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By Steven Ascher and Anna M.Windemuth
The unique status of the cannabis business — legal in a majority of states, but still illegal under federal law — creates a thorny problem for litigants: Federal courts sometimes refuse to hear cannabis-related disputes on the ground that a court will not order a party to engage in illegal conduct. As a result, a federal court is unlikely to hear a claim seeking, for instance, delivery of a shipment of cannabis, or payment for a shipment of cannabis. Similarly, insolvent cannabis producers and distributors cannot file for bankruptcy in federal courts, because administering a cannabis company would implicate the court in violations of federal law.
But despite this seemingly broad background rule, federal courts often agree to hear commercial disputes in the cannabis industry. Courts’ decisions whether to take a case turn on whether the specific remedy requested by the plaintiff would compel violation of federal law by requiring the cultivation, distribution, or possession of cannabis. If so, the dispute cannot be heard in federal court, though it may still be subject to state court jurisdiction. If not, the matter can proceed in federal court.
This article discusses the circumstances under which federal courts will either assert or decline jurisdiction over commercial disputes in the cannabis business, and provides practical guidance not only for litigants, but also for parties who negotiate cannabis-related agreements.
When Federal Courts Exercise Jurisdiction Over Cannabis-Related Disputes
Although federal courts have made it clear that they will not order relief that requires a party to engage in illegal activity, courts have nevertheless enforced a variety of cannabis-related contracts. For example, federal courts have decided several cases in which investors or lenders to cannabis companies sued to recover payments on their investment or loan. In these cases, the court’s willingness to decide the dispute was premised on the idea that requiring a defendant cannabis company to pay damages to the plaintiff did not necessarily require the sale of cannabis, because the cannabis company could in theory repay its debts from funds that were not the result of cannabis transactions. Using similar reasoning, one court even agreed to decide a case involving breach of a contract to buy drug paraphernalia. In this vein, courts have been more likely to enforce cannabis-related agreements if the agreements do not expressly mention cannabis and therefore do not expressly require the defendant to use funds derived from illegal cannabis-related activity to pay the plaintiff.
In deciding to exercise jurisdiction over these types of disputes, courts have sometimes noted that it would be unfair to allow defendants to retain an unjust windfall from not repaying their obligations. Courts have also justified these decisions on related policy grounds, namely, that it would be inadvisable to incentivize defendants to solicit funds for illegal businesses without legal obligations or regulatory oversight.
When Federal Courts Decline to Exercise Jurisdiction
By contrast, federal courts have refused to decide cannabis-related contractual disputes when a plaintiff’s requested remedy would have compelled a defendant to violate federal law by cultivating, selling, or possessing cannabis. In making this determination, the key issue for these courts was the relief that the plaintiff requested.
For example, if a plaintiff requested lost profits as damages, rather than the repayment of a loan or the return on an investment, then the federal courts have declined to hear the dispute, because a cannabis company’s profits necessarily derive from federally illegal activity. Similarly, in cases where a plaintiff has sought the appointment of a receiver to manage a cannabis company’s assets, the court has declined jurisdiction.
The Practical Impact of a Court Deciding that the Requested Relief Would Require a Violation of Federal Law
When a federal court decides that the plaintiff’s requested relief would impermissibly require a violation of federal law, the court can take any of at least three actions.
In some cases, courts have dismissed the claims in which the plaintiff sought the potentially illegal relief, but permitted the plaintiff to proceed with claims that sought permissible relief.
In other cases, the federal courts have dismissed the case from federal court, but remanded it to state court, where the state would presumably agree to decide the case.
And in some cases, the federal court has simply dismissed the case, in which case the plaintiff could decide whether to try to refile in state court. Although the illegality defense to a breach of contract action theoretically applies in state court as well as federal court, certain states in which cannabis is legal have enacted laws that proactively designate cannabis-related agreements “lawful” or not voidable as against public policy, in which case the state courts should not dismiss the refiled case on illegality grounds. And more generally, we have only come across one state case dismissing a breach-of-contract claim on this ground even though medical cannabis was legal in the state (and that case was decided in 2012).
Practical Takeaways
Several practical takeaways emerge for those negotiating cannabis-related contracts or litigating cannabis-related disputes.
First, those negotiating cannabis-related contracts should consider including arbitration clauses in their agreements to avoid the expense and uncertainty associated with litigating this issue in court. The arbitration clause should ideally specify that the parties: (1) agree that the applicability and scope of the arbitration provision will be determined exclusively by arbitration in a forum where cannabis is legal; (2) consent to the forum state’s courts to compel arbitration and to confirm the arbitration award; (3) waive any right to remove the case to federal court; and (4) waive any affirmative defense of enforceability on illegality grounds.
Second, cannabis-related contracts can also reduce uncertainty by including forum-selection clauses that require any litigation to be filed in a cannabis-friendly state forum, waive any right to remove the case to federal court, and waive any affirmative defense of unenforceability on illegality grounds. A provision like this can be included in addition to or instead of an arbitration clause.
Third, if a party anticipates that it may want the option to file a case in federal court, it should also consider, to the extent possible, avoiding cannabis-specific language in its agreements. That will facilitate the assumption that ordering monetary relief does not necessarily involve cannabis-related funds.
Finally, if a plaintiff ultimately decides that federal court is a better forum for its cannabis-related dispute than state court (or arbitration, if available), the plaintiff should carefully frame its requested relief in a manner that does not suggest that the court would be at risk of ordering illegal conduct. For example, litigants should avoid requesting the equitable facilitation of cannabis-related businesses, or an award of lost profits from cannabis-related operations, and instead seek other damages such as the repayment of funds. If the plaintiff needs other forms of relief, it should request them only after considering the risk that seeking those types of relief could increase the expense and timeline of the lawsuit.
Until the tension between state and federal law is resolved, cannabis negotiators and litigators should keep these principles in mind.
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About the Authors
Stephen Ascher is a partner co-chair of Jenner & Block’s cannabis practice. Stephen is a first-chair trial lawyer who has deep experience in the cannabis sector including guiding one of the largest cannabis companies in the United States in several arbitrations and lawsuits related to dealings with minority investors and their securities offerings. Stephen is sought after for his deep understanding of his clients’ businesses, which enables him to communicate with companies in their industry-specific language, and then simplify and explain these concepts to judges, arbitrators, and juries.
Anna Windemuth is an associate at Jenner & Block where she advises clients at all phases of litigation in complex business disputes. She has experience representing clients in the telecom, financial services, and cannabis industries, among others.
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