Financial Services and the US Cannabis Sector | Practical Law

Financial Services and the US Cannabis Sector | Practical Law

The conflict between state and federal laws that apply to the emerging cannabis sector has created significant challenges for US financial institutions. Even if financial institutions avoid providing financial services directly to the cannabis sector due to the risk of federal prosecution or regulatory enforcement, they may still be unable to avoid indirectly dealing with cannabis-related businesses as these businesses increasingly integrate into the formal economy. A federal legislative change might be the only viable solution.

Financial Services and the US Cannabis Sector

Practical Law Article w-019-8346 (Approx. 10 pages)

Financial Services and the US Cannabis Sector

by Margaret E. Tahyar and Jeanine P. McGuinness, Davis Polk & Wardwell LLP
Published on 01 Apr 2019 • USA (National/Federal)
The conflict between state and federal laws that apply to the emerging cannabis sector has created significant challenges for US financial institutions. Even if financial institutions avoid providing financial services directly to the cannabis sector due to the risk of federal prosecution or regulatory enforcement, they may still be unable to avoid indirectly dealing with cannabis-related businesses as these businesses increasingly integrate into the formal economy. A federal legislative change might be the only viable solution.
The conflict between the federal and state laws that govern cannabis has put the financial services sector in a difficult position. Should financial institutions respond to the encouragement of their state governments and provide financial services to cannabis-related businesses, they run the risk of federal prosecution, fines, and regulatory scrutiny. Moreover, financial institutions are finding it increasingly difficult to avoid indirect contact with the cannabis sector, particularly through dealings with businesses connected to the sector.
Financial institutions must grapple with how to treat vendors, service providers, and suppliers of cannabis-related businesses because under federal law, by providing financial services to these vendors, service providers, and suppliers, the financial institutions may be aiding and abetting cannabis-related offenses or may receive proceeds from cannabis-related activities (see Federal Legislative Framework). While some of these businesses specialize in serving the cannabis sector, others deal only minimally with cannabis-related businesses.
As the cannabis sector grows, it is becoming increasingly intertwined with otherwise legitimate businesses. Core cannabis-related businesses are those businesses that touch and handle the plant, such as growers, distributors, and retailers. However, under federal law, dealings with other businesses, which could include printing, office supply, cleaning, and utility companies, that provide services and supplies to core cannabis-related businesses also present risk to financial institutions. How to identify and treat businesses connected to the cannabis sector remains an unresolved question with little federal government guidance.
Cordoning off so many parties from financial services imposes unintended consequences and costs on banks, the legitimate business sector, and the public. At times, refusing to provide even indirect services to cannabis-related businesses results in terminating business with existing clients. According to Robert S. Nichols, the president of the American Bankers Association, a banking sector survey reported that 75% of banks have had to close an account, terminate a client relationship, or turn away a customer because of some connection to cannabis (Robert S. Nichols, The Hill, End the Cannabis Banking Problem (Feb. 18, 2019), available at thehill.com).
Given the threat of federal prosecution and regulatory enforcement, it is hardly surprising that the vast majority of US banks and credit unions have deliberately avoided providing financial services to state-licensed cannabis-related businesses. One study reported that in 2016 only 301 banks and credit unions conducted business with cannabis-related businesses, amounting to less than 3% of the banks and credit unions in the US (Arcview Market Research, The State of Legal Marijuana Markets, at 14 (5th ed. 2017)). The institutions that do provide services tend to be small state-chartered banks and credit unions, and the percentage of banks by asset size is miniscule.
According to the Financial Crimes Enforcement Network’s (FinCEN’s) data on suspicious activity reports, the number of depository institutions actively providing direct banking services, largely deposit accounts and payment services for which hefty fees are charged, to cannabis-related businesses in the US rose to 551 in December 2018 (FinCEN, Marijuana Banking Update (data ending Dec. 31, 2018), available at fincen.gov). While the increase is notable, the percentage of all banks and credit unions actively engaging with cannabis-related businesses remains de minimis.
The shortage of depository institutions and other financial institutions willing to directly assist cannabis-related businesses has reinforced the sector’s dependence on cash. Forcing the cannabis sector to operate outside of the banking system, almost exclusively through cash, exacerbates concerns of public safety and accurate taxation.
The Internal Revenue Service and state tax authorities also face logistical burdens caused by the sector’s cash-intensive nature. Cash transactions do not require a written or digital record, making it harder to track and account for revenues and expenses. Financial statements are consequently harder to verify, and obtaining a reliable accounting of taxes owed can become logistically impossible.
Against this background, this article explores:
  • The current federal legislative framework that governs cannabis-related businesses.
  • The possible solutions to address the provision of financial services to the cannabis sector, including proposals for federal legislative changes.
For more information on the legal and regulatory framework governing US banking activity, see Practice Note, US Banking Law: Overview.

Federal Legislative Framework

Despite the trend toward legalization at the state level, federal law continues to prohibit cannabis and the provision of financial services in connection with cannabis-related activities. Cannabis-related activities are regulated by the following federal statutes:
For information on how bank regulatory agencies examine banks for BSA compliance, see Practice Note: US Anti-Money Laundering and Trade Sanctions Rules for Financial Institutions and Practice Note, Bank Secrecy Act: Compliance Issues.

The CSA

Cannabis remains classified as a schedule I drug under the CSA, a designation reserved for those substances deemed to have:
  • A high potential for abuse.
  • No currently accepted medical use in treatment in the US.
  • A lack of accepted safety for use under medical supervision.
The CSA prohibits knowingly or intentionally manufacturing, distributing, or dispensing cannabis, or possessing cannabis with intent to do any of the foregoing acts. The prohibitions also extend to conspiring to engage in and aiding and abetting these cannabis-related activities.

The MLCA and the BSA

Together with the CSA, the MLCA and the BSA form the core pieces of the federal legislative framework that regulates cannabis-related activities and directly impacts the financial services sector. The MLCA prohibits knowingly conducting certain transactions that involve the proceeds of specified unlawful activities, including cannabis-related offenses under the CSA. The BSA enlists financial institutions to assist law enforcement in the tracking, monitoring, and reporting of financial crimes. It also requires financial institutions to establish anti-money laundering (AML) programs and report illegal and suspicious activities to FinCEN.
The MLCA and BSA reflect the public policy objective of preventing illegitimate funds from entering the financial system. Imposing affirmative obligations on financial institutions to coordinate with law enforcement reflects that these institutions are in a unique position to detect illicit activities, and regulators have not hesitated to impose large monetary penalties on financial institutions that fail to comply with AML laws and regulations.
For an example of how the federal legislative framework impacts financial services providers that seek to provide financial services to cannabis-related businesses, see Box, Case Study: Fourth Corner Credit Union.

Possible Solutions

Multiple solutions have been proposed to address the conflict between state and federal laws as applied to the cannabis sector and the financial services sector. These proposals have taken numerous approaches, including:
  • Federal agency guidance.
  • Congressional appropriation.
  • Establishment of a public bank.
  • Federal legislative change, including:
    • the SAFE Banking Act; and
    • the STATES Act.

Federal Agency Guidance

The Department of Justice (DOJ) has attempted to mitigate the effects of the federal government’s prohibition of the provision of financial services in connection with cannabis-related activities. In 2013 and 2014, the DOJ released the now-rescinded Cole Memoranda. The first Cole Memorandum, issued in 2013, instructed that prosecution of cannabis-related activities should be guided by eight enumerated federal enforcement priorities.
This guidance was supplemented in 2014 by a second Cole Memorandum, which provided that these federal priorities should also guide the prosecution of financial institutions that receive proceeds from cannabis-related activities. The DOJ acknowledged its traditional reliance on state and local law enforcement outside of these enforcement priorities and anticipated that states that legalize cannabis would establish effective regulatory and enforcement schemes to control cannabis activity within their jurisdictions. Consequently, the Cole Memoranda took the position that prosecuting cannabis-related activity and related financial services in instances not implicating the federal enforcement priorities would not be an efficient use of limited federal investigative and prosecutorial resources.
Neither memorandum altered federal statutory authority to prosecute cannabis-related activity. Of particular relevance to financial institutions, the 2014 Cole Memorandum stated explicitly that “money laundering statutes, the unlicensed money remitter statute, and the [BSA] remain in effect with respect to marijuana-related conduct” and “[f]inancial transactions involving proceeds generated by marijuana-related conduct can form the basis for prosecution” under these laws.
Concurrently with the 2014 Cole Memorandum, FinCEN (a bureau of the Department of the Treasury) issued guidance that sought to “clarify [BSA] expectations for financial institutions seeking to provide services to marijuana-related businesses,” noting that compliance with the guidance should “enhance the availability of the financial services for, and the financial transparency of, marijuana-related businesses” (FinCEN, BSA Expectations Regarding Marijuana-Related Businesses, at 1 (Feb. 14, 2014), available at fincen.gov). Specifically, the guidance offered FinCEN’s expectations regarding customer due diligence and suspicious activity reporting, based on whether a cannabis-related business implicates the federal priorities enumerated in the Cole Memoranda.
However, the Cole Memoranda and FinCEN guidance did not bind FinCEN or the DOJ. The Cole Memoranda merely articulated a set of advisory priorities, ultimately retaining discretion for prosecutors to act outside of these priorities. As stated in the 2014 Cole Memorandum, “nothing herein precludes investigation or prosecution, even in the absence of any one of the factors listed above, in particular circumstances where investigation or prosecution otherwise serves an important federal interest.” Even while they were in effect, the Cole Memoranda offered fragile assurances to cannabis-related businesses and financial institutions.
This brief trajectory of more permissive federal policy was interrupted in January 2018 by then-Attorney General Jeff Sessions, who rescinded the Cole Memoranda and instructed US attorneys “to use previously established prosecutorial principles” to guide their cannabis-related prosecution. Although FinCEN maintains its 2014 guidance, the change of course by the DOJ illustrates that FinCEN could easily change or withdraw the guidance in the future.

Congressional Appropriation

Congressional limits on the use of appropriated funds have not offered a viable solution for the financial services sector. The Rohrabacher-Blumenauer Amendment (previously known as the Rohrabacher-Farr Amendment), first enacted in 2014, precludes the DOJ from spending appropriated funds to interfere with implementation of laws governing medical marijuana in states that have legalized medical marijuana. Put simply, under the amendment the DOJ cannot expend funds to prosecute medical marijuana-related activities that would be lawful under state law. A handful of cases have held that the amendment prohibits the DOJ from prosecuting individuals engaged in medical marijuana activities compliant with state laws, which could plausibly serve as the basis for protecting their financial services providers in future litigation.
Even assuming the Rohrabacher-Blumenauer Amendment would cover financial institutions that provide financial services to state-compliant medical marijuana activities, the protection is incomplete and impermanent, as congressional appropriations require periodic renewal to remain effective. While appropriation limits have been enforced in the courts as binding law, because periodic renewal is required, any relief for financial institutions serving the cannabis sector comes with a potential expiration date.
Far from an abstract risk, Congress could fail to finalize a timely appropriations bill due to any number of spending disagreements, most likely completely unrelated to cannabis, as occurred during the recent partial federal government shutdown. Because congressional appropriation limits run the risk of interruption or expiration, they do not provide the certainty needed by financial institutions to make plans for longer-term business relationships or contractual arrangements with cannabis-related businesses.

Public Bank

Advocates for cannabis-related businesses have looked for a solution on the state level as well. One option, proposed in California and a small number of other states, is the establishment of a state- or city-owned public bank dedicated to providing banking services to the cannabis sector. A recent report provided to the California State Treasurer’s Office examined three possible forms that a state-backed financial institution could take:
  • A bank exclusively serving the cannabis sector.
  • A bank primarily, but not exclusively, serving the cannabis sector.
  • A correspondent bank serving other commercial banks.
All three variants were rejected as not feasible for several reasons. A public bank would exist without the support of federal deposit insurance and, more crucially, a master account. Without a master account, the public bank could not directly clear checks or make payments. Because there is no realistic Tenth Amendment safe harbor, the public bank and its personnel would operate under the threat of federal criminal prosecution or regulatory enforcement, which may represent an unacceptable degree of legal risk. Additionally, establishing and operating a public bank was forecast to be non-profitable and likely to incur significant losses. The report found that a public bank would require a prolonged startup period with costs of at least $35 million and require roughly $1 billion in capital obtained through a sizable risk premium.
(Level 4 Ventures, Inc., Jade Compliance Solutions, and RLR Mgmt. Consulting Inc., State-Backed Financial Institution (Public Bank) for the State of California Servicing the Cannabis Industry Feasibility Study 2018 (Dec. 24, 2018), available at treasurer.ca.gov.)
As a result, serious doubts persist about whether a public bank could accomplish its objectives of extending banking services to the cannabis sector. If the federal government lifts restrictions on providing financial services to the cannabis sector within a few years, then the public bank would become irrelevant before offering services. If, on the other hand, the federal government intensifies its prosecutorial and enforcement efforts against cannabis-related businesses and their financial services providers, then the public bank would never open. Based on these findings, the report concluded that a public bank is not feasible.

Federal Legislative Change

The best path to a solution for cannabis-related banking involves federal legislative change. The most workable long-term solution from the financial services sector’s perspective involves the legalization of cannabis, which requires descheduling cannabis under the CSA. While descheduling cannabis might be a straightforward approach, it is unlikely to be swift. This approach would require a transition period to establish a federal legal framework to regulate cannabis-related activity, similar to the tobacco and alcohol sectors.
Full legalization at the federal level is improbable in the near term given the divided Congress and the contentious policy debate. The next best solution for the financial services sector would be to establish a clear and strong system of federal deference to state law. The federal government could undertake prosecution and enforcement against cannabis-related activities in states where such activities are unlawful, but not in states where they are lawful. Two bills take this approach and have received attention in Congress:
  • The Secure and Fair Enforcement Banking Act (SAFE Banking Act).
  • The Strengthening the Tenth Amendment Through Entrusting States Act (STATES Act).
These bills would permit depository institutions, in the case of the SAFE Banking Act, or financial institutions, in the case of the STATES Act, to provide financial services to cannabis-related businesses that operate pursuant to or compliant with state laws. The lists of co-sponsors show that these bills enjoy some measure of bipartisan support.
By the end of the 115th Congress, the 2017 version of the SAFE Banking Act (H.R. 2215; S. 1152) received 95 co-sponsors, including 13 Republicans, in the House and 20 co-sponsors, including four Republicans, in the Senate, and the last version of the STATES Act (S. 3032) received ten co-sponsors, including five Republicans, in the Senate. The bills also have garnered support from state attorneys general and governors.

SAFE Banking Act

The SAFE Banking Act was most recently introduced by Representatives Ed Perlmutter, Denny Heck, Steve Stivers, and Warren Davidson on March 7, 2019 (H.R. 1595) following a hearing entitled Challenges and Solutions: Access to Banking Services for Cannabis-Related Businesses, which was convened by a subcommittee of the House Committee on Financial Services. The SAFE Banking Act would create protections for:
  • Depository institutions that provide financial services to cannabis-related legitimate businesses, which include businesses that engage in any of a list of enumerated activities related to cannabis pursuant to a law established by state or local government.
  • Service providers that sell goods or services to cannabis-related legitimate businesses.
The bill focuses on the banking sector, outlining safeguards specifically for depository institutions and issuing directives to federal agencies that regulate banking. The SAFE Banking Act includes a safe harbor, forfeiture protections, and a provision that addresses proceeds of cannabis-related activity. The safe harbor provision would prohibit federal banking regulators from taking certain actions, including terminating or limiting deposit insurance solely because the depository institution provides financial services to a cannabis-related legitimate business or service provider or prohibiting, penalizing, or discouraging a depository institution from providing financial services to these businesses. In the latest version of the bill, the safe harbor would also protect those who perform payments functions for depository institutions that are serving cannabis-related legitimate businesses.
The protections under the federal law provision of the SAFE Banking Act would exempt a depository institution, and its personnel, that provide financial services to a cannabis-related legitimate business or service provider from liability under any federal law or regulation solely for providing these financial services pursuant to state or local law or regulation. Financial service is defined in the bill to mean financial product or service, a term taken from the consumer portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 establishing the Consumer Financial Protection Bureau (CFPB).
(For information on the CFPB’s examination, investigation, and enforcement procedures for supervised financial institutions, see Practice Note, CFPB Supervision and Enforcement Procedures.)
The federal law provision would also provide protection from criminal, civil, and administrative forfeiture of a depository institution’s legal interest in collateral owned by a cannabis-related legitimate business or service provider. The bill also includes a provision that would exempt proceeds from a transaction conducted by a cannabis-related legitimate business or service provider from being treated as proceeds of a specified unlawful activity solely because the transaction was conducted by a cannabis-related legitimate business or service provider. This provision would protect depository institutions, other financial institutions, and even institutions outside the financial services sector from prosecution under the MLCA.
The SAFE Banking Act also introduces new requirements for depository institutions and their regulators. Depository institutions that file suspicious activity reports on cannabis-related legitimate businesses or service providers would be required to comply with appropriate FinCEN guidance, which must comport with the bill’s purpose and intent and must not inhibit the provision of financial services to such businesses.
The SAFE Banking Act also outlines certain requirements for guidance issued by the Federal Financial Institutions Examination Council (FFIEC) and federal banking regulators. The bill would require the FFIEC to develop uniform guidance and examination procedures for depository institutions serving such businesses, and federal banking regulators to issue guidance and examination procedures consistent with those of the FFIEC.
The SAFE Banking Act could be improved. Specifically:
  • Apart from the provision governing proceeds, the bill does not offer any direct relief to cannabis-related businesses, which would remain vulnerable to prosecution under the CSA. Therefore, even if the SAFE Banking Act would shield depository institutions from prosecution, the absence of similar protections for cannabis-related businesses could limit their ability to seek banking services.
  • Some of the bill’s protections expressly cover only depository institutions. The scope is further narrowed to those depository institutions providing financial services consistent with the definition of financial product or service, which focuses on the consumer protection context and would exclude certain financial services for businesses. Consequently, the safe harbor provision discussed above that relates to federal banking regulators, for example, does not cover other relevant members of the financial services sector, such as broker-dealers, underwriters, asset managers, custodians, and insurance companies. Extending the protections beyond depository institutions would greatly ameliorate the concerns of other financial institutions. While some financial services, such as insurance, are provided by companies that do not have other financial institution affiliates, the vast majority of depository institutions are embedded within a consolidated group whose members provide other types of services. It makes little sense to change the law for only one part of an affiliated financial institution group, and it is not optimal to select the CFPB’s consumer jurisdiction definition of financial services.

STATES Act

The STATES Act was introduced by Senators Elizabeth Warren and Cory Gardner in June 2018 and reintroduced as a proposed amendment in December 2018. The STATES Act has several strengths, and is in some ways more beneficial to the financial services sector than the SAFE Banking Act.
For example, the STATES Act would provide protection not only for financial institutions, but also for the cannabis sector as a whole, including businesses serving the cannabis sector. The STATES Act also would cover all types of financial institutions, rather than solely depository institutions.
Of particular relevance to financial institutions is a rule of construction in the bill’s final section, which would exempt the proceeds from any transaction conducted in compliance with the STATES Act from being treated as proceeds of an unlawful transaction under the MLCA. Further, the bill provides that cannabis-related conduct that complies with the STATES Act and its amendments would not serve as a basis for criminal or civil forfeiture.
More ambitious in scope than the SAFE Banking Act, the STATES Act structurally reforms the underlying legislative framework. Specifically, the STATES Act would add a new section to the CSA. This section would provide that the CSA does not apply to cannabis-related conduct that is compliant with state law, subject to certain violations enumerated under Section 710(c) and (d) of the CSA, such as distributing recreational cannabis to persons under age 21 and employing persons under age 18 for cannabis-related activities. Failure to comply with state law or Section 710(c) or (d) appears to render the STATES Act’s protections inoperable.
For example, the STATES Act’s protection likely would not shield a cannabis-related business from prosecution under the CSA for hiring a minor, even if that were legal under state law. By extension, the STATES Act’s rule of construction would not appear to shield a financial institution from prosecution under the MLCA if the financial institution provided services to a cannabis-related business that was violating the STATES Act.

Compliance with State Law and Due Diligence

The protections offered by both the SAFE Banking Act and the STATES Act appropriately require some level of compliance with state law by cannabis-related businesses. The SAFE Banking Act only expressly shields depository institutions that bank cannabis-related businesses operating “pursuant to” state law. The STATES Act only protects proceeds from transactions conducted “in compliance with” state law, among other requirements. Therefore, the SAFE Banking Act and the STATES Act would not appear to protect depository institutions serving cannabis-related businesses that are not acting pursuant to state law, or financial institutions serving cannabis-related businesses that are not acting in compliance with state law, respectively.
The exact level of compliance required is uncertain. Neither the phrase “pursuant to” in the SAFE Banking Act nor the phrase “in compliance with” in the STATES Act is defined, creating uncertainty about how the bills would apply to situations in which a cannabis-related business commits an immaterial breach of state laws. The SAFE Banking Act’s “pursuant to” standard appears to be less stringent than the STATES Act’s “in compliance with” standard. For example, it would seem reasonable to view a marijuana dispensary operating under a valid state license as engaging in cannabis-related activities pursuant to state law.
For both bills, it is unclear whether the extent of due diligence performed by the financial services provider would factor into the analysis. The bills could address this compliance ambiguity or Congress could instruct federal agencies to address it. Unlike the SAFE Banking Act, the STATES Act does not expressly articulate a role for federal banking agencies, and it should be amended to do so. The failure of the SAFE Banking Act and the STATES Act to address the practical realities and challenges of conducting due diligence may cause financial services providers to remain cautious toward participating in the cannabis sector even if either bill were to become law.

Case Study: Fourth Corner Credit Union

Under current federal law, the federal banking agencies are unlikely to directly assist financial institutions in providing financial services to cannabis-related businesses.
For example, in 2016, in Colorado, which had legalized cannabis, The Fourth Corner Credit Union (Fourth Corner) sought to offer “banking services to compliant, licensed cannabis and hemp businesses and to thousands of persons, businesses and organizations that supported the legalization of marijuana.” Fourth Corner received a state charter from the Colorado Division of Financial Services. Fourth Corner’s applications to secure federal deposit insurance from the National Credit Union Administration (NCUA) and to open a master account at the Federal Reserve Bank of Kansas City (Federal Reserve Bank) were denied.
Both the Federal Reserve Bank and NCUA expressed doubts about the credit union’s ability to comply with applicable laws and regulations, including BSA and AML responsibilities. The Federal Reserve Bank’s reservations focused on the federal illegality of the cannabis sector, and it urged the district court that the outcome should be the same as “if Colorado enacted a scheme to allow trade in endangered species or trade with North Korea in derogation of federal laws, and then chartered a credit union to handle the finances for companies conducting such illegal trade” (Defendant Federal Reserve Bank of Kansas City’s Motion to Dismiss First Amended Complaint, Fourth Corner Credit Union v. Fed. Reserve Bank of Kan. City, (D. Colo. Oct. 21, 2015)).
Eventually, the Federal Reserve Bank conditionally granted a master account, but not without assurances from Fourth Corner that it had revised its business model to avoid cannabis-related businesses until federal legalization. Another condition set by the Federal Reserve Bank was that Fourth Corner obtain deposit insurance from the NCUA, or primary deposit insurance from a private deposit insurance provider suitable to the Colorado Division of Financial Services.
(See Letter from Susan E. Zubradt, Senior Vice President, Federal Reserve Bank of Kansas City, to Deirdra O’Gorman and Christopher E. Nevitt, The Fourth Corner Credit Union (Feb. 2, 2018).)
Because Fourth Corner made a fundamental change to its business model, its lawsuit to compel the NCUA to reconsider its original application for deposit insurance was dismissed as moot in June 2018. As of early 2019, Fourth Corner had yet to acquire the necessary deposit insurance and open its doors to the public.
(See Fourth Corner Credit Union v. Nat’l Credit Union Admin., (D. Colo. July 5, 2016).)