In re Hacienda: Bankruptcy Ruling Reveals Potential Path for Cannabis Businesses

Bankruptcy protection has long existed as a critical tool for struggling businesses, but this protection unfortunately has remained unavailable to those in the cannabis space because of their involvement with a substance that remains illegal under federal law. Historically, the United States Trustee’s Office has successfully dismissed bankruptcy petitions filed by cannabis businesses on the grounds that the debtor is actively violating the federal Controlled Substances Act (“CSA”), which classifies cannabis as a Schedule I drug. Blumsack v. Harrington (In re Blumsack),657 B.R. 505 (B.A.P. 1st Cir. 2024), Arenas v. United States Trustee (In re Arenas), 535 B.R. 845 (B.A.P. 10th Cir. 2015), and In re Way To Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018), aff’d sub nom. In re Way to Grow, Inc., 610 B.R. 338 (D. Colo. 2019) are three such cases where the U.S. Trustee successfully dismissed the debtor’s case on these grounds. Although the federal government is considering rescheduling cannabis and there have been several bills proposed to legalize and regulate cannabis, experience shows that the approach that the federal government takes is likely to be incremental, gradually chipping away at prohibition laws and policies. Until there is some decisive change, cannabis businesses will struggle to avail themselves of certain privileges and protections under federal law, such as bankruptcy.

Nevertheless, there may be signs of light. A recent case from a California bankruptcy court sheds some light on the nuanced approach that bankruptcy courts may apply in the future when a cannabis business seeks bankruptcy protection. In In re Hacienda Co., LLC, 647 B.R. 748 (Bankr. C.D. Cal. 2023), the bankruptcy court denied the United States Trustee’s motion to dismiss the case and allowed the debtor, a former manufacturer and packager of cannabis products, to continue with its plan to liquidate equity shares under a Chapter 11 plan of reorganization. This case is important because it is the first decision where a cannabis business has survived a motion to dismiss by the U.S. Trustee based on violations of the CSA. However, this debtor was only allowed to remain in bankruptcy because it had fully divested itself from all cannabis-related assets by the time it filed its bankruptcy petition.

Even though this case does not represent an opening of the bankruptcy gates for all cannabis businesses, it may signal an opportunity for some until the federal regulatory landscape changes. Businesses that are directly involved in the cultivation, distribution, or possession of cannabis will face steep opposition from the U.S. Trustee and will likely still see their cases dismissed. Businesses that have a more tangential relationship with cannabis, however, may find that they can successfully liquidate or reorganize their business under the current system depending on their level of involvement with cannabis-related assets and their post-bankruptcy plans.

Bankruptcy and Cannabis Law Overview

The Bankruptcy Code, codified under Title 11 of the United States Code, is a body of federal law that provides a mechanism for businesses experiencing financial distress to liquidate assets to pay creditors or reorganize their debts and emerge from bankruptcy as an operational business. Chapter 7 of the Bankruptcy Code allows a debtor to liquidate assets and Chapter 11 allows a debtor to reorganize its business. Section 1112(b)(1) allows a party to move for dismissal of the debtor’s bankruptcy petition for “cause”. 11 U.S.C. § 1112(b)(1). Section 1112(b)(4) contains a list of explicit examples of “cause”, which include a substantial diminution of value to the estate, gross mismanagement of the estate, failure to comply with a court order, failure to provide information requested by the U.S. Trustee, and failure to pay post-petition taxes, among other things. Overall, the “cause” standard is intended to represent a debtor’s act of bad faith in seeking bankruptcy protection. In cannabis cases, however, motions to dismiss a debtor’s case under the “cause” standard are often premised on a violation of nonbankruptcy law, namely the CSA. See 21 U.S.C. § 812(b)(1) (listing cannabis as having “a high potential for abuse” and for which there is “no currently accepted medical use in treatment” and “a lack of accepted safety for use . . . under medical supervision.”). A violation of nonbankruptcy law is not listed as an explicit example of “cause” under Section 1112(b)(4), but several bankruptcy courts have found that compliance with applicable nonbankruptcy law generally is required by statute and allow it as a basis for moving to dismiss under the “cause” standard. If the moving party establishes that “cause” for dismissal exists under Section 1112(b)(1), the debtor has a chance to overcome this finding by identifying unusual circumstances establishing that dismissal is not in the best interests of creditors, among some related requirements.

The Department of Justice maintains a long-standing policy that cannabis businesses cannot be afforded relief under the Bankruptcy Code because the CSA, as a body of federal law, takes primacy over state laws that legalize the medical and recreational use of cannabis. See U.S. Const. art. 4, cl. 2 (the Supremacy Clause). The purpose of this federal prohibition is to prevent bankruptcy trustees from having to administer, sell, or otherwise possess cannabis-related assets, such as situations where the trustee may need to offer cannabis for sale or otherwise possess cannabis plants or products to prevent a diminution of value of those assets (should the plants die, or the product become damaged or expired). The U.S. Trustee, in its role as the watchdog of the bankruptcy system, will therefore move to dismiss any bankruptcy petition filed by a cannabis business on the ground that the debtor is actively violating nonbankruptcy law on the date of the petition.

The Hacienda Case

In Hacienda, the debtor was a wholesale manufacturer and packager of cannabis products under the Lowell Herb Co. brand, also known as Lowell Farms, based in California. The debtor also owned land intended for cultivating cannabis at one point but sold the land in 2020 to pay creditors. In February 2021, the debtor sold its intellectual property in an asset sale to a publicly traded Canadian company called Indus Holdings, which then changed its name to Lowell Farms. In exchange for the sale, the debtor received $4.1 million in cash, which was used to pay off a bridge loan, and 22.6 million shares in Lowell Farms. The debtor then filed bankruptcy with the intent of either distributing the shares directly to creditors or selling its shares and distributing the proceeds to creditors. The debtor wanted to avoid flooding the market with shares of Lowell Farms by selling the shares in smaller increments over time to prevent deflation of the return to creditors. The U.S. Trustee moved to dismiss the debtor’s case for “cause” under Section 1112(b) of the Bankruptcy Code based on the debtor’s alleged violation of the CSA. The U.S. Trustee argued this violation of nonbankruptcy law represented a bad faith filing by the debtor in a Chapter 11 case with no legitimate purpose for reorganization.

In a carefully fashioned decision, the bankruptcy court expressed three reasons why the U.S. Trustee had failed to satisfy the “cause” standard for dismissal. First, the court found that the debtor was not, and had no intention of, engaging in the ongoing distribution of cannabis both during the pendency of the case and after the liquidation of shares completed. Acknowledging that the CSA covers conspiracies with intent to distribute cannabis, the court found that the liquidation would terminate the debtor’s connection to all aspects of the cannabis business and, therefore, the debtor would not be indirectly profiting from cannabis. Second, the court found that the debtor’s representation that it had no intent to use any of its remaining assets to re-invest in the cannabis industry on a post-petition basis was sufficient to rebut the U.S. Trustee’s argument that there was the likelihood of a post-petition violation of the CSA. And, third, the court found that the U.S. Trustee had failed to show that any future bankruptcy trustee would be forced to violate the CSA during the administration of estate assets by possessing, selling, or otherwise handling cannabis products.

The court also recognized, however, that Congress did not adopt a “zero-tolerance” policy under § 1112(b) for any and all illegal activity—citing some of the largest, most significant bankruptcy cases in the nation that also involved alleged illegal conduct (e.g., Enron Corporation, Bernie Madoff, numerous sexual abuse cases involving the Catholic Dioceses, and the opioid cases). Finally, the court found that, even if “cause” for dismissal existed, the debtor had shown that the “unusual circumstances” exception applied because it had divested itself pre-petition from any direct involvement in its cannabis business and a dismissal would threaten the anticipated distribution to creditors where the debtor could legally sell its stock in the Canadian company under Canadian law.

Takeaways

While it is important not to overstate the significance of Hacienda, it represents a willingness of at least one bankruptcy court to apply a more nuanced approach by looking at the debtor’s relationship to the cannabis business and any cannabis-related assets. The closer the debtor’s relationship to cannabis plants or products, the more likely it is that the U.S. Trustee will be successful in dismissing the case. However, it signals that the doors to U.S. bankruptcy courts are not completely closed to cannabis businesses, and there may be situations where it makes sense for a cannabis business to file bankruptcy under the current system, especially where its intent is to fully divest itself from all cannabis-related assets with no intention of returning to the industry.

Cannabis businesses in Connecticut and throughout the Northeast seeking to liquidate their assets and wind down their affairs or reorganize their debts and emerge as an operating business have few options to assist them through this process. In some states such as California, New Jersey, New York, and Massachusetts, debtors can take advantage of a state process known as an assignment for the benefit of creditors (known colloquially as an “ABC”) where they would not face opposition from the U.S. Trustee. Connecticut, however, does not have an ABC process. Cannabis businesses in this state are therefore left with few options other than filing for federal bankruptcy protection and facing a battle with the U.S. Trustee. Recent developments, however, continue to signal a positive shift towards expanding access to the bankruptcy system for cannabis businesses. The U.S. Drug Enforcement Administration recently proposed, and the Biden Administration officially recommended, transferring cannabis from Schedule I of the CSA to Schedule III, based on the Department of Health and Human Services’ view that cannabis has at least one accepted medical use and a lower potential for abuse and physical or psychological dependence. See Schedules of Controlled Substances: Rescheduling of Marijuana (proposed May 16, 2024) (to be codified at 21 C.F.R. pt. 1308). This change signals that the federal government has reached an inflection point in how it treats cannabis, and more comprehensive bankruptcy protection may be on the horizon for state-legal cannabis businesses. This is certainly a development that warrants close attention as the legal landscape continues to change.