The Bureau of Labor Statistics reported this year that about 20% of small businesses fail in their first year. In the cannabis industry, operators face more obstacles than other new businesses. High licensing fees, taxes, and lack of access to traditional banking create high barriers to entry in this extremely competitive market.
What do you do when your cannabis business is in the red and you can’t find an investor? A traditional small business would be eligible to file for bankruptcy. But, federal regulations outlawing the sale of cannabis mean cannabis operators can’t file for bankruptcy. Two recent court cases addressed this issue, but the outcomes of these cases haven’t led to greater clarity. Here’s what we know about bankruptcy in the hemp and cannabis markets.
What does it mean to file for bankruptcy?
Business bankruptcy is when a business owner goes to federal court for assistance in eliminating and repaying debt with the protection and guidance of a bankruptcy court. A business is eligible to file for bankruptcy under three types, depending on its business structure.
- Chapter 7: business bankruptcy, or liquidation. In this scenario, the debts of the business are so substantial that it is not economically feasible to restructure them. The business is usually dissolved.
- Chapter 11: business reorganization. In this scenario, the company is reorganized and continues to operate under a court-appointed trustee. A plan is filed to the creditors outlining how the business will recover, with the creditors voting on whether or not to accept the plan.
- Chapter 13: personal bankruptcy (sole proprietors are eligible to file for Chapter 13). In this scenario, the individual files a repayment plan with the bankruptcy court.
The prevailing legal opinion in the cannabis industry is that cannabis operators aren’t eligible to file for any of these bankruptcies. “To date, courts have generally ruled that debtors who work in the cannabis industry or derive meaningful income from cannabis activity (directly or indirectly) cannot use bankruptcy,” writes one legal blog. But, a recent opinion filed in the Ninth Circuit Court of Appeals under Garvin v. Cook indicates the tide may be turning.
Garvin v. Cook: What happened?
Courts generally determine that debtors who “work in the cannabis industry or derive income from cannabis activity directly or indirectly cannot use bankruptcy.” This covers ancillary businesses, such as those who sell equipment to cannabis companies – or, in this case, to real estate properties.
Garvin v. Cook concerned five real estate holding companies that filed for Chapter 11 bankruptcy in Washington state. One of those five holding companies had leased to a company that used the land to grow cannabis – legally, as Washington is one of the states that permits regulated growth of cannabis.
However, due to the federal regulation banning cannabis, the US Trustee program filed to dismiss the Chapter 11 bankruptcy due to the real estate company’s relation to cannabis. The Trustee Program claimed that “allowing cannabis to be grown on debtor’s land constituted ‘gross mismanagement’”, a classification that disqualifies a company for Chapter 11 reorganization bankruptcy.
The bankruptcy court denied the motion by the Trustee Program. But, in the process, they also gave the Trustee office the opportunity to reassert its motion when the debtors filed to confirm their bankruptcy plan. The plan was confirmed, and the US Trustee “did not renew its objection based upon ‘gross mismanagement’ and the Ninth Circuit, in turn, found that such an objection was waived.”
What are the overall implications for the cannabis industry?
The court found that the Bankruptcy Code does not mandate that courts “police substantive provisions of a bankruptcy plan.” If the overall bankruptcy plan doesn’t violate any federal law, then the plan is valid and can move forward. The court must decide if the “plan was proposed in an unlawful matter,” and nothing more.
If this interpretation sounds murky, it is: and the narrow interpretation only has real implications for ancillary businesses in the cannabis market. And, it should be taken with a grain of salt; last month’s ruling in the Way to Grow case makes things even more complicated.
The Case of Way to Grow, Inc.
In Colorado, another case cracked open the door further for cannabis-adjacent companies to file for bankruptcy. Way to Grow, Inc. and two partner companies provided indoor hydroponic and gardening-related supplies when they filed for bankruptcy. Their expansion plans were tied to cannabis, but not exclusively so – Way to Grow had other customers that were not in the cannabis industry.
In this case, a creditor moved to dismiss their bankruptcy claim because Way to Grow was in violation of the Federal Controlled Substances Act (CSA). The court found that Way to Grow was breaching the provision in the CSA that makes it a federal crime to “‘manufacture’ or ‘distribute’ any ‘equipment, chemical, product or material which may be used to manufacture a controlled substance . . . knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance.’”
Despite the fact that Way to Grow was not directly growing or distributing cannabis, their business model was clearly dependent on the income from the sale of cannabis. There was no way for Way to Grow to restructure their business profitably without selling to cannabis businesses; therefore the bankruptcy court ruled against Way to Grow.
This ruling is now under appeal, so there’s a chance this precedent may change.
What about the hemp industry?
The Way to Grow result indicates that hemp businesses may not be able to file for bankruptcy either, given that most hemp businesses are cannabis-adjacent. A result in Nevada ruled that hemp’s removal from the CSA in 2019 placed hemp companies under the jurisdiction of the US Food and Drug Administration, but fell short of addressing the FFDCA. “There was no discussion of whether a violation of the FFDCA would bar a company from the federal bankruptcy system,” notes one expert.
Key Takeaways About Cannabis Bankruptcy
We don’t expect to see major changes to bankruptcy rulings in favor of cannabis companies any time soon. The Trustee Program, a section of the US Department of Justice, has been cracking down to enforce federal cannabis laws related to personal and business bankruptcy. The agency has filed “88 enforcement actions since 2010, with 53 (or 60%) of those occurring in 2017 and 2018. More than 50% of those actions were for cases in California, Colorado and Oregon,” notes Marijuana Business Daily.
Cannabis and hemp operators facing debt should consult a lawyer or speak to one of our tax experts who may be able to provide financial advice.
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