As an analysis in the National Law Review recently observed, “legal marijuana sales reached $25 billion in the United States, [in 2021], a 40% increase from the previous year.” The authors of that analysis conclude that all parties to cannabis related transactions have been placed at a disadvantage by their “limited alternatives” in the event of a business failure.
Creditors of businesses that have some connection to state-legal cannabis in the US wonder about their legal position when such debtors declare bankruptcy. A September decision in Colorado may somewhat ease their minds. The question, though, will surely continue to be litigated and may eventually have to be resolved by appeals courts.
State-legal cannabis-related businesses, which of course traffic in a product that is still a Schedule I drug under the Controlled Substances Act, present a puzzle for bankruptcy courts, which administer a federal body of law.
How are the bankruptcy courts to react to a petition by a debtor that cultivates, processes, or sells products containing marijuana? Or by an investor in corporations that do so? How are they even to react to a petition by a petitioner with a real but indirect connection to those?
The latest decision addressing this point is In re Roberts. In this matter, the bankruptcy court in Colorado in September 2022 found that a debtor’s alleged ownership interest in cannabis-related companies neither compelled a dismissal of the case nor prohibited a Chapter 7 trustee from administering the debtor’s assets. It is not clear that any private credit funds are involved in this specific case. They may, nonetheless, be affected by the legal principle involved.
Chapter 11 is often called rehabilitation bankruptcy: a system designed to reorganise a business’s capital structure.
Chapter 7, on the other US hand, is a liquidation bankruptcy. Often creditors, facing a Chapter 11 proceeding, will seek to have it converted to a Chapter 7 liquidation. Many creditors, especially those with senior debt, get a better return in the latter case than in the former, because the absolute priority rule is followed; that is, the court will follow a strict hierarchy in the payment of claims – DIP creditors first, then secured, priority unsecured, etc.
Individuals, too, can file under Chapter 11. Their creditors may likewise seek to have the proceedings converted to Chapter 7. That is what played out in In re Roberts. The named debtor filed under Chapter 11, and the bankruptcy court has now allowed a Chapter 7 conversion.
There is an extensive write-up of the Roberts case on the website of law firm Duane Morris. The facts are convoluted. But the bankruptcy court found that the debtor, Roberts, filed a Chapter 11 petition in bad faith. He was seeking to cheat the same creditors who had already been victims of his misconduct.
The Colorado bankruptcy court said that “the mere presence of marijuana near a bankruptcy case” does not prohibit bankruptcy relief. Nor does it prohibit the creditors from protecting their own interests against bad faith in that context. The case will proceed, then, and a Chapter 7 trustee will be appointed.
The law may be moving toward the idea that some (tenuously) cannabis-related businesses are sufficiently distanced from actual transactions in the Schedule I drug to allow them access to Chapter 11 and to allow for the possibility of Chapter 7 conversions under the same circumstances that apply to all manner of businesses and investors.
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