Restructuring Alternatives for Distressed Business in the Cannabis Industry as Bankruptcy Courts Shut Their Doors (Part 1 of 2)

Over thirty states and the District of Columbia have legalized marijuana for medicinal purposes in various circumstances. Moreover, ten states and the District of Columbia have legalized marijuana for recreational use by adults. Other states are actively considering legalizing recreational-use marijuana, although the legalization efforts in New York and New Jersey suffered setbacks earlier this year. Because of these recent legalization efforts, investors are seeking to take advantage of the increasingly lucrative cannabis market.

Nevertheless, a number of cannabis businesses are ultimately likely to fail because of legislative or regulatory setbacks, public health concerns, fierce competition among industry participants, or general market forces. One recent problem confronting the industry is the hundreds of illnesses and several deaths connected to e-cigarettes and tetrahydrocannabinol (THC) “vaping” devices. Some state regulators overseeing the cannabis industry are waiting for further determination about what exactly is causing the health problems related to vaping. On the other hand, Massachusetts recently banned vaping devices for a four-month period, and California is also moving decisively to deter vaping. This is only one risk that cannabis businesses currently face.

Distressed businesses in most industries have the option of commencing a case under the United States Bankruptcy Code. In bankruptcy, a troubled business may preserve value by taking advantage of the automatic stay, rejecting burdensome contracts and leases, shedding debt over the objections of debtholders, and “clawing back” transfers that were made before bankruptcy. Businesses alternatively could sell their assets in bankruptcy, free and clear of liens and other interests.

Unlike most types of businesses, however, participants in the cannabis industry are generally precluded from seeking relief under the federal Bankruptcy Code.[1] This is because marijuana and THC remain illegal under the federal Controlled Substances Act. As a result, businesses that are directly (or even indirectly) involved in the industry are generally unable to use the U.S. Bankruptcy Code to restructure their debts. This is true even in states where recreational or medical use of marijuana is legal under state law. In addition, because cannabidiol (CBD) products are not fully legal under federal law, companies involved in the sale of CBD products likely are also precluded from seeking bankruptcy relief.[2]

The prohibition on bankruptcy relief extends even to businesses that are only tangentially involved with marijuana, such as landlords of marijuana dispensaries and agricultural equipment manufacturers that sell machinery to cannabis growers. Under the Controlled Substances Act, there is no distinction between the seller or grower of marijuana and these ancillary participants.[3] As a result, bankruptcy courts have held that these ancillary businesses cannot avail themselves of bankruptcy relief, because they enable the production or distribution of marijuana.

The official policy of the Office of the United States Trustee (which is a part of the U.S. Department of Justice and is the primary government watchdog in bankruptcy cases) is to ask bankruptcy courts to dismiss bankruptcy cases involving cannabis businesses (including ancillary participants), and to object to any bankruptcy restructuring plan involving those businesses. This policy exists even in states where marijuana is legal. The basis of the U.S. Trustee’s policy is twofold. First, the U.S. Trustee’s position is that the bankruptcy system may not be used as an instrument in the ongoing commission of a federal crime, and bankruptcy courts should not confirm Chapter 11 plans that permit or require continued illegal activity. Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets where doing so would cause them to violate federal law. Moreover, private trustees who are assigned to Chapter 7 liquidation cases and Chapter 13 individual debt adjustment cases have been advised by the U.S. Trustee to seek dismissal of those bankruptcy cases.

The U.S. Trustee treats bankruptcy cases involving cannabis-related businesses differently from those involving many other types of illegal businesses, like Ponzi schemes (where the United States Trustee normally will not seek dismissal). This is because in other types of cases, the criminal activity has already terminated, the company’s managers who were responsible for the illegal activity have been terminated. The principal concern of the bankruptcy court is then to resolve competing claims by victims for compensation. In contrast, a cannabis bankruptcy case usually involves a company that not only is continuing in its business, but is seeking the affirmative assistance of the bankruptcy court to reorganize its balance sheet and thereby facilitate its ongoing violation of federal law.

In this article, we will discuss the treatment of cannabis related bankruptcy cases and the benefits distressed businesses in the cannabis industry forgo by not being able to access bankruptcy courts.

l. Treatment of Bankruptcy Cases Filed by Cultivators and Distributors

As noted above, the U.S. Trustee and private Chapter 7 and 13 trustees virtually always seek to dismiss bankruptcy cases that are filed by businesses that are directly involved in the cultivation or distribution of marijuana. Bankruptcy courts often grant those motions to dismiss, even in states where the use of cannabis is legal under state law.

For example, in In re Mother Earth’s Alternative Healing Cooperative, Inc., Case No. 12-10223 (Bankr. S.D. Cal. Oct. 23, 2012), the bankruptcy court dismissed a Chapter 11 case that was filed by a medical marijuana grower, because the debtor would be unable to propose a Chapter 11 plan in good faith, and any plan would not be feasible.

In Arenas v. U.S. Trustee (In re Arenas), 535 B.R. 845 (10th Cir. B.A.P. 2015), one of the debtors was licensed to grow and dispense medical marijuana under Colorado law, and both debtors leased a building to a medical marijuana dispensary. The 10th Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s order denying the debtors’ motion to convert their Chapter 7 case to Chapter 13, and granting the U.S. Trustee’s motion to dismiss the bankruptcy case. The court determined that the debtors lacked the “good faith” required for Chapter 13 relief because their marijuana business was illegal under federal law. Additionally, even if the case were to proceed in Chapter 13 as the debtors requested, the debtors would be unable to propose a feasible plan and the Chapter 13 trustee would be forced to administer an illegal estate. Ultimately, the debtors’ bankruptcy case was dismissed.

In In re Johnson, 532 B.R. 53 (Bankr. W.D. Mich. 2015), the debtor owned a medical marijuana business that complied with state law. The debtor sought to fund his Chapter 13 plan using only his Social Security benefits, and not using the proceeds from his marijuana business. Nevertheless, the U.S. Trustee filed motion to dismiss his Chapter 13 case. The bankruptcy court noted that even if the debtor segregated the proceeds of his marijuana business from his Social Security benefits, money is fungible and the arrangement would taint the court and the bankruptcy trustee. The court enjoined the debtor from conducting his medical marijuana business while his bankruptcy case was pending.

In In re CWNevada LLC, 602 B.R. 717 (Bankr D. Nev. 2019), the bankruptcy court dismissed the Chapter 11 case filed by a debtor that was in the business of cultivating, producing, and distributing medical and recreational marijuana, as well as CBD products. In that case, the bankruptcy court held open the possibility that a cannabis company mightbe able to access the bankruptcy court in an appropriate case, stating that “[t]here may be cases where Chapter 11 relief is appropriate for an individual or a non-individual entity directly engaged in a marijuana-related business.” However, the court determined that the particular case before it was not such a case.

In In re Andrick, 2019 WL 3842602 (Bankr. D. Colo. July 25, 2019), the bankruptcy court denied confirmation of a Chapter 13 plan that was filed by a husband and wife. Under their proposed plan, the debtors sought to spend money for medical marijuana as a “reasonably necessary expense” going forward. Although marijuana is legal under Colorado law, the bankruptcy court that the Bankruptcy Code bars confirmation of a Chapter 13 plan where the debtors propose to use money (that would otherwise be paid to creditors) to purchase medical marijuana.

ll. Treatment of Bankruptcy Cases Involving Businesses With Only a Tangential Relationship to Cannabis

As noted above, even “downstream” participants, such as commercial landlords and agricultural equipment manufacturers, may be prohibited from accessing relief under the Bankruptcy Code. The Bankruptcy Code provides that a company seeking confirmation of a Chapter 11 reorganization or liquidation plan may only have plan confirmed by the bankruptcy court if, among other things, the plan is proposed in good faith and not by any means forbidden by law. The United States Trustee has taken the position that ancillary businesses cannot meet this standard when they derive income from an illegal cannabis enterprise, and a number of bankruptcy courts have agreed with the U.S. Trustee. However, a potentially powerful counterargument to this position is that the law only requires the debtor to follow a lawful procedure for proposing a plan. This counterargument was adopted by the Ninth Circuit Court of Appeals in the Garvin v. Cook case, which is discussed later.

A bankruptcy court may also dismiss a bankruptcy case if the debtor engaged in “gross mismanagement of the bankruptcy estate.” The U.S. Trustee has taken the position that a debtor who accepts payments from a cannabis business is guilty of “gross mismanagement” because the debtor’s property could become subject to forfeiture in a criminal prosecution. (A counterargument to this position is that the Department of Justice generally has not prosecuted cannabis businesses that are legal under applicable state law, so there is no real risk of forfeiture.)

In In re Arm Ventures, LLC, 564 B.R. 77 (Bankr. S.D. Fla. 2017), the debtor’s single asset was a commercial building that it owned. One of the tenants sold medical marijuana. The debtor proposed a Chapter 11 plan the relied on income generated from its tenants, including the marijuana dispensary. The bankruptcy court held that a Chapter 11 plan that was funded partly from income generated by rent from a tenant in the marijuana business could not be confirmed, because the very fact that the plan was based on income derived from the sale of marijuana can be deemed “bad faith.” The bankruptcy court ultimately allowed the lender to foreclose on the building.

In In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 802-04 (Bankr. D. Colo. 2012), the bankruptcy court found that the Chapter 11 debtor had “unclean hands,” and that cause existed to dismiss the bankruptcy case, because the debtor derived roughly 25% of its revenues from leasing warehouse space to tenants engaged in the business of growing marijuana.

In In re Medpoint Management, LLC, 528 B.R. 178 (Bankr. D. Ariz. 2015), vacated in part on other grounds 2016 WL 3251581 (9th Cir. B.A.P. 2016), an involuntary Chapter 7 case was filed against debtor, whose sole income was fees from a trademark licensed to a medical marijuana company. The bankruptcy court dismissed the involuntary case, because the Chapter 7 trustee would otherwise be forced to administer assets obtained in violation of federal law.

In In re Way to Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018), the bankruptcy court dismissed the bankruptcy case because of the debtors’ involvement in a marijuana-related business. In this case, the debtors’ business involves the sale of equipment for indoor hydroponic and gardening-related supplies. As to their customers' uses of their products, Debtors have represented “[w]hile the hydroponic gardening equipment may [be] and is used for many types of crops, the Debtors' future business expansion plan is tied to the growing cannabis industry which is heavily reliant on hydroponic gardening.” The bankruptcy court concluded that the debtors’ business nevertheless violated federal law, and dismissed the bankruptcy case.

However, courts may be beginning to chip away at the position that ancillary businesses cannot file bankruptcy, at least in the Ninth Circuit. First, in In re Olson, 2018 WL 989263 (9th Cir. B.A.P. Feb. 5, 2018), the debtor (a 92 year-old woman who resided in an assisted living facility) sought chapter 13 relief to stop the foreclosure of her commercial real property. One of her tenants operated a marijuana dispensary. The debtor’s Chapter 13 plan called for her to sell the property to pay off all creditors. The bankruptcy court dismissed the case on the ground that debtor’s acceptance of rents from the dispensary was an ongoing criminal violation that disqualified her from bankruptcy relief. However, the bankruptcy court failed to make adequate findings to determine the standard under which it concluded that dismissal was mandatory. The Bankruptcy Appellate Panel vacated the bankruptcy court’s dismissal order, and remanded to the bankruptcy court for further findings. The fact that the Bankruptcy Appellate Panel did not simply affirm the bankruptcy court’s ruling may indicate a willingness not to take a hard line against all cannabis bankruptcy cases.

Second, in Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019), the Ninth Circuit Court of Appeals affirmed a bankruptcy’s court’s confirmation of a Chapter 11 plan filed by a group of debtors, one of which had leased property to a marijuana grower. In the bankruptcy case, the debtors moved to reject the lease with the grower, and filed a Chapter 11 plan that did not depend on the continuation of the Green Haven lease or revenue generated from Green Haven’s marijuana business. The case culminated with the bankruptcy court’s confirmation of a Chapter 11 plan that paid all creditors in full and provided for the debtors to continue as a going concern. The U.S. Trustee appealed the bankruptcy court’s order confirming the Chapter 11 plan because of the lease, arguing that the plan was not proposed in “good faith and not by any means forbidden by law.” The Ninth Circuit rejected the U.S. Trustee’s argument, holding that the Bankruptcy Code does not provide that confirmation of a Chapter 11 plan can be denied simply because its underlying components may be illegal.

Importantly, however, the Ninth Circuit in Garvindid not address the issue of whether the case should have been dismissed in the first place, making this case of somewhat limited precedential value. Earlier in the proceedings, the U.S. Trustee had asked the bankruptcy court to dismiss the bankruptcy case of the entity that had leased the property to the marijuana grower, based on that debtor’s alleged "gross mismanagement of the estate." However, the Ninth Circuit determined that the U.S. Trustee did not properly preserve that argument, and the argument was therefore waived. Accordingly, the Ninth Circuit never reached the question of whether leasing property to a marijuana grower constitutes “gross mismanagement of the estate.”

In In re Basrah Custom Design, Inc., 600 B.R. 368, 381 n.38 (Bankr. E.D. Mich. 2019), a bankruptcy court in Michigan disagreed with the Ninth Circuit’s conclusion in Garvin, and dismissed a Chapter 11 case that was filed by an entity that leased property to a medical marijuana dispensary.

At this time, it is too soon to tell whether Garvinand Olson are the beginning of a trend that will permit some cannabis-related businesses to seek federal bankruptcy relief.

lll. What Powers Do Cannabis-Related Companies Relinquish By Not Being Permitted to File Bankruptcy?

Because the doors to the bankruptcy court remain closed to most participants in the cannabis industry, these businesses will need to turn to alternative legal processes in lieu of bankruptcy. Unfortunately, these alternatives lack many of the benefits that federal bankruptcy law offers to troubled debtors who are allowed to access it. Some of the principal benefits of federal bankruptcy cases, which businesses in and around the cannabis industry typically cannot fully obtain through other strategies, are summarized below:

A. The Automatic Stay

Immediately upon a debtor’s bankruptcy filing, the bankruptcy “automatic stay” comes into effect. The automatic stay generally prohibits third parties from pursuing judgments, collection activities, foreclosures, and repossessions of property based on any debt or claim that arose before the bankruptcy filing. The stay is designed to provide a “breathing spell” to the debtor, during which the debtor will have an opportunity to either reorganize or to liquidate in an orderly manner.

However, the automatic stay does not apply to a number of actions that might be taken against a debtor. For example, the stay does not stop the commencement or continuation of a criminal action or proceeding against the debtor, a governmental unit’s assertion of its police or regulatory powers, or tax audits and issuances of tax deficiencies by a governmental unit. In certain circumstances, creditors may obtain an order from the bankruptcy court granting them relief from the automatic stay. For example, when the debtor has no equity in the property and the property is not necessary for an effective reorganization, a secured creditor can seek an order of the court lifting the stay to permit the creditor to foreclose on the property, sell it, and apply the proceeds to the debt. Unsecured creditors may also seek relief from the automatic stay, for example, to continue litigation that was pending in another forum before the Chapter 11 case was filed.

B. Rejection of Burdensome Executory Contracts and Unexpired Leases

One powerful tool that a debtor obtains in a federal bankruptcy case is the ability to “reject” burdensome contracts and leases, subject to bankruptcy court approval. Rejection is a bankruptcy court-approved breach of the contract or lease by the debtor, which relieves the debtor from future performance under that agreement, and relegates any claim of the contract counterparty for damages to a general unsecured claim (for which the counterparty may receive little or nothing under a Chapter 11 plan).

Debtors may decide to ask the bankruptcy court to permit it to reject its burdensome contracts and leases, or they may use the threat of rejection to renegotiate the terms of its contracts and leases with counterparties. Although a debtor cannot unilaterally amend the terms of its contracts and leases in bankruptcy – the debtor can only make the unilateral decision to ask the court to assume or reject an agreement – counterparties often agree to amend their agreements with the debtor to fend off the threat of rejection.

C. “Cramdown” of Chapter 11 Plans

Once it commences a Chapter 11 case, a debtor has the power to propose a Chapter 11 plan of reorganization or a Chapter 11 plan of liquidation. A Chapter 11 plan is essentially a bankruptcy court-approved contract with creditors, which (among other things) set forth how creditors will be paid from the assets of the debtor’s bankruptcy estate. Classes of creditors and equity holders that do not get paid in full under a proposed plan have the opportunity to vote on whether to accept or reject a plan.

From the debtor’s perspective, the “magic” behind Chapter 11 is that a plan can bind dissenting creditors and equity holders. In other words, unlike in an out-of-court restructuring, unanimous creditor and equity holder consent is not required. If members of a particular class of creditors or equity holders constituting over one-half in number and over two-thirds in claim amount vote to accept the plan, then that class is considered to accept the plan, even if some individual creditors or equity holders in that class voted to reject it. In addition, the Bankruptcy Code provides that, so long as certain requirements are met, a Chapter 11 plan can be “crammed down” on entire classes that have voted to reject the plan. This “cramdown” tool gives debtors powerful leverage to shape negotiations over their financial future.

D. “Free and Clear” Asset Sales

In bankruptcy, a debtor may sell or lease property outside the ordinary course of the debtor's business with bankruptcy court approval. A sale of assets may be done "free and clear” of liens and interests, so long as one of certain specified conditions are met. In such sales, the lienholder will no longer have a lien on the assets, but rather will receive a lien on the proceeds of the sale. This promotes the expeditious liquidation of assets by avoiding delay relating to the sorting out disputes concerning any competing interests. “Free and clear” sales enhance the value of the debtor by facilitating its realization of the maximum value from its assets.

E. Clawback Actions

Debtors-in-possession and bankruptcy trustees may commence litigation in the bankruptcy court to avoid and recover (i.e., “claw back”) transfers that the debtor had made before filing bankruptcy, as well as certain post-bankruptcy transfers that had not been approved by the court. The most typical types of clawback actions are preference actions (which seek to claw back transfers that were made to creditors within 90 days before the bankruptcy filing, and transfers made to insider creditors within one year before the bankruptcy filing) and fraudulent transfer actions. The purpose behind this clawback power is to more equally distribute assets among a debtor’s non-priority creditors. Clawback actions also augment recovery to creditors, and act as a deterrent for creditors that otherwise might strong-arm payment from a debtor before bankruptcy.

F. Existing Equity Owners of Small Business Debtors Have the Chance to Retain Their Ownership of the Debtor Without Paying Creditors in Full

Under the Small Business Reorganization Act of 2019, which will become effective in February 2020, a “small business debtor” (i.e., one that does not have more than $2,725,625 in non-contingent, liquidated, secured, and unsecured debts, excluding debts owed to affiliates or insiders) may obtain bankruptcy court confirmation of a Chapter 11 plan that does not pay its creditors in full, but still allows existing equity owners to retain their equity interests.

IV. Conclusion

Unless and until cannabis becomes legal under federal law, the bankruptcy will not be an option for troubled businesses that operate in and around the cannabis industry, including downstream participants. As a result, these businesses will need to avail themselves of different methods of addressing their financial distress, which tend to lack many of the benefits of bankruptcy.

In a subsequent article, we will discuss the restructuring alternatives that businesses in and around the cannabis industry may pursue in lieu of bankruptcy.

[1] This general prohibition applies to bankruptcy cases involving business entities, as well as bankruptcy cases involving individuals who derive their income from cannabis. For purposes of this article “businesses” refers both to business entities and individuals.

[2] Although hemp was legalized under the Agriculture Improvement Act of 2018 (the “2018 Farm Bill”), that legislation did not eliminate the federal ban on CBD. Rather, the law created exceptions to CBD’s status as a Schedule I substance in some circumstances. Specifically, cannabis plants and any THC or CBD extracted from those plants were reclassified as hemp, rather than marijuana – and thus, no longer subject to the Controlled Substances Act – only so long as they do not exceed 0.3% THC concentration (once dried). Such products are no longer illegal under federal law, but only if they are produced by licensed growers in a manner consistent with applicable laws and regulations. Moreover, the U.S. Food and Drug Administration continues to view CBD as a drug, meaning that CBD currently may not be added to food or beverages or marketed as a dietary supplement in interstate commerce.

[3] It is illegal to “knowingly open, lease, rent, use, or maintain any place, whether permanently or temporarily, for the purpose of manufacturing, distributing, or using any controlled substance” or to “manage or control any place, whether permanently or temporarily, either as an owner, lessee, agent, employee, occupant, or mortgagee, and knowingly and intentionally rent, lease, profit from, or make available for use, with or without compensation, the place for the purpose of unlawfully manufacturing, storing, distributing, or using a controlled substance.” 21 U.S.C. § 856(a).

10.17.2019  |  PUBLICATION: Other Publications  |   |  INDUSTRIES: Cannabis

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