Guest post by Keith C. Owens, Partner at Fox Rothschild LLP
Like most American businesses, COVID-19 has placed a heavy strain on cannabis-related businesses, which were already struggling due to the highly-regulated nature of the industry, overplanting by farmers and competition from black market suppliers. While bankruptcy would be a useful tool to enable such companies to restructure their financial affairs or to liquidate in an orderly fashion for the benefit of creditors, bankruptcy has generally not been available. However, this may change under a Biden Administration[1] depending on the outcome of the Senate runoff races in Georgia in early January 2020, which will determine whether or not the Republicans maintain control of the Senate.
This article briefly discusses the current status of federal law, how Bankruptcy Courts have addressed bankruptcy cases filed by cannabis-related businesses, the potential impact of the 2020 federal elections on the right of cannabis-related businesses to seek bankruptcy relief, and alternatives to bankruptcy currently available.
Marijuana Remains an Illegal Schedule 1 Controlled Substance under Federal Law
Under the Federal Controlled Substance Act (the “FCSA”), it is illegal to rent, lease, or make available for use or profit from a location for the manufacture, storing or distribution of controlled substances. With few exceptions, federal law imposes criminal liability for aiding and abetting the unauthorized manufacture, distribution, or dispensing of marijuana, which is a Schedule 1 controlled substance.[2] Similarly, the FCSA makes it unlawful for any person knowingly or intentionally to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute or dispense a controlled substance. 21 U.S.C. § 841(a)(1). The United States Department of Justice has stated its commitment to enforce the FCSA consistent with Congress’ determination that “marijuana is a dangerous drug and that the illegal distribution and sale of marijuana is a serious crime that provides a significant source of revenue to large-scale criminal enterprises, gangs, and cartels.”[3]
Cannabis-Related Business Cannot Liquidate or Reorganize in Bankruptcy
Bankruptcy Courts have generally refused to afford companies that engage in the sale or distribution of marijuana or cannabis-related products the same protections available to non-cannabis-related businesses. Indeed, Bankruptcy Courts have dismissed cases even where the debtors do not operate a cannabis business, but operate ancillary businesses such as the manufacture or sale of hydroponic equipment that may be used for cultivating marijuana, or even real estate businesses that lease to marijuana growers.
The Ninth Circuit Offers a Ray of Hope for Cannabis Bankruptcies
In Garvin v. Cook Investments, NW,[4] the Ninth Circuit Court of Appeals confirmed a Chapter 11 plan of reorganization filed by a landlord that leased space to a cannabis grower licensed in the State of Washington, rejecting the United States Trustee’s argument that the plan should be denied because it did not comply with Section 1129 (a)(3) of the Bankruptcy Code, which requires that a plan be filed in good faith and comply with applicable non-bankruptcy law. The Ninth Circuit concluded that Section 1129(a)(3) does not require that the contents of a plan comply in all respects with the provisions of all nonbankruptcy laws and regulations. Because the plan at issue was not unlawful, the Ninth Circuit concluded that the plan was not per se unconfirmable.[5] Notably, the Ninth Circuit rejected the United States Trustee’s concern that Ninth Circuit’s interpretation of Section 1129(a)(3) will result in bankruptcy proceedings being used to facilitate legal violations. “To begin, absent waiver, as in this case, courts may consider gross mismanagement issues under Section 1112(b) … And confirmation of a plan does not insulate debtors from prosecution for criminal activity, even if that activity is part of the plan itself.”[6]
While the Cook Investments decision appeared to offer a ray of hope for cannabis-related businesses that sought bankruptcy relief, I suggested at the time that the decision may have been an anomaly due to the U.S. Trustee’s procedural error of failing to renew his motion to dismiss in connection with the plan confirmation hearing, arguing that the plan should be rejected because its provisions violated federal law.[7] As the Ninth Circuit noted, “[t]his failure was especially significant because it meant the bankruptcy court had no opportunity to consider whether the claimed gross mismanagement had been ‘cured.’”[8] I further suggested that until Congress acts, those engaged in the business of cannabis and their investors and bankruptcy trustees appointed to administer the estates of cannabis-related businesses will need to live with the political uncertainty of whether Congress will change federal law by leaving it up to the states to determine whether and how to regulate marijuana businesses, or whether the president will attempt to enforce the FCSA notwithstanding a marijuana businesses’ compliance with applicable state law.
Post-Cook Decisions Dismissing Cannabis Bankruptcies
Since Cook Investments was decided, several courts have addressed whether bankruptcy law can be used to restructure or liquidate cannabis-related business. The following is a brief summary of those cases:
In re Way to Grow, Inc., 610 B.R. 338 (D. Colo. Sept. 18, 2019)
The United States District Court for the District of Colorado affirmed the Bankruptcy Court’s order dismissing the bankruptcy cases filed by the debtors, which sold indoor hydroponic and gardening-related supplies, for cause under Section 1112(b) of the Bankruptcy Code on the grounds that it violated the FCSA even though the evidence adduced at trial showed that some customers used the hydroponic products to grow legal crops unrelated to the cultivation of cannabis.
In re Basrah Custom Design, Inc., 600 B.R. 368 (Bankr. E.D. Mich. 2019)
The Bankruptcy Court for the Eastern District of Michigan similarly dismissed the debtor’s Chapter 11 case on the grounds that the debtor had unclean hands because the purpose of the bankruptcy filing was to either allow the debtor’s principal to lease commercial space to a marijuana grower or to enter into the marijuana growing business, both of which the Bankruptcy Court found to violate the FCSA.[9]
Notably, although the “good faith” issue was not raised by any party, the Basrah court stated in dictum that the Ninth Circuit’s holding in Garvin was not binding on the court, and questioned the wisdom of the Ninth Circuit’s refusal to decide the dismissal issue on waiver grounds because confirmation of the Chapter 11 plan enabled the reorganized debtor to continue to violate federal law under the FCSA.[10]
The Basrah court also denied the request to convert the case to Chapter 7, finding that conversion would serve no purpose since it would likely lead to relief from stay by a cannabis company in order to obtain possession of the commercial property where the debtor operated its business.[11] As the court noted, granting such a motion would essentially sanction violation of the FCSA. Thus, the Basrah court would likely have had to deny relief from stay on the grounds of unclean hands, because lifting the automatic stay would assist the creditor in its efforts to open and operate a medical marijuana dispensary in violation of federal law.
In re Malul, 614 B.R. 699 (Bankr. D. Colo. 2020)
The United States Bankruptcy Court for the District of Colorado denied a former Chapter 7 debtor’s motion to reopen her case to administer potential claims against a previously undisclosed investment in a marijuana business, concluding that the debtor’s “mere possession” of the rights and interests in a marijuana cultivation and sale business and prosecution of her claims in furtherance of those rights and interests constitute ongoing criminal violations of the FCSA.[12] The Bankruptcy Court rejected the debtor’s arguments regarding the lack of an ongoing marijuana operation or marijuana assets that would have violated FCSA §§ 841, 842 or 843, noting that the debtor violated FCSA § 854 the moment the Subscription Agreement was executed.[13] The Bankruptcy Court noted that cannabis bankruptcy law was murky at best:
If the uncertainty of outcomes in marijuana-related bankruptcy cases were an opera, Congress, not the judiciary, would be the fat lady. Whether, and under what circumstances, a federal bankruptcy case may proceed despite connections to the locally “legal” marijuana industry remains on the cutting-edge of federal bankruptcy law. Despite the extensive development of case law, significant gray areas remain. Unfortunately, the courts find themselves in a game of whack-a-mole; each time a case is published, another will arise with a novel issue dressed in a new shade of gray.[14]
In re United Cannabis Corporation and UC Colorado Corp. (Bankr. D. Colo. 2020)
On April 20, 2020, United Cannabis Corporation and its wholly-owned subsidiary, UC Colorado Corporation, filed voluntary petitions for reorganization under Chapter 11 in the United States Bankruptcy Court for the District of Colorado.[15] As expected, the Office of the United States Trustee filed a response to the Bankruptcy Court’s Order to Show Cause why the bankruptcy cases should not be dismissed due to the debtors’ license of intellectual property to businesses in the cannabis industry, and the fact that the debtors’ website promotes the sale of cannabis products. See United States Trustee’s Response to Order to Show Cause filed on May 11, 2020 [Dkt No. 55]. As of the date of this article, the Court has not issued its ruling on the Order to Show Cause.
In re CWNevada, LLC, 602 B.R. 717 (Bankr. D. Nev. 2019)
On April 16, 2019, CWNevada, LLC, one of Nevada’s largest cannabis companies, filed Chapter 11 bankruptcy after facing 10 lawsuits from investors, makers of edibles, partners, a landlord and workers over failure to pay or pay on time. In re CWNevada, LLC, Case No. 19-12300-mkn. CWNevada was also ordered to pay its former consultant $4.9 million, while the Nevada Department of Taxation shut down two of its dispensaries for failure to pay taxes. The bankruptcy was filed as a preemptive move to prevent the District Court from appointing a receiver.
However, the bankruptcy case was short-lived. On June 3, 2019, Judge Nakagawa issued an order dismissing the bankruptcy cases under the doctrine of abstention.[16] Judge Nakagawa’s 40-page decision provides the most detailed analysis and summary of the state of the law on cannabis-related bankruptcies. Judge Nakagawa found that under the circumstances of that case, where no plan had been proposed, and no objections had been made, the “decision in Garvin is informative, but neither procedurally nor factually apposite.”[17] Although Garvin controlled when a good faith objection to plan confirmation is raised under 11 U.S.C. § 1129(a)(3), Judge Nakagawa emphasized that there was no plan and no such objection before the court. Id. Judge Nakagawa noted, however, that Garvin “offers no guidance on whether dismissal under section 1112(b)(1) on the basis of mismanagement under section 1112(b)(4)(B), or any other ground, would be appropriate in the present case.”[18] Notably, “the Garvin decision does not address whether dismissal independently based on abstention under Section 305(a) is appropriate.”[19] Because CWNevada was subject to multiple state court actions, Judge Nakagawa abstained under Section 305(a) of the Bankruptcy Code, and declined to determine whether the case should be dismissed for “cause” under Section 1112(b) of the Bankruptcy Code.[20] Finally, Judge Nakagawa was unwilling to decide the unclean hands issue as precluding all debtors engaged in cannabis-related businesses, noting that there may be “cases where Chapter 11 relief is appropriate for an individual or a non-individual entity directly engaged in a marijuana-related business.”[21]
Liquidation of Hemp Business Assets Permitted in Bankruptcy
Although most courts have dismissed bankruptcy cases filed by or against cannabis-related businesses, an important exception may exist for businesses that manufacture or sell hemp or cannabinoid products that do not contain tetrahydrocannabinol or THC. Unlike cannabis-related businesses that involve the cultivation, manufacture, sale and distribution of marijuana products, which are illegal under federal law, the 2018 Farm Bill removed hemp (including low-THC derivatives of cannabis such as CBD products) from the definition of marijuana in the FCSA. Prior to the enactment of the 2018 Farm Bill, the FCSA did not differentiate between marijuana and hemp, and virtually all cannabis was listed as a Schedule I controlled substance. This, however, does not mean that all CBD products are legal to sell under federal law. For example, the FDA continues to regulate CBD products that claim to treat or prevent serious diseases.
Nonetheless, most companies associated with hemp and its derived products can legally file for bankruptcy, even though their counterparts in the marijuana industry cannot. For example, GenCanna, a Kentucky-based hemp processor now known as OGGUSA, Inc., filed Chapter 11 bankruptcy in June 2020 in the United States Bankruptcy Court for the Eastern District of Kentucky due to, among other things, overproduction and a steep drop in CBD isolate prices when the coronavirus pandemic hit, followed by a fire at one of its facilities and disputes with construction companies. The Bankruptcy Court approved GenCanna’s Chapter 11 liquidation plan, concluding one of the first bankruptcy cases involving the legal hemp industry.
The Bankruptcy Code’s Prohibition Against Aiding Debtors Whose Activities Constitute Continuing Federal Crimes
Bankruptcy Courts have generally held that involvement in the marijuana industry “betrays a lack of good faith” that prevents one from seeking the shelter of federal law.[22] Thus, so long as cannabis remains a Class I controlled illegal substance under federal law, Bankruptcy Courts will likely continue to dismiss cases – at least those cases where cannabis companies wish to reorganize.
A possible interim solution to the vexing question of whether a debtor that has engaged in a marijuana business or has derived income from a marijuana business that is legal under state law can enjoy the benefits under the Bankruptcy Code may be best stated as follows: “[T]he Debtor must make a choice. He can either continue his medical marijuana business or avail himself of the benefits of the Bankruptcy Code, but not both. If he chooses the latter, the court will require him to discontinue growing, selling and transferring marijuana to any and all patients and dispensaries immediately and to cease using property of the estate to further this activity.”[23]
Although no published decision has yet been reported on the potential conflict between a bankruptcy trustee’s duty to liquidate assets for the benefit of creditors under the Bankruptcy Code and the FCSA’s prohibition on the sale of marijuana-related assets or constitute proceeds of activity criminalized by the FCSA, it is also possible that a Bankruptcy Court might attempt to exercise its inherent equitable powers by appointing an independent trustee not overseen by the Office of the United States Trustee to liquidate such assets – particularly if the business is no longer operating illegally as of the date of the bankruptcy filing. However, in light of the recent Presidential election and possible federal decriminalization of cannabis, a Bankruptcy Court’s powers in this regard may never be tested.
Alternatives to Bankruptcy for Cannabis-Related Businesses
However, this is not to say that distressed, cannabis-related business are without hope. Cannabis-related companies may still qualify for state law alternatives to bankruptcy including receiverships, assignments for the benefit of creditors, creditor compositions or out of court workouts.
A number of cannabis-related businesses may benefit from equity receiverships, which helps preserve collateral, eliminates mismanagement, fraud or other intentional misconduct, freezes creditor actions, and importantly may facilitate the restructuring or sale of corporate assets free and clear of liens.
A general assignment for the benefit of creditors permits a distressed cannabis-related business to transfer all of its assets to a third-party fiduciary called an assignee, who has the authority to market and sell such assets to potential buyers and to administer claims under applicable state law.
A creditors’ composition or workout may enable a distressed cannabis-related business to negotiate with creditors to pay claims (usually at a discount) and/or to obtain the creditor’s consent to forbear from exercising its rights and remedies to enable the company to succeed, thereby maximizing value for such creditors.
And secured creditors may enforce their remedies under the version of Article 9 of the Uniform Commercial Code applicable in the various states, and seek to foreclose on their cannabis-related collateral.
While such bankruptcy alternatives can be successful with careful planning, they are not suitable for every business, particularly larger cannabis-related businesses with many secured and unsecured creditors, landlords, and assets located in numerous jurisdictions. For example, the Bankruptcy Code imposes an automatic stay that stays litigation and collection actions, authorizes nationwide service of process, and offers a single forum and streamlined process for administering claims. If creditors are unwilling to cooperate, bankruptcy may be the best option to help preserve assets and stay litigation.
Chapter 15 Cross-Border Insolvencies
In addition, Chapter 15 of the Bankruptcy Code authorizes foreign companies to file an ancillary proceeding in the United States if there is a pending insolvency proceeding in another country. After the filing, the Bankruptcy Court will designate the foreign proceeding as either “foreign main proceeding” or “foreign non-main proceeding,” with the difference being that in a non-main proceeding, the debtor does not have its main interests in that country. Upon the recognition of a foreign main proceeding, the automatic stay protects the assets of the foreign debtor that are within the United States from execution.
Canadian insolvency law may provide an avenue for distressed cannabis businesses to reorganize under the Companies’ Creditors Arrangement Act (Canada) (“CCAA”) or to reorganize or liquidate under the Canadian Bankruptcy Insolvency Act (“BIA”). Indeed, cannabis producers Wayland Group Corp., AgMedica Bioscience Inc., PharmHouse, Sunniva, Inc., James E. Wagner Cultivation and others have sought protection under the CCAA or BIA to enable them to reorganize. For Canadian companies that have assets or operations in the United States, however, it remains unclear whether the United States Bankruptcy Courts will exercise jurisdiction over ancillary petitions for relief filed under Chapter 15 of the Bankruptcy Code.
The 2020 Federal Elections
Legislation to decriminalize marijuana has become a hot issue over the past decade. Many states have either decriminalized marijuana altogether[24] or have legalized the manufacture, sale, distribution, and possession of marijuana for recreational and medical purposes. [25] All but a handful of states have legalized the use of marijuana (or CBC oil) for medical purposes.[26] Under the Obama Administration, the federal government had eased enforcement of the FCSA and other marijuana laws, permitting cannabis use in small quantities. However, Congress was unable to pass any federal legislation decriminalizing the use, manufacture, or distribution of marijuana and cannabis-related products.
Recently, the Democrat-controlled House of Representatives sponsored the Marijuana Opportunity Reinvestment and Expungement (“MORE”) Act, which seeks to decriminalize marijuana at the federal level, which was originally scheduled for a vote in September 2020. The House delayed the vote until after the November general election.
In addition, the House Democrats sponsored the SAFE Banking Act, which would allow banks and financial institutions to legally do business with the cannabis industry without fear of federal arrest or prosecution. The SAFE Banking language has been included in the COVID relief package passed by Democrats earlier this year, which never became law due to Senate inaction. If Congress provides additional COVID-related relief for American families before the new Congress takes power, it is possible that the SAFE Banking language will be included in the final proposal.
In addition, the 2020 Democrat Vice Presidential nominee, Kamala Harris, pledged during a virtual roundtable hosted on September 14, 2020 that marijuana would be decriminalized under a Biden Administration. While a Biden Administration is more likely to support legislation to legalize marijuana under federal law, the outcome of the Georgia senate runoff elections will likely determine whether such legislation clears the necessary votes to get to the President’s desk. Regardless, we may be hearing a lot more about the MORE Act in 2021. If the bill is approved by Congress and is signed into law by the President, bankruptcy will become a useful weapon in the arsenal for distressed cannabis-related businesses to reorganize or liquidate. However, a divided government will result in piecemeal solutions for distressed cannabis-related businesses that will provide little guidance or certainty.
[1] As of the writing of this article, Democratic presidential candidate, Joseph Biden, has been declared the winner of the 2020 presidential election by major media outlets, and has been certified as the winner in contested “swing states” of Pennsylvania, Michigan, Nevada, Arizona, and Wisconsin. Although the Trump campaign has vowed to challenge the efficacy of the voting, its efforts to date have been unsuccessful. On December 14, 2020, the United States Electoral College will gather in their respective state capitals to cast their official ballots, which will be certified on January 6, 2021.
[2] 21 U.S.C. § 856(a).
[3] See Memorandum for all United States Attorneys: Guidance Regarding Federal Marijuana Enforcement, Office of the Deputy Attorney General (Aug. 29, 2013) (the “Cole Memorandum”). https://www.focusstandards.org/us-govt-position-cannabis/
[4] 922 F.3d 1031 (9th Cir. 2019).
[5] The Bankruptcy Court noted: “Debtors are presenting a plan based on income of all other Debtors. Payments under the plan will be made from non-marijuana related income.” In re Cook Investments NW, SPNWY, LLC., et al, Case No. 17-5516 (BHS), District Court’s Order Affirming Bankruptcy Court, at p. 4. Thus, the Plan did not provide for post-confirmation income derived from the tenant’s marijuana business.
[6] Cook Invs., 922 F.3d at 1036 (citations omitted).
[7] See Keith C. Owens, Distressed Cannabis Companies See Hope In 9th Circ. Ruling – Law360 (May 22, 2019).
[8] Cook Invs., 922 F.3d at 1034 (citation omitted).
[9] Basrah Custom Design, 600 B.R. at 383.
[10] Id. at 381, n. 38.
[11] Id. at 383-84.
[12] In re Malul, 614 B.R. 699, 713-14 (Bankr. D. Colo. 2020).
[13] Id. at 711-12.
[14] Id. at 701.
[15] See In re United Cannabis Corp., Case Nos. 20-12692-JGR and 20-12689-JGR (Bankr. D. Colo).
[16] In re CWNevada, LLC, 602 B.R. 717 (Bankr. D. Nev. 2019).
[17] Id. at 731.
[18] Id. at 730.
[19] Id. at 730-31.
[20] Id. at 747.
[21] Id.
[22] See In re Arenas, 535 B.R. 845, 847 (B.A.P. 10th Cir. 2015) (“the debtors cannot obtain bankruptcy relief because their marijuana business activities are federal crimes”); In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 805 (Bankr. D. Colo. 2012) (finding that participants in the state-legal marijuana industry violate federal law in their normal course of business, and “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.”); Way to Grow, 597 B.R. at 120 (holding that a party cannot seek bankruptcy relief “while in continuing violation of federal law” or “where the trustee or court will necessarily be required to possess and administer assets which are illegal under the CSA or constitute proceeds of activity criminalized by the CSA”); Burton v. Maney (In re Burton), 610 B.R. 633 (B.A.P. 9th Cir. 2020) (upholding the dismissal of a Chapter 13 case based on debtor’s ownership of an interest in an entity that was involved in litigation seeking to recover damages for breach of contracts related to growing and selling marijuana).
[23] In re Johnson, 532 B.R. 53, 59 (Bankr. W.D. Mich. 2015).
[24] Alaska, Arizona, California, Colorado, Connecticut, Delaware, DC, Hawaii, Illinois, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, South Dakota, Ohio, Oregon, Vermont, Virginia, and Washington.
[25] Alaska, Arizona, California, Colorado, Illinois, Maine, Massachusetts, Michigan, Montana, New Jersey, Nevada, Oregon, South Dakota, Vermont, and Washington.
[26] The following states have not legalized the sale of medical marijuana: Idaho, Kansas, Nebraska, North Carolina, Wisconsin and Wyoming.
Keith C. Owens is a Partner at Fox Rothschild LLP, and a strategic ally for clients involved in bankruptcy proceedings, creditors’ rights matters and commercial litigation. Experienced in all facets of bankruptcy, insolvency, distressed acquisitions and dispositions, Keith has represented businesses and individuals in a wide range of industries.
