Cannabis Bankruptcy: A New Legal Framework Emerges (2024)

Breakthrough Victory for Cannabis Industry in Bankruptcy Court: A New Path to Reorganization

In a groundbreaking decision, the U.S. Bankruptcy Court for the Central District of California has defied the historical norm by supporting a cannabis business in not one but two motions to dismiss its Chapter 11 bankruptcy case. This unprecedented ruling provides hope for the cannabis industry and sets a precedent for potential reorganization, potentially opening doors for more cannabis-related businesses to seek bankruptcy relief. In this article, we’ll delve into the details of the case, analyze the court’s decision, and discuss the potential implications for the cannabis industry.

Background

The case in question revolves around Hacienda Co. LLC, a company engaged in the wholesale manufacturing, packaging, and distribution of cannabis products under the name “Lowell Herb Co.” or “Lowell Farms” within the state of California. In 2021, Hacienda transferred its assets, including intellectual property and cannabis-related goods, to a publicly traded Canadian company that subsequently rebranded as Lowell Farms Inc. (LFI). This transfer occurred during a period when both Canadian law and California state law permitted cannabis-related activities. In exchange for its assets, Hacienda received a 9.4% share in LFI.

However, in September 2022, Hacienda filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code, with the intention of monetizing its LFI shares over time. This approach aimed to prevent oversaturation in the market and maintain the value of the shares, ultimately benefiting Hacienda’s estate and creditors.

The Trustee’s Challenge

After Hacienda’s bankruptcy filing, the U.S. trustee filed two separate motions to dismiss the Chapter 11 case. The trustee’s first motion argued that the case should be dismissed under Section 1112(b) of the Bankruptcy Code due to Hacienda’s past cannabis-related activities, which allegedly violated the Controlled Substances Act (CSA). However, the court denied this motion, stating that there was no ongoing violation of the CSA because Hacienda was not actively distributing cannabis at the time of filing, and it had no intent to engage in any cannabis-related ventures in the future.

The court’s decision emphasized that Congress had not adopted a zero tolerance policy that mandated automatic dismissal of Chapter 11 cases whenever potential illegal activities were present. This stance was supported by examples from major Chapter 11 cases, including entities like Pacific Gas & Electric Co., Enron Corp, and Bernie Madoff, which faced legal challenges but were allowed to proceed. The court justified its ruling by focusing on the lawful benefits presented to creditors, Hacienda, and other stakeholders under the Bankruptcy Code.

The trustee, undeterred, filed a second motion to dismiss in May, claiming that Hacienda’s proposed plan of reorganization involved continuing alleged criminal activity post-petition.

The Court’s Opinion

Section 1112(b) of the Bankruptcy Code empowers a bankruptcy court to dismiss a Chapter 11 case for “cause,” without providing a specific definition of “cause.” The party seeking dismissal bears the burden of proving “cause,” and if “cause” is demonstrated, the opposing party can prevent dismissal by demonstrating unusual circ*mstances that make dismissal against the best interests of creditors and the estate.

The trustee argued that there was “cause” for dismissal because Hacienda’s proposed reorganization plan constituted a conspiracy to violate federal criminal laws. It suggested that repaying creditors with assets derived from alleged criminal activity, such as selling stock in a Canadian cannabis organization, was unacceptable. The trustee also contended that federal courts typically reject cases involving illegal contracts, and Hacienda’s ongoing post-petition sale of LFI’s stock constituted a violation of federal law.

The court rejected the trustee’s argument that federal courts automatically dismiss cases involving marijuana-related contracts. It emphasized the flexibility in dealing with such contracts when private parties are involved. Additionally, the court disagreed with the assertion that Hacienda’s post-petition actions violated federal laws, as it failed to show how the stock sale contradicted congressional policy aimed at maximizing payments to creditors.

Regarding other arguments raised by the trustee, the court recognized that Hacienda had likely violated the CSA before its bankruptcy filing through its involvement with cannabis products. It also acknowledged that conspiring to transfer assets in exchange for stock with the intent to hold such stock for a certain period might be a post-petition violation of the CSA. Nevertheless, the court reiterated that Congress had not instituted a zero-tolerance policy, and most bankruptcy cases could be dismissed if any illegality were grounds for dismissal. The court, therefore, used its discretion to determine whether “a debtor’s connection to cannabis profits and any past or future investment in cannabis enterprises warrants dismissal of this bankruptcy case.”

Applying this standard, the court found that the trustee had failed to establish “cause” for dismissal. The court pointed out Hacienda’s indirect connection to any criminal law violation, its intent to liquidate and pay creditors, and the benefits of monetizing the stock for the estate. The court concluded that any CSA violations by Hacienda primarily occurred before the bankruptcy filing, and the post-petition liquidation of its LFI stock did not contradict Bankruptcy Code principles.

Alternatively, the court reasoned that even if “cause” for dismissal could be established, there were “unusual circ*mstances” present that made dismissal against the best interests of creditors and the debtor’s estate. It argued that punishing Hacienda for its pre-petition divestment from cannabis-related activities and its efforts to maximize the estate’s value would undermine the appropriate use of the bankruptcy system. The court deemed Hacienda’s pre-petition actions justifiable as long as it rectified any violations within a reasonable timeframe through the post-petition sale of LFI’s stock.

Ultimately, the court confirmed Hacienda’s plan of reorganization. However, to prevent its decision from being seen as endorsing illegal behavior, the court stressed that a debtor’s connections to cannabis could still lead to a dismissal of their bankruptcy case, and federal prosecutors remained free to pursue remedies for CSA violations and other non-bankruptcy-related offenses.

The In re Hacienda case marks a significant departure from previous bankruptcy court decisions that largely rejected relief for cannabis-related businesses. Although it doesn’t completely open the courthouse doors to the cannabis industry, it does provide a roadmap for pursuing reorganization in the Central District of California. This groundbreaking ruling may encourage more cannabis-related businesses to explore bankruptcy filings, especially when guided by experienced bankruptcy attorneys who can navigate the trustee’s historical opposition to providing bankruptcy protection for such companies.

Assuming this ruling remains unchallenged, more bankruptcy courts may find themselves grappling with the intersection of cannabis and bankruptcy law. As a result, this case could have broader implications for the cannabis industry, offering hope to businesses seeking to reorganize their operations and financials.

The In re Hacienda case has set a new precedent, creating an opportunity for cannabis-related businesses to navigate the complex landscape of bankruptcy proceedings. As the legal and regulatory environment surrounding cannabis continues to evolve, this ruling represents a step forward for the industry, potentially paving the way for more businesses to seek the financial relief they need to thrive and grow within the boundaries of the law.