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Retailers and producers work out structure of storefronts

Focus on Cannabis Law
|Written By Dale Smith
Retailers and producers work out structure of storefronts
Mark Asfar says the province’s goal was to support small business and oppose vertical integration of the cannabis market, where the producers would also be the retailers.

With the rollout of private retail cannabis stores in Ontario, the province put restrictions in place to ensure that licensed producers can only maintain a 9.9-per-cent stake in those retail outlets.

Franchise lawyers say deals between producers and retailers need to be structured in such a way as to comply with both the provincial restrictions on franchises and ensure that the retailers maintain ownership and control.

The Ontario government decided to do the initial rollout of non-transferrable retail licences by way of a lottery for the first 25 stores, to be administered by the Alcohol and Gaming Commission of Ontario.

“Most of the lottery winners are trying to find ways to enter into agreements to still open up their operations,” says Eric Foster, a partner at Dentons Canada LLP in Toronto.

“It’s been a challenge. We’ve already seen an instance of one lottery winner who has been disqualified.”

Those stores must be operated by themselves and can’t be a franchise.

Foster says that, because of the way in which the retail lottery was structured, there were nearly 18,000 entrants, the vast majority of whom were not seasoned retailers who had experience or any industry-specific expertise related to cannabis.

Of the 25 chosen, he says, many did not have the sophistication to get a retail operation up and running in a short time in a very regulated industry.

“They needed to reach out to people who do have that experience, which was essentially consulting services,” says Foster.

Mark Asfar, a lawyer with Momentum Business Law PC in Ottawa, says the province’s goal was to support small business and oppose vertical integration of the cannabis market, where the producers would also be the retailers.

Asfar says this is why the total ownership and control percentage by licensed producers in retail interests is capped at 9.9 per cent.

“You have these highly capitalized businesses that have been in this industry since the medical days,” says Asfar. “If they wanted to, they could blanket the province in stores and not break a sweat.”

Asfar says this is why the ownership rules were put in place, but it also means that those companies with vast sums of capital and professionals and experts in the field with resources to share are effectively locked up.

“It means they’ve re-evaluated their business models and how they want to make money,” says Asfar.

“They’ve said our profits still come from selling product, but we’ll make our expertise and we’ll make our resources available to these retailers to support them in the hope that they will make a friendly and accessible market that will buy a lot of our product.”

Asfar says this is why many of the producers are offering free advice to prospective retailers — to establish friendly relationships that will mean the retailers sell their products.

Chad Finkelstein, a partner at Dale & Lessmann LLP in Toronto, says lawyers need to be aware of the prohibitions in Ontario’s Cannabis Licence Act, as they are very densely drafted, particularly when it comes to restrictions for licensed producers and their affiliates when it comes to control of stores.

“In order to structure an agreement and a relationship that complies with the Ontario Cannabis Licence Act, you need to understand what the distinction is between control, in fact, and franchising,” says Finkelstein.

While franchising is a statutorily defined term that details control over a method of operation, Finkelstein says this is distinct from control in fact.

“Being aware of that distinction, and taking a conventional franchise agreement and making sure that it doesn’t inadvertently cross any lines into control in fact — that has been for a few months a really interesting challenge for those of us who regularly practise in the area,” says Finkelstein.

“If you’re a cannabis brand owner and you want to do business with these [retailers], and since their licence is non-transferrable, you basically have to have some kind of licensing relationship because you are granting rights to a third party to use your brand,” says Finkelstein.

Finkelstein says that because the deals are under tight deadlines and intense regulatory scrutiny, it’s important for lawyers to be aware of what elements in the normal franchising or licensing relationship they need to strip out to ensure that there is no change of control and to be aware of what the disclosure obligations are to the licence operator.

Asfar says that instead of share ownerships or traditional franchise agreements, which are not permissible, lawyers drafting these agreements have to be creative.

“It’s a very exciting period insofar as creative drafting,” says Asfar.

“It’s finding agreements and new structures that don’t quite fit into the old packaged idea of what these agreements might look like.”

Asfar says that instead of a traditional franchise agreement, retailers and producers may have an intellectual property licence to borrow a brand for an annual fee or producers would employ consultants for retail operating advice on which they could collect fees.

“Franchises, when you take them apart and look at their components, they’re basically IP — a trademark — and a way of doing business, a know-how that is more of a ‘secret sauce’ that’s not patentable but an expertise,” says Asfar.

“Franchises usually package this under the franchise model and take their cut of the profit.”

Asfar says that when you take these agreements apart and take away the franchise fee component, it becomes a simple licensing agreement.

Finkelstein says the rules around the non-transferability of licences as a result of the lottery process are something of an anomaly and that future licences will be done in a more conventional method.

Kelly Oksenberg, an associate with Stikeman Elliott LLP in Toronto, says there is a lack of clarity from the province on what the next rollout will look like, given its use of a phased approach rather than a market approach.

“It makes it difficult for licensed producers and other companies generally looking to open retail cannabis outlets,” says Oksenberg. “There’s still a lot of uncertainty in the process.”

Finkelstein says that what has been challenging for lawyers is that the feedback they have received from the government and the AGCO has not been consistent when they have submitted licence agreements for approval.

“It’s tough to draw conclusions that, if you want to get a lottery deal through, you must do this and you must avoid this,” says Finkelstein.

Foster adds that the provincial law does not provide a great deal of clarity.

“You’re dealing with, to a certain extent, an unpredictable regulator, which has made things challenging,” says Foster.

“If you are a lawyer who is currently in the process of trying to get a deal through for the AGCO and you’re representing either the lottery winner or the brand owner, that agreement should be really light on requirements being imposed on the operator,” says Finkelstein.

Finkelstein says that, instead, the agreements should mention optional support or consulting services, as deals structured in that manner will look less like an operator has ceded any control in running their business in a certain way.

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