Cannabis businesses can’t file for bankruptcy before federal legalization | Harris Beach LLC
Although cannabis use has been legalized in approximately 39 states and the District of Columbia¹, cannabis is still federally illegal and classified as a Schedule I drug under the Controlled Substances Act. As a result, cannabis companies and cannabis ancillary companies generally do not enjoy the protections provided by the US Bankruptcy Code.
Filing for bankruptcy allows struggling businesses breathing space from creditors to restructure debts and also helps protect against certain litigation and collection efforts. Clifford J. White III, director of the Justice Department’s Executive Office for U.S. Administrators, and John Sheahan, the agency’s general counsel, wrote in a 2017 article published in the American Bankruptcy Institute (ABI) Journal²:
Unlike other types of cases involving illegal businesses, in which the criminal activity has already ended and the main concern of the bankruptcy court is to resolve the victims’ competing claims for compensation, a bankruptcy case related to marijuana can involve a company that not only continues in its business, but even seeks positive assistance from the bankruptcy court in order to reorganize its balance sheet and thereby facilitate its violations of the law in the future.
Burton v. Maney (In re Burton)³ involved a husband and wife who filed for Chapter 13 bankruptcy. The bankruptcy petition revealed that the husband and wife held a controlling interest in a company legally engaged in the cultivation and sale of cannabis under the Arizona law, but which had since ceased operations. Based in part on the debtors’ interest in a cannabis-related company, the trustee in bankruptcy moved to dismiss the petition. The debtors argued that their remaining funds were not generated from their operation of the cannabis company, but the company was still a plaintiff in two lawsuits pending in state court in which it sought damages for breach of contract relating to the cultivation and sale of cannabis.
The bankruptcy court concluded that any recovery from the lawsuits would arise from conduct in violation of federal law and that allowing the bankruptcy case to continue would likely require the court and the trustee to administer funds obtained in violation of said law. The bankruptcy court granted the trustee’s motion to dismiss. The Ninth Circuit Bankruptcy Appellate Panel upheld, finding that debtors’ cannabis ownership interests constituted “cause” for termination under Bankruptcy Code Section 1307(c).⁴
There are portions of Burton however, an appeal that may apply for the benefit of cannabis debtors; the appeal committee wrote:
The case law continues to evolve and few clear rules have emerged from the decisions published to date. One principle, however, seems implicit in the case law; the mere presence of marijuana near a bankruptcy filing does not automatically bar a debtor from bankruptcy relief.⁵
In the same way, In the Re Players network⁶, concerned a debtor who held a controlling interest in a company that processed cannabis. A creditor requested the dismissal of the debtor’s case under Section 1112(b)(1), arguing in part that the debtor could not propose a good faith plan based on its equity stake. a cannabis-related company. The bankruptcy court ultimately dismissed the case, in part because of the debtor’s ties to cannabis. Similar to Burtonthe court noted that, at least in the Ninth Circuit, “there does not appear to be a rule per se preventing a Chapter 11 plan from being offered in good faith solely on the basis of the debtor’s relationship to the trade involving marijuana or cannabis products”.⁷
Although it appears that the bankruptcy system cannot currently help liquidate or restructure cannabis-related assets, alternatives to bankruptcy are still available to cannabis companies and cannabis ancillary companies. Cannabis entrepreneurs should consult with an attorney to ensure they are structuring their business in a way that allows for the protection of state laws.
¹About 18 states and the District of Columbia have legalized recreational or adult use of cannabis.
² “Why Marijuana Assets Cannot Be Administered in Bankruptcy.” American Institute of BankruptcyDecember 1, 2017, https://www.abi.org/abi-journal/why-marijuana-assets-may-not-be-administered-in-bankruptcy.
³610 BR 633 (BAP 9th Cir. 2020).
⁴Section 1307(c) provides that “upon application by an interested party or the United States trustee and after notice and hearing, the court may convert a matter under this chapter into a matter under Chapter 7 of the this title, or may dismiss a case under this chapter, whichever is in the best interests of the creditors and the estate, for cause. . ..” 11 USC § 1307(c). A non-exhaustive list of causal factors is set forth in Section 1307(c)(1) through (11).
⁵In re Burton610 BR to 637 (emphasis added).
⁶2020 Banker LEXIS 3016 [Bankr D Nev Oct. 23, 2020, No. 20-12890-MKN]).
⁷Identifier. at *11, #18.