California Cannabis Supply Chain Contracts: Inspection and Rejection

Our cannabis business attorneys have drafted many cannabis supply chain agreements (such as distribution agreements, licensing agreements, etc.) over the years. Generally, supply chain cannabis contracts follow the same format and the same nuanced provisions seem to pop up time and time again (I wrote about some of them previously in the context of tri-party supply chain agreements here). One such provision concerns inspection and rejection rights.

Virtually any kind of agreement where commercial products are changing hands gives the recipient the right to inspect products and reject them for certain non-conformance issues. The biggest negotiating point for these clauses are typically (1) how long that inspection period is, and (2) the grounds upon which the recipient can reject the goods. Disputes can crop up during negotiation around whether or not rejection is allowed for things that are discretionary. For example, a recipient may want the right to reject goods if it determines for some reason that it can’t sell them. It goes without saying, but the recipient almost always wants more time and broader rejection rights, where the seller usually wants short rejection windows and very narrowly defined rejection rights.

This is not unique to cannabis. Any time a contract has inspection and rejection periods, these issues come up. What makes them unique for cannabis is that the California Bureau of Cannabis Control (BCC) imposes additional inspection and rejection rights on its licensees. While the rules only apply to BCC licensees, such as distributors and retailers, those are the license types where this usually comes up (the circumstances in which cultivators, for example, receive cannabis products are very limited).

According to the BCC, recipients of cannabis goods are obligated to reject partial or entire shipments of cannabis goods if the shipment differs from the goods on a sales invoice or receipt, contains goods that were damaged during transportation, the cannabis goods not comply with labeling requirements, or the goods exceed their expiration date. Presumably, the BCC would also want recipients to reject goods that otherwise fail to comply with applicable requirements such as not having passed testing. It’s basically implied from the BCC’s rule that this inspection should be done upon receipt of the goods.

This is all important because some sellers may try to negotiate for very narrow rejection rights that contradict the rules, which means the rules must be considered when negotiating a contract to avoid disputes. What happens, for example, if a contract does not allow goods to be rejected based on non-compliance with labeling requirements, and the recipient wants to reject goods that have non-compliant labels? The answer is not always clear and it’s good to understand this while drafting.

Moving beyond just the contract, inspections are important for practical reasons. Once a licensee has accepted a cannabis good, its ability to return those goods is severely constrained. The BCC only allows B2B returns for defective manufactured goods and only upon completing certain exchanges. The BCC does not define what “defective” means, but it arguably includes the things mentioned above for manufactured goods, such as being damaged or improperly labeled. However, it does not include being unsatisfied with goods or flower goods in any case. That’s just one of the reason thorough inspections are important.

Inspection and rejection clauses are often glossed over in contract negotiations. Especially for buyers, the clauses are important. Stay tuned to the Canna Law Blog as we discuss additional issues with supply chain contracts in the cannabis industry. Until then, for more on cannabis supply chain contracts, check out the following: