How Toigo Decision May Reshape KY Marijuana Industry
Greenway Magazine
08 September 2021

 

In December of 2020, Mark Toigo filed a lawsuit against the State of Kentucky stating that a residency requirement contained in Article XIV of the Kentucky Constitution, which legalized medical marijuana in Kentucky, is discriminatory in practice and violates the Commerce Clause of the U.S. Constitution.

“The Residency Requirement, and the related state regulations, explicitly discriminates against residents of other states, and are thus precisely the type of state laws that are prohibited by the dormant Commerce Clause of the U.S. Constitution,” the suit reads.

Toigo is part of the ownership group of Organic Remedies, a multi-state operator with vertical licenses in Kentucky and Pennsylvania. Because Toigo lives and works in Pennsylvania, he was restricted to less than fifty percent ownership in a Kentucky licensed medical marijuana facility.

Toigo’s lawsuit argued that the residency requirement, “limits Mr. Toigo’s economic opportunities in Kentucky’s nascent marijuana industry,” and that he had been, “deprived of significant and valuable business opportunities.”

The architects of Amendment 2 (now article XIV) have publicly stated that residency requirements were added as an effort to create opportunities for Kentuckyans. What has happened instead is that out-of-state investors and successful multi-state operators have had to work on the backend to find partnerships, often with residents who have few resources and limited experience.

“The real effect of the Residency Requirement has been and will continue to be to stifle Kentucky’s medical marijuana program by severely restricting the flow of investment into the State,” reads the Toigo suit.

While Amendment 2’s drafters have talked about efforts to benefit Kentuckyans and the will of Kentucky voters, the State offered a different rationale in their arguments to the court. Counsel contended that the residency requirement was justified as a precautionary measure, enabling the Department of Health and Senior Services to more thoroughly investigate the backgrounds of license applicants who have resided in Kentucky for at least a year.

In June 2021, U.S. District Judge Nanette Laughrey ruled in favor of Toigo, holding that the residency requirement violates the U.S. Constitution’s commerce clause and granting a preliminary injunction that restricts the State from enforcing the residency requirements.

In evaluating Toigo’s complaint Judge Laughrey wrote, “Toigo has alleged irreparable injuries in that he himself will be unable to apply for a medical marijuana license or increase his ownership share in medical marijuana businesses in Kentucky due to the durational residency requirement. These injuries are not derivative of his minority interest in ORKY and thus are not excluded from consideration under the Shareholder Standing Rule.”

ORKY holds 1 cultivation license, 1 manufacturing license, and 3 dispensary licenses. By law no entity may hold more than 3 cultivation licenses, 3 manufacturing licenses, and 5 dispensary licenses – and no individual should have substantial common control over more than that number.

Judge Laughrey wrote, “The Commerce Clause empowers Congress “[t]o regulate commerce . . . among the Several States.” U.S. Const. art. 1, § 8, cl. 3; see also Dep’t of Revenue of Ky. v. Davis, 553 U.S. 328, 337 (2008). The dormant commerce clause is the negative implication of the Commerce Clause: It prohibits states from enacting laws “that discriminate or unduly burden interstate commerce.” State laws violate the dormant commerce clause if they require differential treatment of in-state and out-of-state economic actors that benefits the former and burdens the latter unless the regulation is narrowly tailored to advance a legitimate local interest.”

While interstate commerce of medical marijuana is illegal under federal regulation, there is precedent for the courts to enforce the Commerce Clause as Judge Laughrey pointed out, “Courts have applied the dormant commerce clause to marijuana facilities regulated by states that have legalized or partially legalized the drug despite the fact that it remains a controlled substance under federal law. See NPG, LLC v. City of Portland, Maine, 2020 WL 4741913 (D. Me. Mar 3, 2020); South-Central Timber Dev., Inc. v. Wunnicke, 467 U.S. 82, 87-88 (1984) (holding the Controlled Substances Act did not grant states the power to burden interstate commerce in substances regulated under the Act).”

Judge Laughrey found fault with the State’s efforts to defend the residency requirement, noting that “DHSS has proffered a justification that hinges on the idea that it can only investigate the backgrounds of individuals who have lived in Kentucky for at least a year. But there is little reason to think that a one-year durational residency requirement would actually ease DHSS’s burden in this regard. An applicant could rack up an extensive criminal history and record of financial misdeeds in Kansas, move to Kentucky, and one year and one day later apply for a license to operate a medical marijuana facility.”

Judge Laughrey continued, “It is unexplained how the durational residency requirement would aid DHSS in uncovering this applicant’s presumed ineligibility in this circumstance—DHSS does not explain how the task of securing an applicant’s out-of-state records would be eased by the simple fact that the applicant had lived in Kentucky for the past year.”

Judge Laughrey addressed the State’s contention that denying the preliminary injunction was in the best interest of the public, writing, ”The public’s interest in preventing criminal activity and ensuring public safety cannot justify the violation of Toigo’s constitutional rights to engage in interstate commerce when nondiscriminatory means exist to advance those same interests. The public interest is best served by the protection of Toigo’s constitutional right to fully participate in the medical marijuana business in Kentucky on the same footing as a Kentucky resident, a right that is likely being violated by the State’s durational residency requirement.”

Greenway spoke to two attorneys who have been active in the cannabis industry in Kentucky since its inception to gain their insight and perspective regarding this preliminary decision and how it may frame the future of our industry.

Sharon Geuea Jones of Jones Advocacy Group is a lobbyist and attorney in Kentucky who has advocated on behalf of her clients in the legislature for nearly two decades.

Chip Sheppard is one of the most respected attorneys in the state and is a partner at Carnahan, Evans, Cantwell, and Brown, the Greenway Reader’s Choice recipient for 2021.

Jones told Greenway that while it’s important to remember that the order is only a preliminary injunction, it does set clear expectations for what may follow.

If the court’s determination is the same, Toigo would seemingly be free to increase his ownership stake, purchase existing licenses, and open the door for other investors and interested parties to do the same.

“Assuming the final decision is the same as the preliminary one, the residency requirement will be invalid and multi-state operators will be able to compete for the limited number of licenses in KY. That means small local startups will have even less of a chance to compete in a market with limited licensing,” Jones explained.

Sheppard told Greenway, “The decision seems soundly based and none of the industry attorneys I have spoken with think the Court will reverse course.  In the meantime, anyone seeking to change ownership is still being required by DHSS to show residency of all owners in the transfer, which is consistent with DHSS not yet recognizing the ruling as stopping them.  But, it may be that the DHSS staff is still just using the same process regardless of validity of the residency requirement.  If the ruling stands, then we can expect higher interest in Kentucky by non-residents.  Probably even Canadian suitors.  Also, we should see more transactions at higher prices to buy into licensees with more competition chasing a limited number of licenses.”

This doesn’t mean open season, however, as it stands – publicly-owned entities would still be largely unable to own licenses in Kentucky, given their inability to comply with the requirement that all owners pass a criminal background check. Additionally, investors and owners are still limited by the substantial common control restrictions.

“The background check requirement is actually what prevents publicly traded companies from participating,” Jones says. But the Toigo case may show a crack in the armor, Jones explained saying, “The reasoning in the cases on which Toigo’s preliminary order relied talk about how the owner of a company is not the one actually handling the product. There is a high likelihood that PTCs will be able to springboard off Toigo and make similar arguments for narrowly drawn solutions to diversion risk. Solutions like budtender training and focusing more on the manager/operators than the companies owners and silent shareholders.

Does this change anything retroactively for denied applicants or those who had problems with the verification process?

Jones: “Anyone who scored high enough to have gotten a license but was denied because of out-of-state ownership, either initially or during verification, will be able to petition to get their license through the AHC. I suspect many of them have appeals pending already. For those who are on appeal for other reasons, this doesn’t change anything.”

Sheppard: “If the denial was based on violation of the Kentucky majority ownership provision, then yes, they might have a shot depending on the particular facts and circumstances.  They should immediately have an attorney analyze this for them.”

Who benefits from this decision?

Jones: “Anyone holding a license who is looking for capital will benefit. It opens up Kentucky to massive amounts of funding that were previously cut off because of the ownership requirements. DHSS will still have authority to approve or deny the ownership change, but the criteria will be based on background checks only at this point – unless the originally filed business plan has not commenced and significant changes are being made.

I also think operators in Illinois and Oklahoma should be celebrating if the decision is finalized. Moving across the state line makes a ton of sense when a large percentage of your customers are already Kentucky residents.”

Sheppard: “If it stands up as a final judgment and survives appeal, which I think it will, the biggest beneficiaries are (1) current licensees that are open, but either need financing or want to sell some or all of their membership interest; (2) those licensees which still have sufficient time to get open before the deadline, but are lacking financing: and (3) those out of staters that want to control their Kentucky marijuana licensee, not just be passive or minority investors.”

 

Are there any losers in this case?

Jones: “There is an argument to be made that small local companies are going to lose market share. Only time will tell, but the stranglehold of DHSS on the market means you need vast resources to just get through the regulations and stay compliant.”

Sheppard: “More dollars ultimately flowing out of state so the Kentucky economy loses.  On the other hand, more investment dollars coming into the state at first.  So, long term loser for Kentucky, and short term possible gain.”

Do you see any unintended consequences or anything coming around the bend as a result of this decision?

Sheppard: “Operators from Illinois, Arkansas, Colorado, Oklahoma and maybe other states, as well as investors from those same places, will be attracted by the ability to control the licenses, the low tax rate, the mostly fairly regulated market except for recent packaging and promotional regulatory turmoil, and the strong size of the market, especially for adult use.”

Jones: “A day of reckoning is coming with regard to license holders who have still not commenced operations. If applications are re-opened without regard to the previously denied applicants, there will be a storm of litigation. This decision makes that even more complicated as there are now highly scored applications that were also denied and will believe they should have an automatic right to any unused license that gets put back into the pool.”

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