In contrast with a majority of bankruptcy courts that routinely dismiss cannabis-related cases for perceived violations of the Controlled Substances Act (CSA), the U.S. Bankruptcy Court for the Central District of California in the recent opinion In re Hacienda, No. 2:22-BK-15163-NB, (Bankr. C.D. Cal. July 11, 2023), refused to conform to the same historical standard. Instead, the Bankruptcy Court struck down the U.S. trustee’s motion to dismiss not once but twice in favor of confirming a marijuana business’ Chapter 11 plan of reorganization.

Background

In this case, the debtor, Hacienda Co. LLC, was in the business of wholesale manufacturing, packaging, and distribution of cannabis products to dispensaries within the state of California under the name “Lowell Herb Co.” aka “Lowell Farms.”

In 2021, the debtor transferred its assets, including intellectual property and drug-related goods, to a publicly traded Canadian company that changed its name to Lowell Farms Inc. (LFI). At the time of this transfer, the cannabis industry was legal under Canadian law and California state law. In exchange for its assets, the debtor received a 9.4% share in LFI.

On Sept. 21, 2022, the debtor filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code (the code). As part of its “plan” for emerging from the bankruptcy, the debtor intended to monetize its LFI shares by liquidating these shares over time to avoid flooding the market and diluting the value of the shares. The debtor believed that by engaging in this strategy, the value of the LFI shares would be maximized for the benefit of the debtor’s estate and its creditors.

Following the filing of its bankruptcy case, the trustee filed two separate motions to dismiss the debtor’s Chapter 11 case. In its first motion to dismiss, the trustee argued the Chapter 11 case should be dismissed pursuant to Section 1112(b) of the code, because the debtor distributed or conspired to distribute cannabis in violation of the CSA. This motion was denied as the Bankruptcy Court found that there was no ongoing violation of the CSA because the debtor was not distributing cannabis at the time and had no intent to use its remaining assets to invest in any cannabis-related enterprise in the future. However, the Bankruptcy Court left the door open to a future motion to dismiss stating: “Perhaps, if all the facts and circumstances were known to this Bankruptcy Court … Debtor’s proposed liquidation actually would be a violation of … some … criminal statute.”

Further, the Bankruptcy Court noted that Congress did not adopt a zero tolerance policy requiring the automatic dismissal of a Chapter 11 case under Section 1112(b) wherever potentially illegal activity was present. In support thereof, the Bankruptcy Court listed as examples the major Chapter 11 cases of entities like Pacific Gas & Electric Co., Enron Corp. and Bernie Madoff, as well as smaller businesses like restaurants and apartment buildings in violation of health and safety regulations. In light of this, the Bankruptcy Court justified its ruling by focusing on the lawful benefit the stock sale presented to creditors, the debtor, and other constituencies under the code.

On May 21, the trustee filed its second motion to dismiss. As part of the second motion, the trustee alleged that this motion differed from the first because the debtor planned to continue the alleged criminal activity post-petition in accordance with its proposed plan of reorganization.

The Court’s Opinion

Section 1112(b) of the code authorizes a bankruptcy court to dismiss a Chapter 11 case for “cause.” The party seeking dismissal bears the burden of establishing “cause,” a term that is not defined in the code. If “cause” is established, then the opponent can prevent dismissal by showing unusual circumstances establishing that dismissal is not in the best interests of the creditors and the estate.

The trustee argued that the Chapter 11 case should be dismissed for “cause” as the proposed plan of reorganization was a conspiracy to violate federal criminal laws because it proposed to repay creditors with assets derived from alleged criminal activity (i.e., selling stock in a Canadian cannabis organization).

Further, the trustee argued that federal courts generally close their doors on issues involving illegal contracts. The Trustee also attempted to distinguish this case based upon the alleged ongoing post-petition illegality regarding the sale of LFI’s stock.

The Bankruptcy Court rejected the trustee’s argument that federal courts close their doors, noting that there is some flexibility when private parties seek to enforce marijuana-related contracts and thus the mere involvement of marijuana did not warrant automatic dismissal. Similarly, the Bankruptcy Court rejected the trustee’s contention that the debtor’s violation of criminal laws continued post-petition. Instead, the Bankruptcy Court found that the trustee failed to show how the stock sale would offend congressional policy to maximize payment to the creditors.

With respect to the trustee’s other arguments, the Bankruptcy Court held that the trustee had failed to establish “cause” warranting the dismissal of the Chapter 11 case. First, the Bankruptcy Court acknowledged that the debtor probably violated the CSA pre-petition through its involvement with cannabis products. The Bankruptcy Court also found that conspiring to transfer assets in exchange for stock with the intent to possess such stock for a period of time could also be a post-petition violation of the CSA.

Notwithstanding these acknowledgements, the Bankruptcy Court reiterated its stance that Congress did not adopt a zero tolerance policy when drafting Section 1112(b), and that most bankruptcy cases might be dismissed if any illegality was grounds for dismissal. The Bankruptcy Court then focused on the benefits provided to parties in bankruptcy court, such as maximizing the value of a debtor’s assets, and, as such, interpreted Section 1112(b) as granting the Bankruptcy Court 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 Bankruptcy Court found that the trustee again failed to meet its burden to establish cause for dismissal. In its decision, the Bankruptcy Court cited the debtor’s indirect connection with any violation of a criminal law, the debtor’s intent to liquidate and pay creditors, and the benefits of the monetization of this stock for the estate. The Bankruptcy Court found that any CSA violations by the debtor primarily occurred before the bankruptcy and, in light of the foregoing, the Debtor’s post-petition liquidation of its stock in LFI did not offend Bankruptcy Code principles.

Alternatively, the Bankruptcy Court held that even if the trustee could establish “cause” to dismiss the Chapter 11 case, there were “unusual circumstances” present such that dismissal was not in the best interests of creditors or the debtor’s estate. Specifically, punishing the debtor for pre-petition divestment of cannabis involvement and attempting to maximize the value of the estate to the benefit of creditors would undermine the appropriate use of the bankruptcy system. The Bankruptcy Court found that any illegal acts by the debtor pre-petition were reasonably justified so long as the debtor cured such violation of law within a reasonable amount of time through the post-petition sale of LFI’s stock.

Ultimately, the Bankruptcy Court confirmed the debtor’s plan of reorganization. However, to ensure its decision was not read as condoning illegal behavior, the Bankruptcy Court noted that a debtor’s connections to cannabis could result in a dismissal of its bankruptcy case and that federal prosecutors would not be precluded from pursuing remedies for violations of the CSA or other nonbankruptcy laws.

Conclusion and Commentary

Hacienda represents one of the first bankruptcy court rulings to take a more hospitable approach toward cannabis-related businesses—a marked departure from prior decisions shutting down bankruptcy relief for plant-touching companies. While this case does not fully open the courthouse doors to cannabis-related businesses and seemingly grants the bankruptcy courts a great deal of discretion when ruling on similar cases in the future, cannabis-related businesses may now have a roadmap to pursue reorganization, at least in the Central District of California. This ruling may result in more cannabis-related bankruptcy filings as sophisticated bankruptcy attorneys now have a framework for testing the trustee’s historic opposition to bankruptcy protection for cannabis companies. Assuming Hacienda is not overturned, more bankruptcy courts might be required to weigh in on the intersection of cannabis and bankruptcy law in the future.

Lawrence J. Kotler is co-chair of the bankruptcy and fiduciary representations division of Duane Morris’ business reorganization and financial restructuring practice group. He represents Chapter 11 debtors-in-possession, Chapter 11 trustees, Chapter 7 trustees, liquidating trustees, creditors’ committees, secured creditors and large institutional unsecured creditors in all facets of bankruptcy.

Ryan Spengler, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.