Blaze to bankruptcy

Introduction

The US Bankruptcy Code provides significant advantages to businesses looking to restructure their financial affairs, liquidate assets, and administer claims. The cannabis industry, however, has had particular difficulty gaining access to the Bankruptcy Code. While medical and recreational use of cannabis and cannabis related products is now legal in certain US states, it is still illegal at the federal level. As a result, US bankruptcy courts have struggled to reconcile the federal prohibition against cannabis with businesses and business activities now made legal by a number of US states.

Generally speaking, in bankruptcy, the presumption has been that cannabis related entities categorically are not eligible for bankruptcy protection in the US. US bankruptcy courts had consistently—even reflexively—dismissed cases filed by cannabis related entities based upon violations of a US federal statute, the Controlled Substances Act ("CSA"). Essentially, those courts found that the bankruptcy process, the bankruptcy court, and the court's agents could not approve a plan of reorganization or administer assets in a manner that would be illegal under the CSA. This perceived categorical bar thus prevented US cannabis related entities, and international cannabis related entities with US assets or subsidiaries, from using the US bankruptcy process to reorganize their business, restructure debts, or sell assets. Likewise, international cannabis related insolvency proceedings have been unwilling to seek recognition under Chapter 15 of the US Bankruptcy Code.

Some US bankruptcy courts have begun pushing back against the perceived per se ban. These courts look critically into the bankrupt debtor's assets and business to discern to what degree the debtor's enterprise touch or concern cannabis. Where a debtor's business is adequately removed from ongoing violations of the CSA (and does not arise from the manufacture and distribution of cannabis products) dismissal is not required.

This alternative approach creates a paradigm. On one end of the spectrum are cannabis related entities that directly manufacture and distribute cannabis and cannabis products. Even under recent court decisions, those entities most likely will remain ineligible for bankruptcy protection no matter what court reviews the case. At the other end of the spectrum are those entities which do not directly participate in the manufacture or distribution of cannabis products. A new line of cases appears have emerged, permitting those businesses to avail themselves of US Bankruptcy Code protections.

The foundations and a categorical bar against bankruptcy relief

Until 2019, US bankruptcy courts reflexively dismissed bankruptcy cases filed by cannabis related entities. Generally, the United States Trustee ("UST"), an officer of the United States Department of Justice responsible for overseeing the administration of bankruptcy cases, argued that a cannabis related entity's violations of applicable nonbankruptcy law constituted cause for dismissal.

Typically, the UST would point to violations of the CSA (which, by virtue of the Supremacy Clause of the US Constitution, would prevail over state law when there is a conflict between federal and state law) to justify dismissal. Under the CSA, it is illegal to possess, grow, or dispense cannabis and cannabis related products, and it is unlawful to open, lease, rent, use, or maintain any place to manufacture or distribute cannabis and cannabis related products. All property and proceeds of property obtained in violation of the CSA are subject to forfeiture. These violations, the UST would argue, establish a lack of "good faith," constitute "gross mismanagement" of the bankruptcy estate, and render the bankruptcy court and agents of the court unable to administer the debtor's assets.

Many courts have agreed, particularly where the debtor's business intended to manufacture or distribute cannabis products postpetition, or where the bankruptcy estate would be required to administer proceeds from the actual sale of a cannabis related business for the benefit of creditors. For example, in a Colorado case, the debtor sold indoor hydroponic supplies for use in growing marijuana (a cannabis product). Dismissing the case, the bankruptcy court found the debtor's sale of equipment to the cannabis industry was a violation of the CSA, and the debtor's continued reliance on this income required dismissal. Similarly, courts have ruled that ownership of property used in the cannabis industry constitutes cause for dismissal. For example, a bankruptcy court in Michigan dismissed the case of a debtor which had leased its property to a company that ran a medical marijuana dispensary. Likewise, in Colorado, the bankruptcy court dismissed a case involving a debtor which had leased property to a marijuana growing operation. In all of these cases, the debtor's business operated in contravention of the CSA, and those connections to the cannabis industry were sufficient to restrict a bankruptcy court's ability to provide relief under the US Bankruptcy Code.

Once bankruptcy was not available, distressed cannabis businesses and their creditors were forced to turn to US state-law insolvency proceedings (e.g., assignments for the benefit of creditors; receiverships) or international forums to restructure their debts and liquidate their assets. While viable, assignment proceedings and receiverships are not as advantageous as a sale or plan of reorganization under the Bankruptcy Code. They cannot deliver to any good faith purchaser either the transfer of contracts or leases over the objection of the non-debtor parties to those same agreements, or convey assets free and clear of all liens, claims, and interests. Moreover, these state law proceedings do not provide for recognition of foreign insolvency proceedings as is the case under Chapter 15 of the US Bankruptcy Code.

The developing spectrum of potential bankruptcy relief

Recently, certain US bankruptcy courts in California and Colorado have disagreed that a violation of the CSA requires dismissal of a bankruptcy case. These cases trumpet that "the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from obtaining bankruptcy relief." Rather, due to the varying nature and extent of a debtor's potential involvement in the cannabis business and the wide latitude of discretion granted to US bankruptcy courts, a bankruptcy court must make explicit findings to justify dismissal. Instead of a "bright line" rule, recent courts assert that the totality of the circumstances should be examined to determine (1) whether the debtor's connections actually violate the CSA or other federal statute, and (2) even if there is a violation of the CSA, whether that violation justifies cause to dismiss the bankruptcy case. In other words, these courts discern the degree of connection to cannabis to determine whether dismissal would be appropriate—"ongoing postpetition violations [of the CSA] are far more problematic."

For example, in one 2020 case in California, the debtor's business required and would continue to require the sale of cannabis growing equipment. The bankruptcy court dismissed the case, finding both that the debtor's sale of that equipment was an ongoing violation of the CSA, and the debtor's business would continue to be tightly connected and dependent upon the cannabis industry.

However, just a few months ago, another bankruptcy court in California came to an entirely different result in In re Hacienda Company, LLC, 647 B.R. 748 (Bankr. C.D. Cal. 2023). In Hacienda, the bankruptcy court refused to grant the UST's motion to dismiss a bankruptcy case because it could find no ongoing violation of the CSA. The debtor was a former wholesale manufacturer of cannabis products that had ceased operations altogether and had sold the company in exchange for cash and shares of its purchaser, which was also a cannabis related entity. Entering bankruptcy, the debtor's only asset was the shares of its purchaser, which the debtor intended to liquidate and distribute the proceeds to its creditors. The UST moved to dismiss. The bankruptcy court disagreed with the UST, finding that the debtor's ownership of the stock and proposed sale thereof did not violate the CSA. While the debtor may have previously operated in violation of the CSA, the debtor was not proposing to use its assets to invest in or profit from a cannabis related entity. Further, the sale of the debtor's stock alone did not require the debtor, the court, or the court's agents to violate any federal law. Moreover, on September 22, 2023, the bankruptcy court went one step further and entered an order confirming the debtor's Chapter 11 plan of reorganization, permitting the debtor to sell the shares of its purchaser on the Canadian Securities Exchange and distribute the proceeds to its creditors. Importantly, the bankruptcy court held that a distribution of sale proceeds through the plan is not a sale of cannabis products, "nor will it add a single dollar to any cannabis enterprise."

These same courts have also pushed back against the notion that a violation of the CSA (if it exists) is per se cause to dismiss a bankruptcy case. See, e.g., In re Roberts, 644 B.R. 220, 231 (Bankr. D. Colo. 2022) ("Because the Court cannot explicitly articulate its factual bases for a marijuana-based dismissal beyond an unacceptable level of speculation, the Court will not dismiss [the debtor's] case due to cannabis . . . ."); In re Olson, 2018 WL 989263, at *7 (B.A.P. 9^th Cir. 2018) (J. Tighe concurring) ("the presence of marijuana near the case should not cause mandatory dismissal."). As observed by these courts, bankruptcy courts often consider debtors whose past and present activities include violations of nonbankruptcy law, such as failed Ponzi schemes, alleged sexual abuse, instances of fraud, and countless other material and immaterial violations of federal law. If a violation of nonbankruptcy law required dismissal, bankruptcy courts would be forced to dismiss a great deal of cases in contravention to the express purpose of the US Bankruptcy Code.

Instead, even in the face of a violation of the CSA or other federal law, these courts reason that discretion must be exercised to determine whether, given the facts and circumstances presented, dismissal is in the best interest of creditors and the bankruptcy estate. For example, in confirming the Chapter 11 plan, the bankruptcy court in In re Hacienda found that even if the debtor's ownership and sale of stock in its purchaser (a cannabis related entity) had constituted a violation of the CSA, creditors of the estate and parties in interest actually stood to benefit from the bankruptcy case and an orderly liquidation of assets. Under those circumstances, the court determined that dismissal would not be warranted.

Taking advantage of the spectrum

The willingness of some bankruptcy courts to reject the old per se test in favor of essentially an evaluation of a spectrum of facts and circumstances surrounding how the debtor operates its business may open new avenues of opportunity for both US and international cannabis related entities to gain the protection of the US Bankruptcy Code.

While the contours of this spectrum remain to be tested, US based cannabis related entities and those who invest in them should monitor any new cases filed, as additional enterprises inevitably will seek to take advantage of these new tools and develop the case law available on these issues.

International cannabis related entities and investors may also benefit from this changing landscape, as the recent rejection of a per se ban of cannabis related entities may open the door to Chapter 15 recognition of foreign cannabis related proceedings. Recognition under Chapter 15 of the US Bankruptcy Code grants a foreign debtor many of the protections afforded a debtor under the US Bankruptcy Code, including the automatic stay, recognition of sale orders, and staying enforcement of judgments.

Until recently, US bankruptcy courts may have denied recognition under Chapter 15 pursuant to the "public policy exception," which permits a court to refuse to grant recognition if it would be "contrary to the public policy of the United States." After all, nearly all cannabis related bankruptcies have been dismissed by US bankruptcy courts for "cause" out of fear that the court would be forced to administer illegal assets.

The recent court decisions outlined above, however, may afford bankruptcy courts more latitude to ignore that per se rule depending on where the debtor lands on this new spectrum. If at least some US bankruptcy courts are actually permitting certain cannabis related bankruptcies to proceed, then it becomes much harder for the UST to make its "public policy" objection and demand dismissal. Thus, if a foreign debtor is able to demonstrate that its case would be accepted by a US court, it may well defeat a public policy objection / motion to dismiss brought by the UST.

Further, the usual justifications for dismissal of cannabis related entities are not present in Chapter 15. As discussed, many courts have dismissed cannabis related bankruptcies involving ongoing violations of the CSA for "cause" out of fear the court or its agents would be forced to administer assets in contravention of the CSA. In Chapter 15, however, the applicable sections of the Bankruptcy Code that provide for dismissal for cause (11 U.S.C. § 1112) do not apply. Instead, the only means to deny recognition of a Chapter 15 case is the public policy exception.

Also, a court's concerns of administering illegal assets should be assuaged in a Chapter 15 case, because recognition of a foreign proceeding under Chapter 15 does not create an estate of the debtor's property that must be administered by the US courts. In re JSC BTA Bank, 434 B.R. 334, 341 (Bankr. S.D.N.Y. 2010). Instead, the bankruptcy court must merely recognize and facilitate the reorganization in another (presumably lawful) jurisdiction. Therefore, in applying the public policy exception narrowly, a chapter 15 recognition petition may find success in US bankruptcy courts.

In conclusion, the recent decisions from California and Colorado demonstrate that there is an emerging spectrum of potential relief for cannabis related businesses under the US Bankruptcy Code. Both Chapters 11 and 15 may provide an avenue for restructuring of debts or recognition of foreign proceedings that affords significant advantages for stakeholders, and both US and international cannabis related entities and their investors should monitor this area of the law as it continues to develop.