Bankruptcy Doors Open a Little Wider to Cannabis Companies

February 7, 2023

Danny Newman, Ferdie Ruplin, Jessica Morgan, and Ava Schoen - Tonkon Torp LLP

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In January, a California bankruptcy court issued an opinion providing another lifeline to cannabis companies that could benefit from the protection of the federal bankruptcy code – to reorganize or liquidate assets. The decision was in the bankruptcy case for The Hacienda Company, LLC, a wholesale manufacturer and packaging company that ceased operations in February, 2021, and sold its intellectual property to Lowell Farms, a Canadian publicly traded company that grows and sells cannabis, for 9.4% of the equity shares in Lowell Farms.

Hacienda then filed for Chapter 11 bankruptcy after this sale. While the Ninth Circuit in Garvin v. Cook Investments NW, SPNWY, LLC (upholding the confirmation of a reorganization plan in a bankruptcy involving a debtor that leased land to a marijuana farmer), the Ninth Circuit BAP in In re Burton, and a couple other bankruptcy courts appeared to open the door to bankruptcies with some minor cannabis involvement, bankruptcy courts across the country, typically at the United States Trustee’s (UST) request, have been slamming the door to any cannabis company attempting to enter.

However, in a surprise twist, the bankruptcy court denied the UST motion to dismiss Hacienda’s case.

Hacienda’s Bankruptcy

The debtor filed its Chapter 11 petition in September, 2022, and proposed a plan to sell off the thinly traded Lowell Farms shares in an orderly manner, and use the proceeds to pay creditors. In response, the UST filed a motion to dismiss the case for “cause” under section 1112(b) of the Bankruptcy Code, as USTs across the country have been doing for years.

Because of the limbo legal status of cannabis companies, with the U.S. Federal government considering cannabis distribution a crime and states that have legalized cannabis taking the opposite tact, cannabis companies have generally been denied federal bankruptcy protections.

But Central District of California Bankruptcy Judge Neil Bason outlined a different view in his January 20 opinion, resulting in denial of the UST’s motion to dismiss. The opinion made three major points:

• No ongoing violation of the Controlled Substances Act (CSA): The debtor, Hacienda, is no longer in business; it simply owns stock in a cannabis-related business. Debtor’s passive ownership of stock, with intent to liquidate that stock to pay creditors, will terminate any connection with cannabis. Moreover, it is not a foregone conclusion that the rights of any federal governmental unit to seize assets would supersede creditors’ rights. Therefore, not only did the UST fail to show that a future bankruptcy trustee would have to violate the CSA but, to the contrary, it appears that future trustees probably have a duty to administer assets rather than simply turn them over to the federal agency. Because Hacienda proposed to sell the stock to pay creditors rather than invest in businesses that derived revenue from cannabis, there was no CSA violation.[1]
• Categorical dismissals for “cause” under Section 1112(b)(4) are disruptive to bankruptcy courts: Bankruptcy courts have a long history of considering cases whose activities and operations have included past, present, and possibly ongoing violations of applicable non-bankruptcy, civil, and criminal laws. Dismissing every case that has a connection with illegal activity under Section 1112 would be contrary to Congress’ directives under the Bankruptcy Code and to long-established practice. 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 was attempting to wind up that activity postpetition. Some of the largest business bankruptcy cases, like those of Pacific Gas & Electric Co., Enron Corporation, and Bernie Madoff, involve alleged or actual criminal activity. Should those cases have been dismissed?
• Even if dismissal is generally warranted, Debtor showed unusual circumstances: Hacienda established “unusual circumstances” (under § 1112(b)(2) of the Bankruptcy Code) to overcome “cause” because it was in the best interest of creditors to keep the case in bankruptcy. The Debtor had eliminated any direct involvement in the cannabis industry and there was a good chance of a “substantial” distribution to creditors by selling the Lowell Farms (cannabis) stock.

The Bottom Line

The cannabis industry hit a rough patch last year and that trend will likely continue in 2023. In 2022, Oregon sales fell $190 million to $994 million, a 16% slide as prices plummeted and general economic factors caused a drop in demand. 2022 marked the first annual decline in total sales in the state since 2017, and came after back-to-back years of sales topping $1 billion.

Given the current state of turmoil in the industry, we will likely see more distressed cannabis companies consider seeking bankruptcy relief, or their creditors seeking receivership options. While the Hacienda opinion is narrowly focused, it does open the door for cannabis businesses that are no longer operational to argue that they are entitled to federal bankruptcy protection.

About Tonkon Torp

Tonkon Torp LLP is a leading business and litigation law firm serving public companies, substantial private enterprises, entrepreneurial businesses, and individuals throughout the Northwest. For more information, visit tonkon.com.

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[1] CSA Section 854 prohibits persons who have received income derived from a violation of the CSA to “use or invest, directly or indirectly, any part of such income, or the proceeds of such income, in acquisition of any interest in, or the establishment or operation of, any enterprise [engaged in or affecting interstate or foreign commerce].”