Regulate: The Interim Final Rules, Key Participants And Background Checks

by Mark Yurachek

I’m kind of late to the party in offering my initial thoughts on the USDA’s interim final rules on hemp, but I finally got a few minutes to sit down and read them and I do have some thoughts. As a side note, I am a big fan of the CannaLaw Blog and Jesse Mondry wrote an excellent summary of the relationship between criminal history and licensing under the Rules last week. I want to expand upon some of the questions Jesse’s article raises and dig a little deeper into them.

7 USC §1639p(e)(3)(B)(i) and its parallel provisions in the Rules forbid “any person convicted of a felony relating to a controlled substance under State or Federal law before, on or after December 20, 2018,” from “partcipat[ing] in” the USDA program or “to produce hemp under any regulations or guidelines” established under that statute, “during the 10-year period following the date of the conviction.” The Supplemental Information to the Rules states:

[t]o meet this requirement, the State or Indian Tribe will need to review criminal history reports for each applicant. When an applicant is a business entity, the State or Indian Tribe must review the criminal history report for each key participant in the business. The State and Tribe may determine the appropriate method for obtaining the criminal history report for their licensees in their plan. Finally, any person found by the USDA, State or Tribal Government to have materially falsified any information submitted to this program will be ineligible to participate.

The text of the Rule raises a number of questions for me: 1) what discretion do the states have in applying this Rule? 2) what constitutes a “conviction?” 3) what is “participation?” and 4) what happens to an entity which produces without a license?

What discretion do the states have in applying this Rule?

Not much. The felony ban is clearly important to the USDA as they note that this is the reason that licenses must be renewed every three years: “[b]ecause of the felony ban, we believe it is necessary to review producers’ criminal history to ensure that they have not committed a felony since the most recent license approval that would disqualify them.” Not only must licenses be renewed every three years, but criminal background records must be maintained for that same period, another sign the USDA is not fooling around with this requirement. What would happen if a conviction initially got past the reviewing authority, but then was discovered a year or two later? Does that mean the license could be retroactively denied? Would retroactive denial mean that they were growing hemp without a license? Although this situation might be anomalous, it’s far from impossible, especially if an applicant lied or misstated her criminal history (though that situation would be different from the state or USDA dropping the ball).

The Rules note, “States may adopt more stringent standards and prohibit hemp production within their jurisdiction,” leaving unsaid that they lack the latitude to adopt less stringent standards. If they do, preemption kicks in and the USDA’s Rules will apply. Only state plans that “compl[y] with this part,” including the enforcement provisions, will be approved. Ergo, as with the USDA plan, any state which has submitted a plan to have primary regulatory authority over the production of hemp would at least have to prevent anyone convicted of a controlled substance felony from participating in (or more appropriately profiting from) hemp production for at least ten years following the conviction.

What constitutes a conviction?

The narrative in the Supplemental Information states, “a plea of guilty or nolo contendere or any finding of guilt is a conviction. However, if the finding of guilt is subsequently overturned on appeal, pardoned or expunged, then it is not considered a conviction for purposes of part 990. This definition of ‘conviction’ is consistent with how some other agencies who conduct criminal history record searches determine disqualifying crimes.” This is fairly straightforward and self-explanatory, save the word, “expunged.”

In the Definitions section, the Rules state, “[f]or purposes of this part, a conviction is expunged when the conviction is removed from the individual’s criminal history record and there are no legal disabilities or restrictions associated with the expunged conviction, other than the fact that the conviction may be used for sentencing purposes for subsequent convictions.” This would be good news for clients of mine in Georgia who entered pleas under Georgia’s First Offender Act, since that would fit this definition of expungement, even though Georgia has a separate mechanism for expungement not available in those circumstances. This is in line with the federal First Offender Act, which, like Georgia, does not enter a conviction, but does not expunge either (unless the Defendant was under 21 when the crime was committed). I suspect this would be true of a number of other states that have first offender or deferred adjudication-type provisions.

I am concerned because the narrative says, “[t]his definition of ‘conviction’ is consistent with how some other agencies who conduct criminal history record searches determine disqualifying crimes.” Federal courts, the DOJ and ICE all typically view a first offender/deferred adjudication plea as a conviction. So the Rules are either inconsistent with the two agencies which arguably conduct the most criminal history record checks or would consider certain adjudications which appear to be expunged, per its definition, to be convictions. My hunch is the latter, but this will make for an interesting appeal for when someone gets their license denied on this basis.

There’s an intriguing preemption issue lurking in there, too, because most state-level courts where I have worked won’t consider a first offender plea, for instance, to be a conviction if Georgia does not do so and vice versa. So can a state, consistent with the minimum requirements of these Rules, not consider a first offender/deferred adjudication-type of rehabilitative sentence as a conviction or is it preempted from doing so by federal law? For that matter, could Georgia’s Department of Agriculture follow its own state law and not consider a first offender plea in assessing an applicant’s fitness for licensure under its program or would it have to violate its own state’s law in order to follow federal law? I don’t like it, but I lean toward preemption. I suspect this will have to be something that is either clarified in the final rule or in the courts subsequent thereto. Someone is going to challenge application of this Rule, though.

What is participation, i.e. who is subject to the ban?

I would venture to guess that most of the applicants for licenses to participate in these programs will not be individuals, but corporate entities. Businesses seeking licensure are required to disclose the “full name and title of key participants.” All key participants in the business must be eligible for a license, which takes away the potential for sidestepping the rules with a nominee or strawperson, unless the affected participant wants to give up any ownership interest and or managerial authority over the business and essentially just work as a field hand, which seems unlikely.

Naturally, then, one question is, who is a “key participant?” As pertains to the states, a “key participant” is, “a sole proprietor, a partner in a partnership, or a person with executive managerial control in a corporation. A person with executive managerial control includes persons such as a chief executive officer, chief operating officer and chief financial officer. This definition does not include non-executive managers such a farm, field or shift managers.” The USDA’s plan elaborates:

[k]ey participants are a person or persons who have a direct or indirect financial interest in the entity producing hemp, such as an owner or partner in a partnership. A key participant also includes persons in a corporate entity at executive levels including chief executive officer, chief operating officer and chief financial officer. This does not include other management positions like farm, field or shift managers.

The way I read this, a “key participant” is anyone who has decisionmaking/managerial authority or, as the plan states, “control over hemp production,” and whose profit depends on the license. It is interesting to think that most everyone in the supply chain has at least an indirect financial interest in the entity producing hemp because the whole supply chain is transacting business based on hemp production. Practically, I don’t think this reaches all the way to the truck drivers who transport it, but I do think that most anyone who only gets paid once the hemp is sold is a key participant.

My reading is expansive, but correct, I believe, because the tenor of all these laws is that the feds and the states are trying to keep anyone with a felony drug record out of the industry, so they are going to assure that the Rules reach well into the corporate structure and the supply chain to assure that nobody with a recent drug conviction profits. This would also comport with, for instance, California’s broad definition of an “[o]wner” in its cannabis rules (which may find its way into the hemp rules too). The main difference between California’s “owner” and the USDA’s “key participant” is the twenty percent interest threshold in California, which makes it less expansive than the Rules.

The definitions of “producer” is also relevant to this equation, I believe. The USDA plan defines, “producer,” as, “an owner, operator, landlord, tenant or sharecropper, who shares in the risk of producing a crop and who is entitled to share in the crop available for marketing from the farm, or would have shared had the crop been produced.” This suggests, consistent with the definition of a “key participant,” that a producer is anyone who stands to profit from the original sale of hemp. This brings in not only the farmers who grow the hemp, but peripheral actors whose profit is wholly dependent on its sale. For instance, there are actors who are consulting with, and brokering deals between, growers and processors. It’s hard to imagine that these actors and others similarly situated are not producers and/or “key participants” since they are, “entitled to share in the crop available for marketing from the farm.” So it will be important to growers to keep a watchful eye on who they are doing business with.  

In a footnote, the Rules state that, “[f]or a corporation, if a key participant has a disqualifying felony conviction, the corporation may remove that person from a key participant position. Failure to remove that person will result in a license revocation.” Does that mean if my partner has a felony drug conviction which prevents our company from getting a license, all I have to do is demote her or replace her with a nominee? Maybe, but there’s huge risk inherent in that, particularly for the partner. In order to comply with the law, she would have to divest herself of her partnership stake and any authority to guide the actions of the company. I could then sell the company without my former partner’s assent, the nominee could pocket her money from the proceeds or I could just fire my former partner and she would have absolutely no legal recourse against me or the nominee. Basic contract law dictates that if one of the parties to the contract is legally incapable of forming the contract, it is void and unenforceable, so my former partner is totally SOL. This footnote has the potential of screwing a good many people out of an earned piece of the pie, which seems especially cruel if the Rules, as intended, pave the way to the industry becoming far more profitable.

Nobody seems to know exactly how far the ban reaches, but that should not encourage corporate entities to take risks with the definitions. As CannaLaw Blog noted, the definition probably, “extend[s] through the entire corporate family,” such that holding companies and shells would not allow anyone to evade the requirement for long. I say for long because it’s possible, even likely, that playing a bit of a shell game with an entity’s corporate structure will buy it a little time, but in such a heavily regulated industry, the chances of getting away with cutting corners for more than that are low, as these cannabis operations recently found out in California. That said, the Rules leave it to the states to determine “which employee(s) of a producer shall be considered to be participating in the plan and subject to the felony conviction restriction,” so there is some flexibility in the definition.

What happens to an individual or entity that produces without a license?

The Rules characterize a “[f]ailure to obtain a license or other required authorization from the State department of agriculture” as negligent and not subject to criminal penalties. Three such violations in a five-year period, though, results in the producer being ineligible to produce hemp for five years subsequent to the third violation.

This made me think a multi-state partnership, a least one partner of which has a recent drug conviction. Let’s say the company operates in Oregon, where there is currently no felon ban, Washington (10-year ban), Georgia and N.C. (which both ban anyone convicted of a drug offense permanently). Does Georgia and N.C.’s ban on that partner’s participation mean that the company now has to separate those states’ operations (incorporated separately without that partner’s involvement) from its Oregon operation to assure that no funds are commingled? What if Acme Hemp Oregon is short on cash? It has no legal relationship with Acme Hemp Georgia, such that there would be a smooth transfer of funds to cover the shortage. There would have to be a loan involved. This seems highly inefficient and unwieldy, but necessary to comply with the states’ inconsistent rules. This will be true even when the USDA’s Rules come online and Oregon is forced to harmonize its regulations with them. Someone with an 11-year-old drug conviction, while eligible in Oregon and Washington, is still ineligible in Georgia and N.C..

What happens if a multistate corporation has a management level employee subject to the ban and does not demote or fire her? Does the single act of producing hemp, in at least three separate states, when a partner with a recent felony drug conviction is in place, subject that company to a five-year ban from the industry based on three violations? That would be a harsh consequence for what the USDA characterizes as a negligent act.

The message this sends to any corporation is that, over the next year, before the 2014 Farm Bill expires and the Rules take effect in October, 2020, they should verify the backgrounds of most everyone in a managerial position (I would go through the entire company just to be safe) and address any issues accordingly. The permutations from thatare complex. For instance, while it is clear that a company which has an employee with a recent drug conviction in a managerial position will have to reassign them to a position without managerial authority (or terminate them), what happens if it is a partner in the business? Must that partner be bought out? Or does the fact that she is legally incapable of owning a stake in the business relieve her partners of any obligation to buy her out? What is the incentive for a company to pay the partner anything if she cannot legally enforce any rights against the company?

In Georgia, in addition to ex post facto laws, which deal with criminal offenses, retroactive laws, civil laws which impair established rights under statutes or contracts, are also unconstitutional. A state law provision like that might offer some protection. The U.S. Constitution does not include this extra protection and, therefore, if I had a felony drug conviction from the last ten years and owned an interest in a hemp company and was incorporated in a state which had no protection against retroactive civil laws, I might be looking to sell in a big hurry.

For those who are in managerial positions and would be affected by the ban, you have a year to do one of the following: avail yourself of state post-conviction and/or expungement procedures to try and eliminate the conviction, negotiate the purchase of your ownership share and continue to work as an employee with no managerial authority or simply negotiate the best deal you can and walk away. Conversely, if you are partnered with someone affected by this ban, it may be time to use some leverage and strike a favorable deal for yourself, or, if you are particularly ruthless, wait until these Rules supersede the 2014 Farm Bill next fall and simply push your partner out.

A great many people who are casualties of the failed war on drugs view the burgeoning hemp industry as salvation and it is a great story for the ones who will actually succeed, but as I point out above, there are still many pitfalls between here and outrageous fortune. The felony ban is a significant one.

I have been so lucky to have the advice and consultation of some very brilliant and seasoned cannabis lawyers while working on this post. I want to thank Katy Young and Carrie McClain who answered many no doubt inane questions from me. As always, my new friend Rod Kight has been very encouraging all along. Special thanks also to Robert Head from Blue Cord Farms who has given me something I desperately needed: a non-attorney view of this industry (I’m sorry, I just can’t call it a space). For those reading, I will be at MJBizCon in Vegas in December and, after Carrie and I go out for dinner and what I suspect will be far too many drinks, would love to meet anyone who is interested in meeting me.