Alternatives to Bankruptcy in the Cannabis Sector

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Farella Braun + Martel LLP

Recreational or medicinal cannabis is now legal in 35 states and the District of Columbia. But cannabis is still a Schedule I controlled substance under the federal Controlled Substances Act, which presents a host of problems for cannabis businesses. One issue that many entrepreneurs may not anticipate is that federal bankruptcy protection is generally unavailable for cannabis businesses.

Bankruptcy courts operate under federal law. They will not and cannot aid a violation of federal law. Thus, when a cannabis business files for bankruptcy protection, a bankruptcy court will typically dismiss the petition if proceeding with the case would require the court, trustee or debtor in possession to administer assets that are illegal under the Controlled Substances Act or that constitute proceeds of activity criminalized by the Controlled Substances Act. Some courts have even denied bankruptcy protection to cannabis-adjacent businesses, such as businesses that lease property to cannabis operations or that sell equipment to cannabis growers.

Although cannabis businesses cannot file for bankruptcy, depending on the jurisdiction in which the business operates, there may be other options available to distressed cannabis businesses. Businesses that want to continue operating may benefit from a workout. Those that want to sell their assets in order to pay their debts may be better served by a receivership or an assignment for the benefit of creditors proceeding. Which solution is appropriate will depend on the circumstances of the debtor and the state in which it operates.

Given the highly regulated nature of the industry, a cannabis business exploring any of the foregoing options should work closely with counsel to ensure compliance with applicable law.

Workouts

A workout is an agreement between a debtor and its creditors that restructures the repayment of debts. The agreement typically involves extending the period for repayment and often involves a reduction in the interest rate and perhaps the principal amount of the debt.

A workout is similar to a Chapter 11 bankruptcy in that it gives the debtor the opportunity to continue operating, while allowing management to remain in control. A workout is a nonjudicial process, so it typically is more cost efficient than bankruptcy. However, because a workout requires creditors to consent to restructuring their debts, it may not be a realistic path for a distressed business, particularly one with many creditors.

Receiverships

A receivership is a state-law-based judicial remedy available to a creditor after a debtor has defaulted on an obligation, following the creditor’s initiation of a lawsuit against the debtor. State law generally specifies the grounds for a receiver to be appointed, but the debtor’s insolvency or failure to protect creditor’s interests or property rights are common reasons for such appointment.

A court-appointed receiver typically will obtain control of the business. Although current management will often be forced out, a receivership may nonetheless be an attractive option for businesses unable to reach a workout with creditors. Depending on the circumstances, the receiver may be authorized to restructure the company’s debts or liquidate its assets to generate funds for repaying creditors. The costs of a receivership are often high (with a receiver billing their time at an hourly rate, while sometimes retaining counsel and other professionals), which may make it difficult for a distressed business to survive the process. Thus, receiverships frequently lead to liquidation of the business.

There is some uncertainty regarding whether a receiver can operate a cannabis business without possessing a cannabis license, and therefore, the ability of the receiver to operate a cannabis business will depend on applicable state licensing regimes. In at least Arizona, California and Colorado, courts have appointed receivers to take over cannabis businesses, and there are now businesses that specialize in serving as receivers for cannabis businesses in some states.

Alternatively, if a distressed business wishes to avoid a public legal proceeding such as a receivership, it may choose to engage a restructuring advisor. While engaging such professionals can be costly, it may be an attractive solution for a business that wants to continue operating without the negative publicity that may accompany a receivership.

Assignments for the Benefit of Creditors

An assignment for the benefit of creditors is a streamlined process for liquidating assets similar to Chapter 7 bankruptcy. Like a receivership, it is creature of state law. Although the process varies from state to state, in general, a company will transfer its assets to a trust administered by an assignee specializing in such proceedings. The assignee will then liquidate the company’s assets and distribute proceeds to creditors on a pro rata basis, subject to particular statutory priorities. However, as with receiverships, there is some question about whether cannabis assets may be transferred to an assignee lacking a cannabis license. Thus, the availability of this option will vary by state.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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