In November, Californians will go to the polls to vote on whether to legalize the recreational use of marijuana. This ballot measure, known as the Adult Use of Marijuana Act (AUMA), will permit individuals over the age of 21 to possess, process, transport and share up to one ounce of marijuana and cultivate up to six plants. The measure will also legalize commercial cultivation. If AUMA is approved by voters, California will become the fifth state in the country to legalize the recreational use of marijuana after Colorado, Washington, Alaska and Oregon. Nevada also has a similar measure on the ballot for later this year that would legalize recreational use.

The passage of AUMA would create an entirely new industry in the country's most populous state which in turn may lead to new opportunities, as well as risks for insurance carriers. Over the coming months, this author will address some of the risks and issues that the insurance industry may face if AUMA becomes law. This article, however, will address a primary issue affecting insurance coverage. Marijuana, like heroin, cocaine, and methamphetamine, is a Schedule One controlled substance under federal law. (21 USC § 841) Consequently, it is a crime under federal law to manufacture, distribute, dispense, or possess marijuana and will remain so even if AUMA is approved by California voters. The question facing new businesses and their insurers is: Can there ever be coverage for an activity that constitutes a federal crime? The answer appears to be yes – at least for now.

As written, AUMA does not alter the California Insurance Code to explicitly permit insurers to write policies for marijuana-related businesses. It is unlikely that such an amendment would be necessary. The Insurance Code does not explicitly prohibit insurers from insuring against a loss related to a criminal activity even if the activity constitutes criminal activity under state or federal law. In fact, California case law has previously recognized the validity of criminal act exclusions in insurance policies. (20th Century Ins. Co. v. Schurtz (2002) 92 Cal. App. 4th 1188) The apparent corollary of this recognition is that public policy – on the state level at least – does not bar insurance companies from covering acts that might constitute criminal conduct under federal law.

Even if California courts or the California Legislature created a prohibition on insuring losses arising from criminal conduct on the basis of it being good public policy, it would arguably only apply to activity defined as criminal under California law and federal law where the federal law did not conflict with California law.

In California, currently, insurance is available for the state's non-profit medicinal marijuana dispensaries and the accompanying cultivation operations. This seems to suggest that the state will not place any roadblocks in a carrier's way if it wants to offer policies to new for-profit marijuana businesses. It appears that neither the California Legislature nor the state's Department of Insurance may not raise any objection to insurance carriers writing policies for marijuana businesses or paying claims related to marijuana losses. Likewise, California courts applying state law recognize that coverage can apply to claims involving criminal acts.¹ It can also be argued that California has a public policy interest in seeing marijuana businesses obtain insurance and that the state has no responsibility to implement or further any federal drug enforcement policy.

The confusion arises when federal courts are asked to apply federal public policy to either invalidate insurance contracts covering marijuana operations or deny claims for marijuana losses. Thus far, there have only been two cases addressing this issue and they arrived at different conclusions.

In Tracy v. USAA Cas. Ins. Co., 2012 WL 928186 (D. Hawaii, Mar. 16, 2012) the plaintiff insured brought a breach of contract/bad faith action against defendant homeowner insurance carrier after it denied plaintiff’s theft claim for twelve marijuana plants. The insurer argued it did not have to pay the claim because the plaintiff could not have an insurable interest in the plants since they could not be lawfully replaced under federal law. Plaintiff countered that she acquired the plants lawfully under Hawaii law, which permits individuals to grow marijuana for medicinal purposes.

In ruling on the defendant insurer's summary judgment motion, the district court found that the policy, as written, provided coverage for the theft of the plants and that, under Hawaii law, plaintiff would have an insurable interest in the plants since she could legally own them under Hawaii law. It nevertheless granted summary judgment in favor of the insurer after it found that 1) federal law unequivocally banned the cultivation, possession and use of marijuana for any purpose and that this ban superseded any state law permitting its use for medicinal purposes; and 2) Hawaii law permitted a Court to void an insurance contract that is illegal or against public policy. The Court concluded that “to require Defendant to pay insurance proceeds for the replacement of medical marijuana plants would be contrary to federal law and public policy” (Id.)

While Tracy was a win for the defendant insurer, it represents a loss for both marijuana businesses and the insurance industry. If Tracy is followed, any insurance contract covering a loss related to marijuana could be void as against public policy. One significant effect would be fewer marijuana-related businesses and thus fewer opportunities for carriers to write policies.

The second, more recent case reflects an evolution in federal policy on the enforcement of marijuana laws in states that permit its recreational or medicinal use. In Green Earth Wellness Center, LLC., v. Atain Specialty Insurance Company 2016 WL 632357 a Colorado dispensary sued its insurance carrier after the carrier denied the plaintiff's claim for the theft of processed marijuana flowers. In its summary judgment motion, the carrier argued that the harvested plants were excluded from coverage under the contraband exclusion contained in the insurance policy. In the alternative, the carrier, relying on Tracy, contended that the insurance claim must be denied since permitting coverage would be contrary to federal law and public policy.

The Court rejected these arguments. Looking first at the application of the contraband exclusion, the Court found that the term contraband referred to “goods or merchandise whose importation, exportation or possession is forbidden.” While the Court recognized that marijuana is illegal under federal law, it also noted that federal authorities had made public their ambivalence towards enforcement where a person's possession or distribution is consistent with state law. This lack of enforcement by the federal government, according to the Court, made the contraband exclusion ambiguous. The Court went on to note that the questions asked in the carrier's underwriting documents demonstrated an intention to cover the loss of harvested marijuana plants intended for sale. Given this apparent intention of the carrier to provide coverage and federal authorities' evolving view of enforcement of drug laws in states permitting the use and possession of marijuana, the Court concluded that the exclusion was unenforceable.

After finding the contraband exclusion ambiguous, the Court denied the carrier's request to void the insurance policy on public policy grounds. In doing so the Court noted that, unlike at the time of the Tracy decision, there is currently no clear and consistent federal public policy with regards to the enforcement of federal marijuana laws in states that have legalized its use and distribution.

The Green Earth decision also recognizes the inherent inequity in the insurer's argument to void the policy on public policy grounds. The carrier could issue a policy and collect premiums based on the insured's expectation that it would cover a marijuana related loss and then disavow the policy with no consequence based on a public policy argument. The Court, in condemning this tactic, suggested that even if the policy was void, the insured would have an unjust enrichment action against the carrier for willingly offering what it knew to be illusory coverage.

The take away from Tracy and Green Earth for insurance companies and potential insureds is potentially two-fold. The first is that federal public policy still must be considered when determining the enforceability of insurance policies covering losses related to marijuana. If federal law enforcement continues to take an ambivalent stance toward marijuana in states that permit its use, federal courts will likely issue more decisions like Green Earth upholding the validity of insurance contracts. If federal law enforcement steps up its enforcement of marijuana laws, federal courts will likely adopt the policy shift and be more willing to invalidate insurance contracts. The likelihood of this outcome is increased if the insured is not in compliance with its state's marijuana laws.

The second point is that Courts are not sympathetic to carriers offering policies which the insured would reasonably expect to cover marijuana and then denying a claim on the basis that the insurance policy violates public policy. The Court in Green Earth effectively stated that even if the subject policy was void, the insurer would still be required to pay the claim since it accepted the insured's premium.

The successful legalization of recreational marijuana in California could open the door for a wide array of new businesses, large and small, that will be looking to the insurance industry for risk solutions. Individual carriers that understand the peculiar risks of this new industry and offer reliable, well-defined coverage to its early pioneers will have an advantage as the industry grows in size and acceptance in the coming decades.

Nathaniel Lucey is a partner in the San Jose office. He can be reached at 408.286.0880 or nlucey@ericksenarbuthnot.com.

1. ^{↵ See 20th Century Ins. Co., supra, 92 Cal. App. 4th 1188. While California does prohibit insuring losses caused by the willful act of an insured (Cal. Ins. Code 533) this bar against coverage only extends to acts done for the express purpose of causing damage or acts that are inherently harmful. Ortega Rock Quarry v. Golden Eagle Ins. Corp. (2006) 141 Cal.App.4th 969. It does not bar insuring conduct that, although criminal, was not intended to cause harm or is inherently harmful.}