New York's Broken Cannabis Program: What Happened and How to Fix It ft. Neil Kaufman

New York's Broken Cannabis Program: What Happened and How to Fix It ft. Neil Kaufman

Bryan Fields: What's up guys, welcome back to another episode of The Dime. I'm Bryan Fields, and with me as always is Kellan Finney. This week we've got a very special guest, Neil Kaufman, managing member of Kaufman & Macau. Neil, thanks for taking the time — how are you doing today? Neil Kaufman: I'm doing great, good morning Bryan, it's good to see you. Bryan Fields: Kellan, how are you doing? Kellan Finney: I'm doing really good, really, really excited to talk to Neil, really excited to dive into the New York cannabis market. I don't think there's anyone else closer to all the regulations than Neil, so I'm excited to get all of his takes and just get a deeper understanding. How are you, Bryan? Bryan Fields: Yeah, I'm excited. New York is one of those markets where you see what's going on, and then you miss a day or two and realize, hey, maybe I don't understand what's going on anymore. Neil, from your perspective, we've got a lot to talk about. Maybe the first, most important thing — we don't even need to put you on the record on East Coast versus West Coast, I think New York has already sold you, and I know you're an East Coaster so we're ready to run with that. But right off the bat: New York State's cannabis market, Governor Kathy Hochul overhauling the program — good or bad for the industry? Neil Kaufman: I think it remains to be seen, because we don't really know yet how she's going to try to revamp the program. Clearly the program has been troubled. It's made substantial progress over the last several months, but there are many significant challenges remaining, and the book is only in like chapter two — we've got a long way to go. It's going to be really critical over the next several months to see how the program changes, the extent to which there are regulatory changes, administrative and bureaucratic changes, and in a dream world, statutory changes. All of these, in my view, will be necessary to optimize the program. Look, taking a step back, Bryan — New York was like the 22nd or 23rd state to legalize recreational cannabis in this country. Yes, I'm a New Yorker born and bred, but we've worked all around the country over the last ten years in the cannabis industry. At one point we represented four of the five largest cultivators in California, 3,000 miles away. We've worked in Colorado a little bit too. We've seen what's happened in many states for a long time, and it's obvious that virtually every state has struggled with its recreational cannabis rollout. We hoped that having seen twenty-some-odd states come before it, New York would have learned some of the lessons and crushed it. Unfortunately, that has not been the case, for a variety of reasons we can talk about. It's never too late to get it right. It's too late for some people who have already lost their life savings, and it breaks my heart to see, especially some of the social equity applicants who are the very people the state's elected and appointed officials really wanted so badly to help — a lot of them have already lost their life savings and seen their dreams go up in smoke, no pun intended. That's heartbreaking. So it might be too late for some of them, but the sooner we get this fixed and on the right track on an expedited basis, the more we can mitigate that damage and try to bring the New York market into as vibrant a state as possible, as quickly as possible, and allow the New York licenses to generate the generational wealth that regulators have repeatedly said was the goal of the program. Kellan Finney: Just quickly on that — originally, as the program was initially intended, did it ever, in your opinion, have a chance to be successful? And if there were challenges early on, individuals like yourself who were experienced were vocal about these potential roadblocks — do you think it was internal egos, incompetence, unknowns, different perspectives? Where did we go wrong to end up where we are today? Neil Kaufman: That's a great question, and a little challenging to answer if you weren't occupying the halls of power in Albany for the years prior to the adoption of the MRTA. The original sin here was, on some level, political. Andrew Cuomo was anti-cannabis and refused to seriously consider legalizing adult-use cannabis in New York for years. At some point he softened that position and brought in some very well-informed advisors, like Norman Birenbaum, to help guide the program. That ran into political conflict with the progressive wing of the Democratic party in the state legislature. When Cuomo hit the political rocks and decided to compromise to allow adult-use legalization in New York, unfortunately what came out of that was a statutory structure that I was concerned from the beginning would impede the viability of the New York market — the two-tier structure that New York baked into the MRTA. And there's nothing any regulator can do about it, because it's statutory. The only other state in the country that has adopted this alcohol-like two-tier model for cannabis is Washington State, and nobody I know in the cannabis industry has ever been a huge fan of the Washington market, for a variety of reasons. Some of the more "successful" companies in Washington have been the white guys backed by local billionaires — the antithesis of what New York's elected officials and regulators said they wanted to see. I think they believed they could manage the creation of a widely fragmented mom-and-pop industry that would benefit the social equity applicants they were seeking to favor. Nobody quibbles with the intention to help the people victimized by the War on Drugs — that was obviously a travesty, and we're all in favor of helping them. The problem is that to help the people you want to help, you have to start with a strong industry — you can't accomplish your political and ideological goals in a vacuum. You have to stand up a vibrant industry first, and I think the fundamental misjudgment we've seen play out is that by repeatedly prioritizing equity over industry fundamentals, we've ended up with a crippled industry. That's not to say the social equity goals aren't important — they are — but you can only accomplish them once you have the industry and the money and funding behind it. It's very difficult to do it in reverse. We've observed all around the country the tremendous difficulty in implementing effective social equity programs in cannabis. I was speaking at a conference last year with hundreds of cannabis lawyers from around the country, and during a panel on social equity programs, I asked the whole room: raise your hand if you can identify a social equity program in cannabis that has actually been effective. Zero hands went up. None of us had seen one that worked, barring straightforward block grants of money to social equity applicants and licensees. It's extremely difficult, and if you make that your number one priority over building a viable industry, you're putting yourself behind the eight ball. In some early conversations I've had with Tremaine Wright, who is very smart and has her heart in the right place, and some of the regulators at OCM, when we discussed the practical and logistical challenges of implementing their program, the answer was usually along the lines of, "but if we can do this, it will be so wonderful, watch us, it'll be great." And yes, if they could have achieved their goals it would have been wonderful, no doubt — but the practicalities of business have intruded on those dreams, and they've been unsuccessful in accomplishing those goals, at least to date. We are making some progress now, finally, after three-plus years, but the program has clearly been challenged and has more challenges ahead. Kellan Finney: With social equity — I mean, New York is kind of the capital of free markets, right? So from my perspective, when you look at how the social equity program was rolled out, it was essentially going directly against this macro, philosophical idea of a free market where everyone gets a free chance. It's like, yes, these people are disadvantaged because of these laws, but now we're going to try to change capitalism as a whole just for this situation. Social equity applicants didn't have the same financial capital because they'd been disadvantaged, so if it's a free market, they're already at a disadvantage from a resource perspective. Do you think that fundamental tension had anything to do with the infighting that led to the unsuccessful implementation? Neil Kaufman: Kellan, I think you've put your finger on the root cause of the structural problem that has hobbled the development of the New York market — the two-tier system. Kellan Finney: Can you explain the two-tier system, just in case some listeners aren't familiar? Neil Kaufman: Sure. In New York, like in Washington and no other state, there's a strict delineation between retail and the supply side of the industry. This mirrors the structure of the alcohol industry, where brewers, distillers, and manufacturers of alcohol products aren't allowed to own retail liquor stores. We have this in New York too — some states have state-owned retail liquor stores, others, like New York, have privately owned stores, but there are no Budweiser liquor stores, no Gallo Brothers wine stores. There's a strict prohibition — the two-tier system. If you're on the retail side, you can't be on the manufacturing side, and vice versa. All the other states that have legalized adult-use cannabis have allowed the free market, to varying degrees, to shape the development of the industry. In California, you can be in any segment of the market you want, which allows capitalism to drive the marketplace. We have clients in California who are great cultivators but won't touch retail — or if they have vestigial retail stores, they hate them, because they're fundamentally different businesses. Growing great weed doesn't mean you know how to run a store, and vice versa. Extraction and infusion is a different business too. Distribution is different again. Some organizations are good at more than one, and some companies have succeeded with vertical integration. The true irony is that when New York adopted its medical marijuana program in 2015, it mandated full vertical integration for the initial five, then ten, then eleven licensed registered organizations. If you were in the New York medical market, you were legally required to be fully vertically integrated from seed to retail sale. Then, when they instituted the adult-use market, they prohibited vertical integration. Creating an industry with that kind of inherent structural conflict is virtually impossible, and that's what regulators have been wrestling with for the last three years — no matter how hard they try, no matter how well-meaning, they're swimming against the tide of capitalism. So what did we see? In most states, the easiest way to satisfy retail demand — which turns out to be relatively inelastic, since there's demand for cannabis whether it's legal or illegal, in booms or recessions or even pandemics — is to let the existing medical companies sell adult-use, since they already have the infrastructure, supply, and stores. New York had these vertically integrated medical marijuana companies that had invested millions of dollars building capacity in anticipation of the recreational market opening up, figuring that, like most states, New York would open to their stores first. But because of New York regulators' fear that the big MSOs owning the registered organizations would dominate the market and crowd out the mom-and-pops they wanted to nurture, they said: no, you registered organizations can't sell adult-use retail for a long time — I think it was three years — and we're going to charge you five million dollars per store to let your medical stores become dual medical-and-recreational. So if you had four stores, that's twenty million dollars for the privilege. Surprise, surprise — they filed lawsuits. They'd invested hundreds of millions of dollars in building infrastructure for the transition to adult-use, and these are some of the biggest MSOs, so they can afford lawyers. A lot of people think they also bankrolled some of the other lawsuits, like the one from service-disabled veterans that froze the CAURD program. Voila — the whole New York program was frozen for six months, all because the statute and regulatory structure was conceived out of the belief that they could manage the development of a fragmented mom-and-pop industry and prevent capitalism from functioning normally. Look, I'm not a right-wing nut job, but it's kind of obvious — the Soviet Union failed, right? Economies are too complicated to be micromanaged by governments. There was a bit of hubris involved. They really thought they could manage this brand-new industry and create a fragmented market while helping social equity applicants, market forces be damned. And what happens when market forces are damned? You end up with thousands of illegal stores. Those stores weren't there five years ago — they're a product of this statutory structure, because the process has been so derailed that we still only have about 120 retail stores open in New York. That's nowhere near enough to feed multi-billion-dollar demand, so the free market steps in and fills the void — made even easier by the pre-existing black market. And just to follow up — even with a two-tier system, New York already has ample regulations that govern and restrict unfair influence on the retail sector. So the ownership and investment restrictions imposed on New York's retail tier are, in my view, unnecessarily duplicative of regulations already in place to prevent the predatory conduct regulators were afraid of. The end result: in New York, you're not allowed to own any interest at all in a New York retail cannabis business if you have any economic interest in any non-retail cannabis business anywhere in the world. Think about how insane that is. Over the last ten years we've seen tens of billions of dollars invested in the cannabis industry, so there are now cannabis investment funds, family offices, and individuals who've invested in businesses around the country and the world. Because most of those markets require or allow vertical integration, almost every experienced cannabis investor owns some piece of a supply-side business somewhere. Every one of those investors — the most experienced, deepest-pocketed people who know how to invest in cannabis and would otherwise invest in New York's retail sector, populated by the very social equity applicants everyone wants to help — is prohibited from investing in any of those retail stores. I ran a Cannabis Capital Forum a few months ago and moderated the investor panel — every single investor said, "I'd love to invest in New York retail, but I can't, I'm blocked out." That restriction is completely unnecessary. Many state regulatory structures rely on a control concept: if you control a retail business, you can't also control a supply-side business, because then you'd breach the two-tier structure. Fine, I could live with that — far better than a complete ban on any investment, even a single passive share of stock in a public supply-side company. That would have significantly mitigated the choking-off of capital available to the New York retail tier. Fast forward a year or so, with stops and starts, and New York retail licensees trying to raise money and build stores — regulators basically said, "deal with our two-tier structure, get creative." So people got creative, and now we see all kinds of deal structures, some of which, if regulators fully understood them, they might view as predatory. Chicago Atlantic and the Social Equity Fund is a different, related discussion. In general, financial markets drive investment, and no regulatory dictate is going to force an investor to make investments on terms that aren't viable for them. Investors owe a fiduciary duty to their limited partners; their goal is to generate the biggest return possible. You can't force them into taking minority interests in a startup. For example, if you're starting a tech company in Silicon Valley with no money but a brilliant idea, it's not uncommon for a venture capitalist to take 80% of your company in exchange for funding. In New York, we've got retail licensees whose main qualification was a prior cannabis conviction — many with no cannabis or business experience — the CAURD licensees, who are legally required to hold a majority of shares and sole control of the business. Most investors, if willing to invest in that kind of highly speculative startup, wouldn't allow the founder unfettered sole control, nor restrict themselves to a minority stake. So we had to get creative — but that created a huge disconnect: investors who weren't banned from investing in retail (new investors, not the 99% of experienced cannabis investors who were blocked) were often willing, since New York has so many wealthy people happy to put in half a million or a million dollars to own a piece of their local dispensary. But the terms they demanded weren't consistent with what CAURD licensees were legally able to offer. As a result, the operators who had money themselves — experienced businesspeople who could self-fund, including, frankly, some wealthy guys who got busted young but went on to successful careers — were able to open first. Many social equity applicants who couldn't self-fund and didn't have a network of friends and family to provide capital have struggled mightily, and many have been forced into deals far from what regulators had hoped for. You could call that predatory, or you could call it market forces functioning the way markets do, notwithstanding the regulatory restrictions. Bryan Fields: And the Social Equity Fund itself is a bit different, but with common themes? Neil Kaufman: Right. After the statute passed, Governor Cuomo sat on it — never appointed a Cannabis Control Board, never got the Office of Cannabis Management running. So there was a long delay before Hochul came in, appointed the Cannabis Control Board, got OCM running, and appointed Chris Alexander as executive director. They wanted to catch up for lost time. Meanwhile, there was a cohort of 200-plus hemp farmers, largely upstate, who'd gotten hemp cultivation licenses in prior years and had been destroyed by the collapse of hemp prices. So the elected officials — or maybe OCM — had this idea: let's save the hemp farmers by giving them the first cannabis cultivation licenses. The farmers thought, great, I'm broke growing hemp, now I can grow weed and sell it at high margins. Putting aside that growing high-potency cannabis, especially outdoors, isn't easy, and isn't the same as growing hemp, a lot of these farmers grew cannabis for a year or two — some grew decent product, many didn't — and then harvested it and looked up to find there were no stores to sell it to. So these distressed hemp farmers were sitting on hundreds of thousands of pounds of cannabis with no retail outlet. Seeing that, regulators adopted the CAURD program — initially proposed at 150 licenses — for justice-involved people, killing two birds with one stone: helping the most deserving social equity applicants while giving them retail licenses to sell the backlog of farmers' cannabis. Sounded great in theory, but it was way more complicated than people realized — inexperienced licensees needed financing, a location, a build-out, and the financing was choked off for the reasons we discussed. So they had another idea: let the government find, build, and finance the stores for CAURD applicants. They put the New York State Dormitory Authority — DASNY — in charge of finding locations, negotiating leases, and running a Social Equity Fund seeded with $50 million of state money, which was supposed to be matched by another $150 million in private capital. That $200 million would lease and build stores and provide turnkey operations to CAURD operators, funded at 8% interest, non-recourse. As soon as I saw the RFP for that fund, I told friends at OCM: have you thought this through? I don't see investor demand for a fund lending at 8% non-recourse to inexperienced store owners opening startups in a brand-new industry. If you're charging 8% with a substantial default rate, what real rate of return are investors getting, compared to lending to the biggest MSOs at 20% or more secured, or investing in equity of experienced management teams in established markets? They said, "you'll see, people are going to want to be in this industry, it's going to be great, Chris Webber's going to raise the money." No investor put money into that fund. Surprise, surprise. Eventually the state restructured the fund. Chicago Atlantic — a publicly traded institutional investor, very smart people — said they wouldn't invest equity, but would lend on terms with no risk, negotiating a first lien on New York State's cannabis tax revenues as collateral. Interest rates escalated to 12%, and now they're in the 15–18% range to the ultimate borrowers. During the couple of years that took, DASNY signed very few leases but blocked out many locations it wanted without disclosure or transparency, so CAURD licensees would sometimes find a property only to discover DASNY had already locked up something nearby, with no way of knowing until they'd already signed leases elsewhere. On top of that — there was a legislative hearing about this recently, and the facts are a bit murky — it looks like DASNY marked up build-out costs, where a contractor might build a store for $250,000–$300,000 but DASNY charged the licensee a million dollars or more. So CAURD licensees paid exorbitant amounts for build-outs at much higher interest rates. DASNY completely botched the program. In fairness to OCM, they were frustrated with DASNY from the start, and I think, notwithstanding the recent Office of General Services report that torched OCM, a lot of the fundamental problems with the Social Equity Fund and CAURD program stem from DASNY rather than OCM — though OCM isn't completely faultless. It's a little unfair that DASNY wasn't a target of that OGS report. That's the story of the Social Equity Fund — it was doomed from the start. Governor Hochul announced yesterday, per press reports, that there will be no more investment from that fund; it's dead. For the record, I was quoted in that article as saying I told them this fund was a bad idea — what I meant wasn't that funding social equity applicants is a bad idea, that's great, but that the way they structured the fund was built to fail from the beginning. Bryan Fields: That context is important — people hear one thing and think another. Final question: do taxpayers bear the brunt of New York's mistakes, and what do you see as three logical steps to get New York's cannabis market back on track instead of headed for the rocks? Neil Kaufman: The three things I'd do right now: First, revise the regulations to prohibit investment in New York retail stores only if you have a controlling interest in a New York supply-side business. In the long run, I'd like to see the two-tier structure repealed entirely and the free market allowed to flourish, so New York can nurture national champions — something impossible under the current two-tier structure. That requires legislative change, but in the meantime we need to relax the TPI regulations to open the spigot of investment capital into New York retail and build that side out as quickly as possible. Second, we need the New York Attorney General to enforce the MRTA provisions that prohibit townships and localities from imposing unreasonable zoning restrictions — in many places, especially on Long Island, even in opted-in jurisdictions, towns have imposed restrictions like barring retail stores from retail-zoned areas or limiting them to industrial-only zones. That seems patently unreasonable. There's a mechanism in the statute for the Cannabis Control Board to issue advisory opinions deeming such restrictions preempted and in violation of the statute, but the CCB has been reluctant to use it. They need to start, and it would help to have state funding and litigation manpower to remove those restrictions, which are severely impeding retail development across much of the state. Third — a lot of people would say shut down all the illegal stores. I'm okay with enforcement, but it's not the magic answer, because as long as demand is underserved, there will be more illegal stores; it's just market forces at work. It's much better to swim with the tide than against it — much easier, more efficient, and less costly to taxpayers. And yes, taxpayers ultimately bear the burden — the $50 million likely lost from the Social Equity Fund, and all the lost tax revenue from not having an operational industry for so long. The sooner we ramp up this industry, the lesser that burden. There are a lot of good people at OCM working hard under difficult circumstances. Now that the Governor's report has come out and Chris Alexander is gone, OCM is in a bit of shell shock, which isn't good either — we need to let them do whatever they can to get this industry running as quickly and effectively as possible. Modify the regulations to make that more doable, and to my friends at OCM: go do it. Bryan Fields: I think that's the perfect way to end it. Neil, appreciate it — thanks for taking the time, and we look forward to hearing from you soon. Neil Kaufman: Great, thanks Bryan, thanks Kellan — been a pleasure this morning. Thanks for having me, and I hope this was somewhat informative for your audience. Bryan Fields: Absolutely. Thanks for taking the time.