Cracks in the Wall? The New Year Promise of Cannabis Bankruptcy
February 9, 2023 | Cannabis Law Updates
Article by: Counsel Tomas Ortiz
Every year there is a case or two that promises change in what has been considered by many as an insurmountable wall of law – that is, bankruptcy relief is not available for those distressed businesses who transact in or around cannabis. And, every year, that case or two is dismissed for just that reason.
This year things have gotten off to a fast and early start.
On January 20, 2023, in Los Angeles, California, a bankruptcy court opened the door to the possibility of a “cannabis bankruptcy” in denying a trustee’s motion to dismiss the bankruptcy case of The Hacienda Company, LLC, a former wholesale manufacturer and distributor of cannabis products. (See, In re Hacienda Co. LLC, 22-15163 (Bankr. C.D. Cal. Jan. 20, 2023).)
After ceasing operations in February, 2021, Hacienda sold its assets, consisting mostly of intellectual property, to a public company in Canada that legally grows and sells cannabis products in Canada. As consideration for the sale, Hacienda received 9.4% of the Canadian company’s stock.
Hacienda then filed for bankruptcy protection under Chapter 11 on September 21, 2022. Its intent, as stated, was to propose a plan of reorganization that provided Hacienda the opportunity to sell off the shares of its Canadian buyer “in an orderly fashion and use the proceeds from the stock to pay creditors.”
The U.S. Trustee filed a motion to dismiss, claiming that Hacienda’s prior illegal activities and the proposed sale of stock in a cannabis business were “cause” for dismissal under Section 1112(b)(1) and (b)(4).
The bankruptcy court disagreed and denied the motion.
The bankruptcy court reasoned that despite the several reasons why illegal activity such as the sale of cannabis “might establish cause for dismissal,” the authorities cited by the parties still “reflect some degree of discretion”:
Ongoing post-petition violations are far more problematic than prepetition violations; and although indirect connections with illegal activity might violate nonbankruptcy law, the degree of connection appears to be important to deciding whether to dismiss the case.
Citing In re Burton, 610 B.R. 633 (BAP 9th Cir. 2020), “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief,” so a “bankruptcy court must be explicit in articulating its legal and factual bases for dismissal in cases involving marijuana.”
The bankruptcy court concluded that the U.S. Trustee had not “established any ongoing violation” of the Controlled Substances Act (CSA) and had not shown that a subsequently appointed trustee “would have to engage in a violation of the CSA.” Furthermore, the bankruptcy court found that the plan to liquidate that stock to pay creditors would (in fact) terminate any connection with cannabis.
Although, Hacienda did structure its own liquidation in a manner designed to maximize the value derived from its connection with cannabis, “which might be characterized as an indirect way to ‘profit from’ the cannabis business.” This interpretation of the CSA, according to the bankruptcy court, goes too far: “This appears to be the opposite of an intent to profit from an ongoing scheme to distribute cannabis.”
The bankruptcy court went on to hold that “the lack of any demonstrated illegality, now or in the foreseeable future, is one ground for denial” of the U.S. Trustee’s motion to dismiss.
It is simply not enough that there might have been a violation of the CSA: “Dismissing every case that had a connection with illegal activity would be contrary to Congress’ directives under the Bankruptcy Code” and “would harm the constituencies that Congress attempted to protect.”
Accordingly, the bankruptcy court concluded that the U.S. Trustee had not shown “sufficient cause for dismissal.”
The bankruptcy court’s ruling is promising. There are a long line of cases that hold the opposite position – courts have historically sided with the most tenuous of connections between the debtor and cannabis to find cause to dismiss a pending bankruptcy. Here, however, the court’s reasoning appears in line with the proposition that bankruptcy is not unavailable as a matter of law for the cannabis debtor.
To be fair, the decision is still subject to appeal and it is limited. Hacienda is the perfect debtor in that it walked into bankruptcy court without an operating cannabis business and having sold all of its cannabis-related operating assets. There is also the “hanging” question of Hacienda’s assets comprising completely of stock in an operating cannabis business. Setting that aside, the Hacienda bankruptcy court touches on all the arguments supporting bankruptcy for cannabis, including the argument that to deny bankruptcy protection now would only harm those that benefit from a bankruptcy – namely the creditors.
In re Roberts – Hope in Colorado?
It should be noted that another case in Colorado also signals at the potential crack in the wall. In In re Roberts, the Bankruptcy Court of the District of Colorado held that a debtor’s alleged ownership interest in cannabis-related companies did not require a dismissal of the case and that a Chapter 7 trustee could administer the debtor’s assets.
The bankruptcy court rejected the debtor’s argument that his cannabis-related investments require that the case be dismissed, rather than converted to a Chapter 7, noting that the debtor voluntarily sought relief under Chapter 11 with knowledge of his interests in these companies. Although the debtor alleged that he had an ownership interest in two companies that are involved in the cannabis industry, the specific nature of those companies’ business and the extent of the debtor’s ownership interest remained unclear.
The bankruptcy court explained that, although the debtor’s conduct may have violated the CSA, “a bankruptcy court must be explicit in articulating its legal and factual basis for dismissal for cases involving marijuana,” and the bankruptcy court found that it lacked adequate information on the record to explicitly articulate the factual basis for dismissal.
The Roberts decision, like the Hacienda ruling, may be the cracks in that “insurmountable wall” the cannabis industry has been waiting for vis a vis bankruptcy. A debtor’s involvement in cannabis or cannabis-related business alone is not an automatic death knell to a debtor seeking bankruptcy relief.