Is United Cannabis Far Enough Removed From Marijuana to Receive Federal Bankruptcy Protection? Why the United Cannabis Bankruptcy Proceeding is an Important Test for the Industry

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On April 20, 2020, United Cannabis Corporation, along with its wholly-owned subsidiary, UC Colorado Corporation, filed for Chapter 11 bankruptcy protection in the Bankruptcy Court for the District of Colorado. Generally speaking, federal bankruptcy protection is not available to cannabis companies because, as the United Cannabis court has already noted in an order to show cause issued this week, “activities associated with the marijuana industry are illegal under federal law and cannot be condoned by the bankruptcy courts.” Thus, the filing has garnered significant attention throughout the cannabis industry, and everyone is waiting to see if the case will be allowed to proceed.

The quickly issued order to show cause is a shot across the bow for United Cannabis and could mean that this case will not be around for much longer. Typically, the U.S. Trustee’s office (the bankruptcy “watchdog” of the Department of Justice) challenges bankruptcy filings in their infancy by promptly filing a motion to dismiss at the start of the case.  Here, the bankruptcy judge did not wait for the U.S. Trustee.  Two days after the bankruptcy filing,  Hon. Joseph Rosania entered the show cause order, which directs “the Debtor and the Office of the United States Trustee [to] show cause, in writing, why this case should not be dismissed, failing which, this case shall be dismissed.”

United Cannabis has until May 11 to respond to the show cause order, but we believe they are facing an uphill battle. The District of Colorado is where In re Way to Grow was recently decided. In that case, the debtors sold indoor hydroponic and gardening-related supplies. The supplies were sold to cannabis and non-cannabis companies alike (although the company’s expansion plans indicated a focus on pursuing clients operating in the state-legal cannabis industry). A secured creditor moved to dismiss the case, arguing that: (i) the debtors’ business violated the Controlled Substances Act (CSA); (ii) this ongoing violation of federal law prevented the debtors from proposing a bankruptcy reorganization plan “in good faith”, which is a requirement for plan confirmation; and (iii) this inability to confirm a plan qualified as “cause” for dismissal of the case under Section 1112(b) of the Bankruptcy Code.

The bankruptcy court agreed with this logic and dismissed the case, finding that the debtors were in violation of Section 843(a)(7) of the CSA, which makes it a federal crime to manufacture or distribute any “equipment, chemical, product or material which may be used to manufacture a controlled substance … knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance.”  The bankruptcy court determined there was sufficient evidence to establish that the debtors had reason to believe that their equipment and products would be used by at least some of their customers to produce marijuana. The district court affirmed the dismissal, stating: “as long as marijuana remains a Schedule I controlled substance, a Chapter 11 debtor cannot propose a good-faith reorganization plan that relies on knowingly profiting from the marijuana industry … [a]nd, in turn, inability to propose a good-faith reorganization plan is cause for dismissal.”

There is a wrinkle of hope for United Cannabis, however.  In Way to Grow, the bankruptcy court noted the importance of the marijuana related sales to the debtors’ business model, finding that sales to marijuana growers were such an important part of the debtors’ business that it was “inconceivable” that the debtors could still operate profitably without selling to those customers.  The district court further noted that the debtors’ “primary business” violated the CSA.   We anticipate that United Cannabis will try to distinguish Way to Grow by arguing that unlike the Way to Grow debtors, the “primary business” of United Cannabis relates to hemp (which is legal at the federal level due to the passage of the 2018 Farm Bill), and not sales to the marijuana industry (which comprises less than 1% of its revenue).  Indeed, in a recent filing, United Cannabis stated that “is confident it will demonstrate to the court that it is involved in the legal hemp industry, not Schedule I marijuana.”

Will this “percentage of revenue” distinction be enough to survive the show cause order?  Perhaps.  But it will force United Cannabis to argue that it is not, in fact, a cannabis company.

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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