In the wake of COVID-19, there will be a tsunami of cannabis-related businesses looking for restructuring options. The cannabis industry has been hit especially hard in these unprecedented times. Even before COVID-19, some businesses in this industry were teetering on the brink of insolvency, given limited financing options and unforgiving capital markets. With the added uncertainty of the pandemic, many now have to contend with further liquidity constraints resulting from their inability to receive federal stimulus relief under the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES).
The critical question that cannabis-related businesses must ask themselves: What restructuring options are available when revenue is derived from federally prohibited cannabis products? Unfortunately, the federal government has specifically excluded these businesses from emergency relief funds under CARES and prevented their ability to file for bankruptcy protection. The bankruptcy courts’ distinction hinges on whether products manufactured/sold contain THC, which is classified as a Schedule 1 drug under the Controlled Substances Act (the “Act”). Since the bankruptcy system abides by federal law, courts treat cannabis-related businesses differently depending on their connection to THC. If a cannabis business so much as identifies THC on its business filings, bankruptcy law may prevent them from utilizing the bankruptcy system. On the other hand, purely CBD/hemp companies, which manufacture/sell products legal under the Act, are able to file.
It is common knowledge in the cannabis industry that a bankruptcy case filed by a direct seller or grower of cannabis is in violation of the Act and will be met with a motion seeking immediate dismissal. What most people don’t know, however, is that indirect participants in the cannabis industry, such as third-party investors or equipment suppliers, have the same restrictions on federal bankruptcy filings as direct sellers. Furthermore, the Act states that it is unlawful for landlords to knowingly lease locations to manufacture or distribute a controlled substance. As a result, a company that derives income from products containing THC may not have access to bankruptcy protections.
The rationale behind THC cannabis companies’ inability to benefit from federal bankruptcy protections is twofold. First, these businesses will not be permitted to reorganize under the Bankruptcy Code, since their plan of reorganization must be proposed by a debtor in good faith and “not by any means forbidden by law.” Secondly, a debtor will not be able to repay debts through the sale of inventory or other assets if doing so would cause the company to violate federal criminal law. In the end, struggling THC cannabis businesses, from direct sellers to downstream participants, could be forced to close their doors, potentially exposing business owners to personal recourse from creditors.
If, however, the company only manufactures or sells CBD/hemp products, a bankruptcy case should proceed because these products are not considered controlled substances under the Act. While a business that is comprised of both THC and CBD/hemp products may try to make a case for federal bankruptcy protection, either because the debtor no longer sells THC products or they comprise a minor portion of their revenue stream, courts have been quick to dismiss those cases too. Courts in the Ninth Circuit (California, Arizona, Alaska, Washington, Oregon, Idaho, Nevada, Montana, Hawaii, Territory of Guam and Territory of Northern Mariana Islands), however, seem to be slowly evolving with the reluctance to adopt a per se bright-line rule requiring the immediate disposition of bankruptcy cases in which THC activity is present.
A few U.S. cannabis-related businesses have tried utilizing Canadian bankruptcy protection by maintaining Canadian operations or listing on the Canadian Securities Exchange. In reality, these actions may not be sufficient to meet the jurisdictional requirements for a Canadian insolvency proceeding. In order to move forward with a bankruptcy case in Canada, the business would likely need to have a majority of its assets in Canada or be incorporated there. Bankruptcy courts will take a close look into the debtor’s business operations to determine whether the cannabis company has sufficient ties to Canada to warrant a cross-border bankruptcy filing.
Assuming a United States or Canadian bankruptcy filing is not viable, what alternatives do cannabis-related businesses have to restructure debt, reorganize, or alternatively, liquidate assets? Rather than seek relief through the traditional federal bankruptcy process, distressed cannabis-related businesses operating in the United States will have to follow state-specific guidelines. As of May 2020, thirty-three states permit the use of medical marijuana, and eleven of those authorize recreational use. Thus, cannabis companies with operations in multiple states face the complicated analysis of how to reorganize or wind down their business in each state.
If bankruptcy is not a possible option, there are still a variety of restructuring alternatives potentially available, including the following:
▪ Equity Receiverships: A state court appoints an equity receiver to take over the management of a distressed business and sell certain assets.
▪ Assignments for the Benefit of Creditors: A companytransfers its assets to an independent third-party, who is required to liquidate them and apply the proceeds from the sale of the assets to the company’s creditors.
▪ Compositions: An agreement between a debtor and two or more of its creditors,in which the creditors agree to accept partial payment of the amounts outstanding to satisfy their claims.
While each of the above has advantages and disadvantages, it is worth noting that none of the state-specific alternatives includes the all-important benefit of the “automatic stay.” Under the Bankruptcy Code, the stay prohibits creditors from taking action to collect their outstanding debt, which is the single most important protection as it allows them breathing room to reorganize their business affairs or liquidate their assets in an orderly manner.
The ultimate take-away is that any cannabis-related business (THC or CBD/hemp) facing financial distress needs to review their options carefully with legal counsel. It is only at that point when they can determine the best option given the nature of their business and applicable federal and state laws.