In In re Kojima, No. 8:23-CV-00167-RGK, 2023 WL 4602623 (C.D. Cal. July 17, 2023), the U.S. District Court for the Central District of California (the court) affirmed a bankruptcy court’s order approving a Chapter 7 trustee’s proposed settlement of cannabis-related state court claims held by creditors of the estate.

In so ruling, the court distinguished the case at bar from similar cases, holding that a bankruptcy court’s administration of cannabis-related state court claims against a debtor’s estate is not a violation of the Controlled Substances Act (the CSA).

Background

In 2016, Don and Susan Kojima (the debtors) formed the Adelanto Entities to purchase approximately 47 acres of land in Adelanto, California. The debtors purchased the property with the express purpose of cultivating cannabis alongside their son, Cameron Kojima (collectively with the debtors, the Kojimas). Investors Chase Miles Kaufman, Michael Garrison, and Zachary Powers (collectively, KGP) entered into a profit-sharing agreement with the Adelanto Entities, permitting KGP to use the Adelanto Entities’ cannabis licenses for independent businesses. In 2019, the Kojimas became aware that KGP were noncompliant with state and local cannabis laws regarding the identification and recordation of cannabis products. In addition, KGP made allegedly unauthorized transactions leading to $360,000 in damages being assessed against the Adelanto Entities and the debtors. As a result, the Kojimas terminated the profit-sharing agreement with KGP shortly thereafter.

On Jan. 21, 2020, KGP filed suit against the Kojimas and the Adelanto Entities asserting claims arising from the profit-sharing agreement, seeking damages of $15 million (the state court action). The Adelanto Entities filed a cross-complaint against KGP seeking $360,000 in lost revenue owing from the unauthorized transactions.

On May 26, 2021, the debtors filed a voluntary petition for Chapter 11 bankruptcy relief. The case subsequently converted to a case under Chapter 7. Richard A. Marshack (the trustee) was appointed the Chapter 7 trustee.

On Nov. 29, 2022, the trustee filed a motion to approve a settlement (the settlement) with KGP which, among other things, provided that: KGP would receive a $6.98 million subordinated claim in the Chapter 7 case; KGP would dismiss the debtors from the state court action; the trustee would investigate and, if appropriate, file an avoidance action to recover any property transferred from the debtors to Cameron Kojima and the Adelanto Entities; any proceeds derived from the prosecution of those avoidance actions would go to the benefit of the estate and its creditors, including KGP; and the one parcel of land that was currently used for cannabis operations would go to the benefit of KGP and not the estate.

The Kojimas and the Adelanto Entities opposed the settlement, contending that it violated the CSA by allowing the trustee to settle the cannabis-related state court action, and was not in the best interest of creditors. On Jan. 10, 2023, the bankruptcy court entered an order approving the settlement (the order), relying on the Trustee’s representations that “no cannabis-related assets would come into play” but cautioned the parties that if that was not the case, the trustee would alert the court immediately.

On Jan. 27, 2023, the Kojimas and the Adelanto Entities appealed the order. While the court eventually dismissed the debtors from the appeal for lack of standing, it allowed Cameron Kojima and the Adelanto Entities (collectively, the appellants) to proceed as to the substance of their appeal—namely, that the bankruptcy court erred when it approved the Settlement.

The Court’s Opinion

In affirming the bankruptcy court, the court first noted that as a Schedule I controlled substance, the CSA prohibits the distribution, dispensing of, or possession with intent to manufacture, distribute, or dispense cannabis. As such, the court opined that bankruptcy courts risk “becoming a conduit to a CSA violation” when disposing of cannabis-related assets. That risk is particularly acute when a trustee settles a state court cannabis claim between the estate and its creditors. Nonetheless, the court noted that “the mere presence of marijuana near a bankruptcy case” does not automatically show cause for dismissal.

The appellants argued that the trustee could not settle the state court action as, in so doing, the bankruptcy court would essentially be approving a settlement of cannabis-related claims. Relying on the Malul and Burton decisions, decisions from two separate bankruptcy courts in separate jurisdictions, the appellants contended that a trustee could not settle a debtor’s pending state court claim arising from the cannabis industry at all as such a settlement would run afoul of the CSA. The appellants also argued that the settlement was not fair and equitable. The court rejected both arguments. First, the court distinguished the Malul and Burton decisions from the case at bar. While the Malul and Burton decisions provide that a bankruptcy court’s involvement in a debtor’s affirmative cannabis-related claims is improper, this was not the case here. In this case, the order involved the settlement of third-party claims against the debtors.

Indeed, per the settlement, the debtors would pay KGP, not the other way around. Thus, the court found that the Malul and Burton decisions did not bar approval of the settlement, because while the settlement could lead to the administration of tainted assets, it was not guaranteed to do so. Furthermore, pursuant to the settlement, the trustee was required to dispose of such tainted property, have title vest in KGP, or simply decline to pursue the avoidance action for the cannabis-related property.

Further, the court noted that since the Malul and Burton decisions were from courts in other jurisdictions, they were not binding, that neither case articulated a bright-line rule precluding a bankruptcy court from approving any settlement that may remotely “touch” the cannabis industry, and that reasonable minds may differ on how close a debtor’s actions might come to a CSA violation in connection with a proposed settlement. In further support of its decision, the Court also found that the Burton court expressly declined to articulate such a per se prohibition and noted that bankruptcy courts have considerable discretion to approve proposed settlements.

Second, with respect to the appellants’ argument that the Settlement was not fair and equitable, the court considered the months’ long negotiating leading up to the settlement and the support by unsecured creditors holding 57% of the non-KGP claims. In addition, KGP’s claim was subordinated such that it would not be paid until at least 75% of other creditor’s claims were paid, after which KGP would receive pro rata distributions alongside other unsecured creditors. As such, the court found that the bankruptcy court did not abuse its discretion in approving the settlement.

Ultimately, the court affirmed the bankruptcy court’s order approving the settlement. However, the court did recognize the possibility that CSA violations might unfold in the future and, as such, emphasized that it would rely on the trustee’s representations and business judgment to minimize any potential or actual violation of the CSA.

Conclusion and Commentary

Once again, this decision seems to represent an ongoing trend, at least in the Central District of California, whereby courts have taken a more lenient approach toward cannabis-related parties.

Although the court recognized the greater amount of deference granted to bankruptcy courts in reviewing settlements and justifiably relied on the trustee’s business judgment, the court acknowledged that there is not a zero-tolerance policy toward cannabis issues in bankruptcy, signaling a possible shift/positive sentiment toward cannabis and bankruptcy relief.

In light of this, attorneys should still exercise great caution when advising cannabis-related parties on bankruptcy issues while cannabis remains a Schedule I controlled substance.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.