When Cannabis and Cannabis-Adjacent Businesses Burn Out, Bankruptcy Courts Will Likely Leave Them High and Dry
As the number of states that have legalized medical or recreational cannabis continues to grow, the ongoing paralysis at the federal level regarding pot’s legal status keeps causing headaches for cannabis and cannabis-related businesses. While the lack of access to banking services due to marijuana remaining a Schedule I drug under the Controlled Substances Act (CSA) is the most chronic of these issues, the inability of cannabis businesses – and industry-affiliated businesses – to avail themselves of bankruptcy protection is also a major sticking point. And, if you are paying attention to the news, particularly here in Michigan, you know that this issue will only grow larger as cannabis prices plummet.
Bankruptcy courts across the country are working through the conundrum of how to deal with debtors seeking rights, remedies, and protections under federal law when their business operations, assets, and debts are connected to past or ongoing violations of federal law.
“Zero-Tolerance” Approach
For businesses directly involved in the cultivation, distribution, or sale of cannabis, the door to the bankruptcy courthouse is essentially locked, with trustees across the country regularly and successfully moving to dismiss cases filed by such debtors. As the United States Trustee Program (USTP) stated:
The USTP’s response to marijuana-related bankruptcy filings is guided by two straightforward and uncontroversial principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed. Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal criminal law.
While the doomed fate of cannabis companies such as dispensaries and cultivators in bankruptcy court seems fairly clear, things get much hazier for cannabis-adjacent businesses – those that derive some or all of their income indirectly from a third party that sells, distributes, or cultivates marijuana. These businesses include landlords that rent space to cannabis companies, provide equipment and supplies, or perform services used by cannabis companies.
Until recently, trustees and judges also routinely rejected requests for bankruptcy protection by such debtors. For example:
- In 2012, a Colorado bankruptcy court determined a debtor’s receipt of 25% of its income from property leased to a state-licensed cannabis grower constituted “continued criminal activity.” Because the debtor derived a significant portion of its income from such criminal activity, any plan would necessarily be proposed by “means forbidden by law” and, therefore, not confirmable.
- In 2015, the Bankruptcy Appellate Panel (the “BAP”) for the 10th U.S. Circuit Court of Appeals dismissed a Chapter 13 case where the debtors owned and leased property used for medical cannabis production and distribution since the plan would be funded by income derived from cannabis operations.
- In 2019, a district court in Colorado affirmed the bankruptcy court’s dismissal of a debtor’s Chapter 11 bankruptcy because they relied on profits derived from the sale of gardening supplies to cannabis growers, and their future business plans included marketing and sales to cannabis industry customers.
This “zero tolerance” policy has also been applied to individual employees of cannabis businesses who want to use their wages to pay back creditors in their personal bankruptcies.
9th Circuit Opens the Door – Slightly
Recently on the West Coast, bankruptcy courts and the U.S. Court of Appeals for the 9th Circuit have deviated from the “zero-tolerance” policy taken by trustees and courts elsewhere in multiple cases on bankruptcy and cannabis. Several decisions have taken a much more holistic and fact-based approach rather than automatically dismissing cases with even the faintest whiff of cannabis on a debtor’s assets or income.
As the 9th Circuit BAP declared in a 2020 decision: “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.”
For example, in 2018, the 9th Circuit BAP refused to dismiss a Chapter 13 case of a debtor who leased her commercial property to a cannabis grower through a third-party manager because the bankruptcy court made no finding that the trustee would be administering the proceeds of an illegal business, and there was no evidence that the rents were to be used to fund the plan.
In January 2023, the U.S. Bankruptcy Court for the Central District of California rejected a trustee’s attempt to dismiss a Chapter 11 case filed by a debtor that formerly operated a wholesale cannabis product manufacturing and packaging business. Prior to filing, the debtor had stopped operating and transferred its property to a Canadian cannabis company in exchange for shares in the company. The debtor’s proposed liquidation plan included paying creditors with its shares or the proceeds from selling them.
Adopting a “middle road” approach in which judges would use their discretion based on specific facts and circumstances, the court found that the debtor’s passive stock ownership and intent to liquidate its assets would end any cannabis connection, and the case could therefore proceed.
It remains to be seen whether such fact-specific analyses – which consider the nature and extent of a debtor’s or plan’s connection to cannabis or cannabis-derived proceeds instead of reflexively dismissing these cases – overcome the entrenched antipathy towards cannabis-related debtors. Until cannabis is de-scheduled at the federal level, distressed companies or individuals with cannabis-industry connections should consider other options, such as state court insolvency proceedings (receiverships and assignments for the benefit of creditors), or, if possible, negotiating an out-of-court workout with their creditors. Unfortunately, bankruptcy protection is a far-from-reliable option.