Image of money changing hands

When the CEO of a California marijuana retail chain sued the state in September over so-called “burner distribution licenses,” he focused a spotlight on an issue that many in the state’s cannabis industry are loathe to acknowledge:

Many of the state’s licensed marijuana businesses are bending or breaking the rules – and have been since California’s legal adult-use market launched in 2018 – because there’s so little profit to be had by operating lawfully.

That’s an allegation leveled by numerous industry officials. Such activity has been something of an open secret for years, but the “burner distro” lawsuit has given insiders cover to discuss more openly.

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“The simple answer on what gave rise to (burner distribution licenses) is: Legal operators are trying to find ways to survive. That’s been made very clear to me over the last several years,” said Adam Spiker, the executive director of the Southern California Coalition, a Los Angeles-based cannabis trade organization.

Spiker said high taxes and the ever-present underground market are the most obvious reasons for the lack of profitability, but the obviously shrunken penalties for breaking the law are a big factor as well, since legalization made it easier for the underground market to operate without fear of serious reprisals.

“The legal operator cannot compete doing things fully above board,” he said. “That’s a huge part of it. But there’s virtually no risk for people to do it completely outside the legal realm.”

The burner distro lawsuit – filed by Elliot Lewis, CEO of Catalyst Cannabis Co. – alleges that criminals have been legally buying cannabis distribution licenses by using “front men” to disguise their true identities and intentions.

The suit also claims the rogue distributors are using the licenses to buy vast amounts of legally grown marijuana at wholesale prices and then selling the product inside or outside California through unlicensed channels – a move that undercuts legal retailers and other cannabis businesses.

Lewis’ suit, filed Sept. 15 in Orange County Superior Court, also charges that state officials have ignored the actions of those who hold the burner distribution licenses.

The phrase burner distro is an offshoot of so-called “burner” cell phones, which are intended for short-term use before being discarded.

Spiker and other industry officials say many licensed marijuana companies running burner distro operations are being taken advantage of by third-party actors who had no intention of operating in the legal market.

But industry insiders also contend that many of these licensed marijuana entrepreneurs feel they’ve been given a simple choice because of the state’s harsh business landscape: Break the rules or watch your business die.

“The real takeaway from the burner distribution licenses is that the state’s regulatory framework makes it nearly impossible for legal operators to be profitable. And until that framework changes, illegal activity will continue to exist,” said Hirsh Jain, founder of Los Angeles-based consultancy Ananda Strategy.

Jain added that the current California landscape retains “elements of prohibition,” including:

  • Ongoing marijuana retail bans in more than two-thirds of municipalities and counties.
  • High state and local taxation for legal cannabis.
  • High compliance costs for businesses of all sizes.

“The barriers to entry are such that this is de facto prohibition, even if it’s not prohibition in name,” Jain said. “The real way to mitigate the illegal market is to discard those elements of prohibition.”

California’s Department of Cannabis Control (DCC) is the primary defendant in Lewis’ lawsuit, which asks a judge to force the agency to remedy the situation.

DCC officials, citing agency policy, have declined to comment on the suit. Nicole Elliott, the head of the DCC, declined to comment for this story.

Bending or breaking the rules

Multiple industry insiders guesstimated that anywhere from a third to more than 70% of the state’s thousands of licensed marijuana businesses have been skirting rules in various ways, including offloading legal cannabis into the illicit market through burner distributors.

Couple that with a broad lack of industry oversight and enforcement, industry insiders said, and it’s little surprise that burner distributors have become so widespread.

“I call it a pressure relief valve,” California marijuana consultant Jackie McGowan said. “The industry would be in chaos if it weren’t for this.”

Johnny Delaplane, the president of the San Francisco Cannabis Retailers Alliance, said it’s nearly impossible for many companies to make enough money doing business 100% by the book.

As one example, Delaplane said a company with 20 workers might have to devote three highly paid employees to comply with the state’s seed-to-sale software tracking system, Metrc.

“(Retailers’) margins are anywhere from 1%-5%, net income. At the best stores, really high volume, you might be able to get to 7%-8%,” Delaplane said.

He added that many burner distributors have been “supporting people in the industry that otherwise would be failing, and their businesses would be dying.”

Delaplane said the chokepoints for profit and loss are different for each vertical but, across the supply chain, it’s a similar story.

The same apparently holds true in the Emerald Triangle in Northern California.

But one licensed grower from Humboldt County, who requested anonymity to speak candidly, said most small farmers aren’t bothering to use burner distributors to solve their financial woes.

Instead, they’re following the legacy trafficking practices that were common before California legalized adult use in 2018 and simply marking cannabis as destroyed in the state track-and-trace system. But, in reality, the crops are being shipped across state lines to prohibition markets.

And while those farmers might not be relying on burner distributors, the underlying issue is the same: The business landscape makes it tough for legal companies to be profitable.

“I do not know anyone, not one of them, that has sold legitimately on the (legal) market this year for a profit,” the farmer said.

“Most of them, if not all of them, have taken the weed from last year … and then sold it out of state, because we have no other choice.”

On top of that, McGowan, a longtime industry consultant, said she’s been hearing of social equity program licensees winning distribution permits and then turning around and selling them to underground operators, often with the full knowledge that those licenses will be used as burner distros.

“The social equity programs are completely preyed upon for this license,” McGowan said.

“They look at this system as reparations and thought, ‘I’m going to go get me this golden ticket and get paid.’ … You’re willingly allowing someone to use your name to break the law. And some of them are so desperate, they’re like, ‘I don’t even give a s***.'”

What can be done?

Spiker said state regulators have known about the problem of burner distribution licenses for more than a year, because he’s been telling officials about it and trying to develop a workable solution.

Spiker has not hammered out an agreement. But he remains hopeful the DCC, state lawmakers and Gov. Gavin Newsom’s administration will collaborate on policy changes that give legal businesses a lifeline while cracking down on burner distributors.

Spiker proposes tightening the current 90-day tax-collection window for licensed distributors to 30 days.

He said that would generate more state marijuana tax collections and give burner distributors less flexibility to ship legal cannabis to the underground market.

The tradeoff for cannabis companies: His plan would also lower state cannabis taxes by eliminating the cultivation tax and the occasional wholesale markup rate.

Spiker is shopping around his plan but hasn’t found a bill sponsor in the Legislature to run such a measure.

Still, he suggested officials might be open to the idea.

“We need tax relief to make the legal industry more competitive,” Spiker said.

John Schroyer can be reached at john.schroyer@mjbizdaily.com.