In a previous article, I discussed the ultimately doomed effort by United Cannabis, a cannabis-affiliated company, to maintain its chapter 11 bankruptcy petition in the face of the Bankruptcy Court for the District of Colorado’s sua sponte challenge on the basis of the plan requiring administration of federally illegal cannabis activity. Although that case did seem to further shut the door to cannabis businesses seeking the protections of bankruptcy, at least in the Tenth Circuit, it also indirectly highlighted the growing gap in treatment of bankruptcy cases between the Ninth Circuit and others. In a recent case, In re The Hacienda Company, LLC, No. 2:22-bk-15163-NB, 2023 Bankr. LEXIS 2359 (Bankr. C.D. Cal. Sept. 20, 2023), the Ninth Circuit has doubled down on its liberal treatment of cannabis bankruptcy cases. Specifically, Bankruptcy Judge Neil W. Bason of the Central District confirmed the debtor’s chapter 11 plan of reorganization and denied the U.S. Trustee’s motion to dismiss the petition on the grounds that federally illegal cannabis activity was funding the reorganization.
Debtor in the case, the Hacienda Company, was at one point an active California cannabis cultivator and distributor. However, it fell on hard times in 2021 and sold its assets to Lowell Farms, Inc., a Canadian, company, in exchange for shares of Lowell Farms stock. Eventually, Hacienda declared bankruptcy and proposed, as part of its plan of reorganization, to sell off the Lowell Farms shares and distribute the proceeds to its creditors.
The U.S. Trustee objected, and filed a motion to dismiss under section 1112(b) of the bankruptcy code, which prohibits the confirmation of any plan of reorganization for “cause.” Although “cause” under section 1112(b) has somewhat of a malleable definition, the U.S. Trustee argued that good cause was present because Hacienda was still (technically) involved in federally illegal cannabis business activities—specifically, a “conspiracy” to violate the Controlled Substances Act via its assets-for-stock transaction with Lowell Farms.
Judge Bason disagreed, denying the U.S. Trustee’s motion to dismiss and, in a companion order, confirming the plan of reorganization over the U.S. Trustee’s objections. The court’s reasoning, put briefly, was that evidence of illegal activity by a debtor as part of a proposed plan of reorganization does not, ipso facto, mandate dismissal. Specifically, the court pointed out that Congress did not explicitly list “illegal activity” as one of the grounds for “cause” under section 1112(b). It also pointed out several famous examples of confirmed plans of reorganization where past or ongoing illegal activity was present—such as the Enron and PG&E bankruptcies. Lastly, the court also pointed out that the plan it was approving resulted in the same remedy that would have resulted had the debtor been criminally prosecuted under anti-money laundering statutes: liquidation of the assets for the benefit of creditors.
The court went a step further, and also held that even if there was “cause” for dismissal arising from the illegal activity, the “unusual circumstances” exception of section 1112(b)(2) would also justify denial of the motion to dismiss. The court applied the two-part test for “unusual circumstances,” finding first that there were unusual circumstances such that dismissal was not in the best interests of creditors because dismissal would mean that the debtor’s shares in Lowell Farms would sit on the shelf rather than be liquidated to pay the unsecured creditors. The court then found the plan also met the second prong of the unusual circumstances test in that (1) the plan could be confirmed in a reasonable amount of time and (2) that the resulting ability to pay off the debtor’s creditors in full provided “reasonable justification” for the liquidation of the Lowell Farms stock and would also cure any residual illegal activity by eliminating the last cannabis-connected asset of the company.
Implications and Takeaways
The holding in Hacienda should embolden both cannabis businesses and their service providers in that it has left the door to bankruptcy protection slightly ajar. Of course, the unique factual circumstances of this case likely limit its applicability, but it is notable for the court’s noting that illegal activity—read: involvement in cannabis business—does not automatically disqualify a business from bankruptcy protection and the ability to reorganize under chapter 11. Other would-be cannabis debtors that are winding down their operations, but may have other assets, such as intellectual property, they may want to parlay into another venture will likely take advantage of this rather liberal reading of the Bankruptcy Code. That said, for other cannabis businesses, the juice may not be worth the squeeze in terms of the barriers to entry for bankruptcy, and may elect to pursue dissolution or receivership under state law, as has been the trend.
Aside from Hacienda’s impact on its own terms, it further highlights a growing divide between Bankruptcy Courts inside of different circuits, specifically regarding the application of section 1112(b) for dismissal or conversion of chapter 11 petitions and section 1129(a) for chapter 11 plan confirmation.
As you may recall from my prior article, there is a circuit split between the Ninth Circuit on one hand, and Sixth and Tenth Circuits on the other, regarding the interpretation of section 1129(a)(3). That particular subsection requires that, for a plan of reorganization to be confirmed, that it must be “proposed in good faith and not by any means forbidden by law.” The Ninth Circuit, in Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019), interpreted this clause to mean that the plan must be “proposed . . . not by any means forbidden by law,” not that the plan itself must not contain any illegal activity. The Hacienda court followed this precedent in its order confirming the debtor’s plan. In re Hacienda Co., LLC, 2023 Bankr. LEXIS 2359, at *7-9. In contrast, the Sixth and Tenth Circuits have taken the opposite view and looked at the substantive terms of the plan and, specifically, whether the debtor’s plan consists of any ongoing involvement with federally illegal cannabis business, to determine whether it meets the requirements of section 1129(a)(3). See, e.g., In re Basrah Custom Design, Inc., 600 B.R. 368, 381 n.38 (Bankr. E.D. Mich. 2019); In re Way to Grow, Inc., 610 B.R. 338, 345-47 & n.3 (D. Colo. 2019). Practically speaking, this means that cannabis businesses can have plans confirmed in the Ninth Circuit, but because of the federally illegal nature of their business, the Sixth and Tenth Circuits prevent plan confirmation because the illegal activity prevents a finding that the plans are proposed “in good faith.”
Apart from reinforcing this split, Hacienda answers a lingering question from Garvin. As liberal as the Garvin court was in confirming the plan of reorganization, the court did note that opponents of cannabis business chapter 11 plans could always invoke the section 1112(b) to dismiss the bankruptcy, even if it meets the “proposal” requirements for confirmation under 1129(a), specifically invoking the “gross mismanagement” prong of “cause” for dismissal under that subsection. Garvin, 922 F.3d at 1036. The Hacienda court noted that illegal activity might constitute “gross mismanagement” in the abstract, and impliedly found that the illegal activity by the debtor was not gross mismanagement, although it does not appear that the U.S. Trustee argued that point. One can assume that the relatively “clean” nature of the plan to liquidate the Lowell Farms shares to pay off the creditors left little room for a mismanagement argument. More significantly, the Hacienda court has shown that to constitute cause for dismissal under 1112(b), a movant must show that the illegal activity provides cause for some other reason than its own illegal status. This furthers the divide between the Ninth and Sixth Circuits; although the United Cannabis court did not explicitly say why it was finding good cause under 1112(b) to dismiss the debtor’s petition, one can presume that the “illegal activity” rationale played a role in the good cause finding.
In short, Hacienda’s holding has made the bankruptcy courts of the Ninth Circuit friendlier to cannabis businesses on the issues of cause for dismissal and plan confirmation. Until federal legalization happens, these circuit splits will likely deepen, and is perhaps predictable, if not appropriate, that bankruptcy courts located in the Pacific region—historically the vanguard in cannabis legalization—are providing a more hospitable environment for cannabis business debtors.
 Significantly, the U.S. Trustee and Court noted that although Lowell Farms was wholly legal in Canada, including its public trading on the Canadian Stock Exchange, it likely had operations in the United States that violated federal law.