Until recently, the bankruptcy courts have generally been unavailable for insolvent cannabis companies to liquidate or reorganize. The Office of the United States Trustee (the “UST”) has a mandate from the Department of Justice to move to dismiss cannabis-related bankruptcies when they are filed, and many bankruptcy courts have dismissed such cases, even where the debtor’s ties to cannabis are remote or ancillary to the cultivation, production, sale or distribution of cannabis, or when the debtor no longer has active operations. As a result, insolvent cannabis companies could only avail themselves of the tools available to restructure or liquidate under applicable state law including out of court workouts, receiverships and assignments for the benefit of creditors. The limited options have placed a constraint on a rapidly expanding industry. As legalization of cannabis continues to proliferate across the country, the need for restructuring options will continue to grow, creating a tension between the federal government’s treatment of cannabis as a Schedule 1 controlled substance, and hence, illegal, and the desire to restructure or liquidate under the United States Bankruptcy Code, until either the federal position on cannabis (or at least eligibility for bankruptcy) changes, or courts adopt more flexibility in cases involving businesses with ties to cannabis.
Recently, signs of a potential openness to allowing bankruptcies with ties to the cannabis industry have been gradually emerging within the Ninth Circuit. As discussed in more depth in the companion post by Keith Owens and Michael Herz in Fox Rothschild’s In Solvency Blog, https://insolvency.foxrothschild.com/2023/04/in-re-the-hacienda-company-llc-a-flicker-of-hope-for-distressed-cannabis-companies-bankruptcy-may-be-available-to-liquidate-assets-of-non-operating-cannabis-companies/, there has been a recent trend by courts in the Ninth Circuit to consider a more pragmatic approach to determine whether bankruptcy cases commenced by or against a debtor with cannabis ties may proceed in bankruptcy. A recent opinion from the United States Bankruptcy Court for the Central District of California, In re The Hacienda Company LLC, Case No. 2:22-bk-15163-NB, 674 B.R. 748 (Bankr. C.D. 2023), offers a flicker of hope for at least non-operating cannabis companies to use bankruptcy courts to liquidate assets to pay creditors, and may pave the way for cannabis-related bankruptcy filings under certain circumstances. It also provides a guidepost for creative insolvency professionals to help spin off their clients’ cannabis inventory and operations prior to commencing a bankruptcy filing and using the Bankruptcy Code to liquidate non-cannabis assets to pay creditors and to wind-up their affairs in an orderly fashion.
In his January 2023 opinion, Judge Neil Bason of the United States Bankruptcy Court for the Central District of California held that a “former” cannabis company that terminated its wholesale manufacturing and packaging business prior to filing its chapter 11 bankruptcy petition, could sell its ownership interests in the Canadian acquiring entity to pay creditors. In a case of first impression, the Bankruptcy Court denied the UST’s motion to dismiss, determining that although a cannabis company could not remain in bankruptcy if it was engaged in ongoing violations of the Controlled Substances Act (“CSA”), or it was foreseeable that a future bankruptcy trustee would have to violate the CSA, a former cannabis company could avail itself of bankruptcy protection to liquidate assets to pay creditors. As the Bankruptcy Court noted, there is no per se rule requiring dismissal simply because of the presence of cannabis. In exercising its discretion to permit the bankruptcy case to proceed, the Bankruptcy Court noted that Hacienda’s “passive ownership of stock, with intent to liquidate that stock to pay creditors, will terminate any connection with cannabis” and that Hacienda did not intend to profit from an ongoing scheme to distribute cannabis as long as it did not retain its stock for too long of a time. Alternatively, the Bankruptcy held that even if Hacienda violated the CSA, such a violation would not be enough to constitute cause for dismissal, as bankruptcy courts have discretion to determine whether the specific facts and circumstances of a debtor’s connection to cannabis warrants dismissal. Citing several examples of large corporate bankruptcies by companies that had engaged in illegal activities, the Bankruptcy Court held that “Congress did not adopt a ‘zero tolerance’ policy that requires dismissal of any bankruptcy case involving violation of the CSA (or other activity that might be proven to be illegal).” The Bankruptcy Court ultimately believed that it is the role of prosecutors to address violations of non-bankruptcy law, and that the Court “would be overstepping its role and acting contrary to Congress’ directives within the Bankruptcy Court, if it were to deny creditors, debtors, employees, equity investors, and other constituencies the benefits and protections of bankruptcy based on the facts and circumstances presented.”
Creative lawyers will no doubt carefully read Hacienda and other cases to look for ways to restructure cannabis businesses prior to filing a bankruptcy petition to decrease the likelihood of dismissal. Unless Hacienda is reversed on appeal, cannabis businesses may use the Bankruptcy Code to wind up their affairs and pay creditors after removing their cannabis inventory and licenses, even if the remaining assets are the proceeds of assets used in the operation of a cannabis business that might otherwise violate the CSA. A more detailed analysis can be found by clicking the link above to the authors’ In Solvency blog post.
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