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California Supreme Court Says Lenders Owe No Duty of Care in Loan Modification Negotiations

March 8, 2022/in All Blog Posts/by Jake Ayres

The 2008 financial and foreclosure crisis—in addition to immiserating a generation of homeowners—led to an explosion in litigation against lenders and loan servicers by aggrieved owners. Because of the volume of these cases and the diversity of approaches by the plaintiffs, a split of authority between the various Districts of the California Court of Appeal on a key issue developed: do lenders owe a duty of care in reviewing and processing loan modification applications?

On March 7, 2022, in a unanimous, landmark (and whopping, 54-page) majority opinion authored by Chief Justice Cantil-Sakauye, the California Supreme Court answered that question with a resounding “no.” In Sheen v. Wells Fargo, the Justices held that “lender[s] [do not] owe borrowers a tort duty sounding in general negligence principles to . . . ‘process, review and respond carefully and completely to a borrower’s loan modification application,’ such that upon a breach of this duty the lender may be liable for the borrower’s [solely] economic losses.” (Slip Op. at 2.) On June 1, the Court denied Sheen’s petition for rehearing, effectively finalizing the Court’s decision.

In this case, borrower Kwang Sheen took out a second and third mortgage with Wells Fargo on his home in Los Angeles. Sheen eventually missed payments on both loans and Wells Fargo began foreclosure proceedings, scheduling a trustee’s sale for February 2010. In January of 2010, Sheen, through his representative, contacted Wells Fargo and applied for a loan modification in an attempt to stave off foreclosure. A week after his application for modification, Wells Fargo cancelled the trustee’s sale set for February. Wells Fargo never got back to Sheen directly about the loan modification requests, but did get a set of letters related to the two loans from Wells Fargo in March of 2010, which informed him the loans had been charged off and the balance accelerated. Sheen interpreted these letters to mean that the loans had been modified to become unsecured such that there would be no foreclosure on his property. However, as it turned out, Sheen’s interpretation of the letters was incorrect, and both loans remained secured as Wells Fargo went to the market with the distressed loans.

In November of 2010, Wells Fargo sold the second loan to a third party, and that loan eventually ended up in the hands of Mirabella Investment Group, LLC (“Mirabella,” a client of Gupta Evans & Ayres who prevailed against Sheen on summary judgment, plaintiff’s appeal of which is pending the resolution of the Wells Fargo appeal). In 2014, Mirabella foreclosed on the property and it was sold at a foreclosure sale. Sheen’s lawsuit followed, wherein he brought causes of action for intentional infliction of emotional distress, unfair competition (section 17200), and—most critically—negligence. The California Court of Appeal held summarily dispatched the emotional distress and unfair competition claims, and, in the bulk of the opinion, held that Wells Fargo owed no duty of care to Sheen in processing his loan modification requests, relying on the “economic loss rule” which states that parties to a contract (or a contract negotiation) do not owe each other a duty not to cause purely economic losses that do not arise from the violation of an independent duty. Sheen v. Wells Fargo, 38 Cal. App. 5th 346 (2019). In so doing, the Court of Appeal explicitly noted that “[t]he issue of whether a tort duty exists for mortgage modification has divided California courts for years” and that “[t]he California Supreme Court has yet to resolve this division.” Id. at 348. Picking up the thrown-down gauntlet, the California Supreme Court granted review.

Like the Court of Appeal, the California Supreme Court used economic loss rule as its primary rationale, which provides that a party to a contract cannot recover in tort for purely economic damages—“i.e., pecuniary losses unaccompanied by property damage or personal injury” (Slip Op. at 2.)—unless the plaintiff can show a breach of a duty arising independent of the contract between the parties. Robinson Helicopter v. Dana Corp., 34 Cal. 4th 979, 992-93 (2004). The court relied heavily on this principle in deciding not to impose a duty on lenders, noting the underlying rationale of the rule is to “‘prevent the erosion of contract doctrines by the use of tort law to work around them.’” (Slip. Op. at 15 (quoting Restatement, §3 at p. 2).) The court reasoned that loan modification is just a renegotiation of an existing contract, wherein the lender is attempting to find a way to best enforce and protect the rights established by the original contract. (Id. at 17-18, 23.)

After noting that its approach was consistent with the majority of other jurisdictions (id. at 19-22), the court dispensed with plaintiff’s legal counterarguments. In particular, the court noted that the economic loss rule is not limited to loan origination, but also modification because of its relation to the original contract between the parties. (Id. at 23.) The court also stated that the oft-cited factors from Biakanja v. Irving, 49 Cal.2d 647 (1958)—used to impose a duty of care in certain situations—do not apply when the parties are in contractual privity. (Id. at 37.)

Lastly, and perhaps most importantly, the court rejected plaintiff’s policy arguments. The court did recognize the underlying merit in plaintiff’s contention that the bargaining power in loan modification negotiations are lopsided in favor of lenders and servicers (who may have incentives to promote foreclosure and discourage modification), but ultimately stated that it was the role of the Legislature to strike the balance between those competing costs and benefits. (Id. at 46-55.) The court was not shy about prodding the Legislature to act to address the concerns raised by plaintiff about home loan modification negotiations, stating that “should it choose to the Legislature can both prescribe whether a lender must act ‘reasonably’ and (in some detail, if it chooses) what constitutes ‘reasonable’ behavior within this sphere.” (Id. at 55.) Justice Liu, in his concurring opinion, was more pointed: “[W]hether the mortgage market and affected communities would benefit from manipulative practices and ‘bargaining or information asymmetries’ . . . continues to be ripe for legislative consideration.” (Id. at 11 (Liu, J., concurring).) This open signaling from the California Supreme Court could spur the Legislature to act to address the concerns raised by both plaintiff and the court.

The court also seemingly overruled contrary precedent in a sweeping footnote (id. at 55 n.12), but did not delve into the details of the prior cases from the Court of Appeal that did find duties of care applicable to lenders. One of the handful of cases that did find a duty of care and was heavily relied upon by plaintiffs—Alvarez v. BAC Home Loans Servicing, L.P., 228 Cal. App. 4th 941 (2014)—was addressed in Justice Jenkins’ concurring opinion, wherein he fell on his sword and addressed his participation in that case’s opinion. In short, Justice Jenkins seemed to admit that he, along with the rest of the majority in Alvarez, misapplied the Biakanja factors and overlooked the fact that that analysis only applies where the parties are not in contractual privity. (Id. at 2 (Jenkins, J., concurring).)

In granting review and deciding against the existence of a duty, the California Supreme Court has spoken clearly about the lack of a lender’s duty to process, review, and respond to loan modification—avoiding a potential instantaneous sea change in the allocation of risk and liability between lenders and borrowers. However, at the same time, the Court has also, in asserting its inability to make law on the subject from the bench, laid the groundwork for potential Legislative action. Finally, although the court seemingly has spoken with an intent to close the book on this issue in the judicial sphere, given the passing remarks made by the concurring Justices pointing out the items not conclusively addressed by the majority opinion (id. at 3-5 (Liu, J. concurring); id. at 2-3 (Jenkins, J., concurring)), lender litigants can reasonably expect that borrower plaintiffs will continue to jam their proverbial feet in the door.

Blame Games & Automobiles: Rattagan v. Uber Technologies and the Potential Extension of California’s Fraud Exception to the Economic Loss Rule

January 11, 2022/in Corporate Litigation/by Jake Ayres

An infinite amount of ink has been spilled over the decades regarding the proper boundary between contract and tort law. An important reinforcement to that often-blurry boundary is the economic loss rule, which provides that a party to a contract cannot recover in tort for purely economic damages arising from disappointed expectations. This broad-sounding rule is subject to certain exceptions, including the highly influential ruling established by the California Supreme Court in Robinson Helicopter Co. v. Dana Corp., 34 Cal. 4th 979 (2004), which provides that a contracting party seeking economic damages by alleging fraud—that is, intentional misrepresentation—may avoid the bar of the economic loss rule. Id. at 991. But what about fraudulent concealment—that is, where a party to a contract doesn’t make an outright false statement, but instead lies by omission?

That question was recently and squarely before the Ninth Circuit in Rattagan v. Uber Technologies, No. 20-16796, 2021 U.S. App. LEXIS 35874 (Dec. 6, 2021). In that case, rather than resolve the question of whether fraudulent concealment is excepted from the economic loss rule itself, the Ninth Circuit instead, seeking guidance on the applicable California law, certified that question to the California Supreme Court. How the California Supreme Court decides this issue will have far-reaching effects on how much parties can inject tort claims into contractual disputes.

In Rattagan, an Argentinian lawyer for two Dutch subsidiaries of Uber that planned to launch a ridesharing service in Buenos Aires brought claims against Uber for both contract and tort claims. Plaintiff Rattagan alleged that Uber hid its launch plans from him and as a result, the necessary corporate and tax formalities had not been carried out at the time the ridesharing service went live. As a result, Argentinian authorities raided his office, leaving him subject to potentially significant liability under Argentinian law. Plaintiff Rattagan brought claims against Uber for among other things, breach of the implied covenant of good faith and fair dealing and fraudulent concealment. On Uber’s motion to dismiss, the district court held that because the relationship between Rattagan and Uber was contractual, Plaintiff’s fraudulent concealment claim was foreclosed by the economic loss rule.

On appeal, the Ninth Circuit first analyzed the most recent California Supreme Court case on point—Robinson Helicopter. In that case, the California Supreme Court held that intentional misrepresentation claims were not barred by the economic loss rule because such acts constitute a breach of a duty independent of the duties imposed by contract. In so doing, the Robinson Helicopter court declined to address whether fraudulent, intentional concealment also is excepted from the economic loss rule. The court was careful to circumscribe its holding, stating that it was “narrow in scope and limited to a defendant’s affirmative misrepresentations on which a plaintiff relies and which expose a plaintiff to liability for personal damages independent of the plaintiff’s economic loss.” 34 Cal. 4th at 993. For the sake of context, the fraud in Robinson Helicopter involved defendant making affirmative misrepresentations in the form of fraudulent certifications for mechanical components for aviation (sprag clutches), which exposed plaintiff to potential safety and regulatory liability independent of its economic losses under the contract between the parties. Id. at 991 & n.7.

The Rattagan court went on to note that there had been no authoritative decision on the issue of fraudulent concealment vis-à-vis the economic loss rule in the California Courts of Appeal. Rather, the Ninth Circuit’s survey only turned up unpublished appellate cases pointing in opposite directions. The court concluded by outlining the competing policy concerns—“freedom of contract and abhorrence of fraud.” 2021 U.S. App. LEXIS 35874, at *8 (citations and quotations omitted). That is, applying the economic loss rule to fraudulent concealment might support the freedom of contracting parties to allocate risk between them, at the expense of possibly emboldening (and shielding) dishonest parties to contracts. The opposite would be true for extending the Robinson Helicopter extension to fraudulent concealment claims.

As for reading the tea leaves, one can make the case that the “duty independent of contract” element articulated in Robinson Helicopter would be just as met by a fraudulent concealment claim as an intentional misrepresentation claim. Indeed, fraudulent concealment is only viable as a claim where the law imposes a duty to disclose, which only occurs in certain limited circumstances. CACI 1901. However, the “duty independent of contract” is but one of the two pillars of the rationale of the Robinson Helicopter exception. The California Supreme Court was careful to say in Robinson Helicopter that it was creating an exception for “affirmative misrepresentations . . . which expose a plaintiff to liability for personal damages independent of the plaintiff’s economic loss.” 34 Cal. 4th at 993. In other words, there are two “independence” requirements for the Robinson Helicopter exception to apply: (1) independence of the tort, and (2) independence of damages. See id. at 991 & n.7, 993 (“[Plaintiff’s] claims are based on [Defendant’s] intentional and affirmative misrepresentations that risked physical harm to persons. . . . A properly functioning sprag clutch is vital to the safe performance of the aircraft, and compliance with the certificate requirement is part of an integrated regulatory scheme intended to ensure their safe operation.”). Although the independent duty prong is discussed extensively in Rattagan, the independent damages prong is not. Hopefully, the California Supreme Court will address that strand of Robinson Helicopter’s reasoning in its opinion. At the very least, even if the California Supreme Court finds the “independent tort” prong dispositive of the certified question, it should restate the requirement that damages must be independent as well, to show that opportunistic plaintiffs in contract disputes cannot bring specious fraud claims for the economic damages that are entirely duplicative of breach of contract damages.

Although the economic loss rule can be seen as somewhat of an academic issue, the resolution of this certified question by the California Supreme Court will have repercussions for everyday civil litigation practice in the state. While we eagerly await the California Supreme Court’s resolution of this ripe issue, litigants will continue to argue both sides of the extension of the Robinson Helicopter fraud exception to the economic loss rule.

Author: Jake Ayres

In Trusts We Trust?: Applying the Alter Ego Doctrine to Trusts

December 14, 2021/in All Blog Posts, Corporate Litigation/by Jake Ayres

Most attorneys are familiar with the rigamarole that comes with attempting to reach assets held by the principals of a business entity as a part of analyzing whether a judgment will be collectible—that is, whether the alter ego doctrine will apply such that the creditor may “pierce the corporate veil.” However, the rules for whether a judgment creditor may “pierce the veil” of a trust to reach the settlor behind that trust are a bit quirkier.

Indeed, most of the time when trusts are involved, the creditor is interest in proceeding the opposite direction—that is, reaching the assets held in trust for the benefit of a judgment debtor. Regardless of which direction the creditor may be going, this article discusses the rules of the road for collecting from individual via trust, and trust via individual.

First, it should be noted that the alter ego doctrine doesn’t even come into play where a judgment debtor transfers assets into a revocable trust. In that scenario, the judgment creditor can attach and collect upon the assets in the trust because they are treated as assets of the judgment debtor regardless of their placement into a revocable trust. See Bank One Texas v. Pollack, 24 Cal. App. 4th 973, 980 (1994); Gagan v. Gouyd, 73 Cal. App. 4th 835, 842 (1999), disapproved on other grounds in Mejia v. Reed, 31 Cal. 4th 657, 669 (2003); see also Prob. Code § 18200 (“Property in a revocable trust is subject to creditor claims to the extent of the debtor’s power of revocation.”).

Second, although the alter ego doctrine has been analyzed in the context of trusts rather than business entities, the California Court of Appeal has been careful to note that trusts are in fact not legal entities at all: “‘[A] trust is not a legal person which can own property or enter into contracts . . . It is the trustee or trustees who hold title to the assets that make up the trust estate . . . . [Therefore,] legal proceedings are properly directed at the trustee.’” Greenspan v. LADT LLC, 191 Cal. App. 4th 486, 521 (2010) (quoting Neno & Sullivan, Planning and Defending Domestic Asset-Protection Trusts, Planning Techniques for Large Estates (Apr. 26-30, 2010) SRO34 ALI-ABA 1825, 1869-70)). Moreover, “[b]ecause a trust is not an entity, it is impossible for a trust to be anybody’s alter ego.’” Id. at 522. However, the Court of Appeal did find that “applying the [alter ego] doctrine to trustees” was acceptable because “it’s entirely reasonable to ask whether a trustee is the alter ego of a defendant who made a transfer into the trust.” Id. The court in Greenspan concluded that alter ego doctrine could be applied to a third-party trustee of an irrevocable trust as the potential alter ego of the debtor settlor. Id.

The Ninth Circuit, applying California law a month before Greenspan, reached a similar conclusion in In re Schwarzkopf, 626 F.3d 1032 (2010), with a slight variation: the trust itself, rather than the trustee, can be considered the alter ego of a debtor settlor. In Schwarzkopf, the debtor transferred assets to two irrevocable trusts, naming his minor child as beneficiary and a third party as trustee, but, as to the second trust, “‘dominated and controlled all decisions of the . . . Trust.’” Id. at 1039. The Ninth Circuit first held that the California court’s then-current rule1 against “reverse veil piercing”—that is, attaching the assets of a corporation to satisfy the debts of a shareholder—did not prevent them from considering whether “reverse piercing” could be allowed in a trust context. See id. at 1038 (“In the absence of further guidance from California courts, therefore, we cannot extend the prohibition on reverse piercing to the trust context.”). The court went on to hold that “under California law, equitable ownership in a trust is sufficient to meet the ownership requirement for purposes of alter ego liability.” Id. Although the debtor was not the beneficiary of the trust, nor the trustee, the court still found that the debtor was “an equitable owner of the . . . Trust because he acted as owner of the trust and its assets” because he essentially dictated the actions of the trust to the trustee. Id. Accordingly, the Ninth Circuit held that “the bankruptcy court did not err in finding that the . . . Trust is [debtor settlor’s] alter ego.” Id. at 1040.

But what if the debtor is the trust—or, more accurately, per the admonitions in Greenspan, the trustee—and the creditor wants to reach the assets of the settlor as the debtor trust/trustee’s alter ego? To this author’s knowledge, there has been no California or Ninth Circuit case directly answering this question. One can surmise this is because trusts are used as the vehicle to shield assets of individuals and entities, and do not often themselves incur liabilities. However, it stands to reason that if a trustee of an irrevocable trust can be the alter ego of a debtor settlor per Greenspan, and an irrevocable trust itself can be the alter ego of a debtor settlor per Schwarzkopf, then the converse is also true—that is, a settlor can be the alter ego of a debtor trust or trustee. In other words, alter ego liability would seem to imply a two-way street: the trust/trustee is the settlor and the settlor is the trust/trustee. The waters seem to get murkier if one swaps in the trust beneficiary for the settlor in the foregoing analysis. However, the Schwarzkopf court’s emphasis on equitable title as forming the basis for alter ego liability would seem to suggest that beneficiaries would be subject to the same rules as Greenspan and Schwarzkopf, as well as the potential extension of those opinions to the converse rule. See Walgren v. Dolan, 226 Cal. App. 3d 572, 576 (1990) (“[T]he beneficiary [of a trust] holds only equitable title . . . .”). Of course, the Ninth Circuit’s focus on equitable title, and the California Court of Appeal’s focus on the separation of trust and trustee, could result in a split between state and federal courts in California in how they each handle the trust to settlor liability question.

In short, the current state of the law regarding trust alter ego theories is as follows:

Debtor = settlor of revocable trust → assets of trust collectible, no alter ego showing required
Debtor = settlor of irrevocable trust → assets of trust collectible upon alter ego showing
Debtor = trust or trustee → assets of settlor likely collectible
Debtor = trust or trustee → assets of beneficiary may be collectible

Scenarios 3 and 4 above may remain opaque until the unique scenario of an asset-poor trust and an asset rich beneficiary or settlor come before a relevant court of appeal, but given the relative rarity of that fact pattern, litigants that find themselves in that scenario will likely have to argue by analogy to the existing rules of Greenspan and Schwarzkopf.

Author: Jake Ayres

An Offer You Can’t Refuse, Part II: No Cash, No Claim

August 6, 2021/in All Blog Posts, Corporate Litigation/by Jake Ayres

In a previous article, I discussed the often blurry line between permissible pre-litigation communications and constitutionally unprotected extortionate demands. However, one important dimension of the civil extortion universe was left unaddressed there—that is, no claim for civil extortion can lie unless the victim actually pays the extorter.

In much of the foundational precedent surrounding the issue of civil extortion, courts are primarily concerned with the first step of the anti-SLAPP analysis, wherein the defendant has the burden of proving that the speech at issue is protected. See, e.g., Flatley v. Mauro, 39 Cal. 4th 299, 320, 333 (2006). Under the anti-SLAPP statute’s two-step, burden-shifting framework, only when the defendant has made a prima facie showing that their speech is protected activity does the plaintiff then have the burden of proving a likelihood of success on the merits of their claim. Id. at 314. Flatley and nearly all of its progeny deal with scenarios where the defendant fails to meet their initial burden because their communications are held to be extortionate as a matter of law, and as a result, those courts did not reach the second step of the analysis—that is, whether the plaintiffs have viable claims for civil extortion.

If they had, most of those civil extortion claims would have been found lacking for the victim’s failure to pay.[1] Although extortionate demands may place communications outside of the protections of the constitution and the anti-SLAPP statute, merely receiving those communications does not on its own give rise to an actionable claim. See Fuhrman v. Cal. Satellite Sys., 179 Cal. App. 3d 408, 426 (1986), overruled on other grounds by Silberg v. Anderson, 50 Cal. 3d 205, 211 (1990). Although not termed an action for “civil extortion,” the California Supreme Court “has recognized a cause of action for the recovery of money obtained by the wrongful threat of criminal or civil prosecution.” Id. Because California only recognizes a cause of action for recovery of extorted money, would-be victims of an extortionate demand who do not pay do not have a cause of action for civil extortion.

Indeed, in an unpublished case, the California Court of Appeal rejected a claim for “attempted civil extortion” for this exact reason. Tran v. Eat Club, No. H046773, 2020 Cal. App. Unpub. LEXIS 5299, at *53-54 (Aug. 18, 2020). It is possible that a published case may take a different view, but allowing civil liability for “attempted” torts perhaps skirts too close to concepts of criminal liability.

In short, although an extortionate demand letter may not be entitled to constitutional protections as a matter of law, that does not mean, ipso facto, that the plaintiff has a viable claim for civil extortion. Indeed, without money changing hands, California law currently prohibits recovery of damages.

[1] Or, found lacking because the speech at issue would be protected by the litigation privilege, defeating the likelihood of success on the merits on the second step of the anti-SLAPP analysis. See Malin v. Singer, 217 Cal. App. 4th 1283, 1302 (2013) (holding that where demand letter was “protected by litigation privilege. . . . plaintiff [could not] establish a probability of prevailing where the litigation privilege precludes liability”).

Author: Jake Ayres

The Sphinx on Skunk: Justice Thomas Speaks Out(!) on the Inconsistent Enforcement of Federal Cannabis Prohibition

July 21, 2021/in All Blog Posts, Cannabis, Corporate Litigation/by Jake Ayres

They say that war makes for strange bedfellows. As it turns out, the war on drugs is no exception. In a recent opinion from the United States Supreme Court, conservative stalwart Justice Clarence Thomas rebuked the federal government’s “half-in, half-out” stance on state-legal cannabis, and strongly implied that said approach was untenable from a federalist perspective. This criticism of federal drug policy from the right—rather than the left—could be another omen that more cultural conservative objections to state-legal cannabis are yielding to federalism and economic concerns and could also signal a future bipartisan action to provide safer harbor to legal cannabis businesses.

In Standing Akimbo, LLC v. United States, 594 U.S. __ (2021), the Supreme Court, on June 28, 2021, denied certiorari to a medical cannabis dispensary in Colorado attempting to prevent disclosure of certain company records sought by the IRS. The dispensary was accused by the IRS of impermissibly using 280E of the Internal Revenue Code to deduct business expenses; as the law stands now, cannabis businesses, because they deal in a federally illegal substance, can only deduct the costs of goods sold.

However, in so doing, Justice Thomas took the opportunity to wag his finger at the inconsistency of federal enforcement of the illegality of cannabis: “[T]he Federal Government’s current approach to marijuana bears little resemblance to the watertight nationwide prohibition that closely divided Court found necessary to justify the Government’s blanket prohibition in Raich.” Id. A known advocate for federalist principles, he went on to note that “[i]f the Government is now content to allow States to act ‘as laboratories’ ‘and try novel social and economic experiments,’. . . then it might no longer have authority to intrude on ‘the States’ core policy powers . . . to define criminal law and to protect the health, safety, and welfare of their citizens.’” Id. (quoting Gonzales v. Raich, 545 U.S. 1, 42 (2005) (O’Connor, J., dissenting)).

Justice Thomas’s references to Raich (and Justice O’Connor’s dissent therein) is unsurprising given his own dissenting opinion in that case, in which he voiced similar concerns of federal commerce clause power overreach. Raich, 545 U.S. at 57 (Thomas, J., dissenting). In Raich, the majority held that the federal government had power under the commerce clause to regulate state-legal intrastate cannabis—that is, cannabis that is grown, distributed, and consumed within a state where it is legal. Id. at 22.

Justice Thomas opined that intrastate regulation in that context went beyond the federal government’s commerce clause powers, in that cultivation and consumption of medical cannabis entirely in California was not “commerce” nor interstate. Id. at 59. Moreover, although the majority substantially relied on Wickard v. Filburn, 317 U.S. 111 (1942) for the proposition that intrastate commerce that has a “substantial effect” on interstate commerce is within Congress’ regulatory power, Justice Thomas agreed with Justice O’Connor’s criticism of the majority’s reliance on Wickard. In Justice O’Connor’s dissent, she noted that, unlike Wickard, where the Court was presented with economic studies documenting the effects of personal intrastate wheat cultivation on the interstate wheat industry at large, there was no actual evidence that the small-scale medical cultivation and consumption by appellants had any “substantial effects” on interstate commerce. Id. at 53-54 (O’Connor, J., dissenting); id. at 67 (Thomas, J., dissenting). For his own part, Thomas criticized the majority’s apparent use of the Necessary and Proper Clause to hold that exercising federal police powers over intrastate legal cannabis cultivation was “necessary” to avoid a “gaping hole” in the Controlled Substances Act, id. at 21, reasoning that there was no evidence before the Court to suggest that failing to regulate intrastate cannabis cultivation and use would result in an inability to control interstate drug trafficking, id. at 63 (Thomas, J., dissenting), a criticism he alluded to in Standing Akimbo. 594 U.S. at __ (“A prohibition on intrastate use or cultivation of marijuana may no longer be necessary or proper to support the Federal Government’s piecemeal approach.”).

Indeed, these statements—from an eminent conservative, no less—could be a wake-up call for activist litigation to challenge the ruling in Raich, or for Congress to act to provide some measure of legalization or safe harbor to state-legal cannabis operators. As I have written previously, even if an impact litigant were to challenge Raich on its own rationale—without delving into the more academic discourse of Thomas’s dissent—such a challenge might bear fruit.

In reaching its final holding that Congress had a rational basis for concluding that intrastate cannabis cultivation would have a “substantial effect” on its ability to regulate interstate cannabis commerce, the Court in Raich explicitly premised its decision upon (1) difficulties distinguishing between state-legal cannabis and illegal cannabis grown elsewhere and (2) “concerns about diversion [of state-legal cannabis] into illicit channels.” 545 U.S. at 22. As more and more states legalize cannabis in some fashion—36 states have legalized adult-use cannabis, medical cannabis, or both—both of points one and two become weaker and weaker. That is, as to point one, as legal cannabis packaging becomes more regulated and sophisticated, the visible difference between legal cannabis and illegal cannabis becomes more and more obvious. As to point two, as more and more states legalize, it becomes less and less likely for legal cannabis to be “diverted” into illicit channels. For example, nearly the entire Pacific bloc of states—California, Oregon, Washington, Nevada, Arizona, and Colorado—have legalized medical and adult-use cannabis. Leaving aside state law prohibitions, legal cannabis moved throughout this region is very unlikely to result in “diversion” of legal cannabis “into illicit channels.”

Although whether this shot across the bow of the federal government’s cannabis enforcement regime will result in or motivate any lasting change—either judicially or legislatively—remains to be seen, the cannabis industry will likely view this statement of support from a somewhat unexpected source as a moral victory.

Chapter 420, Part II: Closing the Book on Cannabis-Adjacent Bankruptcy

July 7, 2021/in All Blog Posts, Bankruptcy, Cannabis, Corporate Litigation/by Jake Ayres

In a previous article, I discussed the potential impacts of a then-forthcoming decision in the case of In re United Cannabis Corporation, which had the potential to widen access to federal bankruptcy relief to cannabis-adjacent hemp businesses.

However, the In re United Cannabis case ended not with a bang, but with a whimper. On January 12, 2021, after approximately eight months of consideration, Bankruptcy Judge Joseph G. Rosania, Jr. of the District of Colorado issued a one-page ruling dismissing[1] the bankruptcy petition “pursuant to 11 U.S.C. § 1112(b) and . . . finding good cause.” In so doing, he snuffed out any hope that the District of Colorado could become a hub for hemp businesses that dabble in cannabis to successfully pursue chapter 11 bankruptcy.

Because the ruling does not provide any substantive reasoning for the decision, industry observers are left to speculate. One can only assume that the court found the evidence offered by the U.S. Trustee—namely, that the debtor was not nearly as removed from the cannabis arena as it purported to be based on the debtor’s website and marketing materials—credible enough to justify dismissal on the grounds that a plan of reorganization could not be untainted by federally illegal cannabis money. In so doing, the court left the fundamental question of how the 2018 Farm Bill’s legalization of hemp affects the availability of bankruptcy to businesses that have toes in both the cannabis and hemp pools. For the time being, the safer route—and the route perhaps favored by conventional wisdom—for businesses is to completely segregate their cannabis and hemp businesses, both on a practical and corporate/legal level.

The Bankruptcy Court for the District of Colorado’s declination to decide the issue raised by Way to Grow only illuminates other quirks in the current state of affairs for bankruptcy in the cannabis context. In particular, the ruling in United Cannabis displays the tension between how different bankruptcy courts have construed section 1112 vis-à-vis section 1129(a)(3).

Section 1129(a)(3) provides that a bankruptcy plan shall only be confirmed where, inter alia, “[t]he plan has been proposed in good faith and not by any means forbidden by law.” On its face, this statute would seem to preclude plans funded by federally illegal cannabis, given that those funds would be derived from a “means forbidden by law.” However, the Ninth Circuit disagreed in Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019). In that case, the Ninth Circuit affirmed the Bankruptcy Court for the Western District of Washington’s confirmation of a chapter 11 plan for reorganization over the U.S. Trustee’s objection that one of the debtors was renting real property to a cannabis growing operation. Id. The Ninth Circuit parsed the language of section 1129(a)(3) quite narrowly, holding that that subsection “directs bankruptcy courts to policy the means of a reorganization plan’s proposal, not its substantive provisions.” Id.at 1033. The Ninth Circuit applied that interpretation to the case at bar, and found that although income funneled into the plan would ultimately be derived from a federally illegal source—the cannabis grower tenant—that had no bearing on whether the plan had been proposed in good faith. See id. at 1035-36. Importantly, the Ninth Circuit refused to rule on the argument that section 1112(b) mandated dismissal of the petition, concluding that “the Trustee waived the argument by failing to renew its motion to dismiss” after the Bankruptcy Court’s initial dismissal of a previous motion to dismiss with leave to renew at the plan confirmation hearing. Id. at 1033-34.

This literal interpretation of section 1129(a)(3) has been explicitly criticized in courts within other circuits. Indeed, the Bankruptcy Court for the Eastern District of Michigan sharply critiqued Garvin in dicta for its de facto affirmation of illegal conduct pursuant to a bankruptcy plan:

This Court does not necessarily agree with the Garvin court’s holding about § 1112(a)(3). And, respectfully, one might reasonably question whether the Garvin court should have refused to decide the § 1112(b) dismissal issue. That refusal, on waiver grounds, arguably is questionable, because it allowed the affirmance, by a federal court, of the confirmation of a Chapter 11 plan under which a debtor would continue to violate federal criminal law under the [Controlled Substances Act].

In re Basrah Custom Design, Inc., 600 B.R. 368, 381 n.38 (Bankr. E.D. Mich. 2019).

Moreover, the District Court of Colorado in In re Way to Grow, the very case that seemingly left the door open for United Cannabis in the first place, also criticized Garvin for unduly focusing on the “means forbidden by law” clause of section 1129(a)(3), rather than the “good faith” portion of the same. 610 B.R. 338.

As a result, there is an embryonic circuit split on the issue of interpreting section 1129(a)(3) as applied to cannabis business petitioners, with the Ninth Circuit in the minority and the Sixth and Tenth Circuits in the presumptive majority.

As fascinating as this may be on an academic level, for businesses in the cannabis industry, this circuit split will likely have little bearing on the ultimate issue of whether businesses that dabble in cannabis can obtain the benefits of federal bankruptcy. Reason being, section 1129(a)(3) is just one ground for dismissal on the basis of illegality. Garvin itself noted in its final paragraphs that there are plenty of other reasons to dismiss cannabis bankruptcies—not the least of which is section 1112(b). Garvin, 922 F.3d at 1036. Indeed, running an illegal business as part of a bankruptcy plan could conceivably run afoul of any number of the listed bases for “cause” under section 1112(b)(4), including but not limited to the “gross mismanagement of the estate” prong name checked by the court in Garvin.

The unceremonious dismissal of the petition in United Cannabis raises more questions than answers. Unless and until cannabis is descheduled, or some other form of federal reform occurs, the Bankruptcy Courts will be left to continue to battle it out over interpretations of section 1129(a)(3), comfortable in the knowledge that section 1112 provides a backstop for dismissing cannabis-funded petitions and plans. However, the issue raised in United Cannabis—whether a company that has cannabis-derived revenue can have a chapter 11 plan approved if the plan doesn’t require that revenue—remains tantalizingly unanswered for now.

[1] Curiously, the court styled the order as one “granting” the U.S. Trustee’s “Motion to Dismiss Chapter 11 Cases pursuant to 11 U.S.C. § 1112(b).” However, the U.S. Trustee never filed a Motion to Dismiss. Rather, the U.S. Trustee filed a response to the court’s own Order to Show Cause why the petition should not be dismissed—although, that response did raise section 1112(b) as a reason for dismissing the case.

Back to the Futile: California Court of Appeal Expands Breadth of “Futility Exception” to Prerequisites to Mandamus Claims in Land Use Cases

June 1, 2021/in All Blog Posts, Corporate Litigation/by Jake Ayres

A recent land use decision of the California Court of Appeal has eased one of the many burdens experienced by developers seeking to challenge a public entity’s permit denial. In an opinion by Judge Tangeman, the Second Appellate District reinforced the strength of the “futility exception” to the legal prerequisites in mandamus actions.

In Felkay v. City of Santa Barbara, 62 Cal. App. 5th 30 (2021), the Court of Appeal analyzed the futility exception and found it applicable under the circumstances to the judicial doctrines of ripeness and administrative exhaustion. The futility exception, generally speaking, is a doctrine that provides that where a decisionmaker has indicated that its mind is made up against the petitioner’s desired course of action, the normal procedural bars, such as administrative exhaustion, do not apply as they otherwise would.

In Felkay, petitioner and plaintiff Thomas Felkay purchased an oceanfront lot in the City of Santa Barbara (the “City”) located on top of a seaside bluff. Felkay wanted to develop a luxurious home on the property and applied for the relevant permits to the City’s planning commission (the “Commission”). Upon review by the Commission, it concluded that the proposed development was impermissible. Namely, because the bluff top’s elevation was deemed to be at 127 feet, the coastal restriction prohibited development at any elevation below that level (i.e. closer to the ocean), and the proposed development would take place below 127 feet, the project could not proceed as proposed. Moreover, the Commission also found that an alternative building site further uphill from the bluff top was untenable for geological reasons. Id. at 34-35.

Felkay then appealed the Commission’s decision to the City Council, while also arguing that the Commission’s decision amounted to a taking. The City upheld the Commission’s decision and found that there were other alternative uses to the property such that the Commission’s decision was not a taking. Id. at 35. Felkay filed a petition for administrative mandamus and complaint for inverse condemnation claims against the City. Id. at 36.

The court split the proceedings in two, starting with the writ proceeding and ending with the trial on the inverse condemnation claims. The court denied the writ, holding that the City’s decision was supported by substantial evidence and that Felkay had not introduced sufficient evidence to justify the City’s application of Public Resources Code section 30010, which authorizes development that would violate a coastal development restriction to avoid unconstitutional takings. As for the trial on the inverse condemnation claims, the court found that there had been a taking and awarded and the jury awarded Felkay $2.4 million in damages for the fair market value of the developed lot, along with a substantial attorney and expert fees. Id. at 36-38.

On appeal, the City challenged the trial court’s ruling on the inverse condemnation claims on three bases: (1) Felkay’s claim was not ripe; (2) Felkay had not exhausted his administrative remedies; and (3) Felkay waived his right to argue the section 30010 claims at trial because he did not raise them during the writ proceeding.

As for items 1 and 2 above, the court held that the futility exception applied to both. The City argued that, at a bare minimum, Felkay was obligated to submit an amended application for development before suing the City. However, according to the court, because the City had “made plain” that there was no way they would approve any development as envisioned because anything below or above the bluff top was unbuildable, Felkay was not obligated to submit an amended application. Id. at 40. As for the judicial exhaustion argument, the court held that because the parties had stipulated to try certain issues in the writ proceeding and reserve other issues for the inverse condemnation trial, the City’s argument failed. Indeed, the parties had agreed to reserve the section 30010 claim for the inverse condemnation trial, and any “failure” to raise that issue during the writ proceedings was by design. Id. at 41-43.

In short, the Felkay decision provides another example of when the futility expression excuses a project developer from having to go back to the drawing board before suing a public entity that denies development permit. That is, if there is “NO POINT [sic] in going back” to the decisionmaker with an amended application because it has “‘made plain’ it [will] not allow any development” on the relevant parcel, the prospective plaintiff’s claim is ripe and the exhaustion requirement is met.

Although the “futility exception” issue was the court’s focus in Felkay, perhaps the more interesting takeaway from it is that the trial court found—and the City apparently did not object to the finding—that Felkay had been deprived of “all economic use of the property” resulting in a “de facto taking,” even though the court acknowledged that the land was still usable for “recreation, parking, [and] views.” Id. at 35, 38. This suggests that “de minimis” economic uses of property do not negate a takings claim.

Similarly, another potential takeaway is that this underscores the lack of a due diligence component in inverse condemnation claims. The origin of the issue here is that Felkay originally thought the bluff top was at 51 feet, which opened up a greater area of his lot for development. Id. at 34. As it turns out, he was mistaken, and the City’s determination of the true bluff top elevation torpedoed his entire plan—although he ended up compensated handsomely for his trouble. This suggests that inverse condemnation claims do not take into account whether or not the plaintiff was mistaken, nor whether plaintiff could have reasonably discovered that mistake had he gotten a second opinion from a different surveyor prior to applying for his permit. Perhaps because of the constitutional nature of inverse condemnation claims, courts have never applied a judicial gloss to inverse condemnation claims to cut off rights to plaintiffs who could have discovered their lots were unbuildable prior to purchase.

At bottom, Felkay shows the risks for municipalities in uncompromising applications of their regulations to developers, and also shows the relatively deferential treatment inverse condemnation plaintiffs receive from courts with regard to the exhaustion requirement. Although any administrative law-flavored claim has hoops to jump through, Felkay has clarified the “futile” scenario where there is one less hoop.

Bid Protests and Damages Availability

February 26, 2021/in All Blog Posts, Corporate Litigation/by Jake Ayres

You’re a seasoned litigator and an aggrieved, hardworking contractor comes into your office (or your Zoom room). His recent proposal to the City, which was prepared with painstaking detail and offered the lowest bearable price, was rejected—unfairly, the contractor says. Instead, the City awarded the contract to the contractor’s bitter rival, Dewey/Cheatham, who appears to have a cozy relationship with the City manager. The contractor got second place.

After poring through the evaluation, it’s clear to you that the award process was far from fair, if not downright biased toward Dewey/Cheatem. Your potential client is incensed—the contractor wants to file a lawsuit to give those so-and-sos down at City hall a piece of his mind—and to recover the profits he anticipated receiving under the contract. He asks you: can he recover lost profits damages in bid protest litigation?

You respond in typical, equivocal fashion: probably not. But also maybe.

A disappointed bidder who responded to either a request for proposals or an invitation for bids is not in a contractual relationship with the government entity requesting bids or proposals, which rules that claim out as a basis for recovering lost profit damages. Moreover, because bid documents always allow for the government entity to reject all bids, tort claims, such as fraud, are also ruled out. The case law in California has recognized this quirk, instead sanctioning claims by disappointed bidders on promissory estoppel theories—but only allowing damages for the costs of preparing the bid or proposal. See Kaijima/Ray Wilson v. Los Angeles County Metro. Trans. Auth., 23 Cal. 4th 305, 314 (2000) (“Because the MTA was authorized to reject all bids, Kajima did not know at this point whether the contract would ever be awarded. Nor, because of the secrecy of the bidding process, did Kajima know whether it was indeed the lowest responsible bidder. Therefore . . . bid preparation costs, not lost profits, were the only costs reasonably incurred.”); Eel River Disposal & Resource Recovery, Inc. v. Cnty. of Humboldt, 221 Cal. App. 4th 209, 240 n.12 (2013) (“[A] bidder deprived of a public contract, by the wrongful misaward of that contract, has neither a tort nor a breach of contract action against the public agency.”).

Although Kajima and its progeny have spoken fairly authoritatively on this issue, there remains a glimmer of hope for disappointed bidders that is yet to be conclusively addressed in California courts: whether the presence of bad faith on the part of the government entity entitles a disappointed bidder to recover lost profits damages. The court in Kajima held that lost profit damages were not allowed in the case at bar, noting that it was a “distinctly minority position” to allow lost profits as damages, and that the courts that had done so awarded those damages where bad faith was shown on the part of the government entity. Kajima, 23 Cal.4th at 320. The daylight in Kajima is that while the court in that case said that lost profits were not available to the plaintiff (who had not shown or alleged bad faith), it did not affirmatively say that lost profits damages would not be reachable if bad faith had been shown by the plaintiff. See id. In other words, Kajima was taking the broader position that, generally speaking, lost profits damages are not available to a disappointed bidder under a promissory estoppel theory. It did not speak to the more specific issue of whether lost profits damages are available when bad faith can be demonstrated.

Nonetheless, while the California Supreme Court did not foreclose this possibility completely, the branding of that strand of persuasive authority as “a distinctly minority position” would seem not to bode well for disappointed bidders bringing those arguments in the future. However, the case can be made that although the court in Kajima pointed out that the policy of competitive bidding statutes is to protect the public rather than the expectations of a disappointed bidder, awarding damages to a disappointed bidder who is a victim of bad faith actions by a government entity, which in turn damages the public by potentially awarding the public contract to a more expensive or less qualified contractor, could serve those same public policies by deterring government chicanery and cronyism. See id. at 318-20.

The availability of lost profits damages for disappointed bidders will likely remain a desolate frontier until an optimistic litigant tries to wedge itself into the crevice left by Kajima’s dicta regarding bad faith. In the meantime, disappointed bidders will have to content themselves with bid preparation costs as their only remuneration for unjustly unsuccessful bids.

MORE Legislation, MORE Problems: The MORE Act to Legalize Cannabis Passes the House

December 17, 2020/in All Blog Posts, Cannabis, Corporate Litigation/by Jake Ayres

On December 4, 2020,¹ the United States House of Representatives made history and voted to federally legalize cannabis for the first time by voting to pass the Marijuana Opportunity Reinvestment and Expungement Act (the “MORE Act”). Although the MORE Act still has to pass the historically cannabis-unfriendly United States Senate, the House’s quick action to pass a sweeping legalization bill in a time of presidential transition could signal greater legislative efforts to resolve the federal-state tension over state-legal cannabis.

The key provision of the MORE Act would be to federally deschedule cannabis and thereby remove it from the purview of the Controlled Substances Act. The MORE Act also would enact a 5% federal tax—which would step up by a point each year after the first two years after enactment up to 8%—on cannabis products and earmark those tax revenues to fund various social justice measures via a trust fund (the “Opportunity Trust Fund”). The Opportunity Trust Fund’s money would help fund the Community Reinvestment Grant Program (the “CRGP”), also established by the statute. The CRGP, administered by the newly created Cannabis Justice Office, would be responsible for “provid[ing] eligible entities with funds to administer services for individuals adversely impacted by the War on Drugs, including (1) job training; (2) reentry services; (3) legal aid for civil and criminal cases, including expungement of cannabis convictions; (4) literacy programs; (5) youth recreation or mentoring programs; and (6) health education programs.”

The MORE Act also has several other social justice measures embedded within it. First, it prohibits the denial of any “Federal public benefit”—e.g., welfare benefits, etc.—on the basis of any cannabis-related conduct. Second, the MORE Act would also explicitly authorize SBA loans to legal cannabis businesses. Third, and perhaps most potently, the MORE Act would provide for an automatic expungement process for nonviolent cannabis convictions, where each Federal district would initiate the process without any affirmative steps by the convicted person.

Importantly, despite the proposed sweeping federal changes, the MORE Act would preserve the current federalist contours—that is, individual states can still decide on whether to legalize or prohibit cannabis.

Although the House’s passage of the MORE Act is a watershed moment for cannabis in the United States, it is difficult for the industry to maintain too much excitement given the current United State Senate’s propensity for killing bills, or at least allowing them to die in that chamber. Even putting aside the sweeping legalization measures, the social justice strands of the MORE Act may be the dealbreakers for Congressional republicans, some of whom have already said as much publicly. Of course, if both Georgia Senate seats flip to democrats in the January runoff elections, the 50/50 split in the Senate, then the bill is teed up to have Vice President (and MORE Act Senate sponsor) Harris pushing the bill over the hump.

If that Senate scenario does not come to pass, the likely outcome seems to be that the extremity of the MORE Act may make more incremental cannabis legalization—like the STATES Act, which would federally deschedule cannabis without any other attendant social justice measures—more appealing to a recalcitrant Senate. Even more likely may be the SAFE Banking Act, which would not federally deschedule cannabis, but would provide safe harbor to the financial industry (among other service providers) who service the cannabis industry. Of course, if the MORE Act were to be enacted, it would presumably eliminate the financial industry’s objections to banking for and lending to state-legal cannabis businesses.

In the meantime, cannabis industry participants and onlookers will eagerly watch how this bill fares as the canary in the Senatorial coal mine.

¹ Appropriately enough, the date of the House’s vote was Jay Z’s birthday. However, Jay himself did not identify as a heavy cannabis user, preferring to consume “once in a blue when there’s nothing to do/And the tension gets too thick for [his] sober mind to cut through.” That being said, Jay is ostensibly pro-legalization, having recently introduced his own brand of cannabis and cannabis accessories. Chris Gardner, Jay-Z Debuts Product Line for Cannabis Brand Monogram, The Hollywood Reporter (Dec. 10, 2020), available at https://www.hollywoodreporter.com/rambling-reporter/jay-z-debuts-product-line-for-cannabis-brand-monogram

Chapter 420 Bankruptcy?: How In re United Cannabis Could Open the Doors to Bankruptcy Relief for Cannabis-Adjacent Businesses

September 12, 2020/in All Blog Posts, Cannabis, Corporate Litigation/by Jake Ayres

Let’s say you’re a hemp/CBD business (that also services the cannabis industry in a limited capacity) and COVID-19 has hit you. Hard. You’ve stretched your resources as far as you can, but you’re still on the ropes financially. The California eviction moratorium has been rolled back and your local eviction moratorium—the only thing protecting commercial tenants (in San Diego County and many others)–is about to expire at the end of September. The CDC has issued an order forbidding evictions until the end of the year, but only for residential tenants. Your landlord is waiting in the wings to be paid in full for the back rent you couldn’t afford to pay during the lockdown.

The b-word—bankruptcy—rears its head in your mind. But can you, as a business that is still federally illegal, file for bankruptcy—a creature of federal law?

One would think the answer is “absolutely not.” However, a relatively recent District of Colorado Bankruptcy Court ruling, and its soon-to-be progeny, may eventually provide a glimmer of hope for the distressed cannabis-adjacent business.

On April 20, 2020—a date not without significance for the cannabis industry—United Cannabis Corporation and its associated entity UC Colorado Corporation filed for bankruptcy in the District of Colorado. Shortly thereafter, on April 22, 2020, Bankruptcy Judge Joseph G. Rosania, Jr. issued an Order to Show Cause why the bankruptcy should not be dismissed, citing the rule that businesses whose operations constitute federal crimes cannot take advantage of the federal bankruptcy system. Arenas v. United States Tr. (In re Arenas), 535 B.R. 845, 847 (B.A.P. 10th Cir. 2015).

Despite this seemingly impassable roadblock, the debtors are hoping to take advantage of a narrow gap in the case law hinted at by an earlier bankruptcy case from the District of Colorado—In re Way to Grow, Inc., 610 B.R. 338 (D. Colo. 2019). In that case, the debtors were a group of business entities selling hydroponic agriculture equipment. On December 14, 2018, the Bankruptcy Court dismissed the petition, citing the fact that although hydroponic equipment can be used to grow any number of crops, the overwhelming majority of debtors’ sales were to cultivators. In re Way to Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018). The debtors appealed to the District Court, citing Congress’ passage of the Agriculture Improvement Act of 2018—also known as the 2018 Farm Bill—which legalized hemp on December 20, 2018, mere days after the Bankruptcy Court dismissed debtors’ petition. 610 B.R. at 355. The debtors argued that their products could have been used by their customers for the now-legal cultivation of hemp, as opposed to cannabis. Id. The court demurred, stating “[t]his Court does not opine on whether the timing of the Agriculture Improvement Act’s passage excuses Debtors’ failure to develop a proper record or to advance the argument” that “‘the legalization of hemp means that they could reorganize based on the hemp market.’” Id. at 355-56.

This brief discussion of the tension between federally illegal cannabis and federally legal hemp as it relates to bankruptcy eligibility left the door ajar for a debtor like United Cannabis. United Cannabis has filed a petition tailored to fit through that narrow gap, arguing that its chapter 11 reorganization can be funded by its non-cannabis income. United Cannabis argues that its $4 million bankruptcy estate is overwhelmingly derived from legal hemp/CBD business whose only cannabis-related holding is ownership of stock in WeedMD, a Canadian medical cannabis company whose shares are publicly traded in the United States.

In other words, United Cannabis has placed the exact question the District of Colorado dodged in Way to Grow squarely before the District of Colorado Bankruptcy Court: Can a company with some income derived from cannabis be allowed to file for chapter 11 bankruptcy if it can fully fund its reorganization without that cannabis-derived income?

As of now, that question remains unanswered. The debtor and the U.S. Trustee have filed their responses to the court’s OSC and now the parties—as well as industry watchdogs—eagerly await the court’s decision. The court’s ruling on the Order to Show Cause has been pending since mid-May 2020 and the court has allowed the bankruptcy to proceed as normal in the interim. Although the court itself has offered no timeline for when it will issue its decision on the Order to Show Cause, nor has it indicated why its decision has been pending for nearly four months, one can only speculate that the court may be waiting for guidance from Congress or elsewhere before issuing its decision. Moreover, the length of time that has elapsed since the parties in interest submitted their responses to the Order to Show Cause suggests that the court does not view the issue as a black-and-white one—or, at the very least, as a political hot potato.

Regardless of when the decision will be issued, if the court allows the debtors’ petitions to survive its OSC , it could be a watershed moment for businesses who service the industry in a small capacity by opening the door to bankruptcy relief, provided that they can fund their reorganization without cannabis money. However, the court could easily bypass this question just as the court did in Way to Grow. The U.S. Trustee, citing United Cannabis’ own marketing materials, argued in its response to the OSC that United Cannabis marketed itself largely as a cannabis company, not as a legal hemp/CBD company. Per the U.S. Trustee, United Cannabis had, in the recent past, identified numerous cannabis/THC products that it sold and distributed. If the court finds this evidence credible, it could easily find that United Cannabis is not entitled to bankruptcy relief because it cannot fund its reorganization with non-cannabis money, regardless of whether that route would be a viable path to bankruptcy.

COVID-19 has taken its toll on a wide swath of industries—including the “essential” cannabis industry. Despite this designation, cannabis businesses have been cut off from Paycheck Protection Program loans and bankruptcy, among other federal forms of economic relief. However, if the United Cannabis court decides that mixed hemp/cannabis companies can file for bankruptcy if they can reorganize without cannabis money, that pushes the cannabis industry an inch closer to enjoying the governmental benefits that its non-cannabis business counterparts enjoy.