Around the time Reuters published our article regarding bankruptcy eligibility, the U.S. Bankruptcy Court for the Central District of California (LA Division) issued a decision in In re The Hacienda Company, LLC, that thoughtfully articulates the balancing of governmental policies, bankruptcy purposes and creditors’ rights a bankruptcy court should engage in when dealing with cannabis and cannabis-adjacent debtors. As an update to our article, below describes how the Hacienda decision advances the analysis performed by prior courts.
The debtor was in the cannabis wholesale manufacturing and packaging business until February 2021. After the debtor ceased operations, it transferred its value through a sale of intellectual property to a publicly traded Canadian company whose sole business is cannabis growth and sales, receiving approximately 9.4% of stock as consideration.
In September 2022, the debtor filed for bankruptcy. The U.S. Trustee filed a motion to dismiss the case under Section 1112(b) of the U.S. Bankruptcy Code arguing that the debtor: (i) violated the Controlled Substances Act (CSA) through its stock ownership; (ii) is grossly mismanaging the estate due to its post-petition use of stock or stock proceeds in a cannabis company; and (iii) filed for bankruptcy in bad faith since any plan proposed would be funded from proceeds derived from unlawful sources.
Decision and Appeal:
The court denied the U.S. Trustee’s motion to dismiss, finding that dismissal was not in the best interest of creditors given that the debtor’s passive ownership of stock, which it intended to liquidate to pay creditors, was not an ongoing post-petition violation of the CSA. Further, a future bankruptcy trustee would not have to violate the CSA when liquidating the stock. The court also held that Congress did not adopt a “zero tolerance” policy under Section 1112(b) of the Bankruptcy Code for any illegality. Alternatively, the court held that elements of the “unusual circumstances” test under Section 1112(b)(2) were met.
The decision is subject to appeal by the U.S. District Court, Central District of California. The debtor filed an opposition to the U.S. Trustee’s Motion for Leave to Appeal, which is scheduled to be heard March 6, 2023.
Significance of Decision:
The Hacienda decision is well-supported and expresses the need for nuance and potential deference to more targeted ways to address violations of law when determining if bankruptcy dismissal is warranted. The decision reminds all that bankruptcy provides benefits to both creditors and debtors, and those benefits must be taken into account, rather than strict adherence to a rule that would view dismissal as mandated where there are violations of law.
Application to cannabis, specifically:
Although prior courts have analyzed a debtor’s degree of involvement with cannabis operations when determining whether to allow its bankruptcy to proceed, the court here brings a new perspective, one that articulates the need for a more holistic analysis that encompasses social policies, criminal law, bankruptcy goals and the consequences for all interested parties if the case was dismissed. In such an analysis, the benefits of the bankruptcy filing to the debtor and creditors should be considered, along with the degree of the debtor’s involvement in activity that violates law, whether the violation continues post-petition or ended pre-petition, and the type of law violated.
Ultimately, the decision is a reminder that broadly requiring dismissal whenever the debtor has been involved in any manner in activity that may violate the CSA, can be the beginning of a slippery slope. As the court stated, other bankruptcies, such as Enron and Madoff, have involved elements of criminality. Should debtors be denied bankruptcy protection, and creditors be denied a ready forum for recovery, if a debtor has unpaid parking tickets?
The Hacienda decision is bound to be invoked by other cannabis-adjacent businesses across the U.S., and there will likely be ample opportunity in bankruptcy court in this district, which covers Los Angeles. In fact, depending on the outcome on appeal (and any subsequent appeals), this decision may be relied on not only by cannabis-adjacent debtors, but also other debtors whose activities involve some level of non-compliance with laws.