More than 75% of the U.S. population lives in states that have legalized cannabis for adult and/or medical use.
Pursuant to a 2022 directive from President Joe Biden, a 2023 recommendation of the U.S. Department of Health and Human Services, and a scientific review released in January supporting the HHS's recommendation, the U.S. Drug Enforcement Administration is now evaluating whether to reclassify cannabis as a Schedule III drug.
If it does, the effect on the cannabis industry will likely be seismic because removing the federal prohibition of cannabis should eliminate punishing tax treatment and banking restrictions that are restraining the market's growth.
Rescheduling may also have an effect on cannabis-related bankruptcy proceedings.
Historically, bankruptcy courts have been closed for cannabis-related businesses. However, recent decisions in favor of cannabis-related businesses, coupled with the potential rescheduling of cannabis itself, could possibly change the landscape and, as such, is worthy of further exploration and analysis.
The CSA and Rescheduling
Under the Controlled Substances Act, it is unlawful, among other things, to engage in cultivating and dispensing cannabis, as well as engaging in ancillary downstream business such as providing cannabis companies with equipment, leasing space to such businesses, or managing them.[1]
On Oct. 6, 2022, Biden directed the HHS to initiate the administrative process to review how cannabis is treated under federal law and determine whether it should be reclassified under the CSA. On Aug. 29, 2023, the HHS recommended to the DEA that cannabis be rescheduled from Schedule I to Schedule III under the CSA.
The traditional rulemaking process for rescheduling is quite lengthy, and there is also prior precedent to consider as the DEA denied a petition to reschedule marijuana from Schedule I of the CSA, back in 2016.
At that time, the HHS opined that marijuana had a high potential for abuse, had no accepted medical use, and lacked an acceptable level of safety and, as such, the HHS recommended that marijuana remain on Schedule I. The DEA agreed, denying the petition and maintaining marijuana's status as a Schedule I drug. It is worth noting that the DEA has never overridden an HHS scheduling recommendation.
Even if cannabis is rescheduled, open recreational use would likely still be illegal under federal law and, thus, will still be dependent upon the various state legislatures deciding whether to legalize medical and recreational use.
Rescheduling will have greater implications on other business-related functions, such as the application of Section 280E and determining taxable income for cannabis businesses. However, while there is a clear-line difference that rescheduling will have on tax and banking implications for cannabis businesses, there is less of a clear-line effect on bankruptcy access.
Bankruptcy and Cannabis
Federally, the courts view cannabis as an illegal substance through the lens of the CSA. Notwithstanding the CSA, cannabis is legal for medicinal purposes in 38 states, three territories and the District of Columbia. The District of Columbia as well as 24 of the 38 states also permit cannabis to be used for recreational purposes.
Despite the expansion of legalized cannabis in individual states throughout the country, the bankruptcy courts are federal courts and, as such, are bound by federal law.
Whenever a cannabis business files for bankruptcy relief, a threshold question is whether the debtor can be granted relief consistent with the Bankruptcy Code and other federal law. If the answer to that question is no, the U.S. trustee, in their role as the watchdog of the bankruptcy system and as part of the U.S. Department of Justice, will move to dismiss the bankruptcy case.
The trustee's response to cannabis-related bankruptcy filings is guided by two principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed.
Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal law. The bankruptcy court itself may also require the cannabis-related debtor to show how it plans to comply with the Bankruptcy Code and other federal laws in an order to demonstrate its ability to be a debtor.
Further, under Section 1129 of the Bankruptcy Code, bankruptcy courts confirm debtors' plans of reorganization if certain requirements are met. One such requirement is that the debtor's plan of reorganization must be "proposed in good faith and not by any means forbidden by law."
So long as cannabis use remains federally prohibited, whether as a Schedule I or Schedule III substance, cannabis-related businesses will continue to struggle to satisfy this requirement for bankruptcy reorganization. The bankruptcy court will look to the debtor's post-confirmation business operations, and if those include the administration of cannabis assets, federally prohibited actions, then the court will not be able to allow such plans to be implemented.
Cannabis-Related Case Law
Until recently, bankruptcy courts followed a script in dismissing cannabis-related cases. The trustee would flag such cases via a motion to dismiss, and any cannabis-touching operations would be seen as a violation of the CSA, preventing the bankruptcy courts from being able to allow for the administration of the debtor's estate.
Representing the traditional line of cannabis-related bankruptcy case law, a 2018 decision from the U.S. Bankruptcy Court for the District of Colorado in In re: Way to Grow Inc. dismissed the debtors' Chapter 11 reorganization cases because one of the debtors sold hydroponic gardening supplies to cannabis growers.
Although the debtors' customers included cannabis companies, the debtors also had customers that did not violate the CSA. However, the court found reasonable cause to believe that the equipment and products being sold would be used, by at least some of the customers, to cultivate marijuana, and the debtors knew this to be true. This is the exact scenario discussed above, where the debtor knowingly proposed a plan of reorganization by means forbidden by federal law.
In dismissing the bankruptcy cases, the Way to Grow court stated a party cannot seek equitable bankruptcy relief from a federal court while in continuing violation of federal law.
Furthermore, a bankruptcy case cannot proceed where the court, the trustee or the debtor-in-possession will necessarily be required to possess and administer assets that are either illegal under the CSA or constitute proceeds of activity criminalized by the CSA.
The court also focused its inquiry on marijuana-related activities during the bankruptcy case, and not what occurred prior to the commencement of the bankruptcy case. In light of the debtors' post-petition business activities which included selling products to cannabis-related businesses, the court found cause to dismiss the case.
However, there have been some recent decisions by courts in Colorado and California that have ruled that the mere presence of cannabis is not per se improper.
For instance, in the 2023 case of In re: Hacienda, in the U.S. Bankruptcy Court for the Central District of California, the court twice denied the trustee's motions to dismiss, and confirmed the debtors' plan to liquidate cannabis assets.
The debtor, an American business that was no longer involved in the cannabis industry, transferred its cannabis-related assets to a Canadian company in exchange for stock in the Canadian company. The debtor looked to liquidate these Canadian shares over time without flooding the market and decreasing the price of the Canadian company's stock.
The trustee filed two separate motions to dismiss the bankruptcy case for violating the CSA. The bankruptcy court denied both motions, ruling that involvement in criminal activity pre-bankruptcy does not automatically result in a dismissal — e.g., Enron, Madoff, etc. The court reasoned that the stock sale would be for the ultimate benefit of creditors, outweighing any potential post-petition violation of the CSA, which the bankruptcy court recognized could still result in liability under the CSA outside of bankruptcy court.
The transition from such a strict stance from the court in Way to Grow to allowing post-confirmation administration of quasi-cannabis assets in Hacienda may be a signal that some bankruptcy courts are becoming more lenient toward cannabis-related businesses. However, the Hacienda decision is still in contrast to U.S. trustee guidelines, which expressly state that reorganization plans involving cannabis may not be confirmed.
Rescheduling cannabis to Schedule III on the heels of the Hacienda decision might further sway bankruptcy courts on cannabis-touching entities attempting to participate in bankruptcy proceedings.
Similar to how it is within the DOJ's discretion to federally prosecute cannabis businesses operating in states where cannabis is legal, if rescheduling occurs, trustees will be confronted with a decision of whether to file a motion to dismiss where cannabis-related assets or parties are involved.
Previously Rescheduled Drugs in Bankruptcy
As seen by the treatment of cannabis derivatives in bankruptcy, reclassification of cannabis to Schedule III could result in plant-touching parties participating in bankruptcy proceedings more freely.
For example, in the 2017 case of In re: Arm Ventures LLC, in the U.S. Bankruptcy Court for the Southern District of Florida, the bankruptcy court denied a motion to dismiss the debtor's bankruptcy case, but required the debtor to propose a plan that was not dependent upon the sale of cannabis. In this case, the debtor, owning commercial property and leasing space to businesses selling cannabis-based products, filed for bankruptcy relief.
Even though the debtor failed to present an acceptable plan of reorganization prior to the court's decision on the motion to dismiss, the court allowed the creditors to accept adequate protection payments from the debtor.
The court noted that the payments to the creditors were generated from the sale of Marinol-based products by the businesses. Marinol, a synthetic form of THC, was allowed to be legally sold pursuant to both federal and state regulations regarding pharmacies licensed to prescribe Schedule II and III drugs. Since the businesses were licensed to sell Schedule II and III prescription drugs, the court allowed the creditors to accept the adequate protection payments without violating federal law.
If federal law eventually permits the sale and use of cannabis, similar to pharmacies selling Marinol, cannabis-related parties could start to see greater involvement in bankruptcy cases, such as the pharmacies in Arm Ventures.
Until then, debtors involved in any business operations touching cannabis must exercise extreme caution to avoid risking dismissal of the bankruptcy case or jeopardizing plan confirmation.
Examining the viability of hemp cultivation, the U.S. Bankruptcy Court for the Northern District of Illinois in the 2019 case of In re: Royalty Properties LLC, granted a motion for relief from the automatic stay to enable a creditor to foreclose on the debtor's real property in state court.
The debtor failed to provide adequate protection to the creditor but argued that it did not need to do so as it intended to generate significant income by growing hemp on the real property. The bankruptcy court found that the debtor's plan to grow hemp would likely be unsuccessful due to the creditor's expert testimony that growing hemp was speculative and that the debtor had no experience in such business venture.
Even if cannabis is reclassified under the CSA and legalized federally, debtors, such as the one in Royal Properties, will still face challenges and obstacles from both the bankruptcy courts and creditors to remain in bankruptcy post-petition — and it is safe to assume that in these cases, the bankruptcy courts will require extra assurances of business acumen and apply stricter scrutiny when analyzing cannabis-related assets and plans of reorganization.
Conclusion
Ultimately, the analysis depends on the language the DEA decides to adopt, if it accepts the HHS recommendation to reschedule cannabis to a Schedule III substance.
The recent development of bankruptcy case law surrounding cannabis businesses provides somewhat of a cautious optimism for cannabis entities interested in utilizing the bankruptcy courts albeit, under certain limited circumstances.
Not only is 2024 an important year with the potential rescheduling of cannabis on the horizon, but bankruptcy courts and the trustee will also have to navigate how to treat cannabis businesses seeking bankruptcy relief with the increasing liberalization of cannabis use.
Reprinted with permission of Law360.
