Bankruptcy Isn’t a Choice for the Cannabis Sector, But Options ExistApril 3, 2020 – Alerts
As the cannabis industry continues to expand, there will inevitably be businesses within the sector that encounter financial difficulty and may require insolvency assistance to either restructure or liquidate.
Unfortunately, due to the federally illicit status of cannabis, bankruptcy, which is governed by federal law, is inaccessible for cannabis businesses under present policy. Several federal courts have even extended the bar to bankruptcy access to companies with tangential ties to the cannabis industry, such as landlords that lease space to cannabis businesses or companies that produce equipment utilized in the cannabis industry (although, as discussed below, some flexibility may be emerging for companies with tangential ties to cannabis within the Ninth Circuit, which encompasses Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington).
Notwithstanding the current lack of access to bankruptcy, cannabis businesses may still have several non-bankruptcy options for addressing financial hardship:
Assignment for Benefit of Creditors
An Assignment for Benefit of Creditors (ABC) is in many respects akin to a state court insolvency proceeding through which a company’s assets are orderly liquidated. Presently, 38 states and the District of Columbia have ABC statutes, plus several other states have established ABC mechanisms under common law. (See a list of Jurisdictions with ABC Statutes). In an ABC, a company will transfer its assets to a trust administered by an “assignee” selected by the company. The assignee is charged with liquidating the assets and providing a distribution to the company’s creditors from the proceeds. Given that the company has divested all of its assets, unsecured creditor claims against the remaining shell of the company will be effectively worthless, and thus unsecured creditors’ only means to recovery will be through the ABC distribution, barring rights to collect against third parties such as guarantors or co-obligors. Secured creditors will continue to have their rights in their collateral.
ABCs are typically faster and less expensive than a bankruptcy case, and a sale of assets can be done in a relatively short period of time. Given the nuanced and highly regulated nature of the cannabis industry, a cannabis business considering liquidating through an ABC should select an assignee with familiarity with the industry. Additionally, depending on the jurisdiction, it may be unclear if an assignee will have authority to dispose of a cannabis’ business’ assets, and the inventory in particular given the licensing requirements. However, as discussed below under “Receiverships,” an assignee may be able to obtain authority to dispose of cannabis assets from state courts as necessary to fulfilling the assignee’s duties. Also, ABCs are strictly liquidation proceedings and will not provide a means for a company to restructure and continue operating.
A receiver may be appointed by a state court to steward a company through troubled times. Unlike an assignee in an ABC, who is focused on liquidating the company’s assets, a receiver may continue to operate the company, perhaps to attempt to sell the business as a going concern or to wind-down operations. Receiverships, however, are often initiated by concerned creditors or shareholders, or out of a dispute among partners of a business. While a receivership may help a company improve a teetering financial situation and/or provide clarity for its future direction, the owners of the company may have limited control over the process, including the selection of the receiver.
Like an assignee, there may also be a question as to whether a receiver can oversee the operations and dispose of assets of a cannabis business given the highly regulated nature of the business. Three states (California, Oregon, and Washington) have promulgated regulations under their applicable statutes to permit the operation of the cannabis businesses and/or disposition of assets, and other states are considering similar schemes. Absent statutory/regulatory authority, receivers or assignees may still request that the presiding court, through its equitable powers (if applicable), grant the receiver or assignee authority to operate a business and/or dispose of assets as a necessary expedient for the fulfilment of the receiver or assignee’s duties. Such a request should be noticed on the appropriate state regulators. To the extent states have legalized cannabis and have sanctioned the development of the industry, there is a strong argument that there should be mechanism to allow businesses in the industry to address financial hardship.
A workout is non-judicial process through which a financially distressed company can negotiate with its creditors to restructure the amount or repayment terms of debt. Creditors may be presently more amenable to workouts in light of the circumstances related to the COVID-19 pandemic. A successful workout can enable a company to continue to operate with the same management.
Composition Agreements: A composition agreement is essentially a workout agreement among a company and its creditors generally through which creditors are provided pro-rata payments from a defined source of funds as part of a wholesale simultaneous restructuring of a company’s debt to various creditors.
Article 9 UCC Sales
Creditors with a UCC Article 9 security interest in assets of a cannabis business may attempt to sell the assets through a sale pursuant to UCC Article 9. However, such a sale may engender the licensing issues mentioned above with respect to assignees and receivers.
While bankruptcy has generally been off limits to cannabis businesses so far, it might be an option depending on the business and jurisdiction:
Raw and finished cannabis products with a THC level of 0.3% or below on a dry weight basis is “hemp” and are no longer a Schedule I substance in the federal Controlled Substances Act. This includes CBD products derived from hemp. Considering that hemp and hemp derived products are federally legal, unlike cannabis products exceeding a 0.3% THC level, bankruptcy may be available for companies exclusively producing or selling hemp/CBD products.
Canadian Insolvency and Chapter 15 Bankruptcy
Given the national legalized status of cannabis in Canada, companies that operate in both Canada and the United States may be able to seek relief under the Canadian Bankruptcy Insolvency Act. Chapter 15 of the United States Bankruptcy Code allows for companion bankruptcy proceedings in the United States for affiliates that are subject to an international insolvency proceeding. It has not yet been tested whether a cannabis business within the United States can proceed with a U.S. bankruptcy in connection with a foreign bankruptcy proceeding, but Section 1506 of the United States Bankruptcy Code allows bankruptcy courts to refuse to take such a proceeding it if “would be manifestly contrary to the public policy of the United States.”
Companies with Tangential Ties
Although several courts have ruled that bankruptcy relief is not available to companies with tangential ties to the cannabis industry, such as landlords for cannabis businesses or entities that produce equipment utilized by cannabis businesses, the Ninth Circuit Court of the Appeals has opened the possibility that bankruptcy may be available within that jurisdiction for an entity with tangential ties the cannabis industry. See Garvin v. Cook Investments NW SPNWY LLC, 922 F.3d 1031 (9th Cir. 2019) (debtor allowed to proceed in chapter 11 bankruptcy and confirm a plan of reorganization notwithstanding that it derived rental income from a tenant that was a cannabis grower).
 Cannabis is legal, either recreationally or medically in the majority of states, with the number growing near annually. Despite increasing legalization on the state level, cannabis-related businesses face unique obstacles because products containing more than a 0.3% concentration of THC remain categorized as Schedule I substances in the federal Controlled Substances Act. Cannabis raw and finished products containing a THC concentration of 0.3% or less on a dry weight basis, which is the definition of hemp, were removed from the Controlled Substances Act by the 2018 Farm Bill.