Authored By: Stephanie McGraw and Sonila Themeli[1]

Stephanie McGraw Partner Houston

Sonila Themeli Associate Houston

 

Even before the COVID-19 pandemic decimated financial world markets, the cannabis[2] industry was navigating uncertain regulatory and economic terrain. Its legal status continues to evolve at both the state and federal levels, and despite major shifts in state legalization, marijuana remains a Schedule 1 drug under the Federal Controlled Substances Act (“CSA”).[3] With hyped expectations of exponential growth in 2020,[4] investment in cannabis companies boomed in 2019. However, the boom eventually led to a liquidity crunch—marijuana businesses are faced with high taxes, costly regulatory state and local barriers, and competition with unregulated and un-taxed illegal actors. In fact, despite the rosy projections, 2019 saw cannabis stocks plummet because of unmet earnings projections and overly optimistic expectations.[5] This was followed by a widespread retreat of investors, which in turn resulted in many deals and expansion plans being delayed or cancelled.[6] Although many states deemed cannabis and CBD dispensaries “essential” businesses during the global shutdown, thereby enabling them to continue to serve the public, others did not, and the impact on the industry has been mixed.[7]

The cannabis industry must now attempt to rebound in the midst of an ongoing pandemic; however, unlike other industries, it has less tools available to it.[8] With bankruptcy and its protections generally unavailable, marijuana producers and the ancillary industries that serve them must look elsewhere for ways to liquidate or restructure businesses and seek protections from creditors. This article provides an overview of the current state of the legal developments in bankruptcy proceedings of marijuana-related businesses and state-based options these businesses may utilize.

 

Bankruptcy: an Equitable Remedy Unavailable to the Cannabis Industry

Bankruptcy is one avenue a business in distress can take to seek protection from creditors. It is an equitable remedy. During a bankruptcy proceeding, an automatic stay protects the debtor from its creditors allowing it to rehabilitate or reorganize its “finances and to promote a ‘fresh start’ through the orderly disposition of assets to satisfy his creditors.”[9] As equitable courts, bankruptcy courts “should invoke equitable principles and doctrines, refusing to do so only where their application would be inconsistent with the Bankruptcy Code.”[10] However, lack of good faith on the part of the debtor will bar a debtor from the relief and the broad protection afforded by the courts.

Importantly for the cannabis industry, bankruptcy courts are federal courts and bankruptcy proceedings and the protections afforded by them are governed by federal law. Under the Supremacy Clause, the federal government’s designation of marijuana as a controlled substance supersedes any contrary state law.[11] In 2017, the director of the U.S. Trustee Program (“USTP”) proclaimed that “debtors with assets or income derived from marijuana may not proceed through the bankruptcy system.”[12] He explained that the “USTP’s response to marijuana-related bankruptcy filings is guided by two straightforward and uncontroversial principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed. Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal criminal law.”[13] The USTP directed bankruptcy trustees nationwide to report all bankruptcy cases with marijuana-related activities to the USTP and made clear its intention to move to dismiss all such bankruptcy actions.[14]

 

Little Relief for Marijuana Growers and Dispensaries Under the Bankruptcy Code

Although courts have not adopted “per se bright-line rules requiring the immediate disposition of bankruptcy cases in which marijuana activity is present,”[15] bankruptcy courts have consistently held that bankruptcy relief is not available to debtors engaged in the cultivation, processing and/or sale of marijuana, regardless of the chapter under which the debtors may seek such relief.[16]

For example, in In re Arenas, the bankruptcy court found that while the debtors’ business activities—cultivation and sale of marijuana and marijuana products—were lawful under Colorado law, they violated the CSA.[17] The court concluded that the debtors’ Chapter 13 reorganization “would be funded from profits of an ongoing criminal activity under federal law and would necessarily involve the Chapter 13 Trustee in administering and distributing funds derived from the Debtors’ violation of the CSA.”[18] The court reasoned that because any reorganization plan “would necessarily be executed by unlawful means,” that is the cultivation, processing, and distribution of marijuana, the court could not find under 11 U.S.C. § 1325(a)(3) that the debtors’ plan was “proposed in good faith and not by any means forbidden by law.”[19] The Tenth Circuit affirmed the dismissal of the debtor’s case.[20]

 

Difficulties for Ancillary Businesses Seeking Relief in Bankruptcy

Businesses that derive part of their income from providing ancillary services to the marijuana industry face the same risk of dismissal in bankruptcy court. Landlords that rent property to a marijuana business have found bankruptcy relief is not available to them. For example, in In re Rent-Rite Super Kegs West Ltd.,[21] the debtor derived part of its revenue from leasing warehouse space to marijuana growers. Relying on the CSA, the court reasoned that “[e]ven if the Debtor is never charged or prosecuted under the CSA,” and even though marijuana cultivation was legal under Colorado law, the debtor’s business “involve[d] a continuing violation of the federal Controlled Substances Act.”[22] The court concluded that “a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”[23] The court dismissed the case.

In re Way to Grow, Inc.[24] yielded a similar result. The debtors here sold equipment for indoor hydroponic and gardening supplies. The debtors represented to the court that they sold their products to marijuana producers and their future business expansion plan was tied to the growing cannabis industry.[25] Relying on various provisions of the CSA, the court concluded that the debtors’ business violated the CSA because the debtors knowingly marketed to and sold their “products to customers who [used them] to manufacture a controlled substance in violation of the CSA.”[26]

Creditors have not fared any better. In In re Basrah Custom Design, Inc.,[27] the Court found that both the debtor—the business that had leased the space to a medical marijuana dispensary—and the creditor—the medical marijuana dispensary—had “unclean hands” because their activities constituted a federal crime and were thus not entitled to the protections of the Code.[28]

 

Holders of Interests in Cannabis Businesses

Investors face similar hurdles in bankruptcy proceedings. In In re Malul,[29] the court found that an investor in a cannabis business is precluded from bankruptcy relief because the debtor’s interest in the marijuana company was illegal under federal law.[30] The court explained that under section 854 of the CSA,[31] it was illegal for the owner of the marijuana business to incorporate the company, solicit investments, and sell securities in the business.[32] At the same time, it was illegal for the debtor to execute a subscription agreement with the owner of the business, own an interest in the company, and accept distributions on account of those interests even though the business had no assets or operations at the time of the filing of the petition.[33]

 

Equitable Extension of Protections over Cannabis Companies –
A Glimmer of Hope?

Some courts, however, have avoided such a strict stance and used their discretion to devise some form of relief for debtors with ties to the marijuana industry. One recent example is Garvin v. Cook Investments NW, SPNWY, LLC,[34] which appears to give marijuana businesses or at least ancillary businesses some hope that bankruptcy court may soon be accessible to them. In Garvin, one of the Chapter 11 debtors leased property to a marijuana business. The U.S.T. moved to dismiss, but the court denied the motion on the debtors’ representation that an amended plan would include a rejection of the lease with the marijuana grower and payments under the plan would not depend on a source that violates federal law. The court gave the U.S.T. leave to renew the motion at the time of confirmation of the amended plan. The U.S.T. did not renew its motion, and the court confirmed the plan over the trustee’s subsequent objections that the plan violated section 1129(a)(3)’s requirement that a plan be “proposed in good faith and not by any means forbidden by law.”[35]

On appeal, the trustee again argued that that debtors’ plan be dissolved because the debtor violated the CSA by leasing premises to the marijuana business. In affirming, the Ninth Circuit reasoned that whether the debtors’ plan was confirmable depended “on whether § 1129(a)(3) forbids confirmation of a plan that is proposed in an unlawful manner as opposed to a plan with substantive provisions that depend on illegality.”[36] The court framed the question as one of statutory interpretation and not as one of conflict between federal and state laws. [37] It concluded that “section 1129(a)(3) directs courts to look only to the proposal of a plan, not the terms of the plan.”[38] Here, the court reasoned, the plan was lawfully proposed and met the requirements of section 1129(a), even though rent payment from the marijuana grower provided “at least indirect support” for the plan.[39]

 

What Options Are Available to Distressed Cannabis Companies?

With bankruptcy protections at best uncertain and at worst largely unavailable, distressed marijuana and ancillary businesses have at least two alternatives to federal bankruptcy proceedings: assignments for the benefit of creditors (ABC) and receiverships. Both are governed by state law.

 

Assignments for the Benefit of Creditors

ABCs are governed by state statutory or common law.[40] An ABC involves the voluntary transfer by deed of an insolvent debtor’s assets (assignor) to a third-party fiduciary (assignee).[41] The assignee, usually a disinterested third-party with expertise not only in liquidating businesses but also in the debtor’s industry,[42] is selected by the assignor. He is responsible for liquidating or going concern sale of the assignor’s assets to satisfy the creditors’ claims against the assignor.[43] However, ABCs cannot be used to restructure or financially rehabilitate distressed businesses.[44]

Although the process is similar to Chapter 7 bankruptcy liquidation, there are a few fundamental differences between ABCs and bankruptcy. First, unlike filing a bankruptcy petition, “a distressed corporation will generally need to obtain both board of director authorization and shareholder approval” in order to begin the ABC process.[45] Second, in many states, including California, the ABC process will occur without the involvement of the court.[46]

Also, in an ABC, the transfer of assets is subject to all existing liens, and the assignee does not have the ability to sell the property free and clear of liens.[47] Further, any executory contracts and leases cannot be assigned without the consent of the counter party to the contract,[48] and the assignor’s debts are not discharged.[49] Importantly, there is no automatic stay protection in ABCs, as there is in bankruptcy proceedings,[50] to prevent secured creditors from foreclosing against their collateral.[51]

Finally, a critical difference between ABCs and bankruptcy is that ABCs have limited territorial jurisdiction. This requires that the assignor consolidate its assets in one state before it begins the ABC process.[52]

ABCs can, however, be liquidation vehicles superior to bankruptcy. Due to the lack of judicial oversight and the many statutory provisions governing bankruptcy proceedings, ABCs can often be more cost- and time-efficient as well as more flexible than a Chapter 7 liquidation case.[53] Another important advantage of ABCs is the lack of negative publicity that bankruptcy often attracts.[54]

 

Receiverships

A receivership is an involuntary judicial proceeding typically initiated by a creditor with liens against the distressed company’s assets that will also seek, as one of its remedies, that the court appoint a receiver to preserve, manage, and dispose of the assets of the company.[55]

A receiver is an agent and officer of the court who acts only on behalf of the court and exercises the court’s jurisdiction over the distressed company’s assets.[56] He is also a fiduciary who acts for the benefit of all interested parties.[57] The receiver will operate the distressed business as profitably as possible and market the debtor or its assets for sale. Receiverships are less costly than a Chapter 11 bankruptcy proceeding. Unlike bankruptcy, no creditors’ committee is appointed in a receivership, and also no disclosure statement, plan, or confirmation hearing are necessary. This results in fewer parties being involved, fewer court filings, less time, and as a result, lower costs and attorneys’ fees. In addition, some states have passed regulations allowing receivers to operate a marijuana business during the pendency of the receivership, liquidate its assets, and distribute the proceeds to the creditors.[58]

 

Conclusion

The robust bankruptcy protections available to other industries are largely unavailable to companies with ties to the marijuana industry. State-based alternatives like ABCs and receiverships may offer some limited relief. Until Congress acts to deschedule marijuana, distressed cannabis companies will continue to face uncertainty in nearly every aspect of their business, including end stages.

[1] Stephanie is a partner in the Houston office of Shook, Hardy & Bacon L.L.P. Sonila is a senior associate, also in Shook’s Houston office. Their practices focus on pharmaceutical and medical device litigation, cannabis law, commercial litigation, and bankruptcy.

[2] For this article, marijuana is defined as any cannabis product with THC levels higher than 0.3%.

[3] 21 U.S.C. §§ 801 et seq. On December 20, 2018, President Trump signed the Agriculture Improvement Act of 2018 (2018 Farm Bill) removing hemp from the CSA. See 21 U.S.C.A. § 802(16)(B); 21 U.S.C. § 812; see also 7 U.S.C. § 1639o(1).

[4] The total legal sales of cannabis were projected to grow at a compound annual growth rate of 14% over the following six years, reaching nearly $30 billion by 2025. See New Frontier Data, “The U.S. Cannabis Report 2019 Industry Outlook,” https://newfrontierdata.com/cannabis-insights/u-s-cannabis-industry-market-projections-up-20-to-30-billion-by-2025. The estimated total of legal jobs in the industry in 2019 was 340,000, and was projected to grow to 743,000 by 2025. See New Frontier Data, “Potential Cannabis Market Job Growth,” https://newfrontierdata.com/cannabis-insights/potential-cannabis-market-job-growth/.

[5] https://www.nasdaq.com/articles/why-marijuana-stocks-plummeted-in-2019-2019-11-14;

https://fortune.com/2020/03/04/pot-stock-cannabis-companies-weed-industry/.

[6] https://www.washingtonpost.com/business/2020/04/14/california-weed-industry-coronavirus/;

https://fortune.com/2020/03/04/pot-stock-cannabis-companies-weed-industry/.

[7] https://www.cannabisbusinesstimes.com/article/covid-19-coronavirus-future-cannabis-industry/.

[8] No assistance will be available for the cannabis industry from the recently enacted Coronavirus Aid, Relief and Economic Security Act (CARES Act) because of the federal illegality of cannabis. https://www.cannabisbusinesstimes.com/article/sba-coronavirus-cannabis-operators/.

[9] Matter of Little Creek Dev. Co., 779 F.2d 1068, 1071 (5th Cir. 1986).

[10] In re Beaty, 306 F.3d 914, 922 (9th Cir. 2002) (internal quotations omitted).

[11] See Gonzales v. Raich, 545 U.S. 1, 29, 125 S. Ct. 2195, 2212, 162 L. Ed. 2d 1 (2005).

[12] Statement of Clifford J. White III, Director of the United States Trustees before the House Judiciary Committee’s Subcommittee on Regulatory Reform, Commercial and Antitrust Law on June 8, 2017. https://www.justice.gov/ust/file/testimony06082017.pdf/download.

[13] Id. at 2.

[14] Id.

[15] In re Burton, 610 B.R. 633, 639 (B.A.P. 9th Cir. 2020).

[16] A typical business can file for bankruptcy protection under Chapter 7 or Chapter 11 of the Code. See 11 U.S.C. §§ 101, 109; see also 11 U.S.C. §§ 701 et seq. 1101 et seq. Sole proprietorships or individuals operating unincorporated businesses may also file for bankruptcy under Chapter 13. See 11 U.S.C. §§ 101, 109; see also 11 U.S.C. § 1101 et seq.

[17] In re Arenas, 535 B.R. 845, 847 (10th Cir. BAP (Colo.) 2015).

[18] Id.

[19] Id. (emphasis in original); see also 11 U.S.C.A. § 1325(a)(3) (stating that the court will confirm a restructuring plan under Chapter 13 if “the plan has been proposed in good faith and not by any means forbidden by law.”).

[20] Id. at 847 (holding that “[t]here is no way the Trustee could administer the plan without committing one or more federal crimes.”)

[21] In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 802-04 (Bankr. D. Colo. 2012).

[22] Id. at 802.

[23] Id. at 805.

[24] In re Way To Grow, Inc., 597 B.R. 111, 114–15 (Bankr. D. Colo. 2018), aff’d sub nom. In re Way to Grow, Inc., 610 B.R. 338 (D. Colo. 2019).

[25] Id.

[26] Id.

[27] In re Basrah Custom Design, Inc., 600 B.R. 368, 385 (Bankr. E.D. Mich.), reconsideration denied, 602 B.R. 31 (Bankr. E.D. Mich. 2019).

[28] Id.

[29] In re Malul, No. 11-21140 MER, 2020 WL 1486775 (Bankr. D. Colo. Mar. 24, 2020)

[30] Id. at *5.

[31] Id. at *9; 21 U.S.C. § 854.

[32] In re Malul, 2020 WL 1486775 at *9.

[33] Id. at 9, 11; see also In re Andrick, 604 B.R. 577, 578 (Bankr. D. Colo. 2019) (the court did not confirm Chapter 13 plan where the individual debtor sought exemption for medical marijuana use).

[34] Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031, 1033 (9th Cir. 2019); see also Arm Ventures, LLC., 564 B.R. 77 (Bankr. S.D. Fla. 2017); In re Johnson, 532 B.R. 53, 59 (Bankr. W.D. Mich. 2015).

[35] Id. at 1033-34.

[36] Id. at 1033 (emphasis added).

[37] Id.

[38] Id. at 1035 (emphasis added).

[39] Id. at 1035-36.

[40] Andrew B. Dawson, Better than Bankruptcy?, 69 Rutgers U. L. Rev. 137, 146 (2016).

[41] In re N2N Commerce, Inc., 405 B.R. 34, 42–43 (Bankr. D. Mass. 2009) (quotations omitted); Carly Landon, Note, Making Assignments for the Benefit of Creditors as Easy as A-B-C, 41 Fordham URB. L.J. 1451, 1456-57, 1459 (2014).

[42] Landon 1459, 1465 (A Chapter 7 trustee, on the other hand, is often a lawyer or accountant, who is assigned cases in large numbers and may have no experience in the particular industry of the debtor or in running a business.).

[43] Dawson at 146; Landon at 1456.

[44] Id.

[45] Id. at 1458.

[46] Berman, supra note 14, at 4.

[47] Landon at 1467-68.

[48] Id.; see also 11 U.S.C. § 365.

[49] Dawson at 147.

[50] 11 U.S.C. § 362 (automatic stay in bankruptcy)

[51] Dawson at 147.

[52] Landon at 1468 (citing 28 U.S.C. § 1334).

[53] Id. at 1466.

[54] Id.

[55] See eg. Or. Rev. Stat. § 37.020; Wash. Rev. Code § 7.60.025.

[56] City of Chula Vista v. Gutierrez, 207 Cal. App. 4th 681, 685, 143 Cal. Rptr. 3d 689, 691 (2012) (citing Code Civ. Proc., § 568; Cal. Rules of Court, rule 3.1179.); Or. Rev. Stat. § 37.110.

[57] Id.

[58] See eg. Or. Admin. R. 845-025-1260; Wash. Admin. Code 314-55-137(a).