Surviving and Thriving in the Post-Legalization Cannabis Industry

Torys Quarterly: The Cross-Border Update

Canada has rounded the final bend and is on the home stretch in the race to be the second country to legalize recreational cannabis at a national level.

As October rolls closer, new companies and licensed producers (LPs) continue to emerge. While M&A activity is set to continue in the short term, the rate at which it happens remains to be seen as larger companies might look to grow through means other than acquisition. And of course, not everyone will prosper in this new environment: Those that do will be the ones who are comfortable working in a highly regulated industry and who are executing on business plans that differentiate them from their competitors.

Frontierland for Compliance and Governance

The sector is quickly evolving: Certain financial institutions are breaking ground by participating in deals, insurers are reimbursing patients for medicinal use of cannabis, and established retailers are entering or signaling their entry into the sector. Real estate companies are in the mix too, by renting or considering renting space to cultivators or retailers. Add to this the fact that Canada’s first-to-federally-approve market status for recreational use has stirred significant interest outside of Canada. The risk profile is appealingly low to invest in, launch in, export from, or import into a regulated and stable political environment like Canada.

Early entrants had the luxury of ramping up under different laws, negotiating contracts and securing retail space, forcing late entrants to work harder to set themselves apart.

As of July 2018, Canada has 112 LPs1 and the government has announced there will be no limit on the number of licences it approves, meaning the market may at some stage be faced with a glut of LPs. Not all will survive. Smaller companies with little financial backing or those who are late to the game will need to work especially hard to establish themselves as significant players. Early entrants to the market had the luxury of ramping up under different laws, negotiating contracts and securing retail space, forcing late entrants to work harder to set themselves apart and find their niche. With many interested investors, and the market becoming crowded with LPs, cannabis companies who want to thrive will need to execute an effective business strategy in what will be not only an uncharted (for recreational cannabis) but a highly regulated industry.

Differentiation is critical. Businesses will need to be creative in distinguishing themselves while staying aligned with marketing and advertising compliance. Hefty restrictions on retail sales, packaging and labelling and promotion means companies need to think beyond simply selling their product to provincially operated stores, like the Ontario Cannabis Store (OSC) in the province of Ontario—the sole cannabis retailer in the province. A clear, defined and well-thought-out business plan that speaks both strategically and pragmatically to driving revenues and keeping an eye on expenses and regulation, will be vital to industry longevity.

Part of that execution includes giving close considerations to things like intellectual property (IP), advertising and promotion in a highly restrictive environment, and leveraging trademarks and branding. Trolls and squatters are emerging, as they spot the opportunity to use IP to block market access. An integrated IP strategy that dovetails business strategy is vital to a company’s quest to make its mark in the industry. The race is on for both LPs and companies in the supply chain to seek patents and register trademarks, the latter given imminent changes to the Trademarks Act making it easier for businesses to do so.2

Those investing in this sector will want to be mindful of a few issues that reared their heads in the Cannabis Regulations, published on July 11 and coming into force on October 17. The first is that LPs will need to maintain a record of key investors and provide a report to Health Canada on an annual basis. A key investor is defined broadly as a person who exercises, or is in a position to exercise, direct or indirect control over the LP by providing either money, goods or services, or by holding an ownership interest, right or interest in or in respect of a business operated by the LP. The second is that security clearance requirements may capture officers and directors of corporations that invest in LPs, if the investor corporation exercises or is in a position to exercise control over the LP. There is an exemption for investments in LPs that are publicly traded.

And as we have discussed, compliance and governance needs to be top of mind, impacting procedures and policies of LPs, their employees, officers and directors and investors. Good compliance and governance policies, solid employment, confidentiality and other agreements protecting the LP’s rights and evolving the LP by incorporating current corporate best practices will be key to effective ongoing management of the company.3

Drawing Outside the Lines

With provinces in charge of setting their own rules for the distribution and sale of cannabis, companies may have to think outside the box when it comes to interprovincial trade. For example, if a late entrant to the Ontario market has weak sales or is unsuccessful in selling their product to the OSC for retail sale, it might encounter hurdles if its plan B was to cross the border and enter into a deal with a retailer in a neighbouring province. This is where having a defined strategy, for example, by focusing on alliances, joint ventures, M&A, other corporate/commercial agreements or import/export of cannabis for medical use, might assist in differentiating from other LPs.4

While there is no certainty as to when federal legalization in the U.S. might happen, companies in the sector with a strong understanding of the current state of legalization will be well positioned if the status quo changes.

And when it comes to international borders, while there is no certainty as to when federal legalization in the United States might happen, companies in the sector with a strong understanding of the current state of legalization will be well positioned if the status quo changes. Companies should consider how potential federal legalization in the U.S. would align (or not) with their business strategy—considerations that will give them the jump on the competition in the event of changes to current U.S. federal policy.

Conclusion

As is true at the outset of any new industry, the onset of legalization will be followed by missteps and recalibrations. But with hungry investors and multiple market entrants in Canada, the new industry brings with it a wave of complexity. Businesses need to be conscious of their legal obligations in all aspects with the ultimate goal of creating a strategic business plan that will thrive in post-legalization Canada.

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1 See https://www.canada.ca/en/health-canada/services/drugs-medication/cannabis/licensed-producers/authorized-licensed-producers-medical-purposes.html.

2 See “A Flower by any Other Name: Cannabis Trademarks and Branding.”

3 See “It’s Time for Cannabis to ‘Grow-Up’.”

4 Import and export of cannabis is restricted to medical use or scientific research. Import and export for recreational use is prohibited.

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