BOLO: Cannabis Qui Tam Actions – Cannabis Business Executive

Due to federal illegality, the cannabis industry has long been plagued by federal agencies taking a variety of different enforcement approaches to cannabis businesses. From the U.S. Patent and Trademark Office to the National Labor Relations Board to the Bureau of Reclamation, the cannabis industry has not really received consistent treatment across the board. All that to say that a new threat has entered the chat–cannabis qui tam actions. Not many people know what a “qui tam” action is. And with good reason as it’s fairly antiquated and an obscure means through which the federal government (potentially) seeks financial recovery from individuals and businesses that defraud it. In addition to the “gotchas” of IRC 280E and banking, cannabis qui tam actions are now on the table.

The False Claims Act and Qui Tam Claims

Enacted in 1863, the False Claims Act1 (FCA) was designed by the federal government to stop contractor fraud against the United States in the Civil War. The FCA has two means of enforcement: (1) the U.S. Attorney General; or (2) private citizens through qui tam actions (“qui tam” is Latin for “in the name of the king”). In a qui tam suit, eligible private citizens are authorized to bring suit on behalf of the United States, and they receive a share of the total recovered proceeds, which is the major incentive to bring the matter to the attention of the feds in the first place.

In a qui tam action, you cannot just go ahead and file suit against the alleged fraudster. The “relator” (i.e., the private citizen) files a complaint in federal court, in camera and under seal for 60 days. Not even the defendant in the action will have access to the complaint during this time. The relator must also serve the complaint and all supporting documentation on the federal government. After that, the United States gets a mandatory 60 days to investigate the relator’s allegations to decide whether to intervene in the lawsuit and assume primary responsibility for the litigation. The feds can take longer to make this determination for “good cause”, which is almost always granted.

Ultimately, the relator must prove that the defendant “knowingly” presented to the United States a false or fraudulent “claim” for payment. The elements are that the defendant (1) had “actual” knowledge of the false nature of the claim; (2) acted in “deliberate ignorance” of the truth or falsity of the claim; or (3) acted in “reckless disregard” of the truth or falsity of the claim.

If the feds intervene and assume primary responsibility for the litigation, the relator remains a party to the action (even though the federal government will essentially call all the shots). The government can also decline to intervene but can always come back later and pick up the mantel in the litigation if it so decides. Even if there’s government intervention, the relator is still entitled to a share of any monies recovered from the defendant, which is usually anywhere between 15%-25% of total recovery. Penalties here range from $5,000 to $10,000, plus three times the amount of damages the government sustains per claim. In the end, the more penalties, the bigger the relator’s financial recovery.

Cannabis Qui Tam in Washington State

In a somewhat shocking development that’s been reported to surprisingly little reaction by the cannabis industry, the Department of Justice very recently successfully settled a qui tam action brought against a cannabis ancillary business in Washington State. The alleged fraud was that, Docklight Brands, Inc. (an intellectual property holding company that develops and licenses cannabis brands like Marley Natural), wrongfully applied for, received, and was forgiven a Paycheck Protection Program (PPP) loan from the Small Business Administration (SBA) during the COVID-19 pandemic. The reason? The feds say that Docklight is a “marijuana related business” ineligible for PPP loans. The relator in the case was Sidesolve, LLC, which holds itself out as “a company that uses data to to investigate large-scale corporate fraud”. Sidesolve finds “fraud leads” and then essentially helps the whistleblowers investigate and bring to light the bad behavior against the United States. In this case, Sidesolve was looking for PPP fraud, and in the government’s complaint against Docklight, the government alleges that Sidesolve “came across” Docklight.

The SBA and PPP Loans to Indirect Marijuana Businesses

Prior to and during the height of COVID, the SBA issued a series of guidance and opinions regarding whether cannabis and cannabis-related companies were eligible for PPP loans. In most states, cannabis businesses were deemed essential services and allowed to remain open, but the SBA, an independent federal agency, didn’t see it that way.

In 2019, the SBA issued general guidance for lenders seeking to participate in SBA lending programs. That guidance addressed SBA loans to marijuana businesses as follows:

Because federal law prohibits the distribution and sale of marijuana, financial transactions involving a marijuana-related business would generally involve funds derived from illegal activity. Therefore, businesses that derive revenue from marijuana-related activities or that support the end-use of marijuana may be ineligible for SBA financial assistance.  Whether a business is eligible is determined by the nature of the business’s specific operations. The following businesses are ineligible:

“Direct Marijuana Business” — a business that grows, produces, processes, distributes, or sells marijuana or marijuana products, edibles, or derivatives, regardless of the amount of such activity. This applies to personal use and medical use even if the business is legal under local or state law where the applicant business is or will be located.

“Indirect Marijuana Business” — a business that derived any of its gross revenue for the previous year (or, if a start-up, projects to derive any of its gross revenue for the next year) from sales to Direct Marijuana Businesses of products or services that could reasonably be determined to support the use, growth, enhancement or other development of marijuana. Examples include businesses that provide testing services, or sell grow lights or hydroponic equipment, to one or more Direct Marijuana Businesses. In addition, businesses that sell smoking devices, pipes, bongs, inhalants, or other products that may be used in connection with marijuana are ineligible if the products are primarily intended or designed for such use or if the business markets the products for such use.

The SBA essentially updated the foregoing guidance later in 2019 to address the 2018 Farm Bill and certain hemp-derived activities, but it also expanded on the examples of “Indirect Marijuana Businesses” to include “firms” that:

• Provide marijuana product testing services (strength, purity, etc.);
• Sell or install grow lights or hydroponic or other specialized growing equipment to Direct Marijuana Businesses;
• Sell smoking devices, pipes, bongs, inhalants, or other products primarily designed, intended, or marketed to facilitate marijuana consumption; and
• Advise or counsel Direct Marijuana Businesses on the specific legal,
  financial/accounting, policy, regulatory or other operational issues specifically associated with establishing, promoting, or operating a Direct Marijuana Business.

The Alleged Cannabis Quit Tam Fraud

During COVID, Congress passed the CARES Act, which created the PPP loan program (including the government’s full guarantee of these loans as well as their forgiveness under certain circumstances).

In early 2020, Docklight received a PPP loan in the amount of $492,050, and that loan was later forgiven to the tune of $494,719. As part of receiving the PPP loan, Docklight had to certify to the federal government that it was not in any way engaged in any illegal activity pursuant to federal, state, or local laws, and that all information in its PPP application was true and accurate in all respects. In its FCA suit against Docklight, the DOJ took the position that Docklight was both a “direct marijuana business” and an “indirect marijuana business” by virtue of its cannabis intellectual property holdings, brand development, and IP licensing in connection with state-licensed cannabis companies when Docklight allegedly knowingly, wrongfully, and falsely applied for the PPP loan and forgiveness.

What Happens with Docklight Now?

Docklight basically opted not to fight the case against the DOJ, which is what most targets of qui tam actions do (because once the federal government decides to intervene it’s basically a zero-sum game for the defendant). Instead, Docklight settled with the DOJ to pay the federal government $989,438, which is double the PPP loan amount in the form of penalties. Sidesolve will get $148,416.70 out of those settlement funds.

The Cannabis Qui Tam Problem for the Rest of the Industry

The cannabis industry should be concerned about the Docklight cannabis qui tam action for a few reasons:

• This case was brought in the Western District of Washington. Washington was one of the first states to legalize cannabis for adults 21 and up and the U.S. Attorney on that side of that state has been famously liberal in recent years about prosecuting cannabis-related crimes as a result. In turn, the decision of the U.S. Attorney’s office in the Western District to intervene in this matter should be troubling from a political perspective if nothing else (since U.S. Attorneys have prosecutorial discretion).
• When it comes to the FCA, the DOJ obviously cares about aiding, abetting, and conspiring to violate the Controlled Substances Act. This means that every cannabis-related business that received the benefit of a PPP loan during COVID, including cannabis-oriented law firms, management companies, CPA firms, consultants, etc. that focus their time and energy on the industry and/or that derive any gross revenue from sales or services to “Direct Marijuana Businesses . . . that could reasonably be determined to support the use, growth, enhancement or other development of marijuana” should be concerned. All it will take is a former employee or insider (and maybe a service like Sidesolve) to kick off a domino effect of qui tam actions in this arena, borrowing from the facts of the Docklight case.
• Qui tam actions are business killers because of the exorbitant amount of penalties and damages assessed against defendants. The cannabis industry mostly remains flat across a multitude of states and it is increasingly difficult to fundraise and find money to survive (in combination with the application of IRC 280E). Qui tam actions would be the nail in the coffin for probably every single marijuana-related business out there that took a PPP loan (and there are probably thousands of them) save a select few that could weather the financial impact.

If you’re in receipt of a qui tam complaint, it is not normal litigation and it is not something where you hold almost any leverage as a defendant. As a result, the cannabis industry should get wise to how qui tams function and should be on the look out for future actions like Docklight in order to prepare accordingly.