As those in the cannabis industry are fully aware, the option of bankruptcy has not been available to cannabis or many cannabis-adjacent businesses to date. The courts have consistently indicated debtors who work in the cannabis industry or derive meaningful income from cannabis activity (directly or indirectly) cannot use bankruptcy, a federal mechanism, so long as marijuana remains illegal under federal law. The seminal Arenas decision from 2014 observed that things get especially awkward when “granting [relief to the debtor] directly involves a federal court … administering the fruits and instrumentalities of federal criminal activity.”

This rationale has prevailed without exception for a decade now. Here and there, a bankruptcy court will break away in very limited and specific scenarios, like when the Ninth Circuit confirmed a plan of reorganization for a group of cannabis-adjacent real estate companies in 2019 (see that post here). A recent case highlights perhaps another specific scenario in which a distressed cannabis business was given the chance to pursue bankruptcy under federal law.

Facts of In re: The Hacienda Company, LLC

The Hacienda Company, LLC (“HC”) was in the business of wholesale manufacturing and packaging cannabis products under the “Lowel Herb Co.” brand, also known as “Lowell Farms.” It stopped operating in February 2021. After it ceased operations, it transferred its value to a publicly traded Canadian company by structuring the sale as one of intellectual property, not the sale of an operating cannabis business. The Canadian company’s sole business is cannabis growth and sale, which is legal under Canadian law. In return, HC received 9.4% of the shares of the Canadian company.

After this, HC filed for bankruptcy in the Central District of California. The United States Trustee subsequently filed a motion to dismiss HC’s bankruptcy case under the same rationale that allowing bankruptcy would necessarily involve violations of the Controlled Substances Act (“CSA”).

The Court’s ruling and rationale

The Court denied the Trustee’s motion to dismiss. It started its opinion by indicating that the Trustee had failed to establish any ongoing violation of the CSA, only pre-petition violations – which was a significant factor:

“… [T]he tentative ruling is that this interpretation of section 856(a) of the CSA goes too far. Debtor’s passive ownership of stock, with intent to liquidate that stock to pay creditors and thereby terminate any connection with canabis, appears to be the opposite of an intent to profit from an ongoing scheme to distribute canabis. Therefore, the tentative ruling is that the UST has not established a violation of section 856(a) of the CSA. … Debtor does not propose, postpetition, to use any of its remaining assets to “invest” in any enterprise (canabis-related or otherwise). Instead, Debtor proposes to sell the stock and distribute the resulting cash to creditors.”

Ultimately, the Court believed a bankruptcy court could use its discretion to determine whether the debtor’s connections to cannabis profits or past or future investments in cannabis warranted dismissal of its petition or not. In stark contrast to the trend, the Court went on to write that Congress did not adopt a “zero tolerance” policy for any illegality. It wrote that “some of the largest business bankruptcy cases, like Pacific Gas & Electric Co. … of ‘Erin Brockovich’ fame, involve alleged or actual criminal activity.” Similarly, even small business bankruptcies that involve restaurants or apartment buildings regularly involve violations of health and safety regulations:

“If all of the foregoing examples were ‘cause’ for dismissal, this Court might have to dismiss most bankruptcy cases. That would harm all of the constituencies that Congress attempted to protect using all of the tools of the Bankruptcy Code, including creditors, debtors, employees of debtors, and local governments and communities that depend on debtors’ ability to reorganize their finances and resume making contributions to commerce and society.”

Takeaway

As we’ve written with other cases, this is a very limited situation where the debtor divested cannabis from its assets. A cannabis company won’t be able to reorganize under Chapter 11 or liquidate under Chapter 7 if it’s still a going concern with cannabis products. However, the dicta and overall message of the opinion clearly marks a break from the zero-tolerance approach that has been typical for these cases.

It should be noted that the Trustee did file an appeal of the decision on January 9, 2023. We’ll monitor that docket and report back on how the appellate proceeding plays out over the coming months.

Re-published with the permission of Harris Bricken and The Canna Law Blog