The Many Flavors of Diversion

I previously wrote about how the failure of Washington’s real-time seed-to-sale traceability tracking capability had enhanced the ability of licensees to break the rules.  Doing so became easier and less risky.  Today, the ongoing dysfunction in the regulated market caused by the premature roll-out of LEAF is interfering with some wholesalers’ ability to legally sell their product.  This is increasing financial pressures on an industry that is already, on average, struggling.  Most licensees that I know seem to be decent, honest, hardworking people.  They also seem to be aware of the dramatic declines in average prices within the regulated system and the even larger premiums allegedly being paid for some of the product being sold outside of Washington or being sold outside of regulated channels inside Washington.  This post does not discuss whether diversion IS occurring … it just describes some ways in which it COULD be occurring.

The Washington State Liquor and Cannabis Board (WSLCB, or LCB) would have it be known that DIVERSION is not a problem in the state-legal cannabis market they regulate.  This post sheds light on how, for their assertion to be true, LCB oversight and enforcement efforts would have to consistently succeed across many different points of possible diversion.  Either that, or the honest and hard-working licensees of this industry would all have to be uniformly law-abiding, rule-abiding participants of that industry.

When one hears the LCB speak of diversion, it often seems that they mean instances in which product flows out of the regulated market in ways inconsistent with the laws and regulations they enforce.  Such instances are, according to the LCB, uncommon.  They say that, through their partnership with the MJ Freeway/LEAF software development team, the compliance-reporting¹ system rolling out over the next few months has virtually eliminated the threat of such unreported and possibly untaxed transfers of product.

Such flows of product OUT of the regulated system will be the focus of this post.  This is the class of diversion that I will refer to as out-diversion.

Recently, the LCB communications directorate released information to forestall concerns that the virtual breakdown of the new compliance-reporting system might increase the opportunity for such diversion to occur.  We were reminded that all necessary pieces of information continue to be gathered, and that local records must still be kept by licensees and that video footage of everything still exists² and that enforcement officers can be anywhere at any time when they are not otherwise occupied busting patient/farmer exchanges.

They’ve got it under control.  There is nothing to see here, folks … just move along, please.  The public position of the regulators is that no such diversion is occurring.

Before I dive into the many possible flavors of out-diversion, I’d like to briefly discuss two other classes of diversion: in-diversion and intra-diversion.

In-diversion is any instance in which product inappropriately enters the regulated system (be that at the level of the farm, processor, transporter, lab, or retailer and whether it happens with or without the involvement of the regulators or their enforcement staff).  I will not cover this class of diversion, other than to emphasize that it’s potential benefits include the ability to augment the constrained genetic set available to the regulated market, offering a source of product for post-processing or direct sale that is not constrained by the regulatory framework which constrains regulated wholesalers, and offering a flexible means of pulsing production capacity.  Hidden instances in which wholesalers and retailers were vertically-integrated would clearly be beneficiaries of this class of diversion (and product “white-labeling” would be a useful tool in such efforts).  The existence of in-diversion would result in a subset of the product flowing through the regulated system being, technically, non-regulated (what I will call “apparently-regulated product”).

Intra-diversion is any instance in which apparently-regulated product inappropriately flows between producers, processors, transporters, labs, retailers, regulators and/or legislators.  For example, cases where wholesalers send flower QA samples weighing one ounce or more to labs and where the labs report that all 28+ grams of that flower were consumed during testing are an example of intra-diversion.  Product (or other things of material value) flowing to regulators, enforcers, or legislators in inappropriate ways would be another example of intra-inversion.  Excessive use of educational and/or bud-tender samples, many deals where raw material is processed by processors not affiliated with the producer and mixes of product and cash “pay” for the processing, and multi-store retail chains balancing inventory across stores would also serve as examples of intra-diversion.  In general, any “payments in kind” using product are likely examples of intra-diversion (and something the LCB refers to as “direct money’s worth” in Enforcement Bulletin 15-02).

Out-diversion is any instance in which apparently-regulated product inappropriately flows out of the regulated system.  Two types of out-diversion that stand out in the rhetoric of the LCB (and the DOJ) are the diversion of regulated product across state lines and the diversion of product to minor children for reasons other than medication.  Washington’s is a market where over 1,200 farms are supplying about 400 open retail access points which are, themselves, increasingly geographically clustered in those areas that will allow them to operate.

Data have suggested, since the second year of this market, that retail sales volume has consistently lagged increasing production levels.  Recent data suggest that levels of inventory held at wholesale are increasing and that the motivation for out-diversion has increased dramatically (see related post on HI-Blog here).

The current imbalance between the chokepoint of retail access and the increasing tendency of new businesses attempting to offset low prices through increased production leads to ripe opportunities for out-diversion.  These opportunities are particularly ripe now that wholesale prices of product in other states are often 4-6 times what they recently were in Washington.

 

To efficiently communicate the myriad points of potential out-diversion, I compiled a graphic showing product flows (the arrows) within and out of the regulated system.  The tree/flower icons represent farms, the factories represent processors and the green-cross storefronts represent retail access points.  Transporters are represented by the truck and the Labs are represented by the checkmark.  Flow amongst farms and processors is indicated by the smaller second row of icons.  The LCB and Legislature are portrayed far above the market they define and control as an airplane (to reflect their 30,000-foot view of things).  Consumers are the people to the right.  Product flow within the market tends to move from left to right.

All points of potential out-diversion that seem reasonable have been highlighted by the hazard icon (the red circle with a diagonal slash).  Note that I indicated out-diversion to “inappropriate customers and/or non-manifested transfers” as coming from the 2^nd row of farms, processors, and retailers.  This was just to avoid arrow density — such diversion could just as well come from the primary producing farm, the initial processor and/or the retailer.  It could also come (indirectly) from the airplane, if the regulator/enforcer/legislator(s) in question were serving as middle-people in a product-movement scheme.  I did not include that arrow, as I wanted to stress the fact that any and all flow of product (or cash or promises or business interests or lease payments or whatever) coming from regulated (or certified) players in the industry TO the airplane are wrong.  Many thanks to Governor Inslee for his veto of the anti-sunshine bill that would have helped keep such Legislator involvement secret (if it were occurring).

Many points of potential diversion into, out of, and within Washington’s regulated cannabis market exist. The virtual meltdown of valid traceability reporting comes at a point in time where price declines, sales declines, a supposedly huge fall harvest, and a growing awareness of the revenue potential of selling either out-of-state (whether directly or indirectly) or within-state in a manner that skirts the constraints of the regulated system have all arisen.

It is not just a compliance reporting app that is failing, it is established and newly-designed workflows(that worked yesterday) and repeated re-work and frustration for licensees and the ongoing negative impact on licensed businesses that show that the regulators are failing in their mandate to ensure a functioning market able to adequately serve the needs of Washingtonian consumers while at the same time  inhibiting non-regulated sales and all of the bad things that supposedly come along with those.

If the LCB should ever be able to supply detailed “supply chain” data covering the post-BiotrackTHC days, perhaps we will eventually come to know how much of the potential for diversion is being realized. With the data made available and being collected (or not) today, we cannot know with much certainty.

In truth, I doubt that the LCB can, either.

————————————————————-

Footnotes:

¹ “Compliance Reporting” is the phrase LCB Chief Information Officer Mary Mueller recently used to describe the virtually non-functional LEAF traceability solution that was rolled out on Feb 1 to a fanfare of failure.  By attempting to re-brand LEAF’s $3,081,000 effort to replace BiotrackTHC’s Seed-to-Sale Traceability System as a “compliance reporting” system, the LCB is attempting to lower the bar of expectations regarding system requirements and thereby avoid another in a series of system development failures.

²With approximately 500,000 hours of such footage being recorded daily, it is unlikely that the LCB, given their current levels of staffing, are keeping up with those recordings.  A good deal of signal could easily be hidden in all that video noise.