Alert

Cannabis Companies Lacking Bankruptcy Protections Can Explore State Options

June 7, 2022

As the trend to legalize the medical and recreational use of marijuana continues to blaze through the states, federal law, and bankruptcy courts by extension, have not yet followed suit.[1] Bankruptcy courts have historically prevented cannabis – and even cannabis-ancillary companies – from filing for protection under the United States Bankruptcy Code[2] because marijuana remains illegal under the Controlled Substances Act (CSA) at the federal level.[3] Consequently, financially distressed companies in states where marijuana is legal still have limited restructuring options and must rely on state law options.

Typically, traditional businesses can file for bankruptcy in order to obtain “breathing room” from creditors, restructure debts, and escape certain litigation and collection efforts. So how does a struggling cannabis business, or a business that provides goods or services to the cannabis industry, avail itself of similar legal relief in order to compliantly reset the business on a new path, or even responsibly exit the market? While this lack of bankruptcy protection can be detrimental for many distressed cannabis companies, there are some state-law options available. First, a cannabis company could use an assignment for the benefit of creditors (ABC). An ABC is a state-law mechanism for the orderly (structured) liquidation of assets.  An ABC is similar to a Chapter 7 bankruptcy proceeding where the debtor’s estate is liquidated in an orderly fashion, but ABCs are not governed by the Bankruptcy Code. Instead, each state’s ABC statute provides a process for the liquidation of a debtor’s assets through an assignment of the assets to an assignee. The assignee oversees the liquidation of the assets and distributions to creditors, which is usually faster and less expensive than a bankruptcy proceeding. 

Second, a cannabis company can attempt to negotiate directly with the lender for a “workout” agreement to renegotiate the terms or conditions of a burdensome debt obligation.  However, the company may be unable to avail itself of significant leverage during negotiations with a lender, since the entity cannot threaten to file for bankruptcy protection if no out-of-court agreement can be reached. Nonetheless, an out-of-court restructuring or workout negotiated directly with the lender can potentially lengthen the maturities on debt instruments, amend burdensome covenants in agreements, and provide for more beneficial payment terms, among other benefits.

Disallowing marijuana businesses from seeking protection under the Bankruptcy Code affects all cannabis-touching companies and a wide range of ancillary industries, including suppliers, vendors, finance companies, real estate companies, and any others providing goods or services to the cannabis industry. The Bankruptcy Code’s provisions on automatic stays, distribution priorities, avoiding powers, and discharge, among others,  affect the dynamics of the entire cannabis industry. Until marijuana is legalized at the federal level so that the U.S. Trustee Program (USTP) no longer views the reorganization of such business as their permitting “continued legal activity,” or the Bankruptcy Code is amended to permit cases involving marijuana businesses, the protections offered by the Bankruptcy Code likely will continue to be unavailable to many cannabis and cannabis-ancillary companies.

Many cannabis companies have attempted to seek bankruptcy protections, and more will continue. One recent Chapter 11 (reorganization) filing by Master Equity Group, LLC in the Western District of Michigan seeks to challenge the prohibition and take advantage of the protections the Bankruptcy Code can offer. (Master Equity Group, LLC, a holding company for several cannabis-related companies, filed for bankruptcy under Subchapter V of Chapter 11, which is a recent enactment allowing qualifying small companies to reduce costs and increase the efficiency of the bankruptcy process.)

As long as marijuana remains federally illegal, the bankruptcy courts are unlikely to touch these cases. Despite even a highly critical 2017 article published in the American Bankruptcy Institute detailing these inequities as they apply to cannabis creditors, the Executive Office for U.S. Trustees maintains that it may not “supervise an ongoing criminal enterprise regardless of its status under state law.” However, savvy cannabis industry participants should be knowledgeable about these restrictions, and empower themselves by structuring their businesses from the beginning to avail themselves of protections under state laws and negotiate directly with lenders until the federal tides turn.

[1] In re Way to Grow, Inc., 610 B.R. 338 (D. Colo. 2019) (“dismissal for “cause” is appropriate when the Chapter 11 debtor runs a business dedicated to servicing the marijuana industry in violation of federal law.”)

[2] 11 U.S.C. § 101, et seq. (the “Bankruptcy Code”).

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