Exploring Alternatives to Bankruptcy for Cannabis Businesses

By Charles Alovisetti, Phil Silverman, Jason Adelstone

Apr 17, 2020

One of the many issues arising out of the tension between state and federal law in the cannabis industry is whether cannabis companies can access the protections of the U.S. Bankruptcy Code. Almost all bankruptcy courts faced with this question have clearly stated that marijuana companies cannot access the federal bankruptcy system. The question for hemp companies is more nuanced and may depend on how courts view CBD and violations of the Federal Food, Drug, and Cosmetic Act– though this issue has not yet been litigated.

Bankruptcy law provides advantages for financially distressed companies to restructure debt while continuing to operate. Without the ability to access the U.S. Bankruptcy Code, marijuana companies must turn to out-of-court restructurings and state law insolvency proceedings.

Summary of Bankruptcy Law and Cannabis:

  • Case law is clear that direct marijuana companies do not have access to federal bankruptcy protection.

  • Ancillary marijuana companies are likely excluded from federal bankruptcy protections based on case law.

  • Hemp and CBD processing companies can access bankruptcy protection and there have been high profile examples.

  • CBD brands that sell directly to consumers could have issues with obtaining bankruptcy protection.

  • There are several state law alternatives to bankruptcy: out of court workouts, assignments for the benefit of creditors (ABCs), state receiverships, and state remedies for creditors under the UCC.

  • Transferring licenses in a state receivership is possible, depending on the jurisdiction, and requires careful attention to regulatory issues.


Marijuana Companies and Access to Federal Bankruptcy Courts

Caselaw Regarding Access to Federal Bankruptcy Courts

Plant-Touching Businesses

Courts uniformly agree that businesses growing or selling cannabis may not take advantage of federal bankruptcy laws, even in the case of liquidation. As a bankruptcy court in Colorado put it, “a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aide of a Debtor whose activities constitute a continuing federal crime.” That court further noted that the debtor was barred from bankruptcy protections by the doctrine of unclean hands. Other cases have been dismissed because a trustee or debtor-in-possession cannot take control of a debtor’s property, or liquidate the cannabis company’s inventory, without violating federal law.

When faced with a Chapter 11 protection petition in Mother Earth’s Alternative Healing Coop. Inc., the Southern District of California Bankruptcy Court held that since the debtor’s only means of “funding Chapter 11 protection would be by cultivating and distributing a federally prohibited substance, that the debtor could not qualify for Chapter 11 protection due to his violation of the Controlled Substance Act" (CSA). The inherent bad faith of the proposal required the court to dismiss the case, rather than convert it.

The 10th Circuit also adopted this view. The Bankruptcy Appellate Panel of the 10th Circuit held in In Re Frank Anthony Arenas that, despite the legal classification of marijuana in Colorado, a marijuana grower is not eligible for bankruptcy protection because “neither a Chapter 7 nor 13 trustee can administer the most valuable assets [of the] estate. . . . [and] without those assets or the marijuana-based income stream, the debtors cannot fund a plan without breaking the law.”

There was some hope throughout the cannabis industry when the Ninth Circuit affirmed Garvin v. Cook Invs. NW, SPNWY, LLC, and the marijuana-business debtor’s proposed Chapter 11 bankruptcy plan. However, a closer review of the case indicates that the decision was procedural rather than substantive, and the result was largely due to mistakes by the U.S Trustee. In Garvin, the district court, and the Ninth Circuit, affirmed a Bankruptcy Court ruling that while the plan proposed by the debtor depended on an illegal substantive provision, the court could still affirm that plan because Section 1129 “directs courts to look only to the proposal of a plan, not the terms of the plan.” However, the Ninth Circuit confirmed that a plan of bankruptcy “does not insulate debtors from prosecution for criminal activity, even if that activity is part of the plan itself.” This decision has subsequently faced harsh criticism from other bankruptcy courts. A Michigan bankruptcy court declined to follow the Ninth Circuit’s position, stating in a footnote that it disagreed with the Ninth Circuit and that the court should have dismissed the case rather than setting a precedent which allows a federal court to confirm a Chapter 11 plan that permits a debtor to violate federal criminal law. The court in In re Way to Grow was also critical of the Garvin finding. 

Ancillary Businesses

It is not just licensed cannabis companies that are barred from Bankruptcy courts. Judges have also barred landlords (renting to a cannabis company is prohibited by Section 856(a) of the CSA) and sellers of hydroponic grow equipment (it is a crime to distribute equipment used to manufacture a controlled substance under Section 843(a)(7) of the CSA). But, leasing space to marijuana businesses has proved to be fatal to debtors seeking chapter 11 or 13 bankruptcy protection. However, unlike plant-touching businesses, ancillary businesses appear to have more of an opportunity to convert to Chapter 7 protection, rather than face a dismissal.

For example, in In Rent-Rite Super Kegs Ltd. the Colorado Bankruptcy court ruled that it would dismiss the debtor’s Chapter 11 or convert it to Chapter 7 because the debtor derived 25% of its revenues from leasing warehouse space to a marijuana cultivator.

Likewise, in Arm Ventures, LLC a debtor owning 48.8% of a commercial property intended to lease part of the property to a licensed medical marijuana facility but was denied Chapter 11 protection by the Southern District of Florida Bankruptcy Court. The court demanded that the debtor provide a plan that did not depend on marijuana as a source of income, or the case would be converted to a Chapter 7 proceeding. In In re Basrah Custom Design, the judge dismissed a Michigan bankruptcy case because the debtor business had leased property to a medical marijuana dispensary. The court found that the debtor’s status as a landlord put it in direct violation of Section 856(a) of the CSA, and thus, the debtor had unclean hands and the court could not provide assistance in violating the CSA.

Landlords are not the only ancillary businesses being denied protection. Sellers of products used by state-legal marijuana businesses are also being denied bankruptcy protection. In In re Way to Grow, the court faced a decision of whether to provide bankruptcy protection to a company that knowingly sold hydroponic supplies to both the general public and marijuana businesses. In Way to Grow the court contemplated a debtor’s bankruptcy protection by assessing whether a business must directly and aggressively market to, or aid and abet cannabis consumers in, violating the CSA.

The court in Way to Grow rationalized that a company selling hydroponics to marijuana growers could not hide behind the fact that legal growers also purchased their products. However, focusing on Section 843(a)(6) and (7), the court determined that the debtors did not aid and abet the manufacture of marijuana because a “court would need to conclude [that] debtors share the same intent as their customers to violate the CSA and willfully associate themselves with their customers’ criminal ventures.” Even though debtors do not share this intent, the fact that they knowingly sell their products to customers who will and do violate the CSA is enough to prevent federal bankruptcy protections. The court’s decision appears to have left open the possibility of a more limited application for excluding ancillary business while simultaneously opening up the possibility of broader exclusion for technology companies and other ancillary providers from bankruptcy protection.

The Way to Grow court focused on Section 843(a)(7) because the debtor was selling products used in the production of cannabis. However, using other provisions, such as Section 843 of the CSA and the rational from Way to Grow, a court could deny access to bankruptcy protections to companies providing technology or services to marijuana businesses. For example, 843(c)(2)(A) makes it unlawful to use the internet to advertise a controlled substance (although there is a carve-out for material that merely advocates for use of a controlled substance without attempting to facilitate an actual transaction). At the same time, the holding in Way to Grow may be limited by its exceptional fact pattern. Other ancillary companies may not support the marijuana industry in as open a manner. 

U.S. Trustee

Finally, beyond the separate decisions of bankruptcy courts, the U.S. Trustee, a division with the Department of Justice that is responsible for overseeing the administration of bankruptcy cases and private trustees, has taken a very public and clear position that marijuana assets may not be administered in federal bankruptcy. This policy position, combined with the weight of precedent, strongly indicates that marijuana companies should not expect any access to U.S Bankruptcy Code until a change in federal law occurs.

Chapter 15

Chapter 15 cases are meant to deal with cases of cross-border insolvencies and provide many of the same protections of a chapter 7 or 11 case. It may be possible for a Canadian-based cannabis company to begin insolvency proceedings in Canada and then seek recognition in the U.S. However if the company had any U.S.-based cannabis assets, it appears likely that the filing would be disputed as against public policy for the same reasons as other purely U.S. federal bankruptcy filings.

Alternatives to Federal Bankruptcy Protections 

Out-of-Court Restructurings

An out-of-court restructuring is any transaction where a contractual arrangement is reached outside of a bankruptcy or state receivership proceedings to recapitalize or reorganize the capital structure of a company. There is no legal reason why an out-of-court restructuring could not be used in a cannabis transaction. The difference, however, with respect to marijuana transactions, is that the lenders will know that the debtor does not have access to federal bankruptcy protection.

State Receiverships

A state court receivership provides for the court appointment of a third party to act on behalf of all interested parties (i.e., not merely as an agent of the lenders). Note, that in addition to state receiverships, there are also federal receiverships, but cannabis companies will be limited in their access for the same reasons they are limited to bankruptcy protection. As receiverships have become more common, many states have recently enacted comprehensive receivership statutes.

Appointments typically occur in one of four situations:

  1. A receiver appointed to oversee commercial real estate and collect rent
  2. A receiver requested by the senior secured (or, occasionally, just the unsecured) lenders of a company
  3. A receiver requested by the company itself
  4. A receivership instituted to protect the health and safety of the public (e.g., an Attorney General requesting receivership over a mismanaged nursing home).

Courts do not freely grant receiverships and generally require evidence of insolvency or a need to preserve a company’s assets from being dissipated. And most states grant judges broad latitude in determining whether to appoint a receiver.

Unlike assignments for the benefit of creditors (ABC), discussed below, a receivership is always court-supervised. The court order appointing the receiver will place the company’s property under the control of the receiver and set forth the scope of the receiver’s authority (which can vary significantly).

Assignments for the Benefit of Creditors (ABC)

Another alternative is an ABC. An ABC is generally a non-judicial—although there are also judicial ABCs that are becoming more common—state common-law governed process. Increasingly, however, states are codifying the process by statue and allowing insolvent companies to voluntarily assign its assets to a third party, who then holds these assets in a fiduciary capacity for the benefit of the company’s creditors. This process typically requires the approval of the board of directors and shareholders of the company, which may delay the process (in contrast to a federal bankruptcy petition where shareholder approval is not necessary). The ABC is started by executing a deed of assignment, or assignment agreement, transferring all of the assets of the company to the third party. As noted above, an ABC is not necessarily court-supervised and the regulation of an ABC can vary considerably by jurisdiction.

An ABC has the advantages of possibly being faster and cheaper than a Chapter 7 or liquidating Chapter 11 case, but it is ultimately a dissolution of the company and does not contemplate the restructuring of an insolvent business into a going concern. In addition, an ABC cannot take advantage of the powers provided a trustee in a federal bankruptcy court, such as the ability to assign executory contracts without the consent of a counterparty or the ability to sell free and clear of liens.

Transfers of state licenses can also be more difficult in an ABC than in a state receivership. It will depend on both the marijuana and ABC regulations of the applicable state, which need to be looked at holistically. One question is whether the marijuana regulations require the process to be judicially overseen or if any assignment for the benefit of creditors will suffice. For example, California’s marijuana regulations contemplate a procedure for the transfer of a license under both an ABC and receivership. Colorado, on the other hand, only has expedited license procedures in the case of court appointees. The other question is the nature of an ABC within a jurisdiction. ABCs vary considerably between states and range from being purely a creature of common to being heavily regulated and overseen judicially. Participants in ABCs will need to review the laws governing both marijuana licenses and ABCs in their jurisdiction in order to determine if a license transfer will be practical. There is limited precedent in this area, and it is difficult to predict exactly how it will play out in practice.  

Remedies for State Creditors under the UCC

Under Article 9 of the Uniform Commercial Code (UCC), upon a default, a secured creditor can repossess and dispose of its collateral. Article 9 governs the terms of the repossession and subsequent sale of the collateral. These rules include obligations to provide reasonable notice to the debtor and other parties of interest of the intent to sell the collateral, the use of reasonable efforts to maximize the proceeds of the sale, and to properly apply the proceeds of the sale. If the assets secured are subject to marijuana regulations, however, any state and local marijuana regulatory requirements must be followed in addition to the UCC procedures. For example, if an all assets lien has been filed on the debtor’s property, a lender cannot repossess marijuana or marijuana products. All state regulatory regimes have concluded that only a licensed business can possess and sell marijuana and unless the lender holds the requisite licenses, any attempt the repossess the collateral would be illegal.

Winding Up under State Statute

Finally, a cannabis company can simply wind up pursuant to the rules of its state of formation. In winding up, the company directors, or members, will dissolve the business, signifying the termination of business operations. Treatment of business debt, and whether it needs to be paid prior to dissolution, needs to be evaluated in light of the applicable state laws.

Marijuana Licenses and Insolvency

One area of law that is still quite nascent is how marijuana licenses will be treated in an insolvency scenario. Since marijuana companies are typically excluded from transferring licenses without regulatory approval, the issue of insolvency creates a unique predicament for marijuana companies. There are typically no rules that prohibit an insolvent company from transferring a license; a licensee would need to follow the normal process. Following a typical transfer process may not be possible, though, as it would require initial approval to put a third party in charge of the insolvent company and then a separate approval to sell the license to another party. Given the timeline to close a change of control, this may not be practical. However, some states have adopted regulations that provide for the transfer of licenses in an insolvency scenario.

Colorado

At the time of publication, there have been a limited number of cases involving receiverships and marijuana licenses worth discussing. In Yates v. Hartman, the court dealt with a divorce and the requested appointment of a receiver over the marital property. The marital estate in this case included the “Frosted Leaf” group of businesses, which included medical and adult-use marijuana licenses. Upon the wife’s request, the district court appointed a receiver to “take immediate control of the [businesses] and operated the [businesses] on the Court’s behalf in custodia legis.” At the time of the decision, neither the receiver nor any of its employees had been determined suitable to be an owner of a marijuana license by the Colorado Department of Revenue Marijuana Enforcement Division (MED). And the MED had not approved the transfer of ownership from the marital estate to the receiver. The Executive Director of the Colorado Department of Revenue moved to intervene in the proceedings, and appealed the district court’s decision that its power to appoint a receiver trumped the marijuana licensing laws. The decision was subsequently overturned.

The Court noted, however, that the district court could appoint a substitute receiver who complies with the MED licensing requirements. It’s important to note that at that time the Colorado regulations did not contemplate the appointment of a receiver over an entity holding marijuana licenses. This changed in 2019 and the Colorado regulations now explicitly set forth procedures for the appointment of receivers.

Section 2-275 of Colorado’s Marijuana Rules, which became effective on January 1, 2020, was added to clarify procedures and requirements for court-appointed receivers, trustees, and other court appointees. The regulations permit court appointees to accept an appointment prior to licensure from the state licensing authority so long as they file an application within 14 days of their appointment. While the court appointees cannot establish an independent license, it is authorized to exercise the privileges of a temporary licensee that expires upon the conclusion of the court’s appointment. If necessary, the temporary license is valid for one year and can be renewed annually in accordance with Colorado’s Marijuana Code.  

Washington

One instance where a marijuana license has been successfully transferred through a receivership occurred in Washington. Under state law, the Washington State Liquor and Cannabis Board (WSLCB) is explicitly empowered to approve receiverships over marijuana businesses. Further, the marijuana regulations stated that a receiver appointed over a licensee must notify the WSLCB’s licensing and regulation division in the event of the receivership of any license, and receive approval from the WSLCB unless the receiver is a pre-approved receiver.

The case in Washington involved a landlord with a marijuana business tenant who was not current on rent payments. Complicating matters was the nature of the tenant’s assets: its marijuana license, which cannot be transferred without approval of the WSLCB, and its marijuana inventory, which cannot be sold by an entity not licensed by the WSLCB.

The lead attorney’s experiences in this matter provide a useful map for issues likely to arise with marijuana receivership in the future. The first issue faced in the Washington case dealt with needing to keep the business operational. Washington, like many states, requires a licensed business to remain operational to maintain its license in good standing, so it was vital to have the receiver approved as a suitable entity that could control and direct a marijuana business. In this case, the lead attorney noted that the receivership order included a provision that allowed the receiver to avoid cancellation during the suitability approval process.

Another issue that arose in the receivership process was the fact that the landlord was attempting to evict the tenant. This created an issue since a Washington marijuana license cannot be moved until the new location has been approved by the WSLCB.  Working with the WSLCB, the landlord and receiver obtained the necessary license to sell the company’s inventory and were able to apply those proceeds to the judgment.

California

At least one publicly-traded company has begun an insolvency proceeding: DionyMed, a multi-state operator listed on the CSE, recently defaulted on over $24.81 million after a creditor demanded immediate payment of its approximately $19 million loan. DionyMed then failed to restructure its debt or find a strategic buyer to acquire its assets, triggering the Supreme Court of British Columbia to appoint FTI Consulting Canada Inc. as receiver of the company’s properties and assets. At present, the contemplated asset sale has been sealed, so it is not possible to determine if any of the state marijuana licenses will be transferred.

Hemp and CBD Companies and Access to Federal Bankruptcy Courts

Caselaw Regarding Access to Federal Bankruptcy Courts

With the passage of the 2018 Farm Bill, hemp was removed from the definition of marijuana in the CSA – opening the door for hemp businesses to operate in compliance with Federal law. However, some hemp-derived products will still not fully comply with federal law. The Food and Drug Administration (FDA) has taken a clear position that pursuant to the Federal Food Drugs & Cosmetics Act (FFDCA), CBD cannot be sold as a food ingredient or supplement. Will bankruptcy courts view violations of the FFDCA the same way they have viewed violations of the CSA? Two recent bankruptcy court rulings appear to suggest that courts focus on the CSA and not the FFDCA, but this issue has not yet been dealt with in enough detail to provide much guidance.  

In In re Way to Grow, the Appellants filed a motion of stay pending appeal in which they argued that, with the passage of the 2018 Farm Bill, they could pivot their business to focus on commercial and industrial hemp to avoid violating the CSA. The court, however, did not consider this argument persuasive and noted that the business historically advertised as a cannabis business and there was no way the company could ensure that new customers were buying hydroponic equipment only for legal hemp operations.

On June 3, 2019, the United States Bankruptcy Court for the District of Nevada addressed, albeit in dicta, the question of whether a hemp company could avail itself of the federal bankruptcy court system, stating that a “Debtor’s CBD Business ... may no longer be prohibited under federal law as a result of the [2018 Farm Bill].” The court continued by highlighting the importance of hemp’s removal from the CSA in the 2018 Farm Bill and that the Food and Drug Administration was placed in the position to regulate such products. The court thought it was important that the Debtor’s CBD business might not be in violation of the CSA (assuming the CBD was derived from hemp). But the court did not address the FFDCA at all, and there was no discussion of whether a violation of the FFDCA would bar a company from the federal bankruptcy system.

On February 6, 2020, GenCanna Global USA Inc. (GenCanna), a large Kentucky vertically-integrated producer of hemp and hemp-derived CBD products, filed for bankruptcy. GenCanna noted that it was hurt by a “dramatic plunge” in the price of CBD products. As of today, GenCanna has not been removed from bankruptcy court due to its potential violations of the FFDCA and it does not appear that motions to dismiss for reasons related to federal illegality have been filed. This is a positive indication for the ability of hemp and CBD companies to access the protections of US bankruptcy courts.

Insolvency and Licenses

Unlike marijuana regulatory regimes, it does not appear as though hemp licensing contemplates the possibility of license transfers in receivership or other insolvency scenarios. The Interim Final Rule (which will only govern licenses issued by the USDA directly) notes that “[l]icenses may not be sold, assigned, transferred, pledged, or otherwise disposed of, alienated or encumbered.” So unless a state insolvency proceeding involves a change of ownership, as opposed to a transfer of assets, as is common, there is no possibility of transferring USDA-issued licenses. Practically, this may not be a material concern because obtaining USDA licenses is very different from the process of obtaining state marijuana licenses. These licenses are not limited in number and are generally far easier to obtain, so the inability to transfer the licenses in an insolvency proceeding may not matter. A new license could simply be obtained.

CARES Act and Subchapter 5

One additional option that hemp companies can now consider is Subchapter 5. The Small Business Reorganization Act (SBRA), which recently became effective in February 2020, created a new subchapter under Chapter 11 of the Bankruptcy Code that is commonly called Subchapter 5. It is meant to give businesses with debts under a certain amount a faster and cheaper option for reorganizing than Chapter 11. Under the SBRA, the debt limit to allow access to Subchapter 5 is $2,725,625 or less. However, Section 1113 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was signed by President Trump and became law on March 27, 2020, increased the debt limit to $7.5 million. This may provide a better option for hemp companies attempting to restructure their debts.

This article is for informational purposes only and not for the purpose of providing legal or tax advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. This material may be considered attorney advertising under certain rules of professional conduct.