Are bankruptcy doors now opening for cannabis companies? A decision last week from a California bankruptcy court indicates perhaps so, at least for cannabis companies that are no longer operating.
The Hacienda Company, LLC (the “Debtor”) was in the business of wholesale manufacturing and packaging cannabis products. After it ceased operations in February 2021, the Debtor transferred its value, through the sale of intellectual property, to a publicly traded Canadian company, Lowell Farms, Inc. (“Lowell Farms”), receiving approximately 9% of Lowell Farms’ stock in consideration. Lowell Farms’ sole business is cannabis growth and sales.
The Debtor filed its chapter 11 petition on September 21, 2022. In response, the United States Trustee (the “UST”) filed a motion to dismiss the case for “cause” under section 1112(b) of the Bankruptcy Code, arguing that dismissal was required because: (a) the Debtor’s equity ownership in Lowell Farms violated the Controlled Substances Act (the “CSA”); (b) the Debtor is grossly mismanaging the estate because all of its assets are subject to forfeiture under the CSA; and (c) the Debtor filed its case in bad faith because any plan proposed by the Debtor would be funded from sources obtained in violation of the CSA.
The filing of the motion to dismiss could not have been a surprise to the Debtor given the general hostility of bankruptcy courts to cannabis debtors (see Cannabis and District Courts: Are Those Courthouse Doors Closed Too? | Restructuring GlobalView (restructuring-globalview.com, Cannabis and Bankruptcy: 2020 in Review | Restructuring GlobalView (restructuring-globalview.com, Up in Smoke: More Cannabis Companies Get Shut Out of Bankruptcy | Restructuring GlobalView (restructuring-globalview.com). However, and most likely to the shock of both the Debtor and the UST, on December 21, 2022, the bankruptcy court entered an order denying the UST’s motion to dismiss, and on January 20, 2023, the bankruptcy court issued its memorandum opinion.
The Bankruptcy Court’s Opinion
In its opinion, the bankruptcy court began by explaining why violations of the CSA may constitute “cause” for dismissal. The court specifically noted that such violations may evidence a lack of good faith and gross mismanagement of the estate, and further that CSA violations may warrant dismissal under general principals of equity. However, the court recognized the admonition of the Ninth Circuit Bankruptcy Appellate Panel in In re Burton, 610 B.R. 633, 637-638 (9th Cir. BAP 2020) that “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” The court also noted that it has “some degree of discretion” in considering dismissal, particularly when there are no ongoing postpetition violations of the CSA. With these general principals in mind, the bankruptcy court examined the particular facts of the Debtor’s case.
First, the bankruptcy court rejected the UST’s argument that the Debtor’s ownership of the Lowell Farms stock constituted a violation of the CSA. The UST argued that ownership of the stock violated section 856(a) of the CSA which makes it illegal to “profit from” a place used to manufacture, store, distribute or use cannabis. Although it noted that the Debtor’s ownership of the stock put it in “uncomfortably close proximity to the cannabis industry,” the bankruptcy court held that the Debtor’s passive ownership of the stock, which it intended to liquidate to pay creditors, would terminate the Debtor’s connection with cannabis and was, in fact, the “opposite of an intent to profit from an ongoing scheme to distribute cannabis.”
Second, the bankruptcy court rejected the UST’s argument that the Debtor was violating the CSA by its postpetition use of the Lowell Farms stock or the stock proceeds. Section 854 of the CSA makes it illegal for a person who has received income derived from a violation of the CSA to “use or invest, directly or indirectly, any part of such income, or the proceeds of such income, in acquisition of any interest in, or the establishment or operation of, any enterprise [engaged in or affecting interstate or foreign commerce].” Because the Debtor did not propose to use any of the stock or proceeds of the stock to invest in any cannabis enterprise but was instead proposing to sell the stock and distribute the proceeds to creditors, the court held that there was no violation of section 854.
Third, the bankruptcy court rejected the UST’s argument that any future bankruptcy trustee would have to engage in illegal activity if the Debtor was found to have cannabis or cannabis-related products. The court noted that should such a contingency arise, a trustee could request the responsible federal authorities to dispose of the cannabis and, in an interesting aside, even hinted that a future trustee might have a duty to administer cannabis assets rather than simply turn the assets over to the federal authorities. In short, based on the record before it, the bankruptcy court found that the UST had not satisfied its burden to show that any future trustee would have to violate the CSA.
Fourth, and perhaps most dramatically, the bankruptcy court rejected the concept of a “zero tolerance” policy under section 1112(b) of the Bankruptcy Code for illegal conduct, including violations of the CSA. The court noted that interpreting “cause” under section 1112(b)(4) in such a way could prevent courts from considering a host of bankruptcy cases where there were prepetition violations of nonbankruptcy laws. In fact, the court noted that some of the largest bankruptcy cases (e.g., Enron Corporation and Bernie Madoff) involved alleged or actual criminal liability and applying the UST’s argument to its natural conclusion would lead to the mandated dismissal of these cases. The court reasoned that this would be contrary to the Bankruptcy Code’s policy of maximizing value for the benefit of creditors and preventing individual races to the courthouse. In light of these concerns, the court adopted a middle ground in interpreting “cause,” writing:
[T]his Bankruptcy Court does not interpret Congress’ mandate that this Bankruptcy Court “shall” dismiss or convert a bankruptcy case for “cause” under § 1112(b) to mean that any violation of criminal law requires dismissal. Rather, this Court interprets the statute as giving discretion to determine whether dismissal is warranted based on all the facts and circumstances.
[T]his Bankruptcy Court interprets both § 1112(b) and the UST’s [motion to dismiss] as adopting a middle ground, under which this Bankruptcy Court must exercise its discretion to determine whether, given all the facts and circumstances, a debtor’s connection to cannabis profits and any past or future investment in cannabis enterprises warrants dismissal of this bankruptcy case.
Finally, the bankruptcy court held that even if the UST had established “cause”, there were “unusual circumstances” that prevented dismissal under section 1112(b)(2). Specifically, the court pointed to the fact that the Debtor had divested itself, prepetition, of any direct involvement in the cannabis industry. Further, the court found that there was a realistic possibility of a “substantial” distribution to creditors through the liquidation of the Lowell Farms stock. Based on these facts, the court held that conversion or dismissal was not in the best interests of creditors.
Does the bankruptcy court’s opinion in Hacienda Company change the landscape for struggling cannabis companies? Perhaps to some extent, particularly if the cannabis companies had shut down their cannabis businesses prepetition and are seeking to use Chapter 7 simply to liquidate their remaining assets. In those cases, a court might be open to allowing the bankruptcy case to proceed. Further, cannabis companies in need of bankruptcy relief should be heartened by the court’s conclusion that it would, in lieu or dismissal, “defer to prosecutors … to use their discretion about whether and how to address any violations of nonbankruptcy law.”
The larger, and so far unanswered, question is whether the bankruptcy court’s rationale in Hacienda Company, particularly its rejection of a “zero tolerance” policy and its asserted equivalence between violations of the CSA and other nonbankruptcy law, can be read to support more expansive uses of the Bankruptcy Code by cannabis companies. For instance, can a cannabis company file bankruptcy to sell its assets (operating or not) under section 363 of the Bankruptcy Code? Can a cannabis company utilize chapter 11 to reorganize its affairs? Can a foreign cannabis company utilize chapter 15 to seek U.S. recognition of a foreign insolvency proceeding? Perhaps the only thing we know is that the UST will continue to oppose cannabis bankruptcies and that the outer boundaries of what is and is not permitted will continue to be litigated, at least until Congress removes cannabis from the list of controlled substances.
The UST has appealed the denial of the motion to dismiss. We will monitor the appeal and update our post when a ruling has been issued.