Insights for the 21st-Century Hemp Producer
By Caitlin Houlton Kuntz and Kaleb E. Rumicho
A few months ago, a client called in a panic. This client was a hemp/cannabidiol (CBD) distributor, and the local post office had seized a shipment of industrial hemp that the client was expecting and forwarded the shipment to the post office’s Inspector General. The post office employees flagged it due to its “pungent marijuana-like” smell. This occurred despite the attached lab results showing the Delta-9 tetrahydrocannabinol (THC) levels of the shipment were below the legal 0.3 percent threshold. Even more frustrating, the post office did not provide any additional information or guidance to the client. The client was left in the dark and was understandably upset.
Unfortunately, this is not a unique experience in the re-emerging hemp market. Many folks involved in the hemp business face obstacles and unpleasant encounters with the realities of the undefined (and unclarified) laws and regulations surrounding hemp. The issues usually revolve around the identity of the plant (marijuana vs. hemp), the legality of its transport (e.g., inter- and intrastate commerce), and the status of the plant under federal law (e.g., de-scheduling of hemp and banking regulations). As such, a great deal of tension and frustration remains among those involved in the hemp industry.
The unknown puts hemp businesses in a bind. Understandably, our client and many others in the industry are concerned with the lack of legal clarity and regulatory guidance from the appropriate authorities. It has great potential to hinder their growth and prospect in the market. It becomes difficult for businesses to plan ahead and set out expectations and assumptions to run their companies. Fortunately, in the case of our client, the post office Inspector General’s office promptly released custody of the shipment—but did not provide how to avoid a similar incident in the future nor guarantee this would not happen again.
On Dec. 20, 2018, President Donald Trump signed into law the Agriculture Improvement Act of 2018, Pub. L. 115-334, also known as the 2018 Farm Bill, which legalized hemp production for nearly all purposes (with certain exceptions) and established requirements for growers. This article will discuss what hemp is and how it has historically been used, examine the legal status of hemp today, and address the challenges hemp producers still face in obtaining financial services to support their businesses.
What Is Hemp?
Hemp is a strain of the Cannabis sativa plant species that can be used to make a variety of commercial and industrial products, including rope, textiles, food, and many others. According to the North American Industrial Hemp Council, hemp can be used to make more than 25,000 products, from paper to building materials for homes. Hemp seeds also possess exceptional nutritional value. However, hemp often suffers a bad reputation because it is regularly confused with its cousin plant, marijuana.
Hemp is not marijuana. Hemp and marijuana stem from the same type of plant, and even look similar to an untrained eye. While hemp and marijuana look and smell alike, they are chemically and structurally different. The main difference between the two is the levels of THC the primary psychoactive chemical in marijuana. As defined by federal law, hemp has a THC content at or below 0.3 percent, whereas, marijuana has a THC content above 0.3 percent.
Hemp production was effectively shuttered in the United States with the passing of the Marihuana Tax Act of 1937 (Marijuana Tax Act), which placed an extremely high tax on marijuana. Prior to this ban, however, hemp was a widely used agricultural product. There is evidence of the use of hemp in ancient civilizations, and its production can be traced back to thousands of years ago in Central Asia. The oldest surviving piece of paper, made of hemp, was discovered in China and dates back over 2,000 years.
From the 1600s to 1800s, hemp was a vital fiber crop in Europe, Russia, and North America. In fact, a British royal decree in the early 1600s mandated that colonists in Jamestown grow certain amounts of hemp to be deployed for various uses, such as oil, clothing, canvas, and rope. Hemp was a choice material for cordage and sailcloth for British ships because of the quality and strength of the fiber and its resistance to rot. Similar decrees were subsequently issued in other colonies in North America. Many historians claim that the first flags of the United States were made of hemp cloth.
Growing and using hemp was the standard practice in the United States for many years. However, in the first half of the 20th century, as labor costs increased and synthetic fibers such as polyester and nylon were introduced into the market, hemp’s popularity declined. Although hemp was grown commercially (with increasing governmental interference) in the United States until the 1950s, its doom was inevitable following the passage of the Marijuana Tax Act. The “Hemp for Victory” Campaign during World War II promoted production of hemp for use by the U.S. military, and hemp was briefly widely produced, but by the end of the war, the restrictions under the Marijuana Tax Act resumed. Eventually Congress passed the Controlled Substance Act of 1970, banning the production of hemp outright with few exceptions.
Under the Controlled Substance Act, all cannabis varieties, including hemp, were declared as Schedule I controlled substances (alongside other illicit substances such as LSD, ecstasy, heroin, methaqualone [i.e., Quaaludes], and peyote), with the U.S. Drug Enforcement Administration (DEA) serving as the regulatory authority. While the Controlled Substance Act generally banned hemp, certain growers and researchers were allowed to grow it by obtaining a permit from the DEA.
Currently, the main producers and suppliers of hemp are China and Eastern Europe, where hemp was never banned. In the U.S., legal restrictions surrounding hemp are now fading but not gone. The U.S. Agricultural Act of 2014, section 7606 (“2014 Farm Bill”) initially paved the way for institutions of higher education and state departments of agriculture to grow hemp for research purposes, provided they receive permits from their respective states under regulated research programs. Additionally, the 2014 Farm Bill established a definition of hemp, setting the THC threshold at 0.3 percent on a dry weight basis. Shortly after the 2014 Farm Bill enactment, the Minnesota Industrial Hemp Development Act became law, allowing the Minnesota Department of Agriculture (MDA) to create a hemp research pilot program (the “Industrial Hemp Pilot Program”) to study the growth, cultivation, and marketing of hemp as an agricultural crop.
As part of the application process for the Industrial Hemp Pilot Program, all first-time applicants are required to submit fingerprints to the MDA, provide Bureau of Criminal Apprehension background checks for all persons that would handle hemp seed, provide a detailed map of the growing site, and stated research goals and deliverables. Once approved, the pilot participants are required to provide a report to the MDA regarding seed varieties planted, agronomic findings, and any processing, distribution, and sales of products. Each license is effective for a one-year period and Pilot Program participants must re-apply each year to continue to produce their hemp. According to the MDA, this Pilot Program will continue to be in effect in Minnesota until the U.S. Department of Agriculture (USDA) has approved the state’s 2018 Farm Bill plan (as discussed below), allowing uninterrupted production and processing of hemp while the USDA develops its processes.
Although the 2014 Farm Bill allowed hemp to be grown, it was still considered a Schedule I controlled substance and subject to DEA oversight, continuing to create legal obstacles for those growers and researchers permitted under the 2014 Farm Bill. As such, the 2018 Farm Bill went several steps further and officially legalized hemp by excluding it from the definition of “marijuana” under the federal Controlled Substances Act, provided the crop does not exceed 0.3 percent TCH content.
While the 2018 Farm Bill expands the potential for hemp production, it still does not create a system in which producers can grow it as freely as other crops. The USDA, in lieu of the DEA, now has the authority to regulate hemp and oversee commercial cultivation programs administered by state and tribal governments. The 2018 Farm Bill also set up a shared federal and state regulatory authority over hemp, outlining the steps a state must take to develop a plan to regulate hemp and submit it to the Secretary of Agriculture for approval.
Nonetheless, uncertainty still exists with regards to the legal framework surrounding the legality of hemp production. In an Oct. 29, 2019, press release, the U.S. Department of Agriculture announced the establishment of the U.S. Domestic Hemp Production program, a byproduct of the 2018 Farm Bill. This program is supposed to create a consistent regulatory framework around hemp production throughout the United States.
On Oct. 31, 2019, an interim final rule formalizing the program was published in the Federal Register. This interim final rule allows hemp to be grown under federally approved plans and makes hemp producers eligible for a number of agricultural programs. USDA’s Farm Service Agency (FSA), Natural Resources Conservation Services, and Risk Management are updating guidelines on several programs to support hemp growers, including (1) Whole Farm Revenue Protection (allowing coverage of all revenue for commodities produced on a farm up to a total insured revenue of $8.5 million); (2) Noninsured Crop Disaster Assistance Program (provides insurance-type coverage due to adverse weather conditions); and (3) Farm Loans (making hemp producers eligible for FSA farm loans, like operating, ownership, beginning farmer, and farm storage facility loans).
This rule includes provisions for the USDA to approve hemp production plans developed by states and Indian tribes including: requirements for maintaining information on the land where hemp is produced; testing the levels of THC; disposing of plants not meeting necessary requirements; and licensing requirements. It also establishes a federal plan for hemp producers in states or territories of Indian tribes that do not have their own approved hemp production plan.
As a result, hemp farming is once again on the rise. As of the passage of the 2018 Farm Bill, 46 states have legalized hemp production, with Idaho, Mississippi, New Hampshire, and South Dakota as the only holdouts. According to the annual survey of state departments of agriculture conducted by Vote Hemp, since the passage of the 2018 Farm Bill, over 510,000 acres of hemp were licensed to be grown across 34 states, an increase of more than 455 percent over the previous year’s licensed acreage. Additionally, according to the Minnesota Hemp Farmers and Manufacturers Association, Minnesota has seen a sharp increase in hemp farmers over the same time period—jumping from fewer than 100 growers to nearly 500 certified hemp farmers permitted to produce hemp under Minnesota’s existing pilot program.
Minnesota is currently developing a hemp program that is compliant with the 2018 Farm Bill. In the meantime, Minnesota continues to operate the existing Industrial Hemp Pilot Program, allowing farmers to continue to grow hemp while the new Minnesota state plan is developed, approved by the USDA, and implemented.
So You Want to Find a Hemp Banker?
Like any other enterprise, expanding hemp businesses will likely require financing to get off the ground and scale operations. While many bankers are excited to start building relationships with hemp entrepreneurs, hemp agribusinesses may still encounter challenges when trying to obtain financial services. The 2018 Farm Bill did indeed declassify hemp as a Schedule I controlled substance, but it did not contain any special protections or safe harbors with respect to financial institutions (there is pending legislation regarding banking cannabis businesses which are legal under state law that would do so, but as of late 2019, its fate remained undecided). Ultimately, hemp’s potential to go from a perfectly legal substance to a Schedule I controlled substance without much warning or control, as discussed in the next section, still leaves both practical and regulatory roadblocks to banks signing up hemp farmers as customers.
Banks cannot just hand out loans to anyone who asks. They must review the applicant’s business plan, expected transactions, collateral, credit history, and financial projections in order to establish confidence that the loan will indeed be paid off and the bank will not take a loss on its investment. Hemp as an agricultural crop presents a unique gamble. Lenders will look to the reliability and sufficiency of the hemp crop as collateral, as well as the source of cash flow for the business when considering financing for hemp-growing operations.
The catch, of course, is that hemp can be a volatile crop. It can be difficult for growers to control with certainty the level of THC that will be present in the plants. In the event that a field “goes hot,” so to speak, and the THC content test impermissibly high (above the 0.3 percent threshold), the plants will be considered marijuana under federal law, and the grower can be forced to destroy the crop. Or, suppose the grower’s supply is seized during interstate transport by authorities in one of the few states that have not yet legalized hemp on a state level (as happened over this past summer in South Dakota). In these circumstances, the bank could be facing a borrower lacking reliable cash flow to support the debt servicing or left without sufficient collateral to back up the loan (even where insurance or other collateral is available), necessitating scrutiny from bank management as well as from regulators. In addition, any deposits or cash management transactions the bank has facilitated with respect to the hot crop could potentially be considered proceeds from illegal activities and thus subject to regulatory action.
Lingering uncertainty regarding the rules and regulatory expectations surrounding hemp businesses tends to be the top sticking point for banks considering engaging the industry, with the biggest concern stemming from the requirements of federal laws regarding anti-money laundering (AML). Banks are required to monitor and report on activities of their customers that may be tied to illegal activities, and banks (and individual bank officers!) that process transactions or handle or lend money relating to illegal activities can be heavily sanctioned, fined, or even criminally prosecuted for facilitating money-laundering.
The general response from federal banking regulators has been that banks should continue to follow established policies when engaging hemp customers, and that hemp customer relationships should be evaluated on a case-by-case basis. Federal regulators released joint guidance in December 2019 confirming that banks are not required to file suspicious activity reports solely because a customer is engaged in the cultivation of hemp in accordance with applicable laws and regulations (note that this guidance does not extend to marijuana). Banks are still expected to comply with all applicable regulatory requirements with respect to hemp customers, including maintaining an AML compliance program “commensurate with the level of complexity and risk involved.” Said another way, existing AML laws and compliance expectations still apply, and banks must still file suspicious activity reports if they have a reason to believe a hemp customer is not operating within the requirements for legal hemp production. Compliance with this guidance may involve some trial-and-error as bankers and regulators navigate its practical application, and additional guidance could be forthcoming as hemp programs are launched.
Similarly, on the state level, things are not quite settled. State banking regulators are paying close attention to the development of the federal- and state-level compliance programs, and many are working to craft guidance for their constituent banks on how to safely and soundly engage hemp customers.
Proceeding with Caution
Despite these concerns, some banks have found ways to extend financial services to legal hemp businesses by employing special risk-management procedures and careful oversight. Even when dealing with those financial institutions that feel comfortable engaging the hemp industry, hemp customers can expect to be treated as “high-risk” customers and face stringent due diligence and ongoing monitoring to ensure their business is conducted consistent with state and federal law. Hemp businesses should brace themselves for plenty of questions from their financial institutions. Who is involved with the business, including investors, employees, and vendors? What policies and procedures has the business implemented to ensure compliance with state and federal law? When is the business obtaining the appropriate licensing, and then testing, monitoring, and reporting on its crops and compliance program? Where are crops grown, stored, transported, handled, and processed? How is the business structuring its operations to guard against abuse and criminal activities?
Banks will continue to be cautious until the legal and regulatory considerations are more settled, and attitudes could change as state and federal regulators continue to develop and release additional regulations and guidance with respect to hemp.
The 2018 Farm Bill has and will continue to boost hemp production and sales in the United States. The USDA’s interim final rule is a positive step forward in providing a helpful legal framework to interested parties, including law enforcement, other regulatory agencies, states, and the farmers themselves. Additionally, many people who were initially hesitant to get into this resurging hemp åindustry are now able to pursue their business more confidently and with less concern about federal prosecutions. That said, the industry is still far from a settled legal and regulatory framework. Financial services will continue to be a challenge for hemp entrepreneurs until banks feel more comfortable engaging them without the threat of regulatory sanctions. Work still needs to be done, and all eyes will stay trained on the state and federal regulators as hemp production programs and guidance continue to evolve.
Ms. Houlton Kuntz is an attorney with Fredrikson & Byron. She grew up in the community banking industry and now advises community banks and other financial institutions on a variety of regulatory, mergers and acquisitions, and vendor contract matters.
Mr. Rumicho is an attorney at Fredrikson & Byron. He advises clients in all aspects of commercial and debt finance transactions, mergers and acquisitions, and general corporate matters. In addition to his corporate practice, he practices public law, including election and political law. Prior to joining Fredrikson, he served as a law clerk for both the U.S. Securities and Exchange Commission and the U.S. Senate Judiciary Committee.