Avoid litigation at all costs: Lessons learned

The cannabis community needs to be careful when disputes arise. Issues can be dealt with by filing a lawsuit in court, but that carries many risks. Litigating issues in court will often result in unintended consequences that can be very damaging to the parties. Consider the results of these three recent cases.

Polk v. Gontmakher, No. 2:18-cv-01434-RAJ, U.S. District Court for the Western District of Washington (May 21, 2020) highlights the problems with trying to use litigation to retain equity shares in a cannabis company.

Metsch v. Heinowitz, D074999, 4th.App.Dist California unpublished (April 22, 2020) highlights how appealing a negative ruling may backfire on a litigant.

Colette v. CV Sciences Inc, No. 2:19-cv-10227-VAP-JEM(x), U.S. Distict Court for the Central District of California (May 22, 2020) highlights how litigation in the CBD context is also tricky, and should be avoided for the time being.

1. Polk

In Polk v. Gontmakher, Polk and Gontmakher worked together to create a cultivation business in Washington. Because Polk had a criminal history, they left his name out of the business paperwork, but orally agreed that he is entitled to a fair share of the business. Polk then left the business, and sued when he wasn’t getting paid what he said he was entitled to.

The court dismissed the lawsuit because the parties entered into an agreement for an illegal purpose. The doctrine of illegality is similar to unclean hands, and is based on the idea that the court is not going to enforce an agreement that had an illegal purpose. Rather than wade into the murkiness of the dispute, and decide who was right and who was wrong, the court prefers to “leave the parties where they were prior to the lawsuit.” Philosophically, this rule exists to discourage people from doing such illegal contracts in the first place, because they should know that the courts will not help them if the other party breaks the agreement.

This dismissal functions like a door slammed in Polk’s face. He has spent years of time and energy working on this business, yet has nothing to show for it. By filing his lawsuit in court, and getting it dismissed, he has all but assured that he will not be recovering money from Gontmakher for his role in the company. He does have the option of appealing, but as the next case demonstrates, that can be a costly move that is unlikely to succeed.

2. Metsch

In Metsch v. Heinowitz, the court dealt with a dispute concerning Chronic Catering. The company was formed in 2014 to “produce baked goods and other edibles for the medicinal marijuana industry.” However, some of the owners took the private information from Chronic Catering, and used it for a different company, effectively cutting out the other partners. In August of 2017, the cut out partners filed suit, asking the court to award them thousands of dollars in damages.

In a similar ruling as the Polk case, the court dismissed the lawsuit based on the illegality doctrine. The court said that making a contract to form a cannabis company is not protectable by the law. Because the contract was for an illegal purpose, the court refused to hear arguments over who was correct, and threw the case out. At this point the plaintiffs were probably pretty upset, having incurred significant legal costs to get to this point, with nothing to show for it. They decided to appeal the case. This decision meant taking on the additional time, energy and costs of filing such an appeal, and incurring the risk that the appeals court might not rule any differently.

Their arguments on appeal were based on various problems with the judge’s ruling. Presumably, they felt that the legal problems with the judge’s decision gave them a good chance of succeeding on appeal. The appeals court agreed that the judge had made some mistakes. Technical details of the arguments made below were ignored by the judge in his decision. The judge had also incorrectly applied the California laws that were only enacted in 2016, despite the fact that the contract was entered into in 2014.

However, the appeals court found that these problems with the judge’s decision did not change the fact that the decision he made was the right one. Using a slightly different path, the appeals court arrived at the same conclusion as the first judge, and affirmed the decision to toss the suit from court.

Now the plaintiffs find themselves out thousands of dollars in litigation costs, and still without any recovery from their alleged dispute. They are unlikely to appeal again.

3. Colette

In Colette v. CV Sciences Inc, the plaintiffs are consumers who have purchased CBD products from the defendant. The products include sprays, oil drops, gummies, capsules, and softgels. While the 2018 Farm bill legalized hemp in the traditional sense, that is not the end of the story when it comes to products in the marketplace. There are many rules surrounding the use of CBD products. You cannot claim that CBD has medical benefits, or that it can cure a particular ailment. You also cannot add CBD to food or pet products.

The lawsuit alleges that these products violate the FDA rules on CBD-infused products, which cannot be labeled as dietary supplements or as having medical benefits. The lawsuit claims that the companies have injured not only the people who are suing, but also that the company deceives the public with false advertising and deceptive trade practices.

However, the court did not waste any time in staying the lawsuit. When a lawsuit is stayed, the proceedings are paused until further notice. In this case, as well as a similar one out of Florida, the proceedings are being stayed because the FDA is in the rulemaking process for CBD products. As such, the court will wait to see what rules the FDA announces, and only then will it turn to the plaintiff’s complaint. This means that the plaintiff and his lawyer will have to wait months, possibly years, before seeing any financial recovery from the lawsuit.

Lessons learned

These cases are effective learning tools for any cannabis entrepreneur. There are countless reasons why avoiding litigation is a good idea, and these cases demonstrate some of them.

The illegality doctrine is alive and well

As mentioned above, the illegality doctrine means that a court will refuse to enforce a contract that a plaintiff is using in the lawsuit. Typically it will be a federal court that will invoke the doctrine to dismiss a case. However, in the Metsch case it was the California state court that tossed the suit, because the company was operating without a license.

This is an important point about the illegality doctrine. Even in the most legal of operations, a defendant is allowed to have the case removed, or sent, to federal court. Once there, the federal court will likely dismiss the case based on the illegality doctrine, with some exceptions. Getting the case sent back to state court after removal is possible, but not easy.

In state court, a fully legal operation would avoid this problem, but what if there was some oversight in due diligence? What if a new investor wasn’t reported to the state? What if some plants were transported by someone other than a licensed distributor? Even a small deviation from full compliance means that there is an illegal operation going on, and a court could invoke the doctrine to toss the whole lawsuit. Because of this possibility, litigation must be avoided.

You cannot always predict how a cannabis lawsuit will turn out

Litigation attorneys will often brainstorm different legal arguments before a case is filed. They will try to imagine various contingencies, and try to predict outcomes. But litigation is inherently uncertain, and this is true with cannabis lawsuits even more than in other industries. There are too many procedural things that have to happen, and too many unforeseen developments that could derail a case. The CBD case probably seemed like a strong case to bring, and the lawyers likely couldn’t have predicted that the FDA would start rulemaking when it did, or that the judge would feel that it was necessary to stay the case to await the FDA’s rules.

Similar logic applies to deciding whether to appeal a case. Just because you feel a judge made mistakes doesn’t mean you will win on appeal. First, there is a procedural difference where often the appeals judge is forced to answer the question “did the first judge abuse his discretion in making his decision” instead of “who should have won the case”. This shift in procedural posture can often spell defeat for those choosing to appeal. Also, as we saw in the Metsch case, sometimes even if the first judge was wrong, the second judge will arrive at the same conclusion through a different route.  Appeals can be difficult, costly and time-consuming. While walking away after a loss may be difficult, it is certainly preferable to do it before an additional costly and lengthy appeal that goes nowhere.

No reason to create public record

There is another important reason for the cannabis community to do everything they can to stay out of court. Documents and legal arguments that are filed with the court become a part of the public record. They can be accessed by people like competitors, investors, and regulators. Depending on how a cannabis lawsuit turns out, it may be quite important for the parties to keep information out of the public eye. This information could be worrisome things that will turn off investors, but it also could be information that can harm a company in unforeseen ways.

One example of this is that a lawsuit involving a company typically requires listing the type of formation and its ownership. At the same time, a cannabis company must disclose this information to the Bureau of Cannabis Control (“BCC”), the California regulatory board that oversees state licenses. If there is a discrepancy between what the lawsuit says, and what was told to the BCC, it could be grounds for the revocation of a license. This could happen if the company submitted false documents to the BCC, or if ownership structure changed since it was reported, but it could also be an attorney oversight that wasn’t fixed because it didn’t matter for the lawsuit.  The risk for this kind of costly mistake is needlessly increased by the public nature of the documents.

Similarly, common sense dictates staying out of the limelight. Indivuduals in the cannabis industry remain “drug traffickers” under federal law, with all of the criminal and civil penalties that could come along with it. There is no reason to bring scrutiny or attention to yourself by litigating your disputes in a public forum.

Use mandatory arbitration clauses

These concepts are really just the tip of the iceberg. There are probably hundreds of reasons why the cannabis community needs to take care to avoid using litigating cases in court. The easiest way to do so is by mandating arbitration in all of your transactions. Arbitration is a private forum where a neutral person (often a retired judge or attorney) will consider the evidence, hear from the parties, and make a decision. Arbitration documents do not become public record, and the entire process can be fully insulated from the public eye.

If a contract requires arbitration, no party is allowed to file a lawsuit until arbitration is fully pursued. If a party tries to circumvent the arbitration clause by filing a lawsuit in court anyway, the other party in many instances may seek to move that lawsuit into arbitration by filing what is known as a motion to compel arbitration.  The value of having a strong arbitration clause in your contract can literally save millions of dollars and may help the parties maintain privacy over their dispute. Use a little preventative medicine, and be sure you are doing what it takes to avoid litigation.

Disclaimer: This article has been prepared and published for informational and educational purposes only and is not offered or intended, nor should it be construed, to be legal advice.

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