Marijuana bankruptcy reform could be inching closer for US operators

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Distressed U.S. marijuana operators remain largely unable to access bankruptcy relief, an ongoing challenge in a tough industry where business failures are common.

But with federal marijuana rescheduling possible in the near future – and with signs of shifting attitudes in recent bankruptcy court cases – reform could be somewhere over the horizon.

Ryan Spengler, an associate with Philadelphia-based law firm Duane Morris who practices financial restructuring law, is cautiously optimistic that progress in court rulings, combined with rescheduling, could help open the door to new bankruptcy options for U.S. plant-touching marijuana companies.

“If there’s a movement from these bankruptcy courts before rescheduling even happens, if rescheduling were to happen, you would expect more courts to take similar stances – if not more drastic stances – toward favoring cannabis-related companies in bankruptcy,” Spengler told MJBizDaily in an interview.

In the meantime, some distressed cannabis businesses are finding alternatives to federal bankruptcy such as state court receiverships or out-of-court restructuring – and even turning to Canadian insolvency law, when possible.

Barriers to cannabis bankruptcies

The federal U.S. Bankruptcy Code requires that bankruptcy plans are “proposed in good faith and not by any means forbidden by law.”

Since even state-regulated marijuana companies violate the federal Controlled Substances Act (CSA), they aren’t eligible.

“There is the state approval process and (marijuana) legalization under state law,” Spengler said. “But federal law is still federal law, and the bankruptcy courts are federal jurisdiction.”

Rescheduling alone won’t solve that barrier to bankruptcy, he noted.

The U.S. Drug Enforcement Administration is considering a recommendation to reschedule marijuana to Schedule 3 of the CSA, but rescheduling alone won’t clear that federal barrier to bankruptcy, Spengler noted.

“Bankruptcy would still be seen as a federal violation; it doesn’t matter if (cannabis is) Schedule 1 or Schedule 3,” Spengler said.

Shifting attitudes from courts?

However, some recent court decisions offer hope that change is on the way.

In some recent decisions, Spengler said, “courts are starting to say, ‘Well, we’ll allow you to distribute these cannabis-related assets for the benefit of creditors and debtors.'”

A 2023 decision in the U.S. Bankruptcy Court for the Central District of California, In re The Hacienda Co., looked past the issue of marijuana’s federal illegality.

In part, the court reasoned that other bankruptcy cases – Bernie Madoff and Enron Corp., for example – involved debtors whose activities had broken the law.

The debtor company’s bankruptcy plan involved selling stock in a Canadian cannabis company over time to fund the reorganization.

That could be a CSA violation, but the court allowed it, Spengler explained.

“From what we’ve seen, this is one of the first times – if not the first (time), a bankruptcy court in the United States has allowed this sort of post-(bankruptcy) petition potential violation of federal law,” he said.

‘Potential for more creativity’

Another 2023 cannabis-related bankruptcy case, In re Kojima, was approved by a bankruptcy court and affirmed by a district court.

Spengler said he sees “potential for more creativity” in marijuana bankruptcy cases.

“The more liberalized these bankruptcy courts become in allowing ‘one-step-removed’ distribution of cannabis-related assets, the more creative bankruptcy practitioners might be able to become,” he said.

Spengler said continued court rulings such as Hacienda might eventually impact the U.S. Trustee’s Office’s unforgiving policies toward bankruptcy for cannabis businesses.

He compares that potential shift to how “federal prosecutors are no longer going after” state-regulated marijuana companies.

“You could see a similar swing in the bankruptcy courts,” Spengler said.

“If courts are starting to allow these cannabis-related businesses to operate to a specific extent, one degree removed, you might see the United States Trustee taking a little bit more of a lenient, more cautious approach,” he continued.

“But that’s still to be determined.”

Spengler said that kind of change is hard to predict, but he sees it taking “years, rather than months.”

Bankruptcy alternatives

Kevin McLaughlin, a partner at Philadelphia-based accounting advisory company Centri Business Consulting who leads the firm’s cannabis practice, sees another way in which rescheduling might open new options for insolvent marijuana companies.

Since moving marijuana to Schedule 3 would do away with 280E taxation, McLaughlin anticipates it would be positive for business restructurings.

Eliminating 280E “makes these assets a little bit more attractive; they become more valuable,” McLaughlin told MJBizDaily.

“And when they become more valuable, it makes the opportunities for restructuring a little bit wider,” he continued.

“Because if there’s not a lot of value, you’re not going to have a lot of folks who’d be interested in buying off certain assets.”

McLaughlin added: “If 280E goes away, there’s more profit. You have more … buyers who are interested in a business, a cultivation facility or a retail facility in a specific market, where nowadays, it’s few and far between.”

Receiverships and restructuring

By contrast, McLaughlin said, it’s common in today’s cannabis business environment to see “businesses that are just, quite frankly, liquidating and going out of business.”

Despite the current dearth of bankruptcy options, McLaughlin said cannabis companies have alternatives in both receiverships and out-of-court restructuring.

State court receiverships are one possible alternative to federal bankruptcy courts in some jurisdictions; failed California marijuana distributor Herbl is one recent example.

California, Colorado, Massachusetts, Nevada, Oregon and Washington state all allow receivers to “temporarily operate cannabis businesses and dispose of cannabis assets,” according to a February webinar about marijuana bankruptcies, receiverships and reorganizations presented by Duane Morris and Centri.

In other cases, cross-border U.S. cannabis companies domiciled in Canada have taken advantage of Canadian insolvency law.

For example, Chalice Brands sought receivership in Oregon while seeking creditor protection in Canada in 2023.

Cannabis and accessories distributor Humble & Fume – based in Canada but with operations in California and Texas – sought creditor protection under Canada’s Companies’ Creditors Arrangement Act at the start of 2024.

Cannabis and personal bankruptcy

As regulated U.S. marijuana companies wait for bankruptcy courts to come around to corporate cannabis bankruptcies, income from the plant also remains an issue in personal bankruptcy law.

The U.S. Bankruptcy Appellate Panel for the First Circuit Court of Appeals recently affirmed a court decision to deny personal bankruptcy to an employee of a Massachusetts cannabis business.

However, the panel’s ruling did disagree with the original bankruptcy court’s ruling on several issues, Duane Morris associate Spengler observed in an email to MJBizDaily.

Among other findings, the panel wrote that “Congress has not articulated a ‘zero-tolerance’ policy that requires dismissal of any bankruptcy case involving violation of the CSA” or other illegal activity.

The panel also found that – in theory, if not in this particular case – a debtor with marijuana-derived income could fund a bankruptcy plan with non-cannabis assets.

“This decision continues the movement away from the original bankruptcy court decisions where the courts shut their doors to any debtor involved in the cannabis industry,” Spengler wrote.

The finding that a cannabis-involved debtor could use non-cannabis assets to fund a reorganization plan “even lays the foundation, against the United States Trustee’s arguments and objection, that an individual could work in the cannabis industry (violating the CSA) and still obtain bankruptcy relief,” he wrote.

Solomon Israel can be reached at solomon.israel@mjbizdaily.com.