These days in cannabis, we see lots of toll processing agreements between licensees. And that’s for good reason– not every licensee wants to be vertically integrated, which is expensive and significantly complex. Most licensees simply want the benefits of being able to offer a variety of products that they can’t otherwise directly make themselves. How do they accomplish that? In a variety of ways, including intellectual property licensing and contract manufacturing; but today I focus on the specific basics of toll processing agreements.
What is a toll processing agreement? It’s a contract between two parties in which a “toller” agrees to manufacture a customer’s product (usually derived from raw materials supplied by the customer) for an agreed upon fee (i.e., the “toll”). Toll processing agreements are different than contract manufacturing where, with contract manufacturing, the manufacturer usually supplies the raw materials, itself, and also has the most say over processes, third party vendors, and quality conditions.
Toll processing agreements should be mutually beneficial between the parties:
- The customer receives a customized product (potentially with on-demand services) without the headache and capital outlay of having to make the product itself. The customer also gets say over product integrity and customization, quality assurance, vendors, etc.
- The toller/processor/manufacturer gets a (typically) long term contract getting to do what it does well, making/finishing third party products on auto-pilot using its existing labor force, facilities, equipment, and expertise.
Toll processing agreements are used across many industries that involve any kind of outsourcing of manufacturing or product processing, and they of course can (and often do) include packaging and labeling, too. So what are the big ticket items to be covered in a cannabis toll processing agreement?
Regulatory compliance regarding control and compensation
No matter what cannabis-friendly state you’re in, you need to make sure that toll processing does not violate any applicable cannabis regulation or statute. At this point, all states address issues of ownership (which usually means any kind of direction, management, or control over licensees), as well as “true party” or “financial interests” (which hinges on what parties are receiving any form or net or gross profit from a licensee). In a toll processing relationship, the customer company will have lots of say regarding source material and also regarding exactly what the toll processor does with those source materials to render the final product for retail sale/distribution.
The big question here is whether the terms of a toll processing agreement will amount to “control” under cannabis regulations. And the answer is: It completely depends on your state’s cannabis laws. If the “toll” amounts to a percentage of sales of final product ultimately sold–rather than, let’s say, volume of product produced–you also need to check your state’s cannabis regulations to see whether or not that compensation structure triggers any disclosure requirements (some of which will have specific timing requirements depending on the state).
Product specifications and quality standards
Even though the toll processor is doing the manual labor, the customer company should provide all product specifications and quality standards. (Note that those specifications and standards must also comply with applicable cannabis laws and rules, including around permissible product types). Specifications and quality standards are typically listed on an exhibit to the toll processing agreement, and the parties will need to negotiate over how and when product specifications or quality standards can change. Other points of consideration are: what happens if there’s any kind of production cost change that materially affects the agreement regarding processing expenses; what happens when there are production delays; and which party will bear the costs for any of that. Good toll processing agreements will also ensure that any such change will not be effective unless agreed to by both parties in writing.
Packaging and labeling
Typically, the toll processor is going to handle packaging and labeling, but that should be done in accordance with applicable product specifications. Packaging and labeling must also comply with the litany of cannabis rules and laws set out by state agencies. The customer company will want to make sure that they shift the burden of compliance in this department on to the toll processor, but the toll processor will want to ensure that all product specifications (including packaging and labeling) comply with all cannabis laws and rules from the outset.
Intellectual property license
If the toll processor is going to engage in packaging and labeling of the customer company products–which entails putting the customer company’s intellectual property on that packaging and labeling–the customer company is going to need to grant to the toll processor a limited intellectual property license. The license will typically be royalty-free, as the toll processor won’t be selling the products and is compensated based on toll processing services rendered. If you’re the customer company, make sure that the IP license terminates when the toll processing agreement terminates.
Exclusivity and confidentiality
Lots of trade secrets exist in cannabis markets, and if you’re outsourcing your manufacturing or cultivation processing, you need to make sure that your toll processing agreement addresses exclusivity and confidentiality. This is especially true where more and more cannabis companies are undertaking limited (if any) commercial activity outside of toll processing ventures. If those toll processors are manufacturing/processing for many other licensees, you’re very unlikely to net any kind of exclusivity, but you’ll need to ensure that any confidential product specifications given over to the toll processor remain confidential.
Acceptance, rejection, title, and risk of loss
The parties will need to negotiate over what constitutes final product acceptance or rejection (including any timing and inspection rights). In a toll processing agreement, the toll processor doesn’t usually take title to the resulting product, even though it might retain possession for some time depending on delivery schedule. Further, risk of loss should be negotiated between the parties. Recognize also that, in cannabis, acceptance and rejection of products can have all kinds of regulatory consequences, and any cure of any rejected product is also typically controlled by cannabis quality assurance and testing regulations.
This is always a tricky area, but a cannabis toll processing agreement must absolutely address product recalls. Specifically, the agreement should address who has what obligation in the event of a recall and who will bear the costs. Usually, the customer company will have the power to declare a recall and will also bear the costs of such recall, unless the toll processor engaged in some kind of gross negligence or intentional misconduct in the manufacturing process.
There are additional considerations for parties to cannabis toll processing agreements including: purchase order protocols, representations and warranties, indemnification, and the ability to terminate the agreement– especially if there’s a change to cannabis laws or regulations that bar or cost-prohibitively alter the relationship. The above merely make up the highlights of what any reliable cannabis toll processing agreement should cover.