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Is Chapter 15 Available to a Cannabis MSO? In the Face of Uncertainty, Tread Lightly

By Jarret P. Hitchings
Second Quarter 2021
INSOL World

Is Chapter 15 Available to a Cannabis MSO? In the Face of Uncertainty, Tread Lightly

By Jarret P. Hitchings
Second Quarter 2021
INSOL World

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"Cannabis enterprises have been forced to consider their options when faced with insolvency. Especially in the U.S., these options are limited by the inability of cannabis enterprises to obtain relief under the United States Bankruptcy Code."

On 31 March 2021, the State of New York legalized the use, possession, and growth of cannabis by adults. Within the United States, cannabis is now legal in 16 states including Washington D.C., with legalization taking effect in two more states, Virginia and New Mexico, later this year. This state-level trend toward legalization in the United States continues even though cannabis remains illegal at the federal level.[1] However, in Canada, cannabis has been legal at both the federal and provincial levels since 2018.

The opening of these markets has generated significant investment on both sides of the U.S.-Canadian border. In January 2021 alone, North American cannabis companies reported more than $1.6 billion in capital raises.[2] Despite this activity, numerous cannabis enterprises continue to fail or are currently experiencing financial distress. In many cases, this distress has resulted from oversaturation and a glut of market participants (legitimate and not) or an inability to keep up with (or a mistiming of) an ever-changing regulatory environment in both Canada and the United States. It may also be a sign that the legal cannabis retail market has reached a peak, as reports show potentially sustained declines in month-over-month retail sales of cannabis products.[3]

Against this backdrop, cannabis enterprises have been forced to consider their options when faced with insolvency. Especially in the U.S., these options are limited by the inability of cannabis enterprises to obtain relief under the United States Bankruptcy Code.[4] For multi-state operators doing business in the U.S. and Canada (MSOs), there is therefore no certain process for effecting a compressive cross-border restructuring or liquidation.

The oft-posited solution to this problem is that the MSO first obtain insolvency protection in Canada and then seek recognition of the Canadian proceeding in the U.S. under Chapter 15 of the Bankruptcy Code. To date, this proposed solution remains untested. And while such an approach may be possible in theory under Chapter 15 itself, recent U.S. court decisions involving cannabis debtors under other chapters of the Bankruptcy Code have only created more uncertainty as to whether this Chapter 15 "backdoor" is ever possible in practice.

There is no doubt that the first step – initiation of a Canadian insolvency proceeding – is not only possible, but anticipated, under Canadian law. Indeed, financially distressed cannabis enterprises have increasingly relied on the Canadian insolvency and rehabilitation scheme to address their liquidity and operational issues. For example, in 2016, two years prior to cannabis legalization under federal law, Peloton Pharmaceuticals Inc., a developer and distributor of pharmaceutical-grade cannabis, successfully reorganized under Canada’s Bankruptcy and Insolvency Act.[5] In 2018, Ascent Industries Corp. followed by obtaining creditor protection, and ultimately selling its assets, under the Companies’ Creditors Arrangement Act.[6] Since then, more than 20 major cannabis enterprises – including at least 10 publicly traded companies – have sought protection under the BIA or CCAA.[7]

At the same time, and notwithstanding the state-level movement toward legalization, the doors to the U.S. bankruptcy courts have remained firmly closed to financially distressed cannabis companies. The principal reason for this bar is that the U.S. bankruptcy courts, being an arm of the federal government, have been unwilling to sanction proceedings that: "would require the court, trustee, or debtor in possession to administer assets that are illegal under [federal law] or that constitute proceeds of activity criminalized by [federal law]."[8] While some U.S. courts particularly in the Ninth Circuit, which includes among others; the states of California, Washington, and Nevada, have softened their position on this issue, the ability of cannabis-related enterprises to obtain relief under the Bankruptcy Code has arguably receded due to recent court opinions expanding the bar on such relief to U.S. companies holding equity in cannabis producers[9] or those merely planning to enter the legal Canadian cannabis market.[10]

Yet the routine dismissal of cannabis-related cases under other chapters of the Bankruptcy Code need not portend how a U.S. bankruptcy court would treat a Chapter 15 filing by a foreign cannabis enterprise. First, a Chapter 15 filing generally does not result in the creation of an estate comprised of the debtor’s (cannabis related) property. There is therefore little risk that the U.S. court, or any trustee under its supervision, will be tasked with administering illegal assets or proceeds. Second, a foreign debtor engaged in a cannabis enterprise legal under foreign law does not come to the U.S. court with unclean hands - mitigating the concern over the debtor’s potential lack of "good faith."

Rather, the main hurdle a cannabis-related debtor will face is Chapter 15’s bar on the recognition of a foreign insolvency proceeding that requires action anathema to U.S. public policy.[11] Specifically, Section 1506 of the Bankruptcy Code empowers the U.S. Bankruptcy Court to refuse recognition to any foreign proceeding that is: "manifestly contrary to the public policy of the United States." Id. Notably, the statute does not speak further to specific U.S. public policy of the United States, nor does it provide guidance as to what degree of conflict between U.S. and foreign law is permitted before the "manifestly contrary" threshold is reached.

In this void, the U.S. courts have determined that this exception to recognition should be applied narrowly and only "where the procedural fairness of the foreign proceeding is in doubt or cannot be cured by the adoption of additional protections" or where recognition "would impinge severely a U.S. constitutional or statutory right."[12] In articulating guiding principles for analyzing whether an action taken in a Chapter 15 proceeding is "manifestly contrary" to U.S. public policy, U.S. courts have recognized that "[t]he mere fact of conflict between foreign law and U.S. law, absent other considerations, is insufficient to support the invocation of the public policy exception."[13]

In a similar vein, the U.S. courts have begun to acknowledge that "the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief."[14] Taken together with the guiding principles of Chapter 15, there should be little reason for a U.S. court to reflexively dismiss the Chapter 15 petition of a foreign cannabis enterprise seeking recognition of its plenary Canadian insolvency proceeding. This is especially the case where the debtor’s U.S. operations or assets do not deal directly with the cannabis product.

Still, across the U.S., the law on cannabis bankruptcies remains unsettled, creating uncertainty for domestic and foreign cannabis MSOs. The evolving (or some may say devolving) nature of U.S. law on this point is, in part, the result of judicial deference to Congress for a legislative answer to the question of how a legal enterprise dealing in an increasingly but not-quite-yet legal produce can restructure under U.S. law. As one bankruptcy judge has colorfully recognized: "[I]f the uncertainty of outcomes in marijuana-related bankruptcy cases were an opera, Congress, not the judiciary, would be the fat lady. Ultimately, participants in the marijuana industry will continue to experience difficulty and uncertainty in predicting the outcome of any particular marijuana-related bankruptcy case unless and until Congress provides a legislative solution to the divergent federal and state drug laws. The Court may enjoy the opera, but anxiously awaits the fat lady’s song.[15]"

It remains to be seen if, or when, Congress will act in this regard. In recent months, Congress has been presented with separate legislation to reform the Bankruptcy Code and certain federal banking regulations concerning dealing in cannabis.[16] But neither bill addresses the very immediate demand for access by cannabis enterprises to the U.S. bankruptcy courts. In the absence of a clear legislative solution, insolvency practitioners and their clients should remain cautious in seeking relief under the Bankruptcy Code, even by way of a Chapter 15 process involving a cannabis enterprise legal under foreign law.

Notes

  1. See U.S. Controlled Substances Act, 21 U.S.C. §§ 801-904. 
  2. John Rebchook, "Funding for Marijuana Companies Surges After Democrats Win Control of White House, Congress", MJBizDaily (Feb. 4, 2021), available at https://mjbizdaily.com/funding-for-marijuana-companies-surges-after-democrats-win-control-of-white-house-congress/. 
  3. For example, in January and February, 2021 Canadian retail sales declined more than 5% from each of the prior months. See Statistics Canada. Table 20-10-0008-01 (Retail trade sales by province and territory (x 1,000)). 
  4. 11 U.S.C. §§ 101 et seq. ("Bankruptcy Code"). 
  5. RSC 1985, c. B-3 ("BIA"). 
  6. RSC 1985, c. C-36 ("CCAA"). 
  7. This list has continued to grow in the first months of 2021, as the FIGR Group and Hydrx Farms Ltd. each initiated CCAA proceedings in January and March, respectively.
  8. Burton v. Maney (In re Burton), 610 B.R. 633, 638 (B.A.P. 9th Cir. 2020); see also, Arenas v. U.S. Tr. (In re Arenas), 535 B.R. 845, 853 (10th Cir. BAP 2015) (holding that a bankruptcy case must be dismissed if its continuation would require the trustee or the court to administer assets that are illegal under federal law or that constitute proceeds of criminalized activity). In addition, some courts have held that a bankruptcy filing made by a debtor involved in illegal activity is ab initio not made in good faith and thus disqualifies the debtor from any entitlement to relief. See, e.g., In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 810 (Bankr. D. Colo. 2012). 
  9. In re Players Network, No. 20-12890-MKN, 2020 Bankr. LEXIS 3016 (Bankr. D. Nev. Oct. 23, 2020). 
  10. In re Pharmagreen Biotech, Inc., No. 20-50780-BTB (Bankr. D. Nev. Oct. 7, 2020). 
  11. See 11 U.S.C. § 1506.
  12. In re Better Place, Inc., No. 13-11814 (LSS), 2018 Bankr. LEXIS 322, at *21-22 (Bankr. D. Del. Feb. 5, 2018).
  13. In re Qimonda AG Bankr. Litig., 433 B.R. 547, 570 (E.D. Va. 2010).
  14. In re Burton, 610 B.R. at 637.
  15. In re Malul, 614 B.R. 699, 701 (Bankr. D. Colo. 2020).
  16. Consumer Bankruptcy Reform Act of 2020, S.4991 — 116th Congress (2019-2020); Secure And Fair Enforcement Banking Act of 2021, H.R.1996 — 117th Congress (2021-2022)

Reprinted by permission of INSOL World.