Marijuana Industry Can’t Partake in Bankruptcy Protection

Understand the complexities and nuances of the Bankruptcy Code to better advise clients and prepare for court.

By David McAfee

Companies that do business in the marijuana industry have run into a problem: they can’t get protection under the current federal bankruptcy laws.

California was the first state to make cannabis legal for certain medical conditions, and now 28 other states have followed suit. But despite the high number of states adopting medicinal—and even recreational—cannabis laws, the substance remains illegal under federal law.

This means that federal bankruptcy protections don’t apply to companies that deal with cannabis, directly or indirectly, according to legal experts who work in the field.

Certain companies are prohibited from using federal bankruptcy protections, even if they are “in compliance with state laws regulating marijuana,” Mitchell Kulick, a partner at DFMK Law, New York, told Bloomberg BNA June 19. DMFK provides legal services to clients in the cannabis industry.

“The case law is not particularly well-defined in this area, but in general, any company that derives its income from manufacturing, distributing, dispensing, or possessing marijuana is ineligible to seek relief under the Bankruptcy Code,” Kulick said.

The rule applies to companies that “touch the plant,” like growers and dispensaries, but also those that receive income from cannabis-related activities indirectly, such as landlords, he said.

Industry Still Green

The bankruptcy issue stems from the fact that the cannabis industry is relatively new, and federal laws haven’t caught up to the novel laws in many local jurisdictions, some legal professionals say.

The medical cannabis industry is “still in its formative stages in most states,” Philip C. Silverman, a senior associate at Vicente Sederberg LLC in Quincy, Mass., said. Silverman has practiced bankruptcy law for 25 years.

“There are not a significant number of cases in this area, but the prohibition thus far seems to extend from individuals whose income is derived from marijuana businesses, to businesses that directly deal in marijuana products, to ancillary entities such as landlords whose primary income is derived from marijuana sales,” Silverman told Bloomberg BNA June 15.

Because the case law for legitimate cannabis-related companies filing for bankruptcy is “fairly recent,” it’s “hard to say” what effects the prohibition has had, Silverman noted.

Effects on Distressed Debtors

The prohibition on bankruptcy filings initiated by companies that deal in cannabis has harmed distressed companies in leveraged negotiations, Kulick said. It gives creditors “significant leverage over a distressed debtor,” he argued.

“Bankruptcy, or the threat of bankruptcy, is a powerful bargaining chip that helps distressed companies level the playing field against aggressive creditors or rid itself of burdensome contracts,” Kulick said. “Without this threat, many creditors are able to bully distressed companies into accepting onerous or one-sided terms, and that opens up companies to predatory lenders who have designs on seizing control their operations.”

To combat this side effect, some states and localities have enacted laws to “present a counter-balance” for distressed companies operating in the marijuana market, Kulick said.

“It should come as no surprise that a marijuana company’s most valuable asset is usually its marijuana inventory, and secured creditors that do not meet the requirements to operate legal marijuana businesses under state or local laws are often prevented from seizing possession of that collateral in a foreclosure,” he said.

Chapter 7 Possibility

Though a Chapter 11 reorganization directed at rehabilitating a company while it operates would “be difficult to get through a court at this time,” a better argument could be made for a business that’s no longer operating and has previously liquidated all marijuana assets, Silverman said. In that case, the company might be able to obtain benefits of a Chapter 7 liquidation.

In the past, similar cases have been dismissed because the bankruptcy trustee would normally be expected to take control of assets, including those that are marijuana based, Silverman said.

“Courts have decided that such trustees should not be forced to take control of illegally obtained assets,” thereby arguably putting them in legal jeopardy, “due to a bankruptcy filing and therefore dismiss the case,” Silverman said. “However, the rationale would not appear to apply if all marijuana assets have been liquidated prior to the bankruptcy filing. We will have to wait and see how the courts look at the issue.”

Other Options

If distressed companies that deal in cannabis can’t declare bankruptcy, what can they do?

There are a couple options, according to Christopher F. Graham of Eckert Seamans Cherin & Mellott LLC in White Plains, N.Y., who has been practicing bankruptcy and insolvency-related law since 1982.

Crumbling cannabis companies can’t utilize federal bankruptcy laws because they deal in products banned by the Controlled Substances Act, but they can “possibly liquidate under state law or use an assignment for the benefit of creditors,” Graham said.

“State law receiverships might also be used,” he told Bloomberg BNA June 15.

Kulick agreed that distressed companies still have options to liquidate their assets under state law, including assignments for the benefit of creditors.

But bankruptcy “remains an unlikely option” for marijuana businesses until there is a change in the federal law, he said.

To contact the reporter on this story: David McAfee in Los Angeles at dMcAfee@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

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