Current Trends in Bankruptcy for Cannabis Companies

In a recent bankruptcy decision by the Ninth Circuit Bankruptcy Panel (“BAP”), the BAP had the occasion to explore some of the intricacies of how the Bankruptcy Code interacts with the cannabis industry. Burton v. Maney, 610 B.R. 633 (B.A.P. 9th Cir. 2020) (“In re Burton”). While, generally, a putative debtor cannot enjoy the protections afforded by the Bankruptcy Code if it grows, cultivates or sells marijuana, recent court decisions have started to define how far the boundaries can be stretched. One Court recently summarized the dilemma as follows:

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. In re: Sandra Mulul, 614 B.R. 699, 701 (Bankr. D. Colo. 2020) (“In re Mulul”).

In re Burton

In re Burton involved a Chapter 13 case filed in Arizona. The Debtors, Kent and Carly Rae Burton, disclosed certain information on their bankruptcy schedules which indicated they owned a 65% interest in Agricann, LLC (“Agricann”). Agricann was an “entity that was engaged in cultivating and selling marijuana.” In re Burton, 610 B.R. at 634. While the sale of medical marijuana was legal in Arizona at the time the Debtors filed for bankruptcy protection (2018), it remained (and remains) illegal under federal law.

After the Debtors filed bankruptcy, Agricann (which apparently ceased operating in 2016) sued two other entities in state court for “damages for breach of contracts under which Agricann was to cultivate, grow, and sell medical marijuana.” Id. at 635. Both the Chapter 13 Trustee’s counsel and a creditor in the case sought dismissal of the case because of the “Burtons’ involvement in the medical marijuana industry.” Id. The Debtors contended that because Agricann was no longer operating, no income from that entity would be used to fund their Chapter 13 plan of reorganization. However, the Bankruptcy Court found that a recovery in the state court litigation “would be derived from conduct that is illegal under federal law.” Id. at 634. The Bankruptcy Court ultimately dismissed the case, and the Debtors appealed the decision to the BAP.

As the BAP noted, “…a bankruptcy filing by an individual or entity with ties to a marijuana business raises difficult issues regarding how involved the debtor may be in that business and still be permitted to seek under the [Bankruptcy] Code.” Id. at 673. The BAP went on to state that the case law continues to evolve in this area and there are very few bright line tests. But the BAP also noted that one principle was evident from the case law, “…the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” Id.

After the BAP canvassed some of the case law involving marijuana assets in bankruptcy proceedings, it held that the Bankruptcy Court did not err in dismissing the Debtors’ case. Dismissal under 11 U.S.C. §§ 105(a) and 1307(c) was appropriate “because the continuation of the case would likely require the trustee or the court to become involved in administering of the Agricann litigation, which the court implicitly found would be tainted as proceeds of an illegal business.” Id. at 639.

In re Mulul, In re Green Earth and In re Ginsburg Decisions

Subsequent to the In re Burton case, the In re Mulul decision was issued by the Bankruptcy Court in Colorado. Of particular interest was the Colorado Bankruptcy Court’s evaluation of two other bankruptcy decisions in rendering its decision. The In re Mulul decision helps to help further define when a debtor may be able to enjoy the protections of the Bankruptcy Code.

The first decision discussed by the In re Mulul court was Green Earth Wellness Ctr., LLC v. Atain Specialty Ins. Co., 163 F.Supp. 3d 821 (D. Colo. 2016) (“In re Green Earth”). In re Green Earth involved a lawsuit by a cannabis company against its insurer. The plaintiff sued the insurer for failing to compensate the company for marijuana plants and equipment destroyed in a fire. The insurer claimed it was excused from performing under the insurance contract because of the illegality of the business. The court in In re Green Earth did not declare the insurance policy void on public policy grounds. As the court in In re Mulul noted:

[T]he operative decision point in Green Earth Wellness was Judge Krieger’s careful distinction between ordering the insurer to pay for damages to specific items (i.e., marijuana plants) and merely ordering compliance with the contract, which could be accomplished without reference to the existence of any marijuana asset. Presumably, if the insurance contract specifically required [the insurer] to replace the marijuana plants rather than merely compensate Green Earth for their value, the result would have been different. In re Mulul, 614 B.R. at 707-708.

The second decision analyzed by the In re Mulul court was Ginsburg v. ICC Holdings, LLC, No. 3:16-CV-2311D, 2017 WL 5467688 (N.D. Tex. Nov. 13, 2017) (“In re Ginsburg”). In re Ginsburg involved a loan to a medical marijuana business. Ginsburg, who was the lender, ultimately sued ICC Holdings for, among other things, breach of contract due to defaults under the loan, violations of state and federal securities laws, and the federal Racketeering Influenced and Corrupt Organization Act.

ICC moved to dismiss the lawsuit “because the purpose of the [promissory notes] [was] to fund the cultivation, possession and sale of marijuana, in violation of federal law, [and] the [promissory notes] [were] void and unenforceable because they contravene public policy.” In re Ginsburg, 2017 WL at *3. As the In re Mulul court stated, “…the [Ginsburg] courted noted, due to the fungibility of currency, repayment of the notes would not require ICC Holdings to ‘manufacture, distribute, dispense, or possess marijuana.’” In re Mulul, 614 B.R. at 708 (internal citation omitted).

Where Do We Go From Here?

Given these decisions, is there a pattern emerging from the case law? The answer is yes, in part. The primary lesson learned is that if the debtor and its earnings are directly related to the marijuana industry (e.g., cultivating, selling, etc.) then in all likelihood, it cannot enjoy the protections of the Bankruptcy Code. However, as the connection between the cannabis earnings and the business become more attenuated, then there is a higher probability the debtor can move forward with a bankruptcy case.

There also is a hint of fairness and equity in these decisions, especially In re Ginsburg and In re Green Earth. It would be fundamentally unfair if a party knowingly engaged with a marijuana business, and then attempted to disavow its obligations because of “illegality” or the like. While the law is not always “fair”, at times, it can be.

The bankruptcy process is a very powerful tool that allows debtors to accomplish things it could never do outside of bankruptcy. When a party is deprived of this right, there is no other equivalent under the law. The sole remaining options are to liquidate without court supervision, or via state court receivership. Hopefully, in time, those in the cannabis industry will have the right to seek bankruptcy protection without the mental gymnastics that currently plague the industry. However, for that to occur, changes are needed in federal law.

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