Court Does Not Permit Bankruptcy to Go Up in Smoke

Most bankruptcy courts that have encountered the issue have dismissed bankruptcy cases filed by cannabis and cannabis-related businesses. However, the Honorable Neil W. Bason in the Central District of California published an interesting and well-reasoned bankruptcy cannabis opinion, In re: The Hacienda Company, LLC., 647 B.R. 748 (Bankr. C.D. Cal. 2023) (“Hacienda”).

In Hacienda, the Court denied a motion to dismiss a chapter 11 case filed by the United States Trustee (“UST”) where the debtor intended to propose a plan to liquidate stock in a Canadian cannabis business for the benefit of its creditors. The decision is on appeal to the United States District Court.

Background.

The debtor was in the business of wholesale manufacturing and packaging of cannabis products and ceased operations in February 2021. After the debtor ceased operations, the debtor sold its intellectual property, including its name, to a Canadian company which sole business was growing and selling cannabis, which the Court noted is legal in Canada. In return, the debtor received equity shares of the acquiring entity. The acquiring entity changed its name to Lowell Farms, Inc (“Lowell”).

The debtor filed for chapter 11 bankruptcy in September 2022, the stated intention was to propose a plan of reorganization that provides either for (a) the sale of the shares of Lowell and distribution of the proceeds of the stock sale to pay creditors or (b) distribution of the shares directly to creditors. The UST moved to dismiss the case. After a thorough analysis, the Bankruptcy Court denied the motion to dismiss.

In reaching its decision, the Court acknowledged that violations of non-bankruptcy law may be grounds for dismissal, which grounds were summarized as follows:

1. Bad faith, citing, among other authority, In re Arenas, 535 B.R. 845 (10th Cir. BAP 2015) (holding that the debtors’ marijuana business, while legal under state law, was illegal under federal law, and thus the debtors could not propose a confirmable plan in good faith);
2. Gross mismanagement for exposing the estate to financial losses and criminal sanctions, citing In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 809 (Bankr. D. Colo. 2012) (holding that the debtor’s decision to continue leasing warehouse space to tenants engaged in the business of growing marijuana exposed the debtor to criminal liability and the risk of forfeiture which amounted to gross mismanagement); and
3. Cannabis sales being inconsistent with judge’s obligation to uphold the law, citing g., In re Johnson, 532 B.R. 53, 56-58 (Bankr. W.D. Mich. 2015) (suggesting that authorizing a debtor to continue generating income from marijuana operations appears inconsistent with the judicial oath to uphold the law but concluding that the debtor could remain in bankruptcy and avoid dismissal if marijuana operations were ceased).

The Court found no “cause” for dismissal.

The Court observed in Hacienda that in its view, Congress did not adopt a “zero tolerance” policy for violations of non-bankruptcy law and that the bankruptcy court has discretion. To that end, the Court stated in pertinent part that “. . . this Bankruptcy Court does not interpret Congress’ mandate that this Bankruptcy Court ‘shall’ dismiss or convert a bankruptcy case for ‘cause’ under § 1112(b) to mean that any violation of criminal law requires dismissal. Rather, this Court interprets the statute as giving discretion to determine whether dismissal is warranted based on all the facts and circumstances.” The Court further noted that the mere presence of marijuana near a bankruptcy case does not automatically require dismissal, citing in support Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031, 1036 (9th Cir. 2019) (stating that a bankruptcy judge is not an “ombudsman without portfolio, gratuitously seeking out ‘illegalities’ …, a result that would be “inimical to the basic function of bankruptcy judges …”). In that regard, the Court noted that the degree of connection to cannabis is relevant, and the Court has the discretion to consider whether, given all of the facts and circumstances, a debtor’s connection to cannabis profits, and any past or future investment in cannabis enterprises, warrants dismissal.

Exercising that discretion under the facts in Hacienda, the Court did not find cause for dismissal. Judge Bason found that the debtor’s passive ownership of stock with the intent to liquidate it would terminate any connection with illegal cannabis activity, and that the debtor was not intending to maintain its investment in the Canadian company for very long. Thus, the UST failed to establish any ongoing violation of the Controlled Substance Act, 21 U.S.C. § 801 et seq. (“CSA”) either by (a) a connection to distribution or (b) by stock ownership in the cannabis-related enterprise. The Court did acknowledge that the CSA also encompasses conspiracies with intent to distribute cannabis pursuant to 21 U.S.C. §§ 846 (conspiracy) and 856(a) (illegal to “control any place” or “profit from” a place used to manufacture, store, distribute, or use cannabis). Nevertheless, it rejected the argument that the debtor’s passive ownership of the stock is indirectly carrying on its prepetition cannabis business or profiting from the cannabis business, noting that the intention to liquidate the stock will terminate any connection with cannabis and such intention “appears to be the opposite of an intent to profit from an ongoing scheme to distribute cannabis, at least if the debtor does not maintain its investment in Lowell for too long a period of time (which is an issue that can be addressed in connection with confirmation of any chapter 11 plan).”

Therefore, the Court concluded that the UST failed to establish a violation of section 856(a) of the CSA, and that the lack of current or foreseeable illegality was grounds for denying the motion to dismiss.

The Court also found the existence of “unusual circumstances.”

Even if there is cause to dismiss, Section 1112(b)(2) allows the opposition to prevent dismissal by showing that “unusual circumstances” exist such that dismissal would not be in the best interests of creditors. Judge Bason determined that “unusual circumstances” was applicable on the basis that: (a) the debtor divested itself of any direct involvement in the cannabis business; (b) dismissal would not be in the best interests of creditors because there is a reasonable likelihood of confirming a plan within a reasonable period of time; and (c) the debtor’s attempt to maximize value and pay creditors establishes a “reasonable justification.” The Court took into consideration that any violation can be cured within a reasonable time so long as the process for selling the stock does not take too long.

Final thoughts.

Whether the decision will survive appellate review remains to be seen. Even, in arguendo, it does, it is likely to be limited to the specific facts of this case. Only time will tell whether this decision is a one-off, turning solely on the unique facts of this particular case, or whether its demonstrative of an ever so slightly greater tolerance toward granting cannabis related companies access to the bankruptcy courts and system under specific factors. It is axiomatic that the debtor’s decision to cease operations, convert its interest to stock and to liquidate that stock, played a significant role in the outcome.

Leech Tishman’s Business Restructuring & Insolvency Practice Group regularly assists clients in bankruptcy and bankruptcy litigation matters. If you have any questions about bankruptcy cases filed by cannabis and cannabis-related businesses, or what this case might mean for bankruptcy proceedings, please contact Sandford L. Frey.

Sandy is a Partner with Leech Tishman and Co-Chair of the Business Restructuring & Insolvency Practice Group, where he co-leads the Bankruptcy Chapter 11 Debtor and Bankruptcy Chapter 11 Subchapter V Debtor Groups. Sandy is based in the Los Angeles office and can be reached at 626.796.4000 or sfrey@leechtishman.com.

Leech Tishman’s Facebook Page: https://www.facebook.com/leechtishman

Leech Tishman’s Twitter: https://twitter.com/LeechTishman

Leech Tishman’s Company Page on LinkedIn: https://www.linkedin.com/company/leech-tishman

Leech Tishman Fuscaldo & Lampl, Inc. is a national, full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in business restructuring & insolvency, construction, corporate matters, employment & labor, estates & trusts, intellectual property, litigation & alternative dispute resolution, and real estate. In addition, the firm offers a wide range of legal services to clients in the aviation & aerospace, cannabis, emerging cyber technologies, energy & natural resources, entertainment, healthcare, hospitality, and life sciences industries. With offices in Los Angeles, Leech Tishman also has offices in Chicago, Philadelphia, Pittsburgh, Sarasota, Washington, D.C., and Wilmington, DE.