Published Article

Pot Cos. Can Rely On State Law For Bankruptcy Safeguards

September 19, 2022

The trend to legalize the medical and recreational use of marijuana continues to blaze through the states, but 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 U.S. Bankruptcy Code[2] because marijuana remains illegal under the Controlled Substances Act, or 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.

The U.S. cannabis industry is expected to reach $32 billion in annual sales this year, according to cannabis retail software company Flowhub Holdings Inc.[4]

However, cannabis businesses — and even traditional businesses throughout a wide range of industries, from fertilizer companies to software developers — are required to successfully navigate “a labyrinth of confusing, contradictory and multijurisdictional regulations” at the local, state and federal levels simultaneously to successfully operate their business today, according to a 2019 article in the American Bankruptcy Institute Journal.

Despite this substantial revenue, those challenges, taken together with the other barriers facing the industry — such as high state and federal tax rates coupled with the inability to deduct normal business expenses, lack of access to insurance, limited options for raising capital, and even the inability to simply deposit money with a bank — create an environment in which such businesses consider themselves “rigged for all to fail.”[5]

When traditional businesses fail or experience financial distress, they can file for federal bankruptcy protection to obtain breathing room from creditors, restructure debts, and escape certain litigation and collection efforts.

However, when a cannabis business fails, bankruptcy protection is typically not available, begging the question: How does a cannabis business, or a business that provides goods or services to the cannabis industry, avail itself of similar legal relief to compliantly reset the business on a new and profitable path, or even responsibly wind down the business and exit the market?

Despite being subject to various federal laws, including tax and discrimination, the current status of marijuana as a Schedule I substance and recent trends in court decisions make it clear that marijuana growers, processors and distributors may not file for federal bankruptcy relief.

Generally, this is because courts are unwilling to administer a bankruptcy matter involving an entity related to a marijuana business, since doing so requires the court to take action that would benefit the party violating the federal Controlled Substances Act, and could also result in the court’s appointee operating, administering or taking possession of federally illegal substances, or the profits of the illegal sale thereof.

Indeed, in 2017, a highly critical article published by the American Bankruptcy Institute[6] addressed the inequities suffered by cannabis companies due to lack of federal bankruptcy protection. In response, the Executive Office for U.S. Trustees made clear that it will not “supervise an ongoing criminal enterprise regardless of its status under state law.”

This federal prohibition of bankruptcy protection affects not only marijuana licensees and cannabis-touching companies, but also a wide range of ancillary industries including suppliers, vendors, finance companies and real estate companies.

It may extend to others with more tenuous connections to the marijuana industry, such as printers or repair companies, for example, who may serve even a single industry participant.

Until recently, bankruptcy courts had traditionally dismissed any claim for protection under the federal Bankruptcy Code if the debtor had any connection to marijuana.

Recently, however, there has been a trend of bankruptcy courts approaching cannabis-related bankruptcy issues with more nuance and open-mindedness.

In In re: Olson in 2018, the U.S. Bankruptcy Appellate Panel of the Ninth Circuit unanimously refused to dismiss the bankruptcy petition of a 92-year-old blind woman whose commercial property had been rented through a third-party property manager to a legal marijuana grower in California, suggesting that the mere connection of a debtor to cannabis may no longer categorically disqualify the same from Bankruptcy Code protections for the first time.

Shortly thereafter, the same court entertained the bankruptcy petition of a debtor who operated multiple real estate holding companies, one of which leased a property to a legal marijuana growing business in Washington state, suggesting that a debtor with previous ties to a marijuana business may be allowed to proceed with the debtor’s plan, if it can and has effectively cut all ties to that business for the purpose of paying creditors. [7]

Still, those decisions provide very little, if any, guidance to cannabis and cannabis-ancillary businesses, especially those outside of the jurisdiction of the Ninth Circuit. The overwhelming majority of U.S. jurisdictions have been not only consistent, but also emphatic, in dismissing bankruptcy cases filed by anyone connected in any way to a marijuana business or the proceeds thereof.

While this lack of bankruptcy protection can be detrimental for many companies, there may be state law options available to such a business seeking the protections afforded by the federal Bankruptcy Code.

Further, a cannabis company that understands these options is better equipped to structure its business to avail itself of state-law relief, should it desire to restructure and continue operations or orderly wind down the company and exit the industry.

First, a cannabis company seeking to liquidate and distribute its assets could use an assignment for the benefit of creditors, or ABC. ABCs are state law mechanisms for the orderly, or structured, liquidation of assets.

An ABC is similar to a Chapter 7 bankruptcy proceeding wherein the debtor’s estate is liquidated in an orderly fashion, but ABCs are not governed by the Bankruptcy Code.

Instead, each state provides an ABC statute that sets forth a pre-determined process for and order of the liquidation of a debtor’s assets, which is accomplished through an assignment of the cannabis company’s assets to an assignee.

The assignee then oversees the liquidation of the assets, as well as the distributions to creditors. This option further benefits cannabis companies because the state ABC process is usually faster and less expensive than a federal bankruptcy proceeding.

Second, a cannabis business that is not yet seeking to fully liquidate and distribute its assets can attempt to negotiate directly with the lender for a workout agreement, in order to renegotiate the terms or conditions of burdensome debt obligations.

However, a cannabis company engaging in workout agreement negotiations may find itself unable to avail itself of significant leverage during negotiations with a lender, since the entity does not have the ability to file for bankruptcy protection if the parties cannot reach an out-of-court agreement.

Nonetheless, an out-of-court restructuring or workout agreement 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 affecting the cannabis business itself and its creditors.

The Bankruptcy Code’s provisions on automatic stays, distribution priorities, avoiding powers and discharge, among others — and, specifically, the cannabis and cannabis-ancillary industries’ inability to avail themselves to these protections available to all other businesses throughout the country — dramatically affect the business dynamics of the entire cannabis industry, and beyond.

Until marijuana is legalized at the federal level so that the U.S. trustee program 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.

However, savvy cannabis industry participants should be knowledgeable about these restrictions, and empower themselves by structuring their businesses from the beginning in a way that avails themselves of protections under state laws.

This article was originally published in “Expert Analysis” on September 19, 2022, by Law360. The original publication is available here with a subscription.

[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).

[4] Flowhub. Cannabis Industry Statistics 2022.

[5] Letter to California Governor from cannabis cultivators, manufacturers, distributors, testing laboratories, retailers and consumers of California.

[6] Just Say No to Drugs? Creditors Not Getting a Fair Shake When Marijuana-Related Cases Are Dismissed. American Bankruptcy Institute. September 1, 2017.

[7] Garvin v. Cook Investments NW, No. 18-35119 (9th Cir. 2019).