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As New Jersey remains mired in debate on the legalization of recreational marijuana, New Jersey banks and regulators should begin to consider how best to tackle the thorny issue of banking the marijuana industry. Although this issue is not entirely new to New Jersey (since medicinal marijuana has been legal in the state since 2012), the inevitable onslaught of marijuana-related businesses (MRBs) if and when recreational use is legalized may cause this issue to be one of the most difficult to reconcile in the years following legalization.

The issue is both simple and complex. Marijuana remains a Schedule I substance under the Controlled Substances Act (CSA), sharing that designation with such drugs as heroin, LSD and MDMA. See 21 U.S.C. 812(b)(1). The designation signifies that the substance has a high potential for abuse and no accepted medical use. However, despite being illegal for all purposes under federal law, as of May 31, 2019, medicinal use of marijuana is legal in 33 states and recreational use is legal in 10 states (with Illinois poised to become the 11th state). An estimated 95% of the U.S. population lives in a state where cannabis (including CBD) is legal in some form.

Due to its illegality under federal law, any state or federal financial institution that provides banking services to an MRB is engaging in money-laundering under the Bank Secrecy Act of 1970 (BSA). 12 U.S.C. 1724. This is the case even if the MRB is engaging in activities that are legal under state law.

Since 2014, those banks that have chosen to bank the marijuana industry have been operating under a semi-official set of rules published by the United States Department of the Treasury Financial Crimes Enforcement Network (FinCEN). The so-called "FinCEN Guidance" was published shortly after the U.S. Attorney General James M. Cole issued guidance to federal prosecutors covering marijuana enforcement (Cole Memo). The Cole Memo prioritizes federal enforcement of the CSA to eight categories, including preventing the distribution of marijuana to minors and preventing proceeds from the sale of marijuana from going to criminal enterprises. Activities that did not implicate any of the eight Cole Memo priorities, and were in compliance with state law, were generally understood not to be in danger of federal prosecution. In January 2018, then U.S. Attorney General Jeff Sessions rescinded the Cole Memo.

The FinCEN Guidance clarifies how banks can provide services to MRBs consistent with their BSA obligations and requires the following:

• Enhanced due diligence on any MRB including verifying that the MRB is properly licensed and in compliance with state law;
• On-going monitoring to ensure that the MRB is not conducting activities which implicate one of the Cole Memo priorities;
• The filing of Suspicious Activity Reports (SARs) for each transaction conducted by the MRB; and
• The filing of Currency Transaction Reports in accordance with existing laws and regulations.

The general expectation was (and is) that compliance with the FinCEN Guidance by financial institutions will dramatically reduce the chances of criminal prosecution under the CSA and sanctions under the BSA and other federal banking laws and regulations. However, it is important to understand the limitations of the FinCEN Guidance. It does not carry the force of law. As was the case with the Cole Memo, it can be rescinded at any time. While there is some uncertainty as to the viability of the FinCEN Guidance since the Cole Memo was rescinded, to date neither FinCEN, the U.S. Attorney General's office, nor any federal banking regulator has given any indication that financial institutions may not rely on it.

Despite the FinCEN Guidance, very few banks have chosen to bank the industry. According to the FinCEN, as of June 30, 2018, there are only approximately 440 banks providing services to MRBs nationwide. Many banks simply are not willing to put up with the regulatory burden of enhanced due diligence and filing SARs for each any every transaction completed for its MRB customers. In addition, the FinCEN Guidance does nothing to alleviate the reputational risk associated with the industry. The industry is woefully underbanked.

Those MRBs that can find a banking institution to work with them often are forced to pay exorbitant fees. Those that cannot obtain or afford banking services deal primarily in cash. Tales of taxpayers bringing in bags full of cash reeking of marijuana to state and local taxing authorities are common. Sadly, so are stories of violent crime that are inevitable when dealing with an all-cash business. At least one murder can be directly attributed to a lack of banking resources to MRBs.

Unfortunately, despite the public health and safety issues that are implicated by large amounts of cash involved, Congress has taken no action to rectify the problem. There are currently two bills pending that would be an improvement over the current situation, but neither bill would be a comprehensive solution.

The first, the Secure and Fair Enforcement (SAFE) Banking Act, would create a safe harbor for federal money laundering prosecution and regulatory sanctions for any financial institution that provides services to an MRB that is in compliance with state law. The SAFE Act also would prevent any federal regulator from sanctioning or otherwise punishing a financial institution banking an MRB, and would amend federal anti-money laundering statutes to provide that proceeds from legitimate MRBs are not considered proceeds from unlawful activities. However, even if the SAFE Act is passed, marijuana would remain a Schedule 1 drug under the CSA, and financial institutions would be engaging in commerce with customers that are violating federal law. While the SAFE Act is supported by smaller banks and community banking associations, large banks are generally ambivalent toward the legislation as it would do little to enable these banks to provide lucrative non-banking services to MRBs. The SAFE Act recently passed the House Financial Services Committee by a wide margin. However, passage by the Senate Banking Committee is less than certain.

Unlike the SAFE Act, the Strengthening the Tenth Amendment Through Entrusting States Act (STATES Act) would amend the CSA to restrict federal enforcement against MRBs that are in compliance with state marijuana laws. The STATES Act would also specify that federal money laundering laws are not applicable to proceeds derived from legitimate MRBs in compliance with state law. Larger banks and other non-bank financial services companies are supportive of the STATES Act due to the fact that it amends the CSA to essentially decriminalize commerce in marijuana that is legal under state law. No action has been taken on the STATES Act in either of the appropriate House or Senate committees.

While both the SAFE Act and the STATES Act would certainly alleviate some of the risk to financial institutions, neither would fully eliminate the risks, and it is likely that many, including large commercial banks, would continue to avoid banking the industry. Many banks will likely choose not to enter this marijuana market due the perceived reputational risk associated with the industry. There are other potential legal risks looming as well. For example, a Colorado marijuana grower was sued by private citizens in federal court under the Racketeer Influenced and Corrupt Organizations (RICO) Act, alleging that the grower's facility interfered with the use of their adjacent land. The grower's bank was named as a co-defendant but was ultimately dismissed from the lawsuit. Although the jury found in favor of the defendant, the case was allowed to proceed to the jury. This case illustrates the unknown risks to banks associated with the industry.

Financial institutions doing business in New Jersey should already be preparing for legalization of recreational use. It is not too late to influence the legislation and implementing regulations through lobbying efforts. Stringent regulation of MRBs will enable banks to more efficiently conduct enhanced due diligence and discourage bad actors from entering the market.

Banks that decide to enter the market will need to develop effective initial due diligence and on-going monitoring procedures. Many banks in states such as Colorado and California ask their customers to sign NDAs agreeing not to identify themselves as bank customers. Others have implemented a "kill switch" to enable them to cease banking the market immediately if regulatory policies abruptly change.

Banks that decide not to do business with MRBs must also enhance their due diligence procedures to ensure that they do not unwittingly bank an MRB.  Warning signs include:

• Use of a nondescript business name (such as "Consulting," "Holding" or "Management");
• Use of a middle man or management company to open accounts;
• Frequent large cash deposits;
• Use of different branches to deposit cash; and
• Cash "structuring" and co-mingling of funds.

All banks doing business in New Jersey should at a minimum carefully review the FinCEN Guidance and their list of MRB red flags. Banks should consider investing in enhanced anti-money laundering/fraud detection software or other software to identify potential MRBs. There are several start-up FinTech firms that have designed software intended to detect MRB customers. Traditional due diligence methods such as frequent site visits should also be considered.

Regardless of whether a bank chooses to enter the market, the legalization of recreational marijuana will require each New Jersey bank to take swift action.

Michael Rave is a partner with Day Pitney in Parsippany. He represents financial institutions in all aspects of their business. Megan Bedell is an associate at the firm, who represents commercial real estate developers.