Authored By: Mark A. Salzberg
Mark A. Salzberg Partner
Squire Patton Boggs (US) LLP
2550 M Street, NW
Washington, DC 20037
In 2020, bankruptcy court doors continued to be shut to cannabis companies. Perhaps most troubling is the continued bar for companies that are only tangentially involved in the state-legalized cannabis industry. Although outlier cases exist, and even though courts have hinted that bankruptcy may be appropriate for some cannabis-related individuals and companies in some situations, there is a consensus now that bankruptcy is generally not available to individuals and companies engaged, directly or indirectly, in the cannabis industry. Below are some of the most important decisions from 2020.
Burton v. Maney (9th Cir. BAP)
The year began with the Ninth Circuit Bankruptcy Appellate Panel’s decision in Burton v. Maney (In re Maney).[1] In Maney, husband and wife Chapter 13 debtors held a majority interest in a company, Agricann, LLC (“Agricann”), which was previously engaged in the cultivation and sale of cannabis. These activities were legal under Arizona law, but were illegal under the federal Controlled Substances Act, 21 U.S.C. § 801, et seq. (the “CSA”).
The bankruptcy court entered an order to show cause why the case should not be dismissed based on the debtors’ ownership interest in Agricann. In response, the debtors argued that Agricann was no longer operating and that no Agricann funds would be used to fund their Chapter 13 plan. However, Agricann was still a plaintiff in two state court lawsuits in which it sought damages for breach of contract relating to the cultivation and sale of cannabis. The bankruptcy court concluded that any recovery from the lawsuits would be derived from conduct violative of the CSA and that allowing the bankruptcy case to continue would likely require the court and the trustee to administer funds obtained in violation of the CSA. The appellate panel affirmed the dismissal of the case, finding that the debtors’ ownership interest in Agricann constituted “cause” for dismissal under section 1307(c) of the Bankruptcy Code.[2]
Notwithstanding the ultimate ruling, there are portions of the Maney opinion that ultimately may be helpful to cannabis debtors seeking bankruptcy relief. The appellate panel noted the tension between state-legalized cannabis and the CSA and the “difficult issues regarding how involved the debtor may be in [the cannabis] business and still be permitted to seek relief under the [Bankruptcy] Code.”[3] Importantly, the panel wrote:
The case law continues to evolve and few bright line rules have emerged from decisions published to date. One principle seems implicit in the case law, however; the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.[4]
Further, the panel noted the varying degrees of connection that may exist between a debtor and cannabis and the discretion that bankruptcy courts have, at least in the Ninth Circuit, to determine whether a case should be dismissed when cannabis activity is present.[5] Finally, the panel implied that the bankruptcy court could have allowed the case to remain in bankruptcy but for the numerous other unresolved issues (e.g., the debts exceeded the limitations under section 109(e); the debtors’ failure to propose a confirmable plan in over a year).[6]
In re Pharmagreen Biotech, Inc. (Bankr. D. Nev.)
While the language in the Maney decision could arguably be read as opening the “bankruptcy door” a crack, the bankruptcy court’s decision in In re Pharmagreen Biotech, Inc., [7] appears, on its face, to slam the door shut.
In Pharmagreen, the court considered whether a U.S. company with plans on entering the legal Canadian cannabis market was eligible for protection under the U.S. Bankruptcy Code. The debtor was raising start-up capital to build a cannabis biotech complex in British Columbia and to obtain cannabis licensure in Canada. According to the debtor’s principal, the company had no actual cannabis operations and no plans to operate in the U.S. until federal cannabis laws were changed. Creditors, however, sought dismissal claiming that the debtor’s business model was based on cannabis operations in the U.S.
The bankruptcy court dismissed the case, pointing to a post-petition update published by the debtor that discussed the production of plantlets for cannabis and hemp. While the debtor argued that there were no ongoing operations and that any business plan was prospective only, the court sided with the moving creditors, stating:
But there’s a business and the business page indicating that Pharmagreen Biotech was producing cultures for marijuana, and marijuana is not illegal in the state of Nevada. But marijuana is illegal in the federal – in the federal system. So I am going to dismiss this case for the reasons set forth by [counsel for the moving creditors]. You just can’t – you can’t use the federal courts to protect marijuana cultivation.[8]
What sets Pharmagreen apart from other cannabis cases is that the debtor’s operations were allegedly going to be limited to Canada where the CSA clearly does not apply. It is unclear whether the court’s decision was based on conflicting evidence on this point. Nonetheless, the Pharmagreen decision can be read broadly to preclude bankruptcy for even those cannabis companies whose activity in the United States is passive only, with the actual cannabis cultivation or sales occurring extra-territorially.
In re Malul (Bankr. D. Colo.)
The bankruptcy court’s decision in In re Malul[9] begins colorfully enough:
If the uncertainty of outcomes in marijuana-related bankruptcy cases were an opera, Congress, not the judiciary, would be the fat lady. Whether, and under what circumstances, a federal bankruptcy case may proceed despite connections to the locally ‘legal’ marijuana industry remains on the cutting edge of federal bankruptcy law. Despite the extensive development of case law, significant gray areas remain. Unfortunately, the courts find themselves in a game of whack-a-mole; each time a case is published, another will arise with a novel issue dressed in a new shade of gray. This is precisely one such case.[10]
In Malul, the debtor received conditional approval to reopen her Chapter 7 case in order to include state court litigation claims arising from an equity investment in Heartland Caregivers, LLC (“Heartland”), a defunct Colorado cannabis company. The debtor also sought to exempt those state law claims from her estate. When objections were filed to the exemption, the debtor filed a motion to compel abandonment of the claims on the basis that the claims, or proceeds of the claims, were cannabis related and cannot be administered by the Chapter 7 Trustee. Ultimately, the U.S. Trustee filed a motion seeking to vacate the conditional reopening of the case, arguing that the debtor was impermissibly attempting to use the bankruptcy to improve her position in the state court litigation.
The issue before the bankruptcy court was whether the debtor’s claims were sufficiently connected to cannabis for the reopening to be vacated. The debtor argued that because Heartland was no longer operating, there was no continuing violation of section 841(c) of the CSA which makes it a federal crime to “manufacture, distribute, or dispense, or possess with intent to manufacture, distribute or dispense, a controlled substance[.]” However, the bankruptcy court held that the debtor’s original investment in Heartland was in violation of section 854 of the CSA, which made it a federal crime to solicit investments in Heartland in the first place. Accordingly, the debtor’s “mere possession of those rights and interests [in Heartland], and certainly her prosecution of litigation claims in furtherance of those rights and interests, constitute ongoing criminal violations of the CSA.”[11] The U.S. Trustee’s motion to vacate was granted. In a rejoinder to its opening and a call to Congressional action, the court wrote: “The Court may enjoy the opera, but anxiously awaits the fat lady’s song.”[12]
This may be one of those cases where bad facts make bad law. After all, the debtor certainly appeared to be acting in bad faith by seeking to reopen her bankruptcy case, not in order to better the position of her creditors, but to improve her own position in the state court litigation. Further, the debtor changed her position on her connection to cannabis, representing first that there were no assets or claims against third parties relating to cannabis, but then arguing that the claims should be abandoned because the claims “constitute unvested rights to proceeds derived from the overt and ongoing sale of marijuana.”[13] It is unclear just how much the Debtor’s bad faith contributed to the court’s conclusion that the Debtor violated section 854 of the CSA and that this required dismissal of the case.[14] Had the debtor not engaged in this bad faith behavior and had the debtor been more candid with the court, the decision may have come out differently.
In re Players Network (Bankr. D. Nev.)
In In re Players Network,[15] the court held that a debtor’s equity investment in a cannabis company constituted “cause” for dismissal under section 1112(b)(1) of the Bankruptcy Code.[16]
In Players Network, the debtor held a majority interest in Green Leaf Farm Holdings (“Green Leaf”), a cannabis producer. A creditor sought dismissal of the debtor’s case under section 1112(b)(1), arguing in part that the debtor could not propose a plan in good faith based on its equity ownership in Green Leaf. The bankruptcy court ultimately dismissed the case, in part because of the debtor’s interest in Green Leaf. Nonetheless, the court was careful to note that within the Ninth Circuit “there appears to be no per se rule precluding a Chapter 11 plan from being proposed in good faith based solely on the debtor’s relationship to commerce involving marijuana or cannabis products.”[17] Accordingly, there is language in Players Network (albeit dicta), similar to language in Maney, that arguably keeps open the possibility of a cannabis bankruptcy.
Where are We Now?
The bankruptcy courts continue to remain largely off limits to companies that operate in the cannabis space. This relegates struggling cannabis companies to other forms of relief, primarily assignments for the benefit of creditors under state law and state law receiverships. However, neither of these options provide cannabis companies with a stay, or the ability to restructure or maximize value through a “free and clear” sale as is available under section 363 of the Bankruptcy Code. Instead, these remedial provisions lead inextricably to liquidation of the struggling company, an outcome that may not be in the best interests of the company or its creditors. The situation is unlikely to change until the federal government legalizes cannabis. At that time, the cannabis industry will be able to utilize all options available under the Bankruptcy Code to the benefit of the industry itself as well as its creditors.
[1] BAP No. AZ-19-1126 (B.A.P. 9th Cir. Jan. 14, 2020).
[2] Section 1307(c) provides that “on request of a party in interest or the United State trustee and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 7 of this title, or may dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause . . ..” 11 U.S.C. § 1307(c). A non-exhaustive list of factors establishing cause is set forth in section 1307(c)(1) – (11).
[3] In re Maney, at p. 10.
[4] Id. (emphasis added).
[5] Id. at p. 13.
[6] Id. at p. 17.
[7] No. 20-50780 (Bankr. D. Nev. Oct. 7, 2020).
[8] Transcript of Motion to Dismiss Case at 10, In re Pharmagreen Biotech, Inc., No. 20-50780 (Bankr. D. Nev. Sept. 30, 2020) at p. 10.
[9] In re Sandra C. Malul, No. 11-21140 (Bankr. D. Colo. March 24, 2020).
[10] Id. at p. 1.
[11] Id. at p. 19.
[12] Id. at p. 21.
[13] Id. at p. 6.
[14] In most situations in which a cannabis case is dismissed, the courts have based their rulings on violations of sections 841 and 843 of the CSA.
[15] No. 20-12890 (Bankr. D. Nev. Oct. 23, 2020).
[16] Section 1112(b)(1) of the Bankruptcy Code provides that “on request of a party in interest, and after notice and a hearing, the court shall convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause unless the court determines that the appointment under section 1104(a) of a trustee or an examiner is in the best interests of creditors and the estate.” 11 U.S.C. § 1112(b)(1). Section 1112(b)(4) contains a non-exhaustive list of factor establishing cause.
[17] Id. at p. 9, n. 18.
