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In 2021, most people can be forgiven for feeling as though investing in cannabis companies is completely legal and without risk. After all, the vast majority of states allow adult use, medical use, or at least some type of CBD use, and the federal government’s Farm Bill in 2018 rescheduled hemp-derived CBD.
Investors can now purchase interests in cannabis companies on various reputable exchanges, and many people have increased their wealth by investing directly in closely held companies, or investing early in public companies. More and more, estate planning attorneys find themselves working with individuals who have invested in cannabis companies and are dealing with estates and trusts that hold interests in cannabis companies.
While public perception about investing in these companies has changed, the federal laws have largely not. Cannabis remains illegal at the federal level, and the FDA takes the position that most products containing CBD violate federal laws regulating drugs, food, food supplements, and cosmetics. This creates a serious legal consideration for entities and individuals asked to serve as trustees of trusts and personal representatives for estates holding interests in these companies. Few, if any, states have enacted specific laws protecting a fiduciary holding interests in a cannabis company, and there appears to be no case law directly dealing with weather these investments are appropriate.
This article does not focus on the potential for criminal charges to be brought against a fiduciary holding passive interests in a cannabis company, but it is a topic that should be discussed with a client that is doing estate planning and with the fiduciary, even if the risk is fairly remote. While risk of criminal prosecute is unlikely, it is easy to envision a disgruntled beneficiary using the ownership of an interest in a cannabis company as the basis of attacking a fiduciary, especially if the investment fails to perform. While there are many potential claims a beneficiary could make, the two most obvious are 1) that any trust created for an illegal purpose is invalid, and 2) the holding of an interest in a cannabis company may be contrary to the prudent investor rule.
The first issue largely applies only to trusts. The Uniform Trust Code requires that a trust must be created for a “lawful” purpose. Many states have enacted some version of the UTC, and most that have not instead crafted statutes based on The Restatement of the Law of Trusts. The discussion below will mostly focus on the UTC, but the principals are generally similar under the Restatement. Pennsylvania, and most surrounding states, are UTC jurisdictions, and 20 Pa.C.S.A. § 7734 states a “trust may be created only to the extent its purposes is lawful and not contrary to public policy.” The notes to the UTC and Restatement both state that if the performance of the trust involves criminal or tortious acts by the trustee the trust is illegal, with the Restatement’s comments specifically providing an example of marketing a legally prohibited substance as an unlawful action that would cause a trust to be invalid. If the trust is invalid, the illegal purpose must be rectified or the trust terminated. A trustee continuing the illegal trust would be open to claims.
If a trust owned only a small interest in a cannabis company, it would be difficult to argue that is the primary purpose. There is also a strong argument to be made that public policy now in most states is decidedly in favor of cannabis, especially for medical purposes. If the interest in the company is substantial or if the company is taking actions contrary to the situs state’s law, it may be more difficult to prevail with such arguments.
As stated above, the second major concern for a fiduciary holding these assets would be the fiduciary’s duties of care and the requirement the fiduciary invest the assets according to the prudent investor rule. Most states have incorporated the prudent investor rule into their statutes, and Pennsylvania is not an exception with the rule outlined at 20 Pa.C.S.A. §7201, et. seq. Under the statute, the fiduciary is required to use reasonable care, skill, and caution in its investing.
It has been suggested that the mere investing in a cannabis company by a fiduciary breaches the duty of care based on the laws above, and because under the Controlled Substance Act, it is federally illegal to take the income from the sale of illegal narcotics and invest those funds into another business involved in interstate commerce. That level of risk to the assets is unreasonable. Other commentators tend to think the investment is not a per se violation and must be analyzed under the prudent investor act generally. Under this analysis, the fiduciary would still have to act prudently, which requires the fiduciary to consider the purpose, terms, and distribution requirements of the trust, while exercising reasonable care, skill and caution in selecting the investments. Reasonable care and caution require an analysis of the impact of the illegality, but also requires a risk reward analysis. As a relatively new industry, with volatility, limited public information, compliance risks, and the potential for changes in the law, an increased level of due diligence in a cannabis enterprise is warranted to determine the risk and reward. That is, however, more difficult due to the lack of public information available, and the emphasis on keeping information confidential. This all creates a perception that meeting the prudent investor rule requirements would be difficult with a cannabis company, especially for an investment that was a significant portion of the assets held by the trustee or personal representative.
For the reasons above, and because of the banking restrictions that still remain with cannabis companies, it is unlikely that a bank or trust company will be willing to serve as executor or trustee if there is an interest in a cannabis company. Clients will, however, continue to want their cannabis assets to be placed in trust, and will continue to die owning these assets. While there is no perfect tool to assist an individual fiduciary, there are some steps a drafter and a fiduciary can take to perhaps reduce the risk.
One obvious solution is to determine a method to distribute the cannabis assets from the estate or trust as quickly as possible to remove any imprudent investment; however, this may be contrary to the estate’s or trust’s purpose. Fiduciaries and their counsel need to also be cognizant of state restrictions on the ownership of interests in cannabis companies. These restrictions can include age requirements for ownership, prohibitions on ownership by people with certain criminal convictions, and prohibitions on out-of-state ownership. Clients with ownership interests in cannabis companies will likely want their documents to address this to ensure a distribution is not contrary to state law.
In drafting trust instruments, drafters should consider whether to state that it is the intention of the settlor that the trust holds cannabis stocks or direct retention of those assets. Similarly, drafting to explicitly state the trustee is held harmless and indemnified as to the trustee’s handling of the cannabis stock may provide some level of protection. The grantor may also consider removing the investment authority from the trustee, and delegating it to an investment advisor; however, such an action may not eliminate the duty of care to know whether investments in the trust are illegal. This could create tension or conflict between the trustee and investment advisor.
The use of an in terrorem clause directly addressing the trustee’s holding of cannabis stock may also provide a deterrent to a beneficiary wishing to make claims against the fiduciary. The enforceability of such a clause is not guaranteed, but it could be a barrier to a beneficiary suing the fiduciary.
The fiduciary could also seek to obtain consent of all beneficiaries by agreement to hold the cannabis assets, or allow the beneficiaries to direct the sale of those specific assets. This again may not guarantee protection, but it should provide additional legal and equitable arguments for the fiduciary if litigation arises.
None of the above will fully insulate the fiduciary, and this will remain a complicated area with no easy solutions until the federal law is brought in line with state practices. Practitioners must inform their clients about these risks, and should consider some planning options to mitigate the risks, as it is very unlikely that clients will elect to stop investing in this interesting market.
Attorney Stephen J. Olsen is the head of the Cannabis Law practice as well as Tax, Trust and Estates practice at Gawthrop Greenwood, PC, and a member of its Business Law Group. In his practice, he has represented a number of cannabis companies and investors, and has also served as General Counsel and in various C-level roles with a cannabis grower/processor. Contact Stephen at email@example.com or 610-696-8225.
Reprinted with permission from the May 18, 2021 issue of Legal Intelligencer. © 2021 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.