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Lessons From The Prohibition Era: How New Enforcement Presents Greater Legal Risk For Illicit Market Cannabis Businesses

August 20, 2020 3:58 pm
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By Patrick Devine, Esq.

One of the most notorious individuals of the 20th century, and arguably the most iconic crime figure of all time, is American gangster Al Capone.  Capone rose to prominence in Chicago during the Prohibition Era.  From 1925 to 1929, Capone’s multi-million dollar bootlegging, gambling, and prostitution operation represented the pinnacle of organized crime.[1]  Ruling with an iron fist, Capone built a terrifying reputation for himself and his syndicate through violence and intimidation. 

It is estimated that Capone’s operation generated approximately $100 million (or $1.5 billion in today’s terms) in annual revenue.[2]  Capone spread his wealth strategically, and it is believed that he had numerous police, judges, federal prosecutors, politicians, and high-ranking federal agents in his pocket.  Not only that, Capone was viewed by many as a respected community leader because of his charity work, including feeding the hungry with soup kitchens following the Great Depression.[3]  Together, Capone’s influence and reputation made him effectively untouchable, as he led his criminal empire with nearly no law enforcement interference. 

Due to wealth and power, combined with witness intimidation and lack of written records, crime bosses like Capone were extremely difficult to prosecute during the Prohibition Era.  However, the Assistant Attorney General in charge of enforcing the Volstead Act (which prohibited the manufacture and sale of alcoholic beverages), Mabel Walker Willebrandt, took notice that these wealthy crime bosses were not filing tax returns while simultaneously living extravagant lifestyles.[4]  She theorized that she could successfully prosecute these crime bosses for tax evasion without proving any of their other crimes.[5]   In United States v. Sullivan, the U.S. Supreme Court agreed with Ms. Willebrandt’s theory and rejected the Defendant’s argument that filing income taxes on illegal income amounts to self-incrimination protected by the 5th Amendment.[6] This ruling set the stage for Capone’s demise.

In early 1929, the U.S. Treasury’s Special Intelligence Unit began compiling a tax evasion case against Capone.  Thanks to Ms. Willebrandt, there was no longer a need to prove Capone was running a criminal syndicate of gambling, protection, prostitution, and bootlegging. Proving that Capone was not paying taxes on his income from those illegal businesses was the Intelligence Unit’s sole focus.  Although the Intelligence Unit suspected income of upwards of $100 million, it felt certain it could prove income of approximately $165,000 for years 1926 through 1929.[7]  Interestingly (and perhaps rather oddly), Capone’s own attorney produced a statement demonstrating Capone's income of approximately $266,000, under the guise of settling the tax debt.  This statement was ultimately used as the final evidence against Capone, and on October 18, 1931, he was convicted of tax evasion and sentenced to 11 years in federal prison.[8]  By the time Capone was released, his health had deteriorated and he died five years later. 

Lesson Learned in Enforcement

Flash forward almost 100 years, and a different form of “Prohibition Era” is taking place in California’s cannabis market as unlicensed operators continue to flourish.  Although it is not directly analogous to bootlegging during the Prohibition Era, California’s cannabis black market has certain undeniable similarities, including the difficulty of enforcement and illegal operators generating significant amounts of revenue.  It is estimated that in 2019, California black market cannabis operators collectively generated approximately $8.7 billion in revenue, while legal operators saw a significantly smaller revenue stream of approximately $3.1 billion.[9]

Much like federal authorities looking for a way to take down Capone and other prominent bootleggers in the 1920s, California’s cannabis regulatory agency, the Bureau of Cannabis Control (BCC) is fervently trying to eradicate the cannabis black market.  With limited resources and a territory spanning the largest state in the U.S. by population (and third largest by territory), this battle has been a difficult one.  Last year, as part of a goal to eliminate illegal operators, Governor Gavin Newsom signed AB 97, which allows fining an unlicensed cannabis business up to $30,000 per violation.[10]  In 2020, there has been an increase in raids and seizures, collectively, by the BCC and local regulatory agencies and law enforcement.  Additionally, the BCC has launched a public awareness campaign encouraging consumers to scan a QR code on cannabis products with their smartphones to verify that products were produced by a licensed operator.[11]

While the BCC’s recent efforts have not gone unnoticed by legal operators, much more needs to be accomplished to ensure these legal operators are not negatively impacted by the illicit market.  As the BCC continues to fight this uphill battle, the California Department of Tax and Fee Administration (CDTFA) and California Highway Patrol (CHP) appear to be joining the fight and stealing a page from Ms. Willebrandt’s playbook. 

On July 8, 2020, it was announced that twelve illegal cannabis retailers in Los Angeles and San Bernardino counties will likely face a similar fate as that of Mr. Capone, after each was served with a tax warrant from the CDTFA with assistance from the CHP.[12]  The CDTFA seized nearly $1 million in illegal cannabis products that will be destroyed and approximately $100,000 in cash that will be applied to tax liabilities.  This novel application of a classic prosecutorial strategy may be cause for concern for some unlicensed operators, especially if the CDTFA becomes aggressive with this enforcement strategy.

Section 34016(a)(2) of the California Revenue and Taxation Code grants governmental and policing authorities broad power to conduct inspections “at any place at which cannabis or cannabis products are sold to purchasers, cultivated, or stored, or at any site where evidence of activities involving evasion of tax may be discovered.”  Furthermore, if law enforcement discovers “that a licensee or any other person possesses, stores, owns, or has made a retail sale of cannabis or cannabis products, without evidence of tax payment or not contained in secure packaging, law enforcement is authorized to seize the cannabis or cannabis products.”  As a result, law enforcement and the CDTFA has very broad authority to prosecute illegal operators for tax evasion and seize cannabis products.[13]

The CDTFA’s involvement feels like poetic justice as the current tax structure is perhaps one of the main deterrents preventing operators from entering California’s legal cannabis market.  Legal cannabis businesses must pay a number of taxes, including: a 15% excise tax, a 7.25% sales tax, and any locally mandated cannabis taxes.  In addition, cultivators are subject to a tax of over $150 per pound of flower, nearly $50 per pound of trim, and over $20 per pound of fresh frozen whole plant.  These taxes undoubtedly make legal operations more difficult (and more costly).  As acknowledged by CDTFA Director Nick Maduros during the  July 8, 2020 enforcement announcement, “Tax evasion unfairly shifts the burden onto all other taxpayers and makes it tough for those businesses that are playing by the rules to survive.”

Taxes are not the only additional expense for state licensed operators, as compliant packaging and labeling, testing, quality assurance, and legal transportation all comes at substantial cost.  The data seems to demonstrate that many cannabis business operators weigh the costs of compliance as more than the cost of potential enforcement actions, and therefore choose to remain in the black market.  This pragmatic position is causing grave harm to the legal cannabis industry, forcing licensed operators to unwillingly compete with black market operators selling similar products at a much lower cost, at much higher margins, and with a “zero” tax rate.  During a worldwide pandemic when many consumers are struggling financially, added enforcement is even more important to ensure compliant businesses are able to survive. 

Perhaps the CDTFA joining the fight and employing the prosecutorial strategy that took down one of history’s most iconic crime figures will sway some operators to abandon the black market and establish compliant operations.  Indeed this additional enforcement tool by an alternative state agency could be a significant step towards causing black market operators to rebalance their risk tolerance calculus, causing the threat (and penalty) of enforcement to outweigh raw pecuniary benefits of black market activity. However, unless the CDTFA aggressively employs this strategy, it seems unlikely that it will have any significant impact on California’s ingrained black market.

While much remains to be seen regarding the effectiveness of the CDTFA’s enforcement strategy, the BCC has found itself entangled in a new legal dispute with the U.S. Drug Enforcement Agency (DEA) that could foreshadow yet another layer of enforcement against California’s cannabis black market.  A petition filed with the U.S. District Court for the Southern District of California on July 20, 2020 stated that the DEA delivered a subpoena to the BCC in January 2020 seeking “unredacted cannabis license(s), unredacted cannabis license application(s), and unredacted shipping manifest(s)” for six different unnamed entities in connection with an ongoing DEA investigation.[14]

It seems the BCC declined to comply with the DEA’s initial subpoena by claiming that it lacked specificity and would risk violating certain state privacy laws.[15]  Since the initial subpoena, the BCC has remained firm in its stance to not disclose the requested information.  But, should the petition be granted, the BCC will be mandated to produce the requested records to the DEA.

It may seem reassuring for the entire California cannabis industry that the BCC is standing up to the DEA and not simply producing private records.  However, the DEA is armed with a strong argument that it is authorized to investigate potential violations of the Controlled Substances Act and issue subpoenas relevant to such investigations.  Additionally, any contradicting state law allowing the BCC to refuse disclosure would likely be invalidated by the U.S. Constitution’s Supremacy Clause, as also argued by the DEA in its petition. 

Some legal operators in the cannabis industry are alarmed by the news of these federal investigations, especially given the fact that a DOJ whistleblower recently accused Attorney General William Barr of having personal animus against the cannabis industry. After all, the possibility of a federal raid, followed by asset forfeiture, potential arrest, and prosecution is a risk that remains very real for state-legal cannabis operators.

At this time, it is too early to tell if this DEA subpoena is the first sign of the federal government modifying the hands-off approach we have seen throughout the Trump administration.  It may be the case that the DEA is solely focused on businesses it suspects to be trafficking cannabis in interstate commerce or otherwise conducting significant operations in the black market.  It is widely believed throughout the industry that too much cannabis is being cultivated in California since legalization, and as a result is being shipped and sold out of state.[16]  Given the DEA’s hands-off approach thus far, the size of California’s black market, and the petition being limited to only three licensees (six entities), it is plausible the DEA is focused solely on illegal, interstate operators. 

If that is the DEA’s focus, perhaps the BCC should be open to collaborating with the DEA to increase the enforcement pressure against California’s growing black market alone, which continues to present a number of problems for legal operators.  This could be one more tool to dismantle the black market, by increasing the risk of operating outside the bounds of the legal market and persuading these operators to become compliant. That said, the DEA’s petition lacked the information the BCC needed to draw such conclusions.  Until more information is discovered, all California cannabis businesses should be on notice. 

Patrick Devine, Esq. is an associate attorney at Rimon P.C.  Mr. Devine focuses on corporate law and regulatory compliance for California cannabis companies.  Mr. Devine guides cannabis businesses, brands, and ancillary companies in navigating the highly regulated and constantly evolving cannabis industry.  Mr. Devine is based out of the Los Angeles office.

[1] Al Capone: His Life, Legacy, and Legend, Bair, Deirdre (2016).

[2] Id. at pg. 73.

[3] Id. at pg. 182.

[4] Women as Supreme Court Advocates, 1879–1979, Mary L. Clark, Journal of Supreme Court History (2005) at pg. 47, 52.

[5] Id.

[6] United States v. Sullivan, 274 U.S. 259 (1927).

[7] Al Capone; A BIOGRAPHY (2003) at pg. 81.

[8] Capone v. United States, 56 F.2d 927 (7th Cir.), cert. denied, 286 U.S. 553 (1932).

[10] See California Health and Safety Code Sec. 26160(f).

[13] See, California Revenue and Taxation Code § 34016(a).

[14] United States of America v. The Bureau of Cannabis Control, case number 3:20-cv-01375, in the U.S. District Court for the Southern District of California.


[16] See, https://mjbizdaily.com/california-marijuana-notebook-how-illicit-market-competition-industry-divisiveness-hound-the-states-legal-cannabis-market/.

Photo by JOSHUA COLEMAN on Unsplash.

The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.


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