people like Mike Tyson, who also started his own cultivation operation out in the Mojave Desert. Now I know at this point you might be thinking, oh, this is just another legalized weed video. No. I mean, for transparency's sake, especially for those of you that are new to me, I am pro-legalization, have been for a very long time since it wasn't as accepted. But what we're talking about today is much bigger and it's about kind of the evolution and the resistance and adoption of it. If you don't know, California has a significantly different and special history with marijuana and it has a very unique market. It is a nationwide supplier. Back before recreational legalization, the California Department of Food and Agriculture actually estimated that growers produced

13.5 million pounds of flour, that's the part you smoke, and Californians only consumed about 2.5 million pounds. So the question is, well, where did the rest go? Well, non-government estimates have pinned California as supplying 60 to 80% of the nation's marijuana. And so the big question that we're looking at now is what happens when the nation's biggest marijuana supplier tries to go legit?

Since recreational sales began back in January 2018, the California cannabis market has seen many changes and lots of sloppiness. Those changes have caused the market to crack in several places, and today we're going to be unpacking what's going on with California cannabis. And to just really, really dive into this, I had Dylan Siegel from the team jump into it. Phil's right. California has had a messy time since legalization and regulation took effect, and it's caused a variety of effects that we're going to discuss in this video. I spoke with a range of stakeholders in the industry, the state government, analytics firms, industry associations, growers, manufacturers, laboratories, distributors, retailers, and not just the licensed ones. Their experience in the industry varied, as did their views about the industry's regulations and where it's going.

Let's start with two things. Why California has had a different relationship with marijuana for decades, and how that clashes with the arrival of government regulation. Let's go back in time and talk about why California has been a unique cannabis state for decades now. From the 1970s to the mid-1990s, there were local and statewide efforts to change the legal status of marijuana. Like in 1972, a California ballot initiative sought to decriminalize possession and sale. It failed. In 1976, the Moscone Act shifted possession of an ounce or less from felony to misdemeanor. In 1979, the city of Berkeley made marijuana crimes the lowest priority for police. And in 1992, the San Francisco Board of Supervisors made a similar statement.

And the next one is a huge part of this story. In 1996, Californians approved Proposition 215, known as the Medical Marijuana Initiative or the Compassionate Use Act. California became the first state to decriminalize marijuana for medical treatment. Then, during the late 2000s, Prop 215 survived major challenges to its authority, like a 2010 state Supreme Court case, the People v. Kelly. And then, in the mid-2010s, we saw the trend of full decriminalization and recreational use take root across the U.S., like in Colorado, Oregon, and Massachusetts. In 2016, California

joined up, passing Prop 64 that decriminalized cannabis and allowed for the expungement of certain marijuana crimes. Sale of recreational cannabis began on January 1st, 2018. But it's not just California's long relationship with the greenery that makes it different than other states. Like Phil mentioned at the top, California is a nationwide supplier of marijuana on the black market. It's also the fifth largest economy in the world, making it a large prospective market. Two cannabis market research firms, BDS Analytics and the Arcview Group, estimated that in 2018, California consumers would spend $9.2 billion on cannabis products, with about $3.7 billion in the legal market. For reference, in 2017, beer sales hit $5 billion in California. Imagine that, a formerly illicit plant competing with a formerly illicit liquid. So, California is a big market with its own unique government relationship with cannabis.

But in order to understand why many have been resistant to regulation, we need to think about what the California cannabis market has been like since medical marijuana was legalized in 1996. It has not been a smooth business to be in, but has operated more or less without government oversight for those two decades, causing a disconnect between government and industry as California moves to legal sales. What did medical cannabis look like on the ground in recent years? It's difficult to sum up with just one example, but let's use a retailer for our purposes. They were sometimes hidden in a nook of a nondescript building to avoid being raided by local authorities. In the shop, tons of products lined glass cases,

but the flour was without packaging. That meant that you were mostly judging the product based on look and smell, rarely on any testing results. These places dealt in cash because most banks wouldn't interact with them. Even with security guards, retailers also faced the danger of robbery or raid because of their gray status and how much cash they received. That sense of casual risk pervaded every level of the industry, from manufacturers to growers to customers. But it worked on its own, and there was a loose infrastructure over how it was supposed to work,

and technically, it was legal. Since 1996, this has been the complexion of the grayest of industries. Medical cannabis was used for ailments as wide-ranging as from chemotherapy and epilepsy to social anxiety. While legal in California, clinics and cooperatives faced pressure from local governments that wanted to drive them out. The risk factor of federal prohibition inflated the price of weed. People continued to be convicted of misdemeanor and felony marijuana crimes, usually at disparate rates based on race. Banks wouldn't touch the business because of its federal status as a Schedule 1 drug next to heroin and LSD, meaning everyone paid in cash. And, crucially, there was little government

oversight and regulation across the industry. In other words, the cannabis industry in California is a two-decade-old, cash-based, multi-billion-dollar industry with its own internal control mechanisms and some of the same risks that accompany hard drug trafficking. They had the backing of a law, but also carried plenty of the shadiness of the black market. And for the last year, as California transitions from an industry-created system to a government-created system, Californians have basically been dealing with three segments of the market. The traditional black market, the gray market where medicinal clinics operate under the protection of Prop 215, and the licensed recreational market, operating under the recently passed Prop 64. But the idea is to have everything under the new law, not this fractured

multi-stream system. According to many of the operators in this industry that I spoke with, the transition has been messy, and there's quite a bit of frustration with some of the regulatory hurdles. So let's talk a bit about how licensing works in the state, because it's important to understanding where the disconnect between the industry's operators and the government begins. Let's say you're someone on the supply chain, a grower, manufacturer, distributor, testing laboratory, or retailer. You need some form of approval from your local government. Some localities are pretty informal about the process, while others require an official application and fee, and others even have a lottery system. And don't forget, there

are often lots of zoning requirements, like proximity to a school. Say you've got your local approval, great. Next step is the state government. Depending on your business type, you'll be applying to different agencies for approval. Laboratories, retailers, and distributors go to the Bureau of Cannabis Control and the Department of Consumer Affairs. Manufacturers go to the Manufactured Cannabis Safety Branch and the California Department of Public Health. Growers go to CalCannabis and the California Department of Food and Agriculture. And yes, there is an application and fee. But there are two major hiccups with the licensing system that are not meshing with the industry's own structure. Local control and business structure. Reports indicated that local governments have been very slow to create their own licensing

structure, which you need for a state license. According to the California Cannabis Industry Association, at the end of 2018, less than 20% of cities in California allowed retail cannabis businesses. So, that means that if a city outlaws retailers in their city, many already existing cannabis businesses may continue to operate as medicinal operators and, in turn, not adopt the state regulations. There's another hiccup with the licensing system, how it interacts with business structure. Remember how there are multiple licenses? Many of these cannabis operators are going to want to hold multiple licenses

if they want their operation to stay the same. Tamara Meritz, the California Regional Director of BDS Analytics, a cannabis market analytics firm, described this. The thing about a grower who's used to just like selling in bulk, all of a sudden, you know, it's required to be tested before it gets to retailer shelves, right, and packaged before it gets to retailer shelves. So they have to go through a third-party distributor to do all that for them because they don't have any of those capabilities themselves.

Or they have to develop those capabilities themselves and get a distribution license, right? I mean, these are, and you don't think about it. A lot of people from the outside, they don't think about those small day-to-day details. And boom, your operation just got way more complex. And every bit of that costs money, time, and you need to do it right to be in compliance or face penalties. And the

industry operators I spoke with described a painful process. The net result of taxes and regulation combined with California's unique history is that the industry is fracturing into different segments and the black market is picking up steam again. Here's why. Let's start with taxes. According to the California Department of Tax and Fee Administration, there is a 15% excise tax on recreational sales at the retail level. There's also a cultivator's tax that differs depending on the stage and physical state of cannabis. To put it simply, say you sell a pound of weed, which is hovering around $1,100 on average right now. You're going to pay $148 in taxes on that $1,100, or about 13%. But wait,

there's even more. Did you forget traditional sales tax? That ranges from 7.25% to 10.25% in California. And yes, localities want to cut too, at least the ones that allow cannabis. Reports indicated that some cities tax by sales, others by square footage, and some by flat fees. So yeah, this isn't walking to your guy to pick up a 20. It's a 20 with excise tax, cultivators tax built in, a sales tax, and maybe some other built-in tax from the city you're in. And who do you think takes on these new costs? It's usually the consumer. Most everyone I spoke with described the cannabis taxes as excessive in some way. Morgan Fox, the media relations director of the National Cannabis Industry Association,

expressed some caution. And I think it's very dangerous to set the tax rates too high initially because, I mean, once you set a tax rate anywhere in any state or federal code, it's really difficult to get politicians to wean themselves off of that tax money and decrease those taxes. And one black market boutique grower described it in more harsh terms. It's just as if they think it's a gold rush and we're the victims, the end users and the growers and the people in the industry. However, recent reports indicate

that there's a bill in the California Assembly to temporarily reduce marijuana taxes. Still, there's a million dollar question hidden in there. Does this contribute to the black market? We're going to return to that one in a bit, because taxes aren't the only aspect of that picture. The other large aspect of this picture is what regulations businesses must follow. Let's go there next. California's regulation scheme for cannabis is pretty nuanced. Like we mentioned, the industry is governed by three agencies of the state government. Those three

agencies have released three rounds of regulations so far. The first set of what they called emergency regulations were released in late 2017. They allowed for a kind of grace period on many fronts until July 1st. The second set of emergency regulations, released in May 2018, overrode the first set. And most recently, the proposed set of permanent regulations, released in December 2018, were approved as the law of the land. So, why does that matter? The proposed regulations number 160 pages right now, for just the the law of the land. So, why does that matter? The proposed regulations number 160 pages right now for just the Bureau of Cannabis Control. The Departments of Food and Agriculture and Public Health have regulations totaling 80 and 138 pages respectively. And it's not like these rules were undergoing simple grammatical changes. They received substantive

critiques and changes that business owners needed to adapt to. Alex Traverso, Assistant Chief of Communications at the Bureau of Cannabis Control, the main regulatory agency for weed in California, described an inclusive process to get there. What we tried to do was before, rather than just saying, hey, here's your rules, you know, follow them. We had a series of public meetings around the state, informational sessions to let people know kind of what's going on,

invited them to come out, basically said, hey, look, you guys have been involved in this industry. You know cannabis better than anybody. We want your opinion on what the rules are going to be and if you think things are going to work or they're not going to work. When we first issued our proposed final regulations, that was in July. We had a 45-day comment period. Over the course of that period, I want to say we got close to 7,000 comments. And then during this recent 15-day period, we got another 4,000. For each round of regulation and revision, the government also issues a slew of documents that explains why they changed parts of the regulation. The government's latest statement of reasons for changes to the regulations is a 1,078-page document. Clearly,

they're not making changes without serious consideration. But what does everyone think about regulation? These are what many people described as the biggest regulatory hurdles, laboratory testing and packaging. Laboratory testing is mandatory for anything that hits the shelves. That makes it a threshold that any producer must pass through. We visited a Southern California laboratory, Canalysis, where we spoke to Shwetha Kaul, their chief scientific officer and a member of the California Cannabis Industry Association's board. Cannabis is very, it's a very interesting material. It's a biological material that is also a pharmaceutical.

So unfortunately for testing, you have this conundrum of, do you test it like how we test fruits and vegetables, or do we test it as a pharmaceutical? Because it's kind of both. And additionally, it's more complex than both. And in California, labs are required to test for a number of things. So we have cannabinoids, terpenes, we have to test for pesticides, we have to test for mycotoxins in phase three, We have to test for residual solvents. We have to test for all the microbial contaminations. And this is not even, we haven't even touched the surface of, you know, heavy metals, obviously, but there's also a lot of physical tests we have to do. So you have to test for foreign and filth, which means that you have to make sure, according to

the regs, this is actually in the regs, we have to make sure there isn't a single rodent hair. It is a lot of testing. And it was a lot of testing that got flipped on in a single switch. While testing is a required process in the industry, as of November 2018, the most common reason that products were rejected at the testing level was not for impurities,

but because of inaccurate labeling. There is certainly a sense that these regulations are not all the most scientifically informed. Being part of the testing lab, there's a lot of regulations that are just don't make sense scientifically that we've tried to argue against and maybe not successfully explained where we're coming from. But cannabis is a very complex matrix and there's a lot of analytical challenges involved in testing for it. What does this all mean? Well, testing isn't cheap, and it's another burden, a particularly complex one, on producers. And it's likely having the effect of keeping people away from the regulated market. Let's talk about the other big hurdle,

packaging. Jared Kylo, president of the United Cannabis Business Association and owner of the Higher Path, a state-licensed Los Angeles dispensary, summed it up. And people invest a lot of money. I mean, at first it was the July 1st created childproof packaging for everything. So people invested, you know, $20,000 to $50,000 on a designer to design the package, hundreds of thousands of dollars to buy packaging in bulk so you could get volume discounts, just to have three months later to tell them, oh yeah, all that work and money and time you put into childproof packaging. Yeah, you don't need it anymore. Well, it's like they keep doing that.

And I think people are at this point now of like whiplash is expensive. Every time you turn and try to adapt to what they say the regulations are going to be and they say, do you have to comply with these regulations today? And then they change their mind. Well, people spend a lot more money. And these are the added costs they keep putting on this industry that are unaffordable. Like Jared explained, the child-resistant packaging requirement for manufacturers has essentially been stricken from regulations until 2020. And these are not little changes. They're expensive, long-term manufacturing decisions that change the way products are

packaged. That, in turn, causes fluctuations for the retailer's prices and consumers' buying behavior. Like many industries, there is a line between safety and over-regulation, and many industry stakeholders that we spoke with believe that line has been crossed. On the other hand, nearly every person agreed that regulation was important, whether for quality control, a safe product, or even investment. Even those who spoke to us anonymously agreed that some sort of regulation is necessary. That's a lot of detail, so let's put the pieces back together, and thanks for sticking around this long. Like we mentioned, you've got an industry that has gone unregulated for decades, and is very difficult to get into because some localities won't even

license operators. As we discussed, there are very high taxes, with seemingly everyone wanting a bite out of an industry they believe is flooded with cash. The regulations are another barrier, placing many new rules on producers, both big and small. And it's all supposed to work after less than a year? All of these changes, and burdens, combined, are contributing to a fracture of the California cannabis market, where it's not entirely clear who is legit. You've got licensed operators trying to keep up with numerous burdens, the operators in a gray zone without a license still working under the guise of some medical marijuana protections, and the black market. But in the eyes of the law, if you're operating without a license, you're a black market operator. Same as the corner man. So suddenly, many of the

people who are operating with protection from the state government but can't or won't adapt to these regulations close their doors or they continue in the black market. So, what does that mean? leaving the kiddie pool. Whatever groceries your summer calls for, Instacart has you covered. Download the Instacart app and enjoy $0 delivery fees on your first three orders. Service fees, exclusions, and terms apply. Instacart, groceries that over-deliver. The general assumption is legality leads to a reduction in black market, right? Now, while that is true, it is a bit of uh you know a balance curve right where if you have too much uh regulation it actually increases the black market over

regulation now i don't want to tell the state in california that they're over regulating but i do want to say the black market has gone up remember how we mentioned that somewhere from 60 to 80 percent of the nation's cannabis comes from California? If the nation's largest cannabis supplier is supposed to be regulated, but can find better profits in the black market, what incentive is there for them to stop shipping outside of California? This isn't just an operator thing. Consumers have a hand in this picture too.

Not only does it seem likely that retailers and consumers are turning to some black market suppliers because of taxes and regulation, there's an issue of consumer knowledge too. Some consumers might not stop going to their medicinal dispensary or even know that it's technically illicit. If you want to find a new retailer, you're probably going to go on Weedmaps, where they don't filter by licensed and unlicensed businesses. And if you've been going to the same place for years already, why would you stop? The interesting thing is that as a consumer, you may not be able to tell the difference. So you may have every intention of purchasing safe, legal cannabis, but it's really difficult to tell the differences between the businesses right now. on weed maps, I think that starts to become unfair competition because we're competing for

the same people who don't have an understanding of what the difference is between the two. And no one's really trying to educate the public about what the difference is from a legal and illegal player. This is the takeaway. California's black market is likely seeing a resurgence because of high taxes and overbearing regulation and consumers don't have the tools or desire to shop legal. So with this messy process, what does the future look like? You might have heard of big cannabis or big companies with lots of cash getting into the weed business. The people I spoke with held a number of views about this. Anger over the small farmer getting squeezed to feeling like this was expected all along. Yeah, this is exactly what we all expected to happen.

I mean, you know, with legalization comes opportunity. It's no surprise, you know, we already knew that a lot of external industries, folks from alcohol and tobacco, were keeping a close eye on the industry before legalization. We kind of have an in-house joke where, with some of my associates, where they're like, yeah, everyone who went above board is trying to figure out a way to get back down below. And everyone who's below board only wants to be above board enough to be a presence. The industry was built on the backs of small farmers and, you know, they really took all the

risk and did all the work to get this industry to where it is today. So, you know, big cannabis will come when the time is right and it will completely change the industry. While each of these people had their own unique views about the future, everyone hearkened to the past, to the people who built the cannabis industry in their small farms and risked prison over this plant. Most of the people in this industry held a great deal of respect for those trailblazers. But as the industry changes irreparably, it seems only natural that cannabis will become more corporate and marketable.

Now, if you've made it to this point, as you can see, there are a lot of different people involved in this system. And that's also why you see for some people that it's pretty hard to blame any single group as the biggest culprit. I mean, we look at the government agencies, and they seem to have considered lots of different voices in the rulemaking process. But on the other hand, you have people that can't really blame the growers and retailers for being resistant to these kinds of sweeping changes in such a short timeline. They've had their way of doing things for years now and it's all changing really quickly.

And there are a lot of questions that we can't answer but the reality is that everyone's gonna have to've all paid dearly, both in personal sacrifice as well as economic loss. I mean, yeah, we've made money, but we've all taken significant hints that may or may not have buried us for good dealing with, you're dealing with the, at this point, you're dealing with the cream of the crop, um, that understand how, how to, um, how to get through this. And, and it's just going to keep going. It's just going to keep going. And I, I would hope that the regulators, if they don't understand that yet, I hope that they would start to try to get a grasp on that and continue to make it a viable option for

small business to engage in the cannabis industry.