By Bec Edelson and James Fazio
Claimed “illegality” of cannabusinesses continues to be a critical issue for them in their ability to enforce their rights in the courts. The ability to seek judicial relief may be especially important to some cannabusinesses that are struggling as a result of the COVID-19 pandemic (e.g., to seek bankruptcy relief, or to obtain compensation from customers or suppliers that breach contracts). In our December 2019 articles,we observed that a cannabusiness may find it difficult to pursue its Intellectual Property (IP) rights in certain jurisdictions where cannabis remains illegal. Here, we provide an update on the “illegality” issue, including outside of the IP arena. We discuss some recent legal rulings in the cannabis space and some potential ramifications to cannabusinesses’ ability to seek bankruptcy and other relief in the courts.
Can cannabusinesses can take advantage of federal bankruptcy protection? It depends but likely is an uphill battle. Historically, bankruptcy courts have refused to allow debtors engaged in violating federal drug laws to enjoy the benefits of the bankruptcy laws. In In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012), for example, the debtor derived roughly 25% of its revenues from leasing warehouse space to tenants whom the debtor knew to be growing marijuana. 484 B.R. at 802. Because a “significant portion of the debtor’s revenue [wa]s derived from an illegal activity,” the Court refused to confirm the debtor’s bankruptcy plan. Id. at 809.
However, the Agriculture Improvement Act of 2018 (commonly known as the “2018 Farm Bill”) removed industrial hemp from the Controlled Substance Act’s (“CSA”) definition of marijuana and removed “tetrahydrocannabinols in hemp” from the definition of tetrahydrocannabinols, which, like marijuana, is classified as a Schedule I drug. Additionally, the 2018 Farm Bill amended the definition of hemp to mean “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.” This decriminalization of hemp made it possible for certain (but not all) cannabusinesses to pursue federal bankruptcy relief.
For example, in In re Royalty Properties, LLC, 604 B.R. 742 (Bankr. N.D. Ill. 2019), the Court recognized that the “2018 Farm Bill in effect legalized hemp and its derivative products.” Nevertheless, the Court refused to grant the debtor’s Chapter 11 petition for reorganization and instead converted its petition into a Chapter 7 petition because the debtor “ha[d] no experience producing and selling hemp or hemp seeds” and the Court was not convinced that the debtor’s plan for selling hemp without any prior experience would generate the “million of dollars” necessary for the proposed bankruptcy plan to succeed. While the debtor in Royalty Properties was unsuccessful, the Court’s opinion may suggest that if a debtor can credibly establish that its bankruptcy plan will be funded from the manufacture and sale of legalized industrial hemp or its derivatives, bankruptcy relief may be available.
Recently, on April 20, 2020, United Cannabis Corporation (“UCann”) (a leading manufacturer of CBD products) filed a Chapter 11 petition for bankruptcy in Colorado. UCann owns a patent covering a extract containing 95% cannabinoids which are legal under federal law. The Court, however, issued an Order to Show Cause (OSC) why the bankruptcy petition should not be dismissed because UCann “appears to be engaged in the marijuana industry.” On May 4, 2020, UCann filed a response to the OSC in which it argued that because all its revenues derived from the cultivation, processing and sale of legalized hemp, and not marijuana, UCann’s bankruptcy petition should be granted. Citing and distinguishing several of the cases noted herein, UCann argued that the “Debtors are well established in the hemp and CBD industry” and had “no marijuana-related revenue.” The Court has not yet ruled on the OSC.
Further, the Justice Department continues to object to making bankruptcy relief available to members of the cannabis industry. See“Justice Department Blocks ‘Essential’ Marijuana Workers From Bankruptcy Protection,” The Wall Street Journal, May 28, 2020 (“The department’s policy means the financial safety net that bankruptcy provides … is likely out of reach for those who work in the marijuana industry or businesses supporting state-regulated dispensaries or growers”; “Cannabis remains illegal under federal law, which includes the U.S. bankruptcy code” and the Justice Department is of the view is “based on the legal principle that the U.S. bankruptcy code can’t be used to aid in the violation of federal criminal law.).
Takeaways: If a cannabusiness can credibly establish that its post-petition revenues will stem entirely from the cultivation and sale of hemp and its derivatives (and not from the cultivation and sale of marijuana), it may have a reasonable chance of obtaining bankruptcy relief but still may face hostility from the bankruptcy judge arising from the “illegality” issue. If a cannabusiness is engaged in a business illegal under federal law, then it likely will not be permitted to obtain bankruptcy relief and may need consider other options. For example, depending on the circumstances of the business (including the state(s) in which it operates), it may seek certain relief via a state court receivership or an assignment for the benefit of creditors.
Outside the bankruptcy context, courts are divided as to whether cannabusinesses can seek relief from the courts if their businesses are illegal. On April 22, 2020, a California Court of Appeal affirmed an order dismissing claims relating to a partnership that had been created for the production and distribution of edible cannabis products on the ground that the partnership’s cannabusiness was illegal at the time of defendant’s alleged misconduct. Plaintiffs claimed that a former partner stole the partnership’s trade secret recipes. The trial court, however, dismissed plaintiffs’ claims because the “commercial cannabis operation” at the center of the business was illegal at the time of the defendant’s alleged wrong-doing. The Court of Appeal affirmed, reasoning that because marijuana was a Schedule I controlled substance prohibited by law in January 2014 when the alleged contract concerning the partnership’s ownership of IP related to the business was made, the court could not afford plaintiffs relief.
On the other hand, other courts have rejected arguments that plaintiffs engaged in cannabusinesses are not entitled to any judicial relief because their businesses are illegal. In Siva Enters. v. Ott, 2018 U.S. Dist. LEXIS 223854, at *13 (C.D. Cal. 2018), for example, plaintiff Siva Enterprises (a 10-year cannabusiness) filed suit for trade secret misappropriation and related claims arising from defendants’ theft of Siva’s customer lists and preferences, business strategies, and operation manuals related to its cannabusiness. Defendant argued that Siva was not entitled to relief because it was facilitating drug trafficking in violation of the CSA. However, the Court refused to dismiss the case because the “case does not involve the actual production or sale of cannabis. Rather, the [complaint] concerns the actions of defendants in allegedly misappropriating plaintiffs’ confidential business information.” The Court also refused to dismiss the Lanham Action claims on the same grounds. “Defendants contend that plaintiffs’ Lanham Act also fails because it involves ‘the aiding and abetting’ of the commission of a crime. … This is a mischaracterization of plaintiffs’ allegations, which are predominantly focused on defendants’ alleged theft of plaintiffs’ client lists and client information. Moreover, as explained earlier, the Court finds that the CSA’s prohibition on cannabis does not immunize defendants from federal laws. Accordingly, the Court declines to dismiss plaintiffs’ federal claims based on the Controlled Substances Act.”
Takeaways: Before filing suit, know the views on the illegality issue of the jurisdictions under consideration. To the extent possible, a cannabusiness seeking to enforce trade secret rights should attempt to file its complaint in a jurisdiction where cannabis is legal (unless there are more significant countervailing reasons not to file there). To the extent that a cannabusiness finds itself in a litigation in a jurisdiction where cannabis is illegal (e.g., a federal court to pursue a patent infringement claim), it would behoove the cannabusiness to (i) emphasize the IP nature of its rights (to be distinguished from related activities that may be considered illegal)and (ii) argue that the jurisdiction’s prohibition on cannabis should not immunize defendant’s violations of other laws.
Also, to the extent possible, business should think proactively before there is a need for litigation. For example, a cannabusiness entering into a contractual relationship with another party should carefully consider with counsel whether there are any provisions that can be included to address the potential illegality issue (e.g., favorable choice of law and forum selection provisions).
About the co-author
James Fazio is special counsel in Sheppard Mullin’s intellectual property practice group.
This alert is provided for information purposes only and does not constitute legal advice and is not intended to form an attorney client relationship.
For our prior articles, see Intellectual Property in the Cannabis Industry – Protecting Innovations And Products, Part I (Trade Secrets) and Intellectual Property In The Cannabis Industry – Protecting Innovations And Products, Part II (Patents).
See also In re Arenas, 514 B.R. 887, 891 (Bankr. D. Colo. 2014) (dismissing the bankruptcy petition because administration of the case would be “impossible without inextricably involving the Court and the Trustee in [the debtor’s] ongoing criminal violations of the [Controlled Substance Act (‘CSA’)].”); In re Way to Grow, Inc., 2019 U.S. Dist. LEXIS 207846, at *28 (D. Colo. Sep. 18, 2019) (affirming the dismissal of a bankruptcy petition on the ground that “for the debtors “at least had ‘reasonable cause to believe’ the [hydroponic] equipment [it] sells to at least some of [its] customers will be used to manufacture marijuana” in violation of the CSA). But see Garvin v. Cook Investments, 922 F.3d 1031, 1035 (9thCir. 2019) (affirming confirmation of a bankruptcy plan because, while the debtors intended to lease property to a marijuana grower, §1129(a)(3) of the Bankruptcy Code “directs courts to look only to the proposalof a plan, not the [substantive] terms of the plan.”) (emphasis added); In re Basrah Custom Design, Inc., 600 B.R. 368, 382 (Bankr. E.D. Mich. 2019) (criticizing Garvinand dismissing a bankruptcy petition because the purpose of the proposed plan was to allow the debtor’s principal to either lease or sell commercial space to “some other marijuana dispensary” or “us[e] the property to operate a marijuana dispensary himself” in violation of the CSA).
 7 U.S.C. § 1639o(1).
 604 B.R. at 744.
 Id. at 748-49.
 In re United Cannabis Corp., 20-br-12692, Dkt. 1 (D. Colo. Apr. 20, 2020).
 Id. at Dkt. 14.
 Id., Dkt. 53 at 3-4.
 Id., Dkt. 53 at 9.
Unlike the United States, Canada offers bankruptcy protection to failing cannabusinesses (at least to those incorporated in Canada). See, e.g., Virus Pushes Green Growth To Insolvency Filing In Canada.
Metsch v. Heinowitz, D074999 (Cal. 4thDiv. 1 Apr. 22, 2020), Order Affirming Judgment of San Diego Sup. Ct, 37-2017-28176.
See https://www.cannabislawblog.com/2019/12/protecting-innovations-products-part-i-trade-secrets-protection/ (citingSiva Enters. v. Ott, 2018 U.S. Dist. LEXIS 223854, at *13 (C.D. Cal. 2018))and https://www.cannabislawblog.com/2020/01/protecting-innovations-products-part-ii-patent-protection/ (citingUnited Cannabis Corporation v. Pure Hemp Collective, Inc. No. 18-cv-1922 (D. Colo. 2019); Kenney v. Helix TCS, Inc., No. 18-1105 (10th Cir. 2019); Left Coast Ventures, Inc. v. Bill’s Nursery, Inc., No. C19-1297 MJP, 2019 U.S. Dist. LEXIS 189312 (W.D. Wash. Oct. 31, 2019). InLeft Coast, the plaintiff had filed suit to enforce an option agreement to purchase an ownership interest in a marijuana distribution business. After briefing on defendant’s motion to dismiss, the District Court declined to exercise federal jurisdiction on abstention grounds, ruling that “the federal issues are not easily separable from complicated state law issues with which the state courts may have special competence and federal review might disrupt state efforts to establish a coherent policy” and thus remanded the case to state court for further proceedings. Id., Dkt. 23 [Order Remanding Case at 4].
2018 U.S. Dist. LEXIS 223854, at *2.
 Id. at *5.
 Id. at *15-*16.