Cannabis-Related Due Diligence: What are the red flags for corruption?

As long as U.S. federal law enforcement priorities remain the same, licensed cannabis operators are unlikely to be prosecuted if they are completely compliant with state laws. However, if the DOJ or state regulators discover that a license was acquired through corrupt means, the license will not provide any protection.

Investing in, acquiring, or partnering with a licensed business only to discover that the license was first awarded as a result of bribery could eliminate any value in the transaction, and create substantial legal and reputational risks for all involved.

In order to encourage compliance with the Foreign Corrupt Practices Act, the DOJ and SEC have issued guidance on red flags of foreign corruption.  Transparency International annually publishes a Corruption Perceptions Index that provides a useful starting point for businesses in evaluating the risks they may be facing in foreign markets.  However, due to marijuana’s Schedule I status under the Controlled Substances Act and the fact that the industry is still nascent, there is no similar corruption risk guidance with respect to the state-legal marijuana industry. This post is a first step toward filling that gap.

Factors Facilitating Corruption

Based on our review of recent cases, we believe that the following factors may make a state licensing scheme more susceptible to corruption and should be taken into account when evaluating the relative corruption risks in any particular state:

• A requirement to obtain municipal and/or county approvals before applying for a state license. (For example, although they may serve legitimate policy goals, “host community agreements,” or a requirement to have a properly zoned location locked in before applying, create multiple opportunities for bribe demands.)
• Concentration in one person of the power to provide municipal/county approval.  (Locating issuing power in one person reduces transparency and makes it easier to rig the system.  The allegations in the Fall River indictment provide an example of such a system.)
• A pattern of prior corruption in municipal or state governance, particularly related to cannabis, real estate, zoning, gaming, or alcohol.  (Pre-existing corruption in similar state licensing schemes may have created an entire system of corruption and an expectation of bribes on the part of licensing officials.)
• Limited availability of banking services in the state for marijuana-related businesses. (The lack of banking services results in large amounts of untracked cash which can be more easily used for improper purposes.)
• Lack of transparency around records of licenses. (Sunlight is always the best disinfectant and lack of data about who owns a business makes it easier for the unscrupulous to hide. We discussed access to official records in different state licensing regimes here.

Red Flags

In addition to the above, having analyzed recent cases involving alleged corruption in the state cannabis industry and drawing on our experience with FCPA compliance, we believe that the following can be considered red flags indicating a business may have obtained a state license improperly:

• In obtaining the license, the business used an agent, such as a lobbyist or consultant, whose services are vaguely described and whose role in the licensing process is not clear.  (Vaguely defined services can be indicative of no real services having been performed and the agent being used simply as a pass-through for an improper payment.)
• The agent’s services were compensated at an above market rate.  (Overpayments to an intermediary create surplus which can be used for improper payments.)
• The license was obtained extremely quickly.  (The issuance of a license outside of normal procedures may be an indication that it was obtained improperly.)
• The business has received a local or preliminary permit but does not appear to meet all the statutory criteria for a state license.  (The fact that a business got a license without satisfying relevant requirements suggests that it may have used improper means to get it.)
• The business demonstrated an unusual pattern of political campaign donations shortly before obtaining the license. (As alleged in the indictment of alleged Rudolph Giuliani associates Lev Parnas and Igor Fruman, political campaign donations may be used to influence the licensing process.)
• The business does not have a relationship with a bank that is knowingly and legally serving cannabis-related companies. (If the business is operating in cash or is concealing the nature of its business from its bank, this increases money-laundering risks and the possibility that cash is being used for corrupt purposes. In contrast, participation in a rigorously-administered, compliant banking program indicates that the company has completed the bank’s due diligence onboarding process and that its accounts are reviewed regularly, which may decrease the risk of funds being used improperly.)

None of these should be taken as dispositive proof that a license was obtained illegally; only as red flags indicating that follow-up inquiry is warranted.  As in the FCPA context, exercising due diligence and following up on red flags can help a company to prove that it had no reason to suspect bribery on the part of its business partner and can help to protect it in the event of a corruption prosecution (though such due diligence will not protect it from charges under the Controlled Substances Act should DOJ decide to change what appears to be its current policy and pursue those who do business with state legal businesses).

In short, there is no absolute protection against dishonest business partners, especially in an industry as nascent and murky as cannabis.  But companies that wish to avoid corruption and ensure that their local business partners are compliant with state licensing regimes would be well advised to consider all of these factors when evaluating licensed local partners and potential investments.

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A version of this post first appeared in Baker McKenzie’s Global Cannabis Compliance Blog and is published here with permission.

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Tom Firestone, pictured above left, is Co-Chair of Baker McKenzie’s North American Government Enforcement practice and is a member of the Firm’s Global Compliance & Investigations Steering Committee. He represents clients in matters involving anti-corruption and the FCPA, internal investigations and transactional due diligence. He’s also a member of the firm’s Cannabis Review Committee and has advised clients on compliance issues related to cannabis.

Tanya Hoke, above right, is the Managing Director of Galen Diligence, which has provided investigative due diligence services focused on the legal cannabis industry since 2015. She’s a Certified Fraud Examiner, Certified Anti-Money Laundering Specialist, and a member of the National Cannabis Industry Association’s Banking & Financial Services Committee.