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Impacts of Cannabis Rescheduling on Bankruptcy

August 7, 2024

This article was co-authored with Joel E. Cohen, Stout.

Despite the excitement of many over rescheduling cannabis from Schedule I to Schedule III, the move does not make cannabis “legal” unless it is produced, sold, and used within the tightly regulated parameters of the Controlled Substances Act (CSA). Many medical and adult-use cannabis stores and products that currently exist in approximately four-fifths of the United States are not in compliance with the CSA. These businesses violate federal law now, and they will still be violating federal law if and when cannabis is rescheduled; rescheduling does not make the conduct federally legal.

However, cannabis rescheduling may have a significant impact on the federal taxes that cannabis and cannabis-related businesses currently are required to pay. While Internal Revenue Code section 280E might prohibit a cannabis-related business from taking deductions and credits for most business expenses incurred in carrying on the trade or business of trafficking Schedule I and II controlled substances, 280E typically does not apply to the trafficking of Schedule III substances. Therefore, if rescheduling occurs and cannabis is no longer a schedule I or II substance, cannabis-related businesses could be able to deduct traditional business expenses.

Basics of Bankruptcy & Cannabis Rescheduling

We cannot say that rescheduling will cause similar—nor immediate—changes with respect to bankruptcy. This is because there is no bright-line rule like there is in the federal tax code, whereby cannabis-related businesses (or individuals involved in them) will likely have different legal treatment following rescheduling.

Instead, in the bankruptcy context, a debtor’s proposed plan should not violate the “good faith” requirements of 11 U.S.C §§ 1129(a)(3) and 1325(a)(3) and (a)(7). A debtor must not also run afoul of the doctrine of “unclean hands.” Both rules are equitable concepts which involve the balancing of interests and harms, rather than the application of a bright-line rule. Because these are equitable analyses, different courts could cause different results for parties similarly situated based on the circumstances of a particular case, the values held by the judge deciding their matter, and more.

Equitable concepts such as “good faith” and “unclean hands” provide flexibility in the judiciary’s analyses and, thus, in the outcome of each case. Historically speaking, with respect to bankruptcy courts governed by the U.S. Bankruptcy Code, the federal illegality of cannabis has long have presented a roadblock for cannabis companies seeking bankruptcy protection. However, starting years before the DEA’s rescheduling news was announced, some courts have already started to demonstrate a more nuanced and perhaps more open-minded stance with respect to both state-legal cannabis businesses and individuals who derive income from such business activity. This evolution suggests a departure from blanket refusals, providing hope for cannabis businesses and individuals who derive income from those businesses seeking bankruptcy protection.

Insight for Future Legal Treatment of Cannabis

Indeed, prior to the rescheduling news, there had already been a trend of bankruptcy courts approaching cannabis-related bankruptcy issues with more nuance and open-mindedness. In the last year, two important cases demonstrating a moving-away from a complete prohibition when it comes to bankruptcy for both businesses and individuals who derive, or at some time in the past derived, income from a federally illegal cannabis business.

In re Blumsack

In In re Blumsack, 647 B.R. 584 (Bankr. D. Mass. 2023), an employee of a cannabis business filed for bankruptcy. As explained above, Chapter 13 of the Bankruptcy Code states that the debtor’s bankruptcy plan must be in good faith and not forbidden by law. The bankruptcy court granted the trustee’s motion to dismiss Blumsack’s filing, finding that requiring a Chapter 13 trustee to administer the bankruptcy would involve the trustee in illegal activity. However, on appeal, the Bankruptcy Appellate Panel rejected the application of a bright-line rule since “equitable concepts like good faith ‘are peculiarly insusceptible to per se rules.’”

The bankruptcy court ultimately found that the debtor could not receive the benefits of federal bankruptcy law while “continuously” and “contemporaneously” earning income from federally illegal activity, further highlighting the importance of ceasing operations or involvement with cannabis-related activity pre-bankruptcy.

In his argument to the court, the debtor in Blumsack posited that denying his petition simply on the basis that he continued to work as an employee of the cannabis business after filing is untenable, making a “slippery slope” argument. The debtor argued that, given the cannabis industry’s contribution to a wide spectrum of the state’s economy, such a position would result in a large swath of the community – including the janitorial agency that cleans a dispensary, a pizza shop where dispensary employees get their lunch, Federal Express that delivers packages for a dispensary, the electric utility company, public schools, and perhaps even 2.3 million Walmart employees – being ineligible for bankruptcy relief because they derive an economic benefit from cannabis-related businesses. The court made clear that these may be good arguments, but such policy arguments needed to be addressed to Congress, not to a Massachusetts bankruptcy court.

Notwithstanding disagreeing with the bankruptcy court on the bright-line rule, the BAP ultimately affirmed the ruling of the bankruptcy court dismissing the Blumsack chapter 13 case.

In re The Hacienda Company, LLC

Hacienda Co, LLC, a business engaged in manufacturing and producing cannabis products, transferred its assets, including intellectual property and drug-related goods, to a publicly traded Canadian company. In exchange, it received a 9.4% share in the Canadian company. Hacienda subsequently filed for bankruptcy protection in the Central District of California. The United States Trustee moved to dismiss the bankruptcy petition arguing creditors would be repaid (receiving stock in a cannabis company) with assets from federally illegal criminal activity. In re The Hacienda Co., 647 B.R. 748, 756 (Bankr. C.D. Cal. 2023).

However, the court denied the motion to dismiss. That denial may have marked a significant development in Chapter 11 bankruptcy litigation, departing from similar cases. It may also lay the groundwork for other cannabis-related companies pursuing bankruptcy.

Specifically, the court cited the absence of an ongoing violation of the CSA. Any CSA violations the company committed occurred before the bankruptcy filing The Court rejected the trustee’s argument that there exists a bright-line rule requiring dismissal of every bankruptcy case involving any past CSA violation by a cannabis-related business. The court noted that a past violation of the CSA by itself did not warrant the dismissal of a bankruptcy case.

By way of comparison, the court compared past illegal activity in this case to other bankruptcy cases involving different types of federal law violations. The court noted that neither post-petition nor pre-petition illegal conduct ruled out those companies remaining in chapter 11 bankruptcy. It stated:

Dismissing every case that had a connection with illegal activity would be contrary to Congress’ directives under the Bankruptcy Code. Consider what would happen if the doors of the bankruptcy courts were closed to any debtor who had crossed the line into illegal activity prepetition and were attempting to wind up that activity postpetition.

Some of the largest business bankruptcy cases, like those of Pacific Gas & Electric Co. of “Erin Brockovich” fame, Enron Corporation, and Bernie Madoff, involve alleged or actual criminal activity. Should those cases have been dismissed? How about cases involving sexual abuse? See CWNevada, 602 B.R. at 728 n. 25 (citing, inter alia, NCR Staff, Catholic Diocese and Orders that Filed for Bankruptcy and Other Major Settlements, National Catholic Reporter (2018), (last visited on January 18, 2023) (listing numerous bankruptcy proceedings to address sexual abuse claims, from July 6, 2004, through approximately February 28, 2018)).

Rescheduling will not redraw the legal lines applicable to cannabis-related activity. Until cannabis is legalized at the federal level, or until the Bankruptcy Code is amended, the protections offered by the Bankruptcy Code likely will likely to be unavailable to many cannabis and cannabis-ancillary companies, as well as to their employees. However, the Hacienda court’s analysis may help provide insight into the future treatment of cannabis-related business activity following rescheduling, and it suggests that rescheduling may help continue this more cannabis-permissive trend in bankruptcy courts.

Bankruptcy Alternatives for Cannabis Related Businesses

In response to the difficulty accessing federal bankruptcy courts, state court receiverships have emerged as a potential avenue for distressed cannabis businesses to find relief.

Receiverships in the Cannabis Industry

Receivers can legally control and operate a business’s property in the ordinary course, obtaining the right to control and sell/distribute the property legally. A cannabis business adds an additional layer of complexity because those permissions are typically only granted to cannabis licensees.

The vetting and pre-approval process required by state authorities to obtain the right to control, sell, and distribute the assets of a cannabis business can be impractical or even impossible in some cases, creating hurdles for both the receivers and the parties involved.

For example, the receiver may not qualify as a true party of interest under the state’s regulations or may not wish to submit to the necessary criminal, financial, and other background investigations involved in the vetting procedures. Or it may be impracticable for the involved parties to wait out the approval process, which in some states can take months, if not years.

State Legislation Around Cannabis-Related Receiverships

When dealing with cannabis-related cases in receivership, considerations such as selecting a receiver or determining the appropriate jurisdiction introduce a new set of challenges given the significant regulation of licensed receivers’ conduct.

In Colorado, known as a cannabis-friendly state, issues arise due to the absence of legislation accommodating cannabis businesses receiverships. For instance, the courts may reject the appointment of a receiver, citing licensing requirements.

In contrast, cannabis laws in states like Oregon specifically address concerns around receivership with laws such as the following:

• Receivers must be eligible to be a licensee. OAR 845-025-1260(2).
• Receivers may obtain a temporary authority to operate a licensee “to allow orderly disposition of the business.” OAR 845-025-1260(1).
• Receivers may be granted an extension of the temporary 60-day authority to allow for the disposition of the business. OAR 845-025-1260(3), and OAR 845-025-1260(4).
• Receivers must begin to operate the business immediately upon receiving the authority. OAR 845-025-1260(2)
• Temporary authority is granted for 60 days and may be extended as necessary to allow for the disposition of the business. OAR 845-025-1260(4). The provision enables an orderly disposition of the business within a 60-day period, with the possibility of extensions. Such legislative foresight streamlines the process and mitigates delays caused by the licensing approval process.

Ultimately, the differences in receivership legislation, licensing requirements, and court familiarity with cannabis-related receivership can play a vital role in determining a legal strategy.

Overall Effects of Rescheduling on Bankruptcy & Insolvency Alternatives

In short, when an individual or business has connections to (what will remain, even after rescheduling) federally illegal cannabis-related activity, the rescheduling of cannabis may help influence the judiciary—sitting in equity—to continue the trend of more keeping cannabis-related businesses in chapter 11.

However, until cannabis is legalized at the federal level, or the Bankruptcy Code is amended, the protections offered by the Bankruptcy Code will continue to be unavailable to the great majority of cannabis and cannabis-ancillary companies, as well as to their employees. State court receiverships have emerged as a potential avenue for distressed cannabis businesses to find relief.

Further, the improved tax treatment may lead to lessening the need for financial restructuring in the first instance. And the tax deductibility of expenses will likely lead to better bottom lines throughout the cannabis industry. Therefore, while not directly impacting bankruptcy filings, that 280E will not apply if cannabis is moved to schedule III may provide a measure of financial relief to cannabis-related businesses and their creditors such that there will be less of a need to explore bankruptcy and other financial restructuring alternatives.

Reproduced with permission. Published July 2024. Copyright 2024 by Bloomberg Industry Group, Inc. (800-372-1033) http://www.bloombergindustry.com