Cannabis-Related Companies Can’t File Bankruptcy Until Federal Legalization

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Although the use of cannabis has been legalized in approximately 39 states and the District of Columbia¹ , cannabis is still illegal federally and classified as a Schedule I drug under the Controlled Substances Act. As a result, cannabis and cannabis-ancillary companies are not typically afforded the protections provided by the U.S. Bankruptcy Code.

Filing for bankruptcy allows distressed businesses some breathing room from creditors to restructure debts and also allows protection from certain litigation and collection efforts. Clifford J. White III, director of the Justice Department's Executive Office for U.S. Trustees, and John Sheahan, a trial attorney for the agency, wrote in a 2017 article published in the American Bankruptcy Institute (ABI) Journal² :

In contrast to other types of cases involving illegal businesses, in which the criminal activity has already terminated and the principal concern of the bankruptcy court is to resolve competing claims by victims for compensation, a marijuana bankruptcy case may involve a company that not only is continuing in its business, but is even seeking the affirmative assistance of the bankruptcy court in order to reorganize its balance sheet and thereby facilitate its violations of the law going forward.

Burton v. Maney (In re Burton)³ involved a husband and wife who filed for Chapter 13 bankruptcy. The bankruptcy petition disclosed that the husband and wife had a majority interest in a company that was legally engaged in the cultivation and sale of cannabis under Arizona law, but had since ceased operation. Based in part on the debtors’ ownership interest in a cannabis-related company, the bankruptcy trustee sought dismissal of the petition. The debtors argued that their remaining funds were not generated by their operation of the cannabis company, but the company was still a plaintiff in two pending state court lawsuits in which it sought damages for breach of contract relating to the cultivation and sale of cannabis.

The bankruptcy court concluded that any recovery from the lawsuits would be derived from conduct in violation of federal law and that allowing the bankruptcy case to continue would likely require the court and the trustee to administer funds obtained in violation of said law. The bankruptcy court granted the trustee’s motion to dismiss. The Ninth Circuit Bankruptcy Appellate Panel affirmed, finding that the debtors’ cannabis ownership interests constituted “cause” for dismissal under section 1307(c) of the Bankruptcy Code.⁴

There are portions of the Burton appeal that may inure to cannabis debtors’ benefit, however; the appellate panel wrote:

The case law continues to evolve and few bright line rules have emerged from decisions published to date. One principle seems implicit in the case law, however; the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.

Similarly, In Re Players Network⁶, involved a debtor who held a majority interest in a company that processed cannabis. A creditor sought dismissal of the debtor’s case under section 1112(b)(1), arguing in part the debtor could not propose a plan in good faith based on its equity ownership in a cannabis-related company. The bankruptcy court ultimately dismissed the case, in part because of the debtor’s cannabis ties. Similar to Burton, the court noted that, at least within the Ninth Circuit, “there appears to be no per se rule precluding a Chapter 11 plan from being proposed in good faith based solely on the debtor’s relationship to commerce involving marijuana or cannabis products.”⁷

While it appears that the bankruptcy system cannot currently aid in liquidating or restructuring any assets associated with cannabis, state law alternatives to bankruptcy are still available to cannabis and cannabis-ancillary companies. Cannabis entrepreneurs should seek legal counsel to ensure they are structuring their business in a way that allows for state law protections.

¹Approximately 18 states along with the District of Columbia have legalized recreational or adult-use of cannabis.

²“Why Marijuana Assets May Not Be Administered in Bankruptcy.” American Bankruptcy Institute, 1 Dec. 2017, https://www.abi.org/abi-journal/why-marijuana-assets-may-not-be-administered-in-bankruptcy.

³610 B.R. 633 (B.A.P. 9th Cir. 2020).

⁴Section 1307(c) provides that “on request of a party in interest or the United State trustee and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 7 of this title, or may dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause . . ..”  11 U.S.C. § 1307(c).  A non-exhaustive list of factors establishing cause is set forth in section 1307(c)(1) – (11).

In re Burton, 610 B.R. at 637 (emphasis added).

⁶2020 Bankr LEXIS 3016 [Bankr D Nev Oct. 23, 2020, No. 20-12890-MKN]).

Id. at *11, n 18.

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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