Before the onset of COVID-19, the cannabis industry was facing a series of challenges: a more difficult than expected regulatory environment, disappointing sales, and a “capital crunch” as potential sources of financing narrowed. With the outbreak of the coronavirus, those challenges have only been exacerbated, despite cannabis businesses being deemed “essential business” in almost every state in which they operate. These challenges may leave less financially secure cannabis businesses insolvent.[1]

 

Author: Jacob Setton

Contact: Jacob jsetton(at) fordham.edu

 

Generally, firms facing insolvency enter into the bankruptcy system to either restructure (Chapter 11) or arrange for the orderly liquidation of assets (Chapter 7). This process is governed by a federal law known as the Bankruptcy Code (“Code”). However, due to the illicit status of marijuana, a Schedule I substance under the Controlled Substance Act, [2] and because the bankruptcy code cannot be used to facilitate federally illegal activity or administer assets that cannot be possessed or sold under federal law, federal bankruptcy protection is not available to the cannabis industry.[3] Bankruptcy courts thus far have dismissed cannabis-related cases on the grounds that: (a) the bankruptcy trustee cannot possibly administer the assets without violating federal law[4] and (b) Section 1129 of the Code, the good faith requirement, would be violated because such a plan would necessarily seek to breach federal law.[5]

The Code offers several advantages to debtors that are unavailable to cannabis enterprises. The most important provision is the “automatic stay,” which requires creditors to halt their debt-collection efforts when a firm enters bankruptcy.[6] Additionally, the automatic stay activates bankruptcy’s centralized process for resolving creditor claims, thus avoiding expensive duplicitous lawsuits. If the debtor is ultimately liquidated, its assets are sold off in a coordinated, auction, which helps avoiding fragmentation that depresses sales prices.[7] In addition, businesses hoping for a reorganization are empowered by the Code under the right circumstances to obtain credit and incur new debt that they would not have been able to receive otherwise, known as Debtor in Possession Financing (“DIP Financing”).[8]

Since domestic bankruptcy is currently unavailable under federal law, some industry analysts and forward-thinking attorneys have suggested a workaround for cross-border insolvencies under the Canadian Bankruptcy Insolvent Act.[9] Chapter 15 of the Code offers bankruptcy protection within the United States to debtors that are the subject of an insolvency proceeding in another country, in order to provide comity with foreign courts and foreign bankruptcy proceedings. Chapter 15 was enacted in 2005 to “incorporate the Model Law on Cross-Border Insolvency so as to provide effective mechanisms for dealing with cases of cross-border insolvency,”[10] and to facilitate cooperation between the courts and other competent authorities of the United States with foreign countries in cross-border insolvency cases.[11]

In order to begin a Chapter 15 case, a foreign representative[12] authorized to administer a foreign debtor’s estate must file a petition for recognition of a foreign proceeding in a U.S. bankruptcy court. If the bankruptcy court recognizes the foreign proceeding under Chapter 15, the foreign representative is entitled to seek substantive relief in U.S. bankruptcy court.[13] In theory, this would allow for a cannabis business with operations in Canada to file for bankruptcy in Canada (where cannabis is legal), and then have a representative file a petition under Chapter 15 of the Code in an American bankruptcy court seeking recognition of the Canadian proceeding to administer its operations and assets in the United States. If allowed, cannabis businesses would be able to benefit from the automatic stay, restructure their debts, and either emerge as a stronger company after bankruptcy or liquidate in an orderly fashion that maximizes value for stakeholders. Canadian cannabis companies are able to use the Canadian Bankruptcy and Insolvency Act to restructure.[14]

Section 1506: Public Policy Objection

The cross-border insolvency approach under Chapter 15 of the Code has not yet been tried in a bankruptcy court in the United States for cannabis companies with cross-border operations. A cannabis debtor that is seeking Chapter 15 recognition of a Canadian bankruptcy proceeding should expect the United States Trustee to dispute the filing.[15] The U.S. trustee will look to §1506, a public policy objection, which permits a U.S. bankruptcy court “to refuse to take an action governed by Chapter 15… if the action would be manifestly contrary to the public policy of the United States.”[16] The United States Trustee would argue that because cannabis is illegal under federal law it would be “manifestly contrary to the public policy of the United States”[17] to allow cannabis businesses to benefit from bankruptcy proceedings they would not otherwise have received under the Code.

However, the interpretation above, is not the natural meaning of the public policy exception or the words “manifestly contrary to the public policy of the United States.” In fact, the burden for proving that the requested relief in Chapter 15 is “manifestly contrary” to public policy is extraordinarily high.[18] lthough the Bankruptcy Code does not e

Statutory Interpretation:

The words “manifestly contrary to … public policy” were adopted from the model law put forth by the United Nations Commission on International Trade Law (UNCITRAL).[19] When creating the Bankruptcy Code in 2005, Congress inserted this model law almost verbatim into Chapter 15.[20] Therefore, UNCITRAL’s interpretation of the words is instructive as to their true meaning. The UNCITRAL Model Law Guide (“Guide”) explains that this article should be limited to only those policies that reflect “fundamental principles of law” and that courts should only use this exception when the application of foreign law would contravene those principles.[21] While there is no statutory definition, the word “manifestly” in international usage restricts the public policy exception to the most fundamental policies.[22] In an international context this has meant that relief sought violates the constitution or a similarly fundamental policy of the state.[23]As such, the public policy exception should be construed strictly in the context of international business relations and in recognition of foreign laws and acts of foreign states. This interpretation is also in line with the statute’s purpose of promoting international cooperation.

Section 1506:

The public policy exception of §1506 provides an exception to the presumption in favor of comity and recognition of the proceedings of other countries. The word “manifestly” was added as a qualifier to public policy in §1506 in order to emphasize that the exception should be interpreted restrictively to protect only the most fundamental policies of the United States.[24] Indeed, the legislative history and the accompanying text that resulted in Chapter 15 is consistent with a strict interpretation of “manifestly contrary”. The House Report states that §1506 “follows the model law article 5 exactly, … and has been narrowly interpreted on a consistent basis throughout the world.”[25] The reason that the Model Law, and thereby §1506, restrict this exception to fundamental public policy is that “international cooperation would be unduly hampered if public policy would be understood in an extensive manner.”[26]

Application of §1506 by Bankruptcy Courts:

Furthermore, the bankruptcy courts in practice have only utilized the public policy exception in exceptional circumstances concerning matters of fundamental importance to the United States.[27] In determining whether or not to apply §1506, the courts have focused on two factors, the first is whether the foreign proceeding violates “fundamental standards of procedural fairness”[28] and secondly, whether the application of foreign law or the recognition of a foreign proceeding under Chapter 15 would severely “impinge upon” the value of a U.S. statutory or constitutional right, and hinder bankruptcy courts’ ability to administer a Chapter 15 case.[29] Those who oppose the recognition of a proceeding under Chapter 15 “bear the burden of proof”[30] – as a bankruptcy judge explained “it is obliged, as reflected in the mandatory nature of section 1517, to err on the side of recognition, subject only to what… is treated uniformly as a narrow exception.”[31] In In Re Creative Fin., the bankruptcy court held that “the most blatant effort to hinder, delay, and defraud a creditor this Court had ever seen” did not rise to the public policy exception of §1506.[32] The court held that although the conduct was “offensive” it did believe that §1506 had been “inappropriately invoked to deal with it”.[33] If a case that the court recognized as a bad faith abuse of the law was not a good enough reason to trigger the public policy exception, it stands to reason that the court has recognized in practice the high bar for triggering the public policy exception.

The only cases in which the burden was met included elements of an abrogation of basic notions of justice or a violation of direct constitutional rights. The first case in which the burden was met In re Toft, the foreign representative initiated the Chapter 15 proceeding for the sole purpose of accessing the debtors private email accounts stored on US servers. The court held that the burden was met when granting that the cross-border proceeding “would directly compromise privacy rights … incorporated in the fourth amendment as well as constitutions of many states.”[34] Rights protected by the Constitution of a State have uniformly been considered a valid trigger for the application of a public policy exception.[35]

In the second case, In re Gold & Honey, the court refused to recognize an Israeli receivership based on the §1506 exception. In this case, the petitioners were appointed as receivers in Israel in violation of an automatic stay already issued by the U.S. bankruptcy court. The court writes that “recognition of the Israeli receivership… would be manifestly contrary to the public policy of the United States because such a recognition would reward and legitimize… violation of the automatic stay and this Court’s orders regarding the stay.”[36] While this case did not implicate constitutional issues, the court held that a public policy exception should be triggered when it is inconsistent with basic notions of justice. In this case, granting the foreign order sought in violation of the same court’s automatic stay order would be rewarding the “wrongdoer for his wrongdoing.”[37]

These cases demonstrate that the burden to overcome the presumption of recognition of a foreign proceeding based on a public policy decision is both difficult to meet and must be met on constitutional grounds — or at least grounds that implicate basic notions of justice. Therefore, as noted previously, the court has repeatedly held that “the public policy exception should only be invoked when the most fundamental policies of the United States are at risk.”[38] While the violation of constitutional rights or basic notions of justice is a necessary condition for overcoming this burden, it is by no means a sufficient one. For example, in Re Epherda Prods, the court found that certain provisions approving a claims resolution in Canada had violated important due process rights.[39] However, upon request from the court, the foreign representative amended the claims resolution in order to cure the due process violations, and the bankruptcy court recognized the foreign claims proceeding. As a bankruptcy court explained, “even the absence of certain procedural or constitutional rights will not itself be a bar under Section 1506.”[40]

In addition, the court has repeatedly refused to recognize the public policy exception in many cases in which §1506 was invoked and resulted in a different outcome than would have occurred under the Code and laws of the United States.

In In re Metcalfe, the bankruptcy court stated that “the relief granted in the foreign proceeding and the relief available in a U.S. proceeding need not be identical.”[41] The court in In re Rede Energia, held that even when the U.S. courts have conflicts of law with an international body, deference is given to the foreign court. In that case, a Brazilian bankruptcy court a) permitted substantive consolidation, even though a U.S. court would not have granted substantive consolidation under a similar circumstance, and b) approved the debtors plan despite differences between the U.S. and Brazilian cram-down rules.[42] Additionally, in In re Petroforte Brasileiro de Petroleo Ltda., the court held that even if the debtors would not even be in court if this were US law, the public policy exception is not met. In that case, the bankruptcy court refused to invoke the public policy exception even though extending the bankruptcy case to the debtors was “manifestly unjust and contrary to U.S. law because [the movants] could not have been brought in as debtors under U.S. law”.[43]

These decisions support the conclusion that even though the application of foreign law leads to a different result than US law, or that the foreign law is different than U.S. law is insufficient to support a §1506 public policy exception. The court explained in In re Rede Energia that when “the proceedings in the foreign court progressed according to the course of a civilized jurisprudence and where the procedures followed in the foreign jurisdiction meet our fundamental standards of fairness, there is no violation of public policy”.[44]

What does this mean for Cannabis businesses?

Utilizing Chapter 15 has not yet been tested for cannabis businesses in U.S. bankruptcy court.[45] herefore, the results of such a proceeding are difficult to predict with certainty. However, a bankruptcy court can legitimately hold that the recognition of a Canadian insolvency proceeding does not violate the public policy exception. In determining whether to apply §1506 the courts have focused on two factors, procedural fairness, and whether the recognition of a foreign law would impinge upon the value of a U.S. Statutory or Constitutional right (fundamental right).[46]

The condition of procedural fairness is easily met by a cannabis business that has operations in Canada and the United States. Canadian bankruptcy procedure has been viewed as fair and is routinely recognized as fair by United States courts in bankruptcy and other contexts.[47] The bankruptcy court has held, as previously noted, “when the proceedings in a foreign court … meet our fundamental standards of fairness, there is no violation of public policy.”[48]

The second part of the test is whether the relief sought infringes upon the value of a U.S. Statutory or Constitutional right will be more difficult to apply in a U.S. bankruptcy court. However, section 1506 is a narrowly tailored exception, and the party invoking the exception bears the burden of proof.[49] The bankruptcy courts have held repeatedly that the burden that must be met to trigger the public policy exception is an extraordinarily high bar.[50] The bankruptcy courts have held that in order to qualify for a public policy exception, the violation has to rise to the level on a fundamental policy, which it determined to mean inherent in the constitution or a large abrogation from our intuitive sense of justice.[51]

Forty-eight states have some form of decriminalized cannabis program, therefore state-legalized marijuana is likely going to affect an increasing number of debtors. Allowing a cannabis company to access Chapter 15 of the Code would promote US policy interests of a) affording relief to honest debtors, b) ensuring the equitable distribution of assets to the creditors of the debtor and c) protecting a nascent US industry.

Even if cannabis were illegal in every state, providing a Chapter 15 bankruptcy proceeding is insufficient for triggering the public policy exception. It is arguably a violation of a federal statute, which is not the equivalent of a policy that is “manifestly contrary” to U.S. public policy. As the court explained in In re Fairfield Sentry Ltd. “Section 1506 does not create an exception for any action under Chapter 15 that may conflict with public policy, but only an action that is ‘manifestly contrary’.”[52] A cannabis company in the United States is not violating any constitutional laws when a cross-border bankruptcy proceeding is permitted. The purpose of Chapter 15 is to preserve international comity. Permitting the court to deny bankruptcy protection in Canada to cannabis businesses in the United States, would defeat the purpose of Chapter 15, which is to focus on international collaboration and cooperation.[53] The model guide provides for a narrow public policy exception. Congress recognized that narrow intention, when it chose to adopt that language in Chapter 15.[54] Providing cannabis businesses with cross border bankruptcy proceeding, doesThe best way to effectuate the statute would be to provide cross border bankruptcy under Chapter 15 to cannabis businesses.

The bankruptcy courts thus far have repeatedly held for a trustee to engage in any administration of the bankruptcy estate for a cannabis company would violate the Controlled Substances Act. However, in a Chapter 15 case, the courts have held repeatedly that diverging outcomes from what would have resulted in a U.S. bankruptcy proceeding does not violate the public policy exception of Chapter 15. It would similarly violate US bankruptcy law for the court to uphold a plan confirmed in a foreign jurisdiction that violates the absolute priority rule,[55] or one that discriminates amongst similarly situated creditors[56]— however those priorities of US law have been overlooked by the bankruptcy courts when confirming Chapter 15 cases. Chapter 15 Cases have been confirmed even in the cases in which the debtors would not have otherwise had standing to access to the bankruptcy courts in the United States.[57] Therefore, even though cannabis businesses would not be able to access the courts in a traditional bankruptcy setting, it has no bearing on whether or not they can utilize the cross-border insolvency statute of Chapter 15. As the Fourth Circuit Court eloquently stated in Jaffe “The fact that application of foreign law leads to a different result than application of U.S. law is, without more, insufficient to deny comity. It is therefore clear that a conflict between foreign law and U.S. law is not sufficient to constitute a §1506 exception. There can be little doubt that the whole purpose of chapter 15 would be defeated if local or parochial interests routinely trumped the forum law of the main proceeding.”[58] Allowing a cannabis companies bankruptcy proceeding to proceed would allow a forum for the debtors likely substantial creditor body the right to an orderly and equitable distribution of the estates assets, and the potential to augment the value of the estate through the exercise of the trustees avoidance powers in bankruptcy.

When considering whether the violation of a specific federal law in enforcing the bankruptcy proceeding is “manifestly contrary” to public policy, the goals of protecting creditors and debtors, and ensuring the equitable distribution of the estate should be strongly considered against the violation of the Controlled Substances Act. This is particularly true in the case of a liquidation, in which the trustee could destroy the cannabis product, and distribute the property assets of the estate, which arguably would not violate the federal law.[59] Chapter 15 recognizes the importance of international comity and is written in a way that favors recognizing foreign law even when it contravenes US law. When it comes to cannabis, the acceptance of the industry in almost every state is indicative of a federal law that is out of touch with US state policy and therefore should not be considered a policy that is “manifestly contrary” to public policy.

 

Conclusion:

U.S. courts should interpret the public policy exception of §1506 narrowly when applying it to cannabis businesses. The purpose of the chapter is to focus on international collaboration and cooperation. To that end, the courts have held an extraordinarily high bar to qualify for the public policy exception– namely a violation of a constitutional right, or an abrogation of our fundamental sense of justice. A cannabis company in the United States is not violating any additional laws when permitted to engage in a cross-border bankruptcy proceeding. Strictly because the outcome of a bankruptcy procedure would have turned out differently in a foreign court as it would in a United States court is insufficient to satisfy the public policy exception of §1506. In fact, public policy would be better served by allowing cannabis companies to engage in Chapter 15 bankruptcy proceedings. There is no constitutional right at stake, no harm to creditors, nor is there a particularly strong public policy to ensure that cannabis companies that already exist and are operating cannot access Chapter 15 of the Code. As the economy continues to dwindle as a result of COVID-19, new industries will be necessary to pull the United States out of a recession. Allowing for cannabis business to access bankruptcy will allow for cheaper capital for new investments into a growing industry that will help put Americans back to work. Additionally, it provides creditors and debtors alike with a forum to efficiently reorganize and liquidate their assets. Bankruptcy courts should allow cannabis businesses to access cross-border bankruptcy, under Chapter 15 of the Code.

SOURCES

[1] Tom Angell, Coronavirus Crisis Shows Marijuana Is ‘Essential’ and Mainstream, Marijuana Moment, https://www.marijuanamoment.net/coronavirus-crisis-shows-marijuana-is-essential-and-mainstream/ (last updated Mar. 23, 2020).

[2] Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. §§ 801, Et. Seq (1970).

[3] See Steven Schain, CANNABIS Financial Hardship SOLUTIONS: WORKOUTS, RECEIVERSHIPS, AND ASSIGNMENTS FOR THE BENEFIT OF CREDITORS, Hoban Law Group, https://hoban.law/2020/04/cannabis-financial-hardship-solutions-workouts-receiverships-and-assignments-for-the-benefit-of-creditors/ (last updated Apr. 6, 2020)

[4] See Arenas v. U.S. Trustee (In re Arenas), 535 B.R. 845, 852-53 (10th Cir. BAP 2015).

[5] See In re Medpoint Mgmt., LLC, 528 B.R. 178, 184-87 (Bankr. D. Ariz. 2015)

[6] Squire, Richard. Corporate Bankruptcy and Financial Reorganization (Aspen Casebook Series) (p. 13). Wolters Kluwer. Kindle Edition.

[7] Id.

[8] Id. at 251.

[9] Nick Thomas, Some Struggling US Cannabis Companies May Look to Canada for Possible Bankruptcy Protection, Mjbizdaily (Feb. 5, 2020), https://mjbizdaily.com/some-struggling-us-cannabis-companies-may-look-to-canada-for-possible-bankruptcy-protection/

[10] 11 U.S.C § 1501(a).

[11] Id.

[12] See 11 U.S.C § 1504 (A “foreign representative” is the person or entity authorized in the foreign proceeding “to administer the reorganization or liquidation of the debtor’s assets or affairs or to act as a representative of such foreign proceeding.”)

[13] See 11 U.S.C § 1507; see also 11 U.S.C § 1521.

[14] Aurora Cannabis Buying Late-Stage ACMPR Applicant Peloton Pharmaceuticals, New Cannabis Ventures (Mar. 6, 2017), https://www.newcannabisventures.com/aurora-cannabis-buying-late-stage-acmpr-applicant-peloton-pharmaceuticals/

[15] Clifford J. White III & John Sheahan, Why Marijuana Assets May Not Be Administered in Bankruptcy, Justice.gov, https://www.justice.gov/ust/file/abi_201712.pdf/download

 

[16] 11 U.S.C § 1506

[17] Id.

[18] In re Quimonda AG, 470 B.R. 374,387 (E.D Va. 2012) (“Those courts that have addressed [Section 1506] . . have made one thing very clear: it should be invoked only in extremely narrow circumstances.”).

[19] UNCITRAL Model Law on Cross Border Insolvency with Guide to Enactment and Interpretation, (2014) [hereinafter UNCITRAL Model Law and Guide], available at http://www.uncitral.org/pdf/english/texts/insolven/1997-Model-Law-Insol-2013-Guide-Enactment-e.pdf

[20] See Fogerty v. Petroquest Res., Inc. (In re Condor Ins. Ltd.), 601 F.3d 319, 322 (5th Cir. 2010) (noting that Chapter 15 closely hewed to the text of the enactment and that any departures from the actual text of the Model Law were as narrow and limited as possible.); see also 11 U.S.C. § 1501 (discussing the purpose and scope of application of Chapter 15).

[21] Supra note 19.

[22] See In re ABC Learning Ctrs. Ltd., 728 F.3d 301, 309 (3d Cir. 2013) (“The purpose of the expression ‘manifestly’ . . . is to emphasize that public policy exceptions should be interpreted restrictively and that [the exception] is only intended to be invoked under exceptional circumstances concerning matters of fundamental importance for the enacting State.”) (quoting Supra note 19.)

[23] Supra note 19.

[24] Supra note 22.

[25] H.R. REP. NO 109-31, at 109 (2005).

[26] Supra note 19 at art. 6.

[27] See In re Rede Energia S.A., 515 B.R. 69, 92 (Bankr. S.D.N.Y. 2014) (noting that “public policy exception” is to be applied “sparingly).

[28] In re Metcalfe & Mansfield Alt. Invs., 421 B.R. 685, 697 (Bankr. S.D.N.Y. 2010).

[29] Supra note 18 at 570.

[30] In re Ashapura Minechem Ltd, 480 BR at 139.

[31] Transcript of Hearing Before Honorable Brendan L. Shannon, United States Bankruptcy Judge, 14 November 2017, at 9:00 am, at 43 [ECF No. 87].

[32] In re Creative Fin., Ltd., 543 B.R. 498, 502 (Bankr. S.D.N.Y. 2016) (emphasis added).

[33] Id.

[34] In re Toft, 453 B.R. 186, 195-96 (Bankr. S.D.N.Y. 2011)

[35] Supra note 19.

[36] In re Gold & Honey, Ltd., 410 B.R. 357 (Bankr. E.D.N.Y. 2009).

[37] Michael Garza, Case Note, When Is Cross-Border Insolvency Recognition Manifestly Contrary to Public Policy, 38 Fordham Int’l L.J. 1618 (2015).

[38] In re Vitro SAB de CV, 701 F.3d 1031, 1069 (5th Cir. 2012); see also, In re Fairfield Sentry Ltd., 714 F.3d at 139; see also In re ABC Learning Ctrs. Ltd., 728 F.3d 301, 309 (3d Cir. 2013).

[39] Supra note 27 at 78.

[40] In re OAS S.A., 533 B.R. 83, 104 (Bankr. S.D.N.Y. 2015).

[41] Supra note 28 at 685.

[42] Supra note 27 at 69.

[43] In re Petroforte Brasileiro de Petroleo Ltda., 542 B.R. 904, 906 (Bankr. S.D. Fla. 2015).

[44] Supra note 27 at 69.

[45] Thomas, supra note 9.

[46] Supra note 28.

[47] In re Sino-Forest Corp., 501 B.R. at 663 (Holding the U.S. and Canada share the same common law traditions and fundamental principles of law. Canadian courts afford creditors a full and fair opportunity to be heard in a manner consistent with standards of U.S. due process.).

[48] Supra note 27 at 69.

[49] Supra note 30.

[50] Supra note 18.

[51] Supra note 27.

[52] Supra note 38.

[53] Supra note 19.

[54] Supra note 25.

[55] Supra note 38.

[56] Supra note 27.

[57] Supra note 33.

[58] Jaffe v. Samsung Elecs. Co., 737 F.3d 14, 29 (4th Cir. 2013).

[59] Steven J. Boyajian, “Just Say No to Drugs? Creditors Not Getting a Fair Shake When Marijuana-Related Cases Are Dismissed,” ABI Journal, September 2017, at 24.