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PART 4 OF 5: THE BUSINESS FUNDAMENTALS EVERY CALIFORNIA CANNABIS COMPANY NEEDS TO KNOW: CONTRACT FUNDAMENTALS

PART 4 Of 5:

The Business Fundamentals Every California Cannabis Business Should Know: CONTRACT FUNDAMENTALS

OR “Dude, Where’s My Indemnity Clause and Other Super Fun Terms Every Cannabis Business Should Know” 🙂 

As California cannabis entrepreneurs are increasingly relying on written agreements over handshake deals, a primer on common terms may be helpful. Notably, business owners/operators who have a working knowledge of these terms will be better able to negotiate deals, enter into agreements, and address contract disputes. Particularly in our volatile emergent industry, those businesses who fully understand the terms they are binding themselves to will be better protected in their business dealings and, as such, may be more likely to survive this difficult transition period. Here’s the rundown:

  1. THE ESSENTIAL TERMS
The essential terms (aka the “material terms”) form the crux of the agreement, usually money for product, or money for services. It often makes sense to begin the contract with a clear description of these agreements, because that’s the point of the contract in the first place, right? Importantly, however, a contract consisting only of these terms is nothing more than a “purchase order,” meaning the parties don’t have any agreements about what happens if one party can’t hold up their side of the bargain.

Thus, the essence of the agreement should also include, at minimum, (1) what happens if the money isn’t paid or comes late, (2) what happens if the product or service is delivered late or is unsatisfactory, (3) the “term” of the agreement (i.e. a recurring deal or one-time thing) and (4) how the contract can be terminated.

In our view, a delegation of the requisite  regulatory responsibilities is also an essential component of cannabis-related contracts to ensure strict compliance with applicable laws.

  1. THE RISK ALLOCATION TERMS
Written agreements commonly shift inherent risks from one party to another, depending on the economics of the deal. The most common risk allocation terms are (1) indemnity clauses, (2) limitations on liability, and (3) insurance requirements.

Indemnity Clauses
Indemnities are where one party assumes the risk (i.e. costs) of a loss potentially incurred by the other party. Indemnities are usually tethered to losses caused by the indemnifying party, but some folks sneak in broad language requiring one party to cover the other for unrelated losses, so be wary.

For example, some common distribution agreements ask farmers to indemnify the distributor for issues with the “composition” of cannabis flowers, which may make sense because the farmer grew the product. But if damage occurred after the product left the farm (such contamination caused by grading/sorting on the distributor’s dirty machines), then an indemnity makes less sense.

Another example is in the white-label manufacturing context.  A brand owner who contracts with a manufacturer for producing a product under the owner’s brand may reasonably require that the manufacturer indemnify the brand owner for product liability claims.  However, if the brand owner requires the manufacturer to use specific formulas or processing methodologies, the manufacturer may want to exclude from its indemnification obligation liabilities caused by compliance with the brand owner specifications where a COA was obtained.

Since an indemnity clause can have massive financial repercussions if a deal goes south, no one should sign off on an indemnity clause without understanding what the heck it actually means in the real world.

Limitations on Liability
Contracts often include a liability “cap,” meaning one party will “cap” the maximum damages the other party is entitled to, often irrespective of fault or the total actual damages. However, limitations on the types of damages are also common, as one party may agree to “direct damages” (arising as a direct result of nonperformance), while seeking to limit “consequential damages” (arising as an indirect result of the nonperformance).

The following example may be helpful:

A distributor agrees to pre-pay for $50,000 worth of cannabis, but the cannabis delivered is unusable. The “direct damages” consist of the $50,000, but the “consequential damages” would include the distributor’s lost profits (which at 100% markup would be an additional $50,000), for a total loss of $100,000.
Thus, if a farmer’s entire season is riding on a single deal, and nonperformance would result in the farmer’s inability to fund the next season, those folks may not want to agree to consequential damage limitations.

Also be careful when a limitation of liability clause attempts to cap the other party’s indemnification obligations.  For example, if a manufacturer in a white-label agreement promises to indemnify a brand owner for product liability claims, but then limits its indemnification obligations to the amount of fees the manufacturer was paid by the brand owner under the agreement, a brand owner could be significantly exposed to product liability claims that are the result of the manufacturer’s wrongdoing.

Insurance Requirements
Insurance is a great way to shift risk, as insurance can pay losses the parties may not be able to cover, which is extremely common in California cannabis. Particularly for products liability, the benefit of a contractual insurance requirement cannot be overstated.

Representations and Warranties
“Reps and warranties” are the factual assertions one party makes to the other, such as “Seller represents and warrants its operations strictly comply with all applicable law and regulations.” Although reps and warranties do far more than allocate risk, they are a great way to minimize risk by requiring the other party to declare basic assumptions.

In addition, representations and warranties can detail a receiving party’s expectations about a product or service, such that if the representations and warranties are not met, the receiving party can clearly reject the product or service and either not be liable for the contract price or be entitled to a refund.

  1. THE DISPUTE TERMS

Although no one wants to think about what happens if the deal falls through, wise business operators will include dispute terms in their agreements. Here’s a few of the most common:

Choice of Law and Venue
Most folks want to be governed by California law because no one wants to be defending a cannabis contract under federal rules. Locking down the venue (aka the County) is wise too, as farmers and distros/manufacturers are often in different locations. Getting a venue closer to home is often ideal, particularly if the home court is friendly to cannabis.

Mediation and Arbitration (“ADR”)
Mediation/arbitration clauses are designed to keep folks out of court. Mediation is generally non-binding, meaning the mediator facilitates a discussion but the parties are not bound. Arbitration, on the other hand, is a more formalized process the parties usually agree to be bound by.

Particularly in cannabis, where there is no shortage of odd or novel disputes, alternative dispute resolution (“ADR”) requirements can be helpful.

Force Majeure
A “force majeure” event is something beyond everyone’s control, such as  fire, pandemic, and riots, all hot button issues in today’s world. This term excuses the parties from performance when something truly unexpected happens. In light of volatility in our market, wise entrepreneurs will not leave this clause out of their written agreements.

CLOSING THOUGHTS
In closing, courts look to the “intent of the parties” as reflected in the language of the contract in adjudicating contract disputes, meaning the company’s owners and/or operators themselves must understand what they are binding themselves to. While attorneys are helpful to negotiate and prepare the contract, the onus is on industry, i.e. the businesses themselves, to have a working knowledge of these terms and how they affect later disputes.

Stay tuned for the final piece of this series, “Contracts Overview: What Paper to Push?” which will include a sample Purchase Agreement! Make sure you’re on our email lists:

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