How does a federal enforcer protect competition in a federally illegal market? As cannabis transitions from an unlawful substance to a prescribed medical treatment and recreational drug now legal in several states, Spencer Parts examines how the Department of Justice’s antitrust division has been policing the fledgling industry.
Marijuana still makes lawyers laugh. Introducing a keynote presentation at the American Bar Association’s 2020 virtual antitrust spring meeting, chair Brian Henry, a competition counsel for Coca-Cola, joked that no one in the audience had ever used the drug.
As legalisation has rapidly progressed at a state level, however, the cannabis market has become serious business, with revenues predicted to reach hundreds of billions of dollars before the end of the decade.
The drug remains a federally illegal “schedule one” substance in the US, deemed by the federal Food and Drug Administration to be highly dangerous and unauthorised for medical use. But with the tacit acceptance of law enforcement – federal prosecutors have so far declined to bring charges against buyers and sellers who abide by state laws – 33 states have now legalised the drug in some way. In 10 states, adults can buy the drug for recreational use while in the other 23, medical use is permitted.
Against this backdrop, businesses across the US are looking to grab their slice of this up-and-coming market. It remains a particularly challenging environment, in part, because it is illegal under federal law to transport the drug across state lines. Companies also have to navigate dramatically different rules in the different states in which they operate. Washington state, for example, bans vertical integration among marijuana growers and sellers, while New York and Florida’s licensing regimes require that same type of integration. Both states – which under current law only allow marijuana for medical use – provide just one type of licence, so each company must operate all parts of the supply chain. Lending to cannabis companies is also constrained by the fact that marijuana is illegal under the Controlled Substances Act.
Despite those hurdles, a wave of deals took place in 2019. Last summer, Canadian cannabis seller Cannex bought cannabis brand development company 4Front. Chicago-based Cresco – which sells pre-wrapped marijuana cigarettes under the brand name High Supply, and says its mission is to “normalise, professionalise and revolutionise cannabis” – closed a deal to buy Californian distributor Origin House in January this year. A month later, Massachusetts-based cannabis seller Curaleaf paid $875 million to buy Grassroots, expanding its footprint from 12 to 19 states. Curaleaf said the deal made it the “world’s largest cannabis company”.
Less than 5% of deals reported to the antitrust agencies ever receive requests for further information, but all three of those mergers drew federal antitrust scrutiny. Cannex and Cresco both announced publicly that the Antitrust Division had issued a second request for information about their acquisitions. Curaleaf and Grassroots, which first announced their deal in July 2019, told investors this January that they had complied with a request for information on the antitrust aspects of the deal, indicating that they also received a second request. Curaleaf revealed a month later that the agency had not taken any additional action, allowing the company to close the deal.
Other tie-ups have been less successful. In April 2019, Chicago-based Verano Holdings agreed to buy cannabis company Harvest Health for $850 million in a deal that included licences to operate in 11 states. But in March this year, the companies announced that they had mutually agreed to cancel the deal, citing a delay in securing antitrust approval as one of the reasons. Verano and Harvest Health also received a second request from the DOJ.
“While both organisations worked very hard to consummate this transaction, significant delays in closing started with the Hart-Scott-Rodino antitrust review process,” Verano chief executive George Archos said at the time. “Those were followed by state and local regulatory complexities in multiple states.”
A directive from five floors up
The DOJ declined to comment until the day before Antitrust Division attorney John Elias was due to testify as a whistleblower before the House of Representatives judiciary committee on 24 June.
In prepared testimony, Elias asserted that in-depth reviews of deals in the marijuana industry were directed by attorney general William Barr and prompted by his “personal dislike of the industry”. Elias also said that Barr called in senior Antitrust Division leadership for a meeting on marijuana industry mergers in March 2019, where he personally ordered a second request of cannabis company MedMen’s $682 million all-stock purchase of east coast rival PharmaCann. Elias did not himself attend the meeting.
Career staff raised concerns about the second request, as the deal was unlikely to cause competitive harm because it took place in a fragmented sector and involved companies with relatively small market shares – but Barr ordered the Antitrust Division to issue the second request anyway, Elias said. Antitrust Division leadership subsequently said the agency needed to find out more about the industry as it had not assessed deals in that market previously, Elias added.
Since then, the Antitrust Division has conducted nine more cannabis merger investigations, which followed a similar pattern with staff raising objections, Elias said. He calculated that cannabis industry investigations accounted for nine out of 31 DOJ second requests, or 29% of the total that took place in the 2019 fiscal year. There were so many of these investigations that staff from outside the merger division who were primarily responsible for the deals were called in to assist with the reviews, he added.
Some aspects of the investigations appeared to be designed to impose a burden on the merging companies, Elias said. Antitrust Division leadership denied applications to make second requests narrower and less burdensome, even though staff did not review many of the documents turned over to the agency, he said. In one case, staff began the process of ending their merger investigation before the documents were produced, Elias added. Staff were also told not to interview customers or competitors as part of their reviews so as to “draw less attention to the investigations”, Elias said.
Delrahim at one point apparently said the investigations were motivated by Barr’s views of the cannabis industry. At a September 2019 all-staff meeting, Delrahim “acknowledged that the investigations were motivated by the fact that the cannabis industry is unpopular ‘on the fifth floor’,” a reference to attorney general Barr’s offices, Elias said.
The DOJ responded to the prepared testimony by saying it “strongly disagrees with Mr Elias’s claim that the Antitrust Division acted inappropriately in any investigation.” A spokesperson said in a statement that the DOJ’s Office of Professional Responsibility reviewed complaints from “anonymous whistleblowers” on the marijuana merger investigations, but determined that the Antitrust Division acted appropriately. “OPR found that the cannabis industry provided a unique challenge to federal and state regulators alike, and it was reasonable for the Antitrust Division to seek additional information from the industry through its second request process,” the spokesperson said.
Documents provided to OPR for the review show that the Antitrust Division successfully negotiated with companies to narrow the scope of some of the requests, the spokesperson added. DOJ attorneys carefully analysed the competitive consequences of the mergers and “often explained how the actions of state regulators offset any competitive concerns,” the spokesperson explained.
“An automatic second request”
Akerman antitrust partner Larry Silverman says Elias’s testimony confirmed widely held suspicions in the cannabis industry that the second requests were the result of animosity toward the industry within the DOJ rather than legitimate competition concerns.
“Everyone expected that,” Silverman says. “We all presumed they were doing this”
Silverman told GCR USA in May that there is a perception in the cannabis industry that second requests are automatic for these types of deals. But this is unusual because of the fragmentation of the market and the absence of any dominant players with a significant national presence, he explained. At this point, companies are buying each other because of potential growth and not because of a strong record of profitability.
This perceived scrutiny has discouraged companies from agreeing deals that exceed the reporting thresholds, which “has led to a significant freeze because people are afraid”, Silverman says. In the fast-changing marijuana industry, a long delay because of a second request can upend the economics of a merger. When a company purchases another company using shares instead of cash, which is more common in the cannabis market because of financial difficulties, its valuation may not support the purchase eight months after complying with a second request. “To do one of these deals and then have to sit on the sidelines for a year is a problem,” Silverman says.
Fishkin, who spent 15 years as a staff attorney in the Mergers III division at the Federal Trade Commission, said in May that this level of scrutiny by the DOJ is unusual, but that the DOJ has to familiarise itself with any industry that is new to the agency. As recently as a few years ago, no cannabis deals were being reported to the agencies because of legal prohibitions against the sale of cannabis, he says.
“With mergers in any new and developing industry, the agencies have to investigate the issues and understand what’s changing,” he says. “That’s probably why the DOJ issued so many second requests on these matters.”
Stringent federal and state-level regulatory requirements are not unique to deals in the cannabis market, Fishkin says, citing telecom or utility mergers as other examples. “Just because an industry is subject to regulatory approvals, either at the state level or federal level, doesn’t give you an out,” Fishkin says. Other products subject to strict regulation because of health or social effects, such as alcohol and tobacco, are also subject to conventional antitrust enforcement to protect consumers from anticompetitive conduct that might lower quality or raise prices.
Heightened interest from the DOJ has prompted questions in the industry about how cannabis deals will be treated by federal law enforcement, says Silverman’s colleague Zachary Kobrin, a special counsel at Akerman, who formerly worked in-house at medical cannabis company Cansortium.
Even though it was widely assumed that the DOJ was using second requests to hold up cannabis deals, it was “pretty shocking” to hear that from inside the DOJ, Kobrin told GCR in June. “I am hopeful – but not holding my breath – that this testimony will pull back the curtain completely and give cannabis transactions an equal footing to other mergers of similar size and scope and remove the unnecessary microscope,” Kobrin says.
He predicts that a major wave of consolidation would follow legalisation of cannabis at a federal level. Right now, criminalisation of the drug is holding back major companies in the pharmaceuticals and tobacco markets from the industry. But if federal prohibition ends, those companies will sweep up a large share of the market, he predicts.
David Cicilline, chair of the House of Representatives antitrust subcommittee, had suggested prior to Elias’s testimony that political influence was potentially behind the DOJ’s interest in the cannabis market. In written questions sent to assistant attorney general Makan Delrahim following a November oversight hearing, Cicilline asked whether attorney general William Barr has “attended or otherwise been involved in any of the reviews of mergers involving the marijuana industry.”
Delrahim declined to answer that question in his written responses, citing the agency’s policy not to comment on specific investigations. “However, attorney general William Barr, in his role as attorney general and head of the Department of Justice, oversees the Antitrust Division,” Delrahim wrote.
Barr has not reinstated Obama-era DOJ guidelines that were issued in 2013, which helped give states confidence to legalise marijuana. Those guidelines instructed prosecutors not to bring criminal charges in states that have legalised the drug, although former attorney general Jeff Sessions rescinded that guidance in 2018. In Barr’s confirmation hearing that year, he said he supports a nationwide marijuana ban, but he would not upset “settled expectations” in states that have legalised the drug.
Looking to the future
Although deals in the cannabis market have drawn scrutiny from the DOJ, industry observers say state antitrust enforcement is rare. Typically, state licensing requirements play a larger role in limiting companies’ expansion prospects rather than state antitrust enforcement.
California, which legalised the recreational use of cannabis in 2016, is now one of the world’s most lucrative lawful markets for the drug. Kathleen Foote, who leads antitrust enforcement for California attorney general Xavier Becerra, says she has not yet observed any antitrust concerns in the cannabis market. Currently, there are “lots of mom and pop producers so mergers are not a question,” she says.
Some states have tried to prevent antitrust issues from arising by incorporating competition laws and principles in their new marijuana regulatory regimes, says Andrew Livingston, director of economics for law firm Vicente Sederberg, which advises marijuana companies and investors. Massachusetts, for example, limits horizontal consolidation in the market by capping the number of stores a particular retailer can operate.
Other states limit vertical integration. Washington requires different companies to manage production, distribution and retail, which is comparable to alcohol restrictions that exist in most states.
Dr Jeff Chen, who leads a cannabis research institute at the University of California at Los Angeles and gave a keynote on the market at the ABA antitrust spring meeting, thinks the industry would benefit from greater consolidation. Unlike markets for other products, the cannabis industry is particularly fragmented because large national companies are put off by federal illegality, he said.
Uneven regulation and poor consumer knowledge about cannabis is getting in the way of appropriate and healthy use of the drug, he said. Chen thinks customers should be receiving better information about marijuana and might do so in a more organised market. In his home state of California, the market is still a “free-for-all,” four years after the state legalised recreational marijuana.
Chen expects the cannabis market to normalise if the federal government ever legalises the drug, with large operators pushing out the “mom and pop shops” that have flourished amid legal uncertainty.
If that does happen, DOJ lawyers will have a head start on assessing that consolidation, having closely observed the market’s development as the drug remained federally illegal.