A recent U.S. bankruptcy court opinion out of the Central District of California may have cracked the door open for companies formerly tied to the cannabis industry to pursue legal strategies using bankruptcy. Federal prohibitions on cannabis have complicated the industry’s entitlement to legal protections, including chapter 11 bankruptcy. Judge Neil W. Bason’s opinion signifies a shift from the standard of bankruptcy courts dismissing cases filed by cannabis-related businesses and leaves open the possibility that with the right set of facts, a cannabis business seeking to reorganize or liquidate may be able to avail itself of the tools of chapter 11 of the Bankruptcy Code.
CANNABIS-RELATED BUSINESSES IN BANKRUPTCY COURT
After a decade-long boom for the nascent legalized cannabis industry, many companies in the space are facing financial difficulties related to price deflation, market saturation and illegal operations outside of regulatory enforcement that are able to undercut prices because they are not paying taxes, license fees or the like. Unlike other industries, cannabis companies have largely been shut out of traditional banking services and legal restructuring options like bankruptcy—meaning they have fewer options when it comes to liquidating their assets and restructuring debts.
The Office of the U.S. Trustee, which oversees bankruptcy administration, has taken a hard stance on the issue because of the federal prohibition of cannabis under the most restrictive category of drugs under the Controlled Substances Act (the “CSA”). A component of the Department of Justice (“DOJ”), the U.S. Trustee is charged with enforcing federal law, in this instance blocking debtors from using bankruptcy to further the ongoing commission of federal crimes. The U.S. Trustee will generally move to dismiss any bankruptcy case where a debtor is a cannabis-related business. Furthermore, bankruptcy courts cannot confirm reorganization or liquidation plans that rely on violations of federal criminal law. Notably, this approach contrasts with the more hands-off approach taken by the DOJ with respect to prosecuting violations of the CSA that otherwise comply with state law.
Given that context, courts have consistently held that cannabis growers, processors, distributors, retailers and any other cannabis-related business would not be able to seek bankruptcy relief due to ongoing violations of the CSA. Even cannabis-related equipment dealers and landlords have been found to violate the CSA, resulting in them being barred from bankruptcy relief. See, e.g., In re Way to Grow, Inc., 610 B.R. 338, 341 (D. Colo. 2019) (affirming the bankruptcy court’s decision to dismiss the debtors’ chapter 11 cases where their businesses relied on knowingly selling equipment to cannabis growers); In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 809 (Bankr. D. Colo. 2012) (finding cause for dismissal where the debtor knowingly maintained leases with cannabis growers during the pendency of its chapter 11 bankruptcy case).
The question remains whether bankruptcy courts will allow businesses no longer operating or receiving any income derived from growing, marketing, processing, manufacturing, selling, distributing or delivering cannabis to proceed in chapter 11 despite their past connections to the cannabis industry and violations of the CSA.
THE HACIENDA COMPANY DECISION
In a case involving an issue of first impression, The Hacienda Company, LLC (“Hacienda”) asked the bankruptcy court to decline to apply a bright-line rule that all cases having any relationship to the cannabis industry, no matter how tangential, should be dismissed. The bankruptcy court then exercised its discretion and declined to dismiss Hacienda’s case, noting that dismissing every case with connection to illegal activity under non-bankruptcy law would harm the constituencies that Congress attempted to protect through the tools of the Bankruptcy Code.
Hacienda ceased operations in February 2021 and transferred its value to a public company called Lowell Farms, Inc. in Canada, where cannabis-related businesses are legal nationwide. Hacienda then filed its chapter 11 petition in September 2022. In its initial status report, Hacienda proposed that it intended to file a plan that provided for the sale of the shares in Lowell Farms, Inc. and paid creditors with the proceeds or the distribution of the shares to the creditors directly.
The U.S. Trustee predictably moved to dismiss the case as a bad faith filing, arguing Hacienda’s ownership of a cannabis business was cause for dismissal and that it intended to rely on proceeds from unlawful sources to fund its plan.
Before delving into his reasons for denying dismissal, Judge Bason cited a 2020 Ninth Circuit Bankruptcy Appellate Panel decision that held that there is no per se rule requiring dismissal where the presence of cannabis is near a case. In Colorado, Judge Joseph G. Rosania Jr. has cited the same decision favorably for the proposition that bankruptcy courts must explicitly articulate their factual bases for dismissal of a cannabis-related case. See In re Roberts, 644 B.R. 220, 231 (Bankr. D. Colo. 2022) (quoting Burton v. Maney (In re Burton), 610 B.R. 633, 637–38 (B.A.P. 9th Cir. 2020)).
Even though the court stated that Hacienda’s ownership of over 9% of the stock in a cannabis business put it in “uncomfortably close proximity to the cannabis industry,” it held that the U.S. Trustee had not established any ongoing violation of the CSA by Hacienda or that any future trustee would have to violate the CSA to administer the case. Because of Hacienda’s passive stock ownership in Lowell Farms, Inc. and its stated intention to liquidate its assets, the court found that its connection with the cannabis industry would end. Judge Bason reasoned 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, which he noted could be an issue dealt with in the plan confirmation context.
In the alternative, Judge Bason held that even if the U.S. Trustee could establish a violation of the CSA, such a violation would not be enough to constitute cause for dismissal. The judge reasoned that Congress did not intend 11 U.S.C. Section 1112(b) to mandate dismissal for any violation of criminal law. Instead, section 1112(b) was interpreted to allow the bankruptcy court to exercise its discretion in determining whether the specific facts and circumstances of a debtor’s connection to cannabis warrants dismissal.
Judge Bason also held alternatively that the “unusual circumstances” exception to dismissal under section 1112(b)(2) applied. Even if Hacienda’s acts and omissions in seeking to divest itself of its stock to pay creditors ran afoul of the CSA, the court found such acts and omissions were reasonably justified as long as Hacienda’s liquidation did not take too long.
Based on this decision, which remains subject to challenge on appeal, a business that has ceased any ongoing cannabis-related operations and divested itself of any direct involvement with cannabis-related businesses for a period of at least a year may have the opportunity to seek bankruptcy relief where there is a realistic possibility of substantial payment to creditors. Once in bankruptcy, however, a post-petition violation of the CSA could be grounds for dismissal. Cannabis businesses have thus far conducted liquidations under state law processes such as receiverships in state court or assignments for the benefit of creditors. Hacienda may open the door for federal bankruptcy supervision of such liquidations if deemed desirable, although operating a cannabis business that violates federal law while under the protection of chapter 11 remains forbidden.
This document is intended to provide you with general information regarding cannabis-related businesses and bankruptcy and restructuring strategies. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.