California’s Growing Illicit Cannabis Problem

The legalization of cannabis provides tremendous opportunities, not only for legitimate cannabis growers, distributors, and dispensaries, but also for criminals and criminal networks looking to establish or expand illegal operations. As I have discussed in previous issues of this publication, the path to legalization is fraught with potential regulatory mistakes, which can create, exacerbate, or reinforce illicit market activity.

The recently filed lawsuit by Catalyst Cannabis Company against the California Department of Cannabis Control (DCC) provides an interesting window into how illegal actors exploit regulatory loopholes and enforcement weaknesses to reap massive illicit profits.

The lawsuit alleges that the DCC is aware of loopholes in its track and trace system, yet has not acted to close them and is not enforcing against violations. According to the suit, the scheme of so called ‘burner distributors’ is resulting in the diversion of ‘millions of pounds’ of legally grown cannabis into illicit markets across the country.

The plaintiff is not seeking monetary damages but is asking the court to issue an injunction and compel the state to enforce against and shut down the alleged illegal cannabis distribution network. At the core of the complaint is the concern that the state is violating its duties to regulate the cannabis industry and enforce adequately against illicit actors.

What is the alleged scheme?

The suit describes the scheme of burner distributors, aptly named after burner phones used by illegal dealers for short term transactions, which are then discarded to avoid risk of detection.

These burner distributors acquire a distributor license from the state of California to buy cannabis from fully licensed growers and then instead of selling the product to licensed dispensaries in California, divert the product to unlicensed and illicit sellers in California and beyond. As soon as the distributors face the threat of enforcement, they shut down the operation and vanish.

According to court documents and articles published on the issue, burner distributors exist in California for a variety of reasons:

• Cannabis is heavily taxed in California through state cultivation taxes, as well as state and local excise taxes. Depending on the jurisdiction, these taxes can exceed 40%. This heavy tax burden creates an incentive to divert legal product to illicit markets.

• Because of restrictive zoning that limits retail locations, yet unlimited growing capacity, California grows more cannabis than it can sell. This results in the diversion of legal cannabis to illicit state sellers within the state and out of state. According to a report by Forbes magazine, well-known West Coast cannabis brands are widely available in New York speakeasies as a result of this widespread diversion.

• It is comparatively easy to obtain a distribution license in California. Licenses can be acquired directly through the state or via the secondary market.

According to court documents and reporting, California’s license requirements lack regulatory rigor by, for example, not inspecting the physical locations of applicants or by not conducting adequate background checks. As a result, a small ‘burner distributor’ who has not much more than a laptop and a cell phone can get the same license as a fully-fledged distributor with climate-controlled secure warehouses and a state-of-the-art vehicle fleet.

California’s track and trace system was implemented to thwart exactly these kinds of schemes and identify diverted volume or flag suspicious transactions. However, according to the plaintiff’s complaint, the implemented track and trace system is allegedly not flagging these transactions.

The suit claims that Florida-based Metrc, the track and trace provider for the state of California, had notified state authorities of a loophole in the system, which does not adequately report diverted volume and does not flag suspicious activity.

According to the complaint, Metrc has notified state authorities of a needed upgrade or modification to the existing track and trace system, but DCC has not authorized the system change. In summary, the suit alleges that DCC has ‘turned a blind eye’ to the diverted volumes to protect the cultivation taxes collected.

According to the California Department of Tax and Fee Administration (CDTFA), as of the second quarter of 2021, the state has collected over $2.8 billion in cannabis tax revenue, including $1.4 billion in excise taxes, $347.4 million in cultivation taxes and $1 billion in sales taxes.

In addition, the plaintiff alleges that the DCC only investigates participants or operations that were reported to DCC through its anonymous complaint process, instead of investigating or enforcing against illicit actors identified through its own track and trace system. The plaintiff alleges that DCC is not enforcing because it doesn’t want to risk the cultivation tax revenue.

California’s path forward

In my opinion, given the size of the various tax streams, it would be illogical for DCC to protect a few hundred million in cultivation taxes while not collecting excise and sales taxes, which total five times that amount.

If there is a loophole in California’s track and trace system, it is more likely is a result of fast-paced implementation and limited resources. And the delayed implementation of a required upgrade could also be caused by limited resources. The DCC is a young agency with just 300 employees. It was created in July 2021, by consolidating the three former state cannabis authorities: 

• Bureau of Cannabis Control (Department of Consumer Affairs).

• CalCannabis Cultivation Licensing Division (California Department of Food and Agriculture).

• Manufactured Cannabis Safety Branch (California Department of Public Health).

The reorganization of these three agencies into a single entity is likely also causing additional inefficiencies.

Regardless of the outcome of the lawsuit, the illicit cannabis market stemming from California has been well documented and has been thoroughly reported. According to a POLITICO Report last month, California’s illegal market is approaching $8 billion annually, or twice the volume of legal sales.

The drivers of this thriving illicit market are as mentioned above: 1) high taxes, 2) limited dispensary licenses and 3) high number of licensed growers and cultivators. These inefficiencies are then potentially compounded by loopholes in the state’s track and trace system.

California needs to address this thriving black market not only for the fiscal interests of the state, but also because California is supplying illegal cannabis to the rest of the United States. California has the opportunity to address this illicit market through a variety of straightforward approaches: 

• Make it easier to get a dispensary license and make it harder to get a distributor and grower license: California has 6,000 licensed cultivators and 1,039 active licensed cannabis distributors yet has only 823 licensed brick and mortar cannabis shops. This creates an obvious and unsustainable oversupply.

California needs to focus on either a) drastically expanding its dispensary licenses, or b) reducing the amount of distributor or grower licenses. As discussed in a previous article, Canada is in the process of addressing similar conditions by rapidly increasing dispensary licenses.

• Increased scrutiny on distributor licenses: California needs to implement a rigorous, but not arduous, licensing scheme with background checks, physical location verification and regular location inspections for its distributor licenses. Until that is implemented, California should put a pause on the issuance of new licenses while conducting an immediate inspection of all active licensed distributors to identify any illegal players.

• Upgrade track and trace/close reporting loopholes: California should immediately implement any system upgrades, patches and software fixes to close reporting loopholes. California can then use its track and trace system to identify suspicious distributors and can prioritise inspections and enforcement.

In addition, California should examine the implementation of additional technologies to help with the identification of suspicious activities and actors among its licensees.

• Increase data-driven enforcement: according to the lawsuit and other reporting, DCC is mainly focused on investigating complaints made through its complaint portal. If this is accurate, this approach allows illegal players to operate indefinitely and with impunity until a complaint is filed.

California and the DCC should instead focus on data-driven investigations to identify burner distributors. To aid this enforcement, DCC also needs to ensure that its enforcement unit is adequately funded and staffed.

While this lawsuit works its way through the courts, it will be increasingly important for California to double down on its enforcement against illegal cannabis markets.

Sven Bergmann is the founder and CEO of Venture Global and advises brand owners, technology providers and governments on anti-counterfeit strategies, programmes and technologies. Send your comments to [email protected].