Cannabis clients are often surprised to learn that the bankruptcy courts are unavailable to liquidate or reorganize most cannabis businesses. Indeed, the Office of the United States Trustee (the “UST”) has a mandate from the Department of Justice to move to dismiss cannabis-related bankruptcies when they are filed, and many courts have dismissed such cases, even where the debtor’s ties to cannabis are remote or ancillary to the cultivation, production, sale or distribution of cannabis, or when the debtor no longer has active operations. As such, many bankruptcy professionals instinctively advise that until Congress removes cannabis as a Schedule 1 controlled substance under the Controlled Substances Act (the “CSA”), insolvent cannabis companies can only avail themselves of the tools available to restructure or liquidate under applicable state law including out of court workouts, receiverships and assignments for the benefit of creditors. The limited options have placed a constraint on a rapidly expanding industry. As legalization of cannabis continues to proliferate across the country, the need for restructuring options will continue to grow, creating a tension between the federal government’s treatment of cannabis as a Schedule 1 controlled substance, and hence, illegal, and the desire of cannabis businesses to restructure or liquidate under the United States Bankruptcy Code, until either the federal position on cannabis (or at least eligibility for bankruptcy) changes, or courts adopt more flexibility in cases involving businesses with ties to cannabis.
Signs of a potential openness to allowing bankruptcies with ties to the cannabis industry have been gradually emerging within the Ninth Circuit. Due to the widespread legalization of cannabis within the Ninth Circuit, there may be an impetus for courts to consider a more practical approach when determining whether a bankruptcy commenced by or against a debtor with cannabis ties may proceed. Thus far, the Ninth Circuit has affirmed the confirmation of a chapter 11 plan where the plan would be supported by rental income from a cannabis cultivating tenant, see Garvin v. Cook Investments, 922 F.3d 1031 (9th Cir. 2019), and the Ninth Circuit Bankruptcy Appellate Panel has stated that “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” In re Burton, 610 B.R. 633, 637 (B.A.P. 9th Cir. 2020). At least one bankruptcy court within the Ninth Circuit has been even more direct, noting that “there may be cases where Chapter 11 relief is appropriate for an individual or a non-individual entity directly engaged in a marijuana-related business.” In re CW Nevada, LLC, 602 B.R. 717, 747 (Bankr. D. Nev. 2019).
Some bankruptcy judges have stepped back from the practice of reflexively granting the UST’s motions to dismiss cannabis-related bankruptcy cases and have attempted to test the heretofore amorphous boundaries for determining whether and when a cannabis-related business can use the bankruptcy courts to liquidate or reorganize their affairs. As discussed below, until there is a legislative solution, bankruptcy courts are left with the difficult task of determining how to reconcile the CSA’s prohibition and criminalization of the manufacture, distribution, and possession of marijuana – a Schedule I controlled substance – with the fundamental goals of the federal bankruptcy laws enacted by Congress under Article I, Section 8 of the United States Constitution, which is intended to give debtors a financial “fresh start” from burdensome debt while preserving the interests of creditors and other stakeholders by maximizing recovery in an orderly and efficient fashion.
Following this trend, a recent opinion from the United States Bankruptcy Court for the Central District of California, In re The Hacienda Company LLC, Case No. 2:22-bk-15163-NB, 674 B.R. 748 (Bankr. C.D. Cal. 2023), offers a flicker of hope for at least non-operating cannabis companies to use bankruptcy courts to liquidate assets to pay creditors, and may pave the way for cannabis-related bankruptcy filings under certain circumstances. It also provides a guidepost for creative insolvency professionals to help spin off their clients’ cannabis inventory and operations prior to commencing a bankruptcy filing and using the Bankruptcy Code to liquidate non-cannabis assets to pay creditors and to wind-up their affairs in an orderly fashion. The advantages to cannabis businesses of using the bankruptcy courts to restructure their financial affairs, streamline operations, liquidate assets and administer claims with powerful tools only available under the Bankruptcy Code including the automatic stay (which stays most litigation), the ability to reject burdensome contracts and leases, and the availability of nationwide service of process, among other things, cannot be understated. While receiverships or assignments for the benefit of creditors are certainly viable options to liquidate the assets of a cannabis business, they are not as attractive to preserve going-concern value as a sale under section 363 of the Bankruptcy Code or to reorganize or liquidate under a chapter 11 plan. In short, there is simply no state law mechanism available to cannabis businesses and their creditors that offers the flexibility, efficiency and predictability of the Bankruptcy Code.
In his January 2023 opinion, Judge Neil Bason of the United States Bankruptcy Court for the Central District of California held that a “former” cannabis company that terminated its wholesale manufacturing and packaging business prior to filing its chapter 11 bankruptcy petition, could sell its ownership interests in the Canadian acquiring entity to pay creditors. See In re The Hacienda Company, 674 B.R. at 756. The Hacienda Company (“Hacienda”) was a Beverly Hills-based cannabis company engaged in the business of wholesale manufacturing and packaging of cannabis products under the brand “Lowell Herb Co.” a/k/a “Lowell Farms.” Hacienda ceased operations on February 25, 2021 and transferred its assets to a public Canadian company now known as Lowell Farms, Inc., in exchange for 9.4% of Lowell Farms, Inc.’s shares. Lowell Farms sells and grows cannabis in Canada, where it is legal. The transaction was structured as a sale of intellectual property rather than a sale as an operating cannabis business.
In September 2022, Hacienda filed its Chapter 11 bankruptcy petition. In its status report, Hacienda “stated that it intended ‘to propose a plan of reorganization that provides for Debtor to sell off the shares of [Lowell Farms, Inc. that] it owns in an orderly fashion and use the proceeds from the stock to pay creditors [or] … Debtor may elect to distribute the shares it owns to its creditors directly.’” Id. at 750 (quoting Tr. 12/20/23 (docket no. 76), p. 16:19).
Not surprisingly, the UST moved to dismiss the Chapter 11 case as a bad faith filing as it does in virtually all cannabis bankruptcy cases, noting that 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 Chapter 11 plan. As previously discussed on the Fox Rothschild In Solvency Blog, the UST has taken a strict view that no bankruptcy cases filed by a cannabis-related business including cannabis growers, processors, retailers, or distributors, or businesses that tangentially touch a cannabis business including landlords or equipment dealers, can be a debtor under the Bankruptcy Code. See Keith C. Owens, The Uncertain Future of Cannabis Bankruptcies and the 2020 Elections | In Solvency (foxrothschild.com)
In a case of first impression, the Bankruptcy Court denied the UST’s motion to dismiss, determining that although a cannabis company could not remain in bankruptcy if it was engaged in ongoing violations of the CSA, or it was foreseeable that a future bankruptcy trustee would have to violate the CSA, a former cannabis company could avail itself of bankruptcy protection to liquidate assets to pay creditors.
The Bankruptcy Court found that the UST did not meet its burden of establishing a violation of the CSA. However, even if “the UST could establish a violation of the CSA (which it has not done), that it not enough.” As the Bankruptcy Court noted, there is no per se rule requiring dismissal simply because of the presence of cannabis. Id. (citing In re Roberts, 644 B.R. 220, 231 (Bankr. D. Colo. 2022); In re Burton, 610 B.R. at 637–38).
Even though the Bankruptcy Court found that Hacienda’s ownership of over 9% of the stock in a cannabis business put it in “uncomfortably close proximity to the cannabis industry,” Id. n.3, it held that the UST had not met its burden of proving that Hacienda was engaged in ongoing violations of the CSA or that any future trustee would violate the CSA to administer the bankruptcy case. In short, the Bankruptcy Court found that Hacienda’s “passive ownership of stock, with intent to liquidate that stock to pay creditors, will terminate any connection with cannabis.” The Bankruptcy Court noted that 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, and that this issue could be addressed at plan confirmation.
Alternatively, the Bankruptcy Court held that even if the U.S. Trustee could prove that Hacienda violated the CSA, such a violation would not be enough to constitute cause for dismissal. As the Bankruptcy Court noted, section 1112(b) of the Bankruptcy Code did not mandate dismissal for any violation of criminal law but gave the Bankruptcy Court discretion to determine whether the specific facts and circumstances of a debtor’s connection to cannabis warrants dismissal. The Bankruptcy Court further found that the “unusual circumstances” exception to dismissal under section 1112(b)(2) applied because even if Hacienda’s acts and omissions in seeking to divest itself of its stock to pay creditors violated the CSA, such acts and omissions were reasonably justified for Hacienda to maximize value to pay its creditors if Hacienda’s liquidation did not take too long.
Further along these lines, the Bankruptcy Court opined that “Congress did not adopt a ‘zero tolerance’ policy that requires dismissal of any bankruptcy case involving violation of the CSA (or other activity that might be proven to be illegal).” Id. at 754. Referring to large corporate bankruptcies such as Pacific Gas & Electric Co. “of ‘Erin Brockovich’ fame,” Enron, and Bernie Madoff, cases involving sexual abuse, as well as small business bankruptcies involving restaurants or apartment buildings that may have a history of violations, the Bankruptcy Court asked to “[c]onsider what would happen if the doors of the bankruptcy court were closed to any debtor who had crossed the line into illegal activity prepetition, and were attempting to wind up that activity postpetition.” Id. The Bankruptcy Court ultimately believed that it is the role of prosecutors to address violations of non-bankruptcy law, and that the Court “would be overstepping its role, and acting contrary to Congress’ directives within the Bankruptcy Court, if it were to deny creditors, debtors, employees, equity investors, and other constituencies the benefits and protections of bankruptcy based on the facts and circumstances presented.” Id. at 757-58.
On January 5, 2023, the UST filed a Notice of Appeal and Motion for Leave to Appeal the Bankruptcy Court’s interlocutory ruling. [Dkt. Nos. 83-84].
In Hacienda, Judge Bason took a pragmatic approach when determining whether a cannabis-related business can avail itself of the benefits and protections afforded debtors under the Bankruptcy Code. Judge Bason, following the framework adopted by the Ninth Circuit Bankruptcy Appellate Panel in In re Burton, rejected the hard and fast rule adopted by the Department of Justice that would necessitate dismissal of a bankruptcy case based on “the mere presence of marijuana near a bankruptcy case . . . .” As the Ninth Circuit Bankruptcy Appellate Panel noted, a “bankruptcy court must be explicit in articulating its legal and factual bases for dismissal in cases involving marijuana. . . .” 610 B.R. at637-38. In doing so, the Hacienda decision may be the greatest signal yet of bankruptcy courts, at least in the Ninth Circuit, adopting a more flexible approach to cases with cannabis-related elements.
At bottom, Judge Bason exercised his discretion to conclude that Hacienda’s intended use of the Bankruptcy Code to pay creditors from the proceeds of sale of stock in a cannabis company organized under the laws of the Canada did not require dismissal. It is certainly less clear whether he would have permitted a trustee of a non-operating cannabis company to sell cannabis inventory or a cannabis license, or collect accounts receivable from cannabis customers, to pay creditors, though Judge Bason did postulate that a trustee’s duty to administer assets on behalf of creditors may supersede a federal governmental unit’s rights to seize assets. Id. at 753. These are difficult decisions and will require trial and appellate courts to determine where to draw the line where a non-operating cannabis business, seeks to liquidate cannabis-related assets in bankruptcy. It is important to note that the decision does not address whether businesses ancillary to cannabis businesses, which do not touch the flower but that are used in the operation of cannabis businesses, may be a debtor under the Bankruptcy Code. However, Judge Bason’s analytical framework and pragmatic approach to determine whether a cannabis-related business can avail itself of the benefits and protections afforded debtors under the Bankruptcy Code, may be instructive in determining whether such ancillary businesses can liquidate or reorganize under the Bankruptcy Code.
Creative lawyers will no doubt carefully read Hacienda and other cases to look for ways to restructure cannabis businesses prior to filing a bankruptcy petition to decrease the likelihood of dismissal under section 1112(b) of the Bankruptcy Code. Indeed, unless Hacienda is reversed on appeal, this opinion suggests that cannabis business may use the Bankruptcy Code to wind up their affairs and pay creditors after removing their cannabis inventory and license, even if the remaining assets are the proceeds of assets used in the operation of a cannabis business that might otherwise violate the CSA. Until Congress acts, we must rely on the courts to determine the facts and circumstances under which a business “involving marijuana” can avail itself of the Bankruptcy Code.
 The Ninth Circuit includes the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. With the exception of only Hawaii and Idaho, each of these states has legalized recreational adult-use cannabis (and Hawaii has legalized cannabis for medical use).
 In its appeal pending in the United States District Court for the Central District of California, Case No. 2:23-cv-00125-JFW, the UST identified the following issues on appeal:
- Whether the Bankruptcy Court erred when it denied the United States Trustee’s motion to dismiss this bankruptcy case;
- Whether the Bankruptcy Court erred when it held that neither owning nor transferring interests in an illegal marijuana business violates the Controlled Substance Act (“CSA”);
- Whether the Bankruptcy Court erred when it determined that cause to dismiss this case under 11 U.S.C. § 1112(b) did not exist although debtor’s primary assets violate the CSA, the distribution of the debtor’s assets would violate the CSA, and the bankruptcy court would be required to supervise and administer assets the value of which depends on ongoing violations of the CSA; and
- Whether the Bankruptcy Court erred when it applied the unusual circumstances exemption to dismissal under § 1112(b) when there are ongoing CSA violations.
See Statement of Issues on Appeal filed on January 19, 2023 [Dkt. 99]