TL;DR: While yesterday’s cannabis news is monumental, if it goes through, I don’t see much actually changing for a long time, except for 280E.
Now the long version – news like this has me breaking my short posts rule. I needed to sleep on it to get away from the 500 permutations and combinations that all of this could follow from here and remind myself that the political and legal machine favors state’s rights and guarantees a slow, grinding path now more than at any other time in history. The only real signals here amidst some serious noise. The news is getting both celebrated by the powers that be and criticized by the long tail of the industry for a lot of the usual reasons. Here are my thoughts:
- First things first, this is far from a done deal. The DEA still has to say “yes” to what HHS is recommending here. It’s true that there is ample precedent for the DEA to say yes when a “scientific body” like HHS (and embedded in there, FDA) makes a recommendation. But this is different both scientifically and politically, and there is no timeline for any kind of DEA review and decision. I don’t think we’ll wake up in 30 days to news that the DEA said yes. They’re likely to run their own full-scale review, and it’s hard for me to see that happening without legal forces getting involved. I don’t think you can sleep on conservative forces stepping in at this point in the handoff to try and push the DEA to slow-roll this – and I wouldn’t be surprised if it just didn’t go anywhere at all now that the ball is in the DEA’s court. The best way for conservative powers to win is to have no outcome at all – bury this in administration and legal review. Even if they do say yes, do we really think there won’t be immediate legal challenges trying to reverse their decision?
- Taking a step back, I’m not sure the general population is picking up on perhaps the most important embedded snafu in all of this. Yes, snafu. You have the FDA making the recommendation here. But the FDA isn’t set up to regulate this. Single molecule :: single therapy, yes. Multi-molecule :: multiple therapy areas (the entourage effect), no. I can go way deeper here, but check out our posts under Insights at frontierrisk.com that address this concept. Put simply, the FDA doesn’t have the institutional infrastructure to regulate this, and it will take serious time to build. I wasn’t surprised by this announcement, but I’m surprised as to why the FDA is still trying to convince themselves they can handle the cannabinoid platform when they know they can’t, and have publicly commented they can’t, recently, regarding CBD.
- I’m seeing a lot of commentary from some very smart folks and good friends (@brettpuffenbarger, to name one) that movement to Schedule III means death for state programs, death for recreational use in states, this is a win only for MSOs and there will be heightened M&A activity for them, on and on. Brett and a lot of our peers are clairvoyants in the space. But I’m not sure I agree entirely with this line of reasoning. Here’s why:
- Schedule III being death for state programs: I find this hard to believe. Again, we live in a time when states do basically what they want, and the more money that’s involved, the more that’s true. Do we really think that all these states, who are starting to print serious tax revenue receipts from their individual programs, are just going to give that up because the federal government now says you need a prescription to buy cannabis? I don’t think so. Regardless of whether or not you agree, I think you can be absolutely sure that if the federal government tries to impose its will on this issue, states will sue, and this will be tied up in 30+ state lawsuits for years to come.
- Death for recreational: I think there is a very tempting legal and logic argument deserving serious debate here. Some prominent and intelligent legal voices have quipped in the last 24 hours that you can’t just walk down to the corner store and buy ketamine or testosterone. That’s true. They argue, then, that a given state’s recreational cannabis program means a state is saying you can use a substance that requires a prescription without a prescription. Strong point, but I still think misses the above point that states litigate this until the end of the earth and this legal argument starts to become moot as states will allow programs to continue until any litigation is ultimately decided.
- I thank the legal pundits for drawing the analogy to ketamine, because it raises a hugely important topic: Big pharma can and will ruin cannabis as a holistic wellness approach to therapy. Take a deep dive on ketamine and patient outcomes in pharma settings versus non-pharma settings. Settings that incorporate guiding music, talk therapy, environmental comfort, etc. There’s a lot of money to be made by big pharma in cannabis. But does the cannabis consumer really want to buy cannabis from big pharma? Most don’t. Specific therapy areas, see Epidiolex, yes. But that’s single molecule, single target therapy area. See above FDA infrastructure point. Don’t expect Eli Lilly to be the brand on the flower jar, the pre-roll, the “full spectrum” vape cart, etc. They’re not set up to be regulated to sell these things.
- Which is a segue to my final point on this topic: M&A activity at the large MSO level. I don’t think this move accelerates large MSOs coming together. What I’m talking about is big pharma acquiring the big guys. Again, skeptical here. I’m not here to knock MSOs, but I don’t know that MSOs survive the diligence process when the Ernst & Young quality of earnings team parachutes in 50 guys and girls to run down all the internal controls. One or two may make it and then require serious investment by the acquirer to get up to pharma grade throughout all their infrastructure. But again, pharma acquirers have to ask themselves, what am I really getting here if my entire infrastructure is pharma grade and my entire buyer universe is someone having a prescription?
- Does this move accelerate SAFE Banking? Probably. But I’m not sure there’s a need for SAFE anymore if this goes through. Why would there be? Revenue receipts from Schedule III narcotics don’t require Suspicious Activity Reports to be filed by banks. No SARs, no banking woes. I’ve spoken to more than 250 banks with federal charters in my career – the vast majority weren’t looking for something absolutely definitive to jump in, they were looking for some direction, however relevant or not, to tilt them towards participation.
- The 280E fix cannot be overstated in its importance. The bigger the cannabis operator, the more tax liability they’re sitting on. A lot of institutional investors have stayed away for that specific reason alone even after getting comfortable with the federal disconnect. I can’t tell you the number of board-level conversations I’ve overheard at the large players where people articulate the strategy of “don’t pay, let’s fight the IRS on this for the next 5 years, in that timeframe 280E will be fixed, we’ll be grandfathered in, the liability goes away”. I think there is $10 billion + in free cash flow over the next decade tied up in 280E levels of effective tax rates. If all of that is taken and reinvested into growth, the industry (namely job creation, investments in more fixed asset infrastructure to meet rising demand) benefits. Don’t expect the large MSOs to start paying out dividends anytime soon. This cash is desperately needed to fuel what is an extremely capital intensive industry. And forget MSOs for a second. I’ve spoken with thousands of sub-scale operators (a lot of whom have no desire to be anything but sub-scale, which I applaud) who are under more pressure from 280E than the big guys. It’s crushing cannabis entrepreneurs and hampering economic growth – remember that small businesses are the backbone of the US economy, and are definitely the backbone of the US cannabis industry. Small players don’t have the funds to accrue these tax liabilities and the legal fights that come with them. This potential relief is massive to put people on a more equal playing field. People will roll eyes when I say market-driven solutions are the most efficient, but money talks when you’re a young entrepreneur, especially a young entrepreneur of color that the government hasn’t allowed to fight fairly.
- On the social equity front, I read an intelligent quote in Politico from Justin Strekal that said, to paraphrase, that rescheduling in this manner doesn’t end criminalization, it just rebrands it. I agree with this, and it’s a major issue. This is the core area where moving from I to III doesn’t go far enough. If you’re caught with ketamine and you’re not supposed to have it, the government has every right to put you in jail. Why is cannabis as a Schedule III narcotic any different? Communities that have suffered unjustly in the past for cannabis possession shouldn’t expect to see any relief if this announcement materializes into something real, and that’s wrong.
- And a nod to insurance: this going through doesn’t change one iota that historical loss runs are few and far between for the cannabis industry. How do you price risk when you don’t have those historical datasets? Maybe the datasets get built faster now, but reinsurance still needs to be guided in with real data, perhaps now more than ever as things really start to move and the opportunity set grows.
Originally posted on LinkedIn on August 31, 2023.