Though controversial, cannabis[1] has steadily grown into a booming industry. Despite this rapid growth and the legalization of cannabis in numerous states[2], cannabis is still classified as a Schedule I drug under the Controlled Substances Act (CSA). As cannabis is illegal under federal law, individuals and companies involved or related to the cannabis industry face an uphill battle when insolvency issues arise. Federal forums that traditionally address insolvency matters, such as bankruptcy, have historically been unavailable to those engaged in the cannabis industry, forcing them to seek state-controlled alternatives, such as receivership. However, as more and more states have legalized commercial transactions involving cannabis in some form, bankruptcy courts have begun to adopt two distinct paths: one for individuals and entities directly engaged in growing, processing, distributing, or selling cannabis products, and one for entities that are associated with cannabis more indirectly, which the bankruptcy system recently has been more open to.

Cannabis Companies in Bankruptcy

Bankruptcy courts consistently hold that individuals and entities directly engaged in growing, processing, distributing, or selling cannabis products for medical or recreational purposes may not seek the protections afforded by the bankruptcy code. When these cases are filed, they are usually dismissed, oftentimes at the request of the Office of the United States Trustee (the U.S. Trustee) — an arm of the Department of Justice.

U.S. Trustees act as the “watchdog” in bankruptcy proceedings. They are tasked with overseeing the administration of a bankruptcy case and enforcing the bankruptcy code and other federal law to ensure the integrity and efficiency of the bankruptcy proceeding for the benefit of the debtor, its creditors, and the public.

U.S. Trustees take a hard stance and follow an officewide directive that a U.S. Trustee must seek to dismiss cases that are directly involved in the cannabis industry. The U.S. Trustee Program has explained this officewide mandate:

The USTP’s response to marijuana-related bankruptcy filings is guided by two straightforward and uncontroversial principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed. Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal criminal law.[3]

In accordance with this mandate, a U.S. Trustee generally seeks to dismiss a cannabis bankruptcy for “cause” under section 1112(b) of the Bankruptcy Code. The Bankruptcy Code does not define “cause,” so a party is afforded leeway in asserting justifications for dismissal. A U.S. Trustee make take one or more of the following positions, all of which have been held to constitute sufficient “cause” to dismiss a case:

• The violation of nonbankruptcy law is itself a sufficient “cause” to dismiss the bankruptcy;
• The violation of nonbankruptcy law establishes a debtor’s lack of good faith;
• The violation of nonbankruptcy law may constitute “gross mismanagement” of the estate; and
• The violation of nonbankruptcy law disrupts the equitable principals of the court as a court of equity as it requires the judge to violate federal law.

Bankruptcy courts have consistently agreed with these positions and dismissed bankruptcy cases of individuals and entities when they are directly involved in the cannabis industry.

Cannabis-Related Companies in Bankruptcy

Though it seems reasonably clear-cut that individuals and entities directly involved in the cannabis industry may not seek protections under the Bankruptcy Code, it is less clear whether entities that engaged in commercial activity that is closely related but ancillary to the cannabis industry, may successfully seek safe haven under the Bankruptcy Code. To confirm, U.S. Trustees consistently seek to dismiss these types of bankruptcies pursuant to their mandate. However, several recent decisions have created a narrow path for these companies to escape the bright line rule of dismissal. Recently, at least one bankruptcy court has strayed from what has seemed like a per se practice of dismissing cannabis bankruptcy cases and adopting a more holistic approach.

In September 2023, the Bankruptcy Court for the Central District of California kept the door open for these types of bankruptcies. In Hacienda,[4] the bankruptcy court rejected the U.S. Trustee’s second request to dismiss the bankruptcy of a debtor who, at one time, manufactured, packaged, and distributed cannabis, but had since ceased operations and transferred its assets to a publicly traded Canadian company that engages exclusively in cannabis growth and sales (which is legal under Canadian law). In exchange for the assets, the debtor received approximately $35 million in the Canadian company’s equity. Approximately 18 months after the debtor ceased operations, it filed for bankruptcy intending to sell the shares in the Canadian company and distribute the proceeds to creditors. The U.S. Trustee’s first motion to dismiss alleged that the debtor itself was effectively engaged in the sale of cannabis products, but the bankruptcy court did not find that the U.S. Trustee had met its burden. In its second request, the U.S. Trustee asserted that the debtor had not taken sufficient steps to withdraw from an ongoing conspiracy to violate the CSA.

In denying the U.S. Trustee’s second motion to dismiss, the bankruptcy court found that prepetition, the debtor engaged in conduct that would violate the CSA. The bankruptcy court also found that postpetition, the debtor probably had violated the CSA by not withdrawing from the prepetition conspiracy to profit from cannabis. However, the bankruptcy court noted that a postpetition violation of federal law does not per se mean the bankruptcy case must be dismissed. To create such a bright line rule and dismiss every case that had a connection with illegal activity would disrupt the goals of the Bankruptcy Code and harm the constituencies that Congress attempted to protect under the Bankruptcy Code. In rejecting such a bright line rule, the bankruptcy court stated the following:

There is no doubt that a debtor’s connections with cannabis can, in some circumstances, result in dismissal of their bankruptcy case. But in this case Debtor is attempting to divest itself of its investment in a Canadian cannabis business that is legally traded on a Canadian stock exchange; nothing that Debtor proposes to do postpetition will foster a single additional sale of cannabis products, nor will it add a single dollar to any cannabis-related enterprise; and Debtor’s proposed Plan provides for an orderly liquidation for the benefit of creditors, much as a receiver under the Money Laundering Statutes would do.

The Hacienda decision reflects a recent trend in which federal bankruptcy judges have been reluctant to endorse a bright line rule dismissing a bankruptcy for cannabis-related individuals and entities. It suggests that bankruptcy courts should take a holistic approach and consider both the timing of the cannabis-related conduct and how connected the debtor is to the cannabis industry. It remains to be seen how widely the reasoning that underlies the Hacienda decision and others like it will be adopted, or if the treatment overt cannabis companies receive in bankruptcy, discussed above, will resurface for cannabis-related debtors. With the landscape uncertain, cannabis and cannabis-related debtors should continue to consider state-controlled or out-of-court alternatives, such as receiverships.

A State-Controlled Alternative: Receivership

With the doors of the federal bankruptcy courts closed to entities that directly participate in the cannabis supply chain, the only recourse for distressed cannabis operators are state law remedies such as receivership.

A receivership proceeding generally arises under a state court’s equity jurisdiction. Unlike a bankruptcy, the party seeking the court’s appointment of a receiver is generally a secured creditor or judgment creditor of an indebted party. Although a receivership proceeding also may involve the imposition of a stay of other legal proceedings involving the encumbered property — which may be of benefit to a debtor — the purpose is primarily to benefit creditors. Any receivership must follow state regulatory requirements, and in the cannabis arena there is generally a marijuana regulator, a taxing authority, and/or a state attorney general’s (AG) office involved as well.

For example, the matter of Teneo Funds SPVI I LLC v. Ermont, Inc.,[5] which concluded in September, was the first instance in which a Massachusetts cannabis company was liquidated through a court-appointed receivership. Under the Massachusetts Cannabis Control Commission’s regulations, the court-appointed receiver needed the commission’s prior approval. Further, the change in ownership for Ermont, a medical cannabis operator, also required approval from the commission before the sale of Ermont’s assets to MariMed Inc., a multistate operator, could proceed.

Once appointed, a receiver’s options run the gamut from operating the company as-is, restructuring operations to maximize profit, or liquidating the business as a whole or in pieces. The receiver has a fiduciary responsibility to determine the option that best satisfies creditors, like the duties required of a trustee in a bankruptcy.

Cannabis receivership, however, is not for the faint of heart — given the complex interplay between the receivership system and state cannabis laws and regulations, and the fraud potential arising from the all-cash nature of most marijuana businesses.

A case study comes from Marriage of Humphrey,[6] where the Colorado Court of Appeals ruled that because Colorado law requires anyone who owns, operates, manages, controls, or works in a licensed marijuana business to be licensed in accordance with the Colorado Medical Marijuana Code and/or the Colorado Retail Marijuana Code, a Colorado court could not appoint a receiver to oversee cannabis operations who had not received the necessary marijuana license(s).

In Marriage of Humphrey, a court presiding over a divorce proceeding had appointed a receiver over marital property that included several licensed medical and recreational marijuana businesses. The receivership order authorized the receiver to “take immediate control of the [businesses] and to operate the [businesses] on the Court’s behalf[,]” and gave the receiver the “powers and duties” to “manage, operate, maintain, repair, and otherwise control the [businesses] as necessary to preserve [them].” After it learned of the situation, the Colorado Department of Revenue, the licensing authority for the state’s Marijuana Enforcement Division, represented by the Colorado AG’s Office, moved to intervene in the proceeding and for modification of the receivership order. The lower court allowed the motion to intervene but denied the motion to modify and an appeal to the Colorado Court of Appeals followed. The appellate court ruled that the lower court’s appointment of an unlicensed receiver, in violation of Colorado’s marijuana statutes and regulations, exceeded its equitable powers.[7]

Ultimately, in Yates v. Sterling Consulting Corp., a post-remand matter arising out of the Marriage of Humphrey litigation, the Colorado Court of Appeals affirmed a Denver district court order refusing to discharge the receiver whose initial refusal to obtain the necessary state marijuana licenses prompted the appeal in Marriage of Humphrey. In Yates, the receiver’s principal surrendered his marijuana licenses amid the Denver district court’s conduct of an inquiry into the receiver’s management of the marijuana businesses. The receiver, Sterling Consulting Corp., argued that the principal’s surrender of his marijuana licenses automatically effected its discharge. The lower court disagreed and entered an order appointing a second receiver and stripping Sterling of its power to “manage, operate, maintain, repair, and otherwise control” the marijuana businesses but refusing to discharge Sterling, given the court’s concerns about Sterling’s performance and the effective release of claims against Sterling that would come with such a discharge.

Marriage of Humphrey and Yates demonstrate that even though receivership can be a viable option for cannabis entities denied access to the federal bankruptcy system, it is not without its own risks and complexities, requiring careful management and the advice of skilled counsel.

[1] For purposes of this article, “cannabis” refers to marijuana, which means all cannabis that tests as having THC concentration level of higher than 0.3%on a dry weight basis.

[2] Currently, 24 states, including the District of Columbia, have legalized both adult-use and medical marijuana.

[3] Why Marijuana Assets May not be Administered in Bankruptcy, Why Marijuana Assets May Not Be Administered in Bankruptcy (justice.gov) (last accessed October 9, 2023).

[4] In re Hacienda Company, LLC, Case No. 22-15163, 2023 WL 6143216 (Bankr. C.D. Cal. Sept. 20, 2023).

[5] Suffolk Superior Court No. 2184CV01563 (Mass. Super. Ct.).

[6] 488 P.3d 348 (Colo. App. 2018).

[7] No. 21CA1777 (Colo. App. March 23, 2023) (unpublished opinion), 2023 WL 2639577.