The commercial litigation landscape for CBD, hemp and marijuana is constantly evolving as federal and state courts issue decisions that impact investors, commercial contracts, employment issues, intellectual property and insolvency. The CannaBizDisputes™ blog regularly tracks and reports on these developments.
California State Appeals Court Focuses on Illegality at Time of Contract to Dismiss Commercial Cannabis Dispute
A recent California state appellate decision makes clear that cannabis companies and counsel need to pay careful attention to differences in state illegality doctrines when deciding where and how to pursue operations. In particular, in Metsch v. Heinowitz, 2020 WL 1933189 (Cal. App. 4th Apr. 22, 2020), a California state appellate court affirmed the dismissal of a civil complaint on illegality grounds; unlike New York courts, the California court did not consider whether its ruling would yield a windfall to the other party. And even though California has now legalized cannabis for both adult and medicinal purposes, because the claims arose from the operation of a contract that was illegal at the time of formation, the California court applied the illegality doctrine.
The plaintiffs and defendants in Metsch v. Heinowitz entered into a series of contracts pursuant to which they agreed, among other things, to form a partnership for the purpose of operating Chronic Catering – a company dedicated to the production of “baked goods and other edibles for the medicinal marijuana industry.” Metsch v. Heinowitz, 2020 WL 1933189, *2 (Cal. App. 4th 2020). The defendants (both of whom were chefs) agreed to help develop products and recipes to be used in Chronic Catering’s medicinal marijuana business in exchange for certain payments and partnership shares in the partnership itself. Following a subsequent falling out, plaintiffs filed a civil complaint in California state court, asserting claims against defendants for breach of contract, conversion and breach of fiduciary duty, seeking $500,000 in damages. Plaintiffs alleged that the defendants breached their contractual obligations, stole partnership assets (including intellectual property and recipes) and used them for their own personal benefit.
The defendants moved for summary judgment and dismissal of plaintiffs’ claims on illegality grounds, asserting that “the commercial cannabis operation at the center of plaintiffs’ [complaint] is illegal and a violation of criminal law.” Id.at *3. As a result, the defendants argued, plaintiffs have no right to come into Court and seek recovery or enforcement based on an illegal transaction;” citing to California Civil Code Section 3517 which provides that “[n]o one can take advantage of his own wrong.” West’s Ann. Cal. Civ. Code Sec. 3517. The defendants also argued that the plaintiffs lacked a valid license to operate a commercial cannabis business. Id.
In affirming the trial court’s order granting the defendants’ motion for summary judgment and dismissing the plaintiffs’ complaint in its entirety, the California Court of Appeal, Fourth District, concluded that the defendants had established that “[p]laintiffs’ claims are based on agreements to perform, or to assist in the performance of, illegal marijuana transactions.” Id.at *5. As a result, courts may not “assist in providing relief to plaintiffs, regardless of the merits of the claims.” Id. Notably, the court concluded that, “in applying the illegality of contract doctrine as a defense, courts do not consider whether its application results in unjust enrichment in favor of the party opposing enforcement of the contract.” Id. Instead, under California law, courts are required to consider “a higher interest – that of the public, whose welfare demands that certain transactions be discouraged.” Id.
This stands in stark contrast to New York’s own illegality doctrine, which provides that the defense is inapplicable where it would result in “a substantial forfeiture to one party while allowing the other party, who has already reaped the benefit of the transaction, to avoid the corresponding obligation.” Grape Solutions, Inc. v. Majestic Wines, Inc., 2015 WL 2207528, *5 (Sup. Ct. N.Y. County May 11, 2015). For a more fulsome summary of the current state of New York’s own illegality doctrine, please see our prior publication on the topic. (New York’s Illegality Doctrine and Its Implications for Cannabis Contracts).
In concluding that the agreements from which the plaintiffs’ claims arose were unenforceable on illegality grounds, the Court in Metsch noted that cannabis is a “Schedule I controlled substance” under California law, and that “possession, cultivation, or processing of marijuana” violated California law at the time those contracts were entered into in January of 2014.” Metsch, 2020 WL 1933189, at *9. The Court also noted that the defendants had shown that neither Chronic Catering, nor the plaintiffs themselves, were licensed to operate a commercial cannabis business. Id. In a break with the trial court, the Court held that an affirmative defense of illegality turns on what is legal at the time the contract is entered into – as opposed to when a party attempts to enforce it – but nevertheless affirmed the trial court’s conclusion because the relevant California law had not changed from January of 2014 (when the agreements were entered into) and July of 2018 (when the trial court entered its decision). See id.
In rejecting the plaintiffs’ arguments in opposition, the Court found that plaintiffs did not have qualified immunity from the statutes that made their sale of cannabis products illegal because they had failed to show that Chronic Catering was formed and operating as a cooperative. The Court also refused to consider their argument that defendants’ illegality defense was barred by the doctrine of unclean hands on procedural grounds.
Metsch provides a window into the ways in which state and federal statutes that criminalize some or all forms of the cultivation and distribution of cannabis can impact parties’ otherwise enforceable commercial agreements, and result in the dismissal of civil claims even where dismissal may result in a seemingly unfair outcome for one of those parties. And while the outcome in Metsch was very much a product of California’s seemingly stringent illegality doctrine, it may nevertheless prove to be a harbinger of future decisions in jurisdictions with illegality cases that may not be as forgiving, or as equity-minded, as New York’s.
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05.21.2020 | PRACTICE AREAS: Litigation and Dispute Resolution | INDUSTRIES: Cannabis