On January 20, 2023, as few courts, such as the U.S. Bankruptcy Court for the District of Colorado, have consistently done, the U.S. Bankruptcy Court for the Central District of California (the “Bankruptcy Court”) further hewed a path for former cannabis businesses to utilize the protections of the U.S. Code's eleventh title (the "Bankruptcy Code") in spite of a mostly inhospitable (and frequently hesitant) jurisprudence--and the steady opposition of  the U.S. Trustee's Office (the "UST").

It did so in the opinion released that very date in In re Hacienda Co., LLC, 647 B.R. 748 (Bankr. C.D. Cal. 2023), which elaborated upon the reasons that it denied a motion to dismiss filed by the UST in a December 20, 2022, order, and that formally allowed the chapter 11 case of Hacienda Company LLC (the “Hacienda Company”) to proceed, saying the Hacienda Company had removed its wholesale cannabis product manufacturing and packaging business by the time it filed and was not looking reorganize as a cannabis concern.

“Just the Statutes”

The Controlled Substances Act of 1970 (the “CSA”) outlaws the possession, use, and distribution of marijuana.

Section 1112(b) of the Bankruptcy Code provides that “the [bankruptcy] court shall convert a case under this chapter to a case under chapter 7 or dismiss a case under this chapter, whichever is in the best interests of creditors and the estate, for cause ....”

Section 1112(b)(4) contains a laundry list of sixteen situations that qualify as “cause” for purposes of section 1112(b):

• (A) substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation;
• (B) gross mismanagement of the estate;
• (C) failure to maintain appropriate insurance that poses a risk to the estate or to the public;
• (D) unauthorized use of cash collateral substantially harmful to 1 or more creditors;
• (E) failure to comply with an order of the court;
• (F) unexcused failure to satisfy timely any filing or reporting requirement established by this title or by any rule applicable to a case under this chapter;
• (G) failure to attend the meeting of creditors convened under section 341(a) or an examination ordered under rule 2004 of the Federal Rules of Bankruptcy Procedure without good cause shown by the debtor;
• (H) failure timely to provide information or attend meetings reasonably requested by the UST (or the bankruptcy administrator, if any);
• (I) failure timely to pay taxes owed after the date of the order for relief or to file tax returns due after the date of the order for relief;
• (J) failure to file a disclosure statement, or to file or confirm a plan, within the time fixed by this title or by order of the court;
• (K) failure to pay any fees or charges required under chapter 123 of title 28;
• (L) revocation of an order of confirmation under section 1144;
• (M) inability to effectuate substantial consummation of a confirmed plan;
• (N) material default by the debtor with respect to a confirmed plan;
• (O) termination of a confirmed plan by reason of the occurrence of a condition specified in the plan; and
• (P) failure of the debtor to pay any domestic support obligation that first becomes payable after the date of the filing of the petition.

Two things are worth noting about section 1112(b)(4):

• Not one of its examples of "cause" impliedly references violations of non-bankruptcy law, or expressly refers to "a criminal action or proceeding against the debtor" like section 362(b)(1), which contains exceptions to the Bankruptcy Code's automatic stay.
• Arguably, as the Bankruptcy Court observed, such violations could constitute "gross mismanagement" of the estate, within the meaning of section 1112(b)(4)(B), "because violations of nonbankruptcy law might expose the estate to financial losses and criminal sanctions, and violating the law might constitute 'mismanagement.'"

“Just the Facts”

Based in Beverly Hills, Calif., the Hacienda Company had stopped operating in February 2021 and transferred its property to Lowell Farms Inc., a public Canadian company that grows cannabis in Canada, where it is legal. In return, Hacienda received 9.4% of Lowell’s shares. Only months later, on September 21, 2022 in fact, did the Hacienda Company file for chapter 11 relief. Sometime thereafter, it proposed a chapter 11 plan to liquidate after paying creditors with either its Lowell shares or the proceeds from selling the shares.

“Just the Law”

The Bankruptcy Court essentially adopted a “middle road” approach to adjudicating the possible dismissal of a chapter 11 case, if filed by a cannabis business, for “cause” under section 1112(b). Many federal courts had read this statute’s requirement a bankruptcy court “shall” dismiss or convert a bankruptcy case for “cause” to mean that any violation of criminal law compels dismissal. The Bankruptcy Court saw no reason to adopt such an “extreme position.” To explain this reluctance, it gave several different reasons, including: 

• the widespread understanding of section 1112 as a grant of discretion, not an insistence on action, by federal courts generally and bankruptcy courts particularly; 
• the federal courts’ longstanding refusal to adopt a blanket rule classifying all prepetition violations of nonbankruptcy law as “cause” for dismissal, especially considering the “many remedies for any debtor’s violations of any law, rule, or procedure” that exist and the fact that “dismissal is one of the more extreme remedies”; 
• Burton v. Maney (In re Burton), 610 B.R. 633 (B.A.P. 9th Cir. 2020), among other cases, which said “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief”; 
• the commonsensical distinction between a debtor’s prepetition, and post-petition, violations of the CSA by either (a) any connection to distributing cannabis or (b) stock ownership in a cannabis-related enterprise; and 
• Congress’ failure to specify what should be the bankruptcy-specific remedy for any violation of the CSA. In light of these factors, the Bankruptcy Court concluded that section 1112(b) empowers it (and any bankruptcy court) to “exercise … discretion to determine whether, given all of the facts and circumstances, a debtor’s connection to cannabis profits and any past or future investment in cannabis enterprises warrants dismissal ….”

Applying this standard, the Bankruptcy Court declined to dismiss the Hacienda Company’s case, as: 

• "passive stock ownership and intent to liquidate would end any post-petition (and post-bankruptcy) connection with cannabis”; 
• "dismissing every case that had a connection with illegal activity would be contrary to Congress’ directives under the Bankruptcy Code”; 
• the Hacienda Company’s demonstrable intent to liquidate its assets and pay creditors; and 
• the apparent benefits of a bankruptcy case for all parties in interest, including creditors.

Whether this opinion is a harbinger of a sea change, or just another outlier, well, that’s a story for another day, one that only time will tell.

“Just Further Reference”

For more on the relevant arguments and many of the pivotal and representative cases on every aspect of this contentious divide, please see the article on this issue, co-written with Claudia Springer and Jake A. Ziering, posted on the author’s page on SSRN.