Barred from Bankruptcy: Struggling Marijuana Businesses Need to Learn Their ABCs

This article first appeared in ABI Journal. 

Eleven states, plus Washington, D.C., have now legalized the recreational use of marijuana, and 33 authorize its use for medical purposes.¹ According to New Frontier Data, legal marijuana sales totaled $10.3 billion in 2018 and are expected to grow to almost $26 billion by 2025.² The marijuana industry is growing, and many entrepreneurs and investors are trying to get in on the “green rush.”

However, dark clouds have gathered over the industry as of late. While 2018 saw big stock gains for marijuana companies listed on the public markets, 2019 and early 2020 ushered in a sharp reversal in fortunes. Virtually across the board, marijuana stocks sunk, in many cases resulting in steep double-digit losses, as investors who were high on the industry took a closer look at the fundamentals. Discussions about potential growth shifted to concerns about distress for an increasing number of companies running short on cash in a capital-intensive business. According to the Los Angeles Times, “one senior executive at a large cannabis company predicts that as many as a dozen smaller companies may fail by the second quarter of 2020.”³

Analysts have cited a range of issues for the industry’s decline in 2019, including regulatory challenges, difficulty in accessing capital and the suppression of legal sales due to cheaper black-market alternatives. The COVID-19 crisis has reportedly led to an increase in sales of marijuana in many states and in Canada, but it is yet to be determined whether the surge is due to the stockpiling of product by consumers — which could lead to a dampening of sales in the future — or is a reflection of greater, sustainable demand.⁴ For many companies, increased sales also might not be sufficient to offset the real possibility that marijuana businesses will have less access to capital moving forward if investors in the industry become more risk-averse due to an economic downturn.

Regardless of the root causes for the decline, the undeniable result is that there is distress rippling through the industry, and significant rightsizing through restructuring seems all but certain. Unlike in other industries, marijuana businesses do not have access to one of the major tools in the restructuring toolkit: bankruptcy relief.

Despite widespread legalization at state levels, marijuana, which is considered a Schedule 1 drug under the Controlled Substance Act,⁵ remains illegal at the federal level. While the U.S. Department of Justice has provided some assurances that it will not prosecute those who produce, distribute or sell marijuana within the regulatory frameworks of states in which marijuana has been legalized, that does not mean that those businesses can take advantage of certain benefits of federal law, such as tax credits or bankruptcy protection.

Because marijuana is illegal under federal law, U.S. bankruptcy courts, backed by arguments from the Office of the U.S. Trustee, have consistently rebuffed attempts by those in the industry — and even those adjacent to it — to seek bankruptcy relief.⁶ Bankruptcy courts bar access, even for those whose connection to the industry is relatively tangential. For example, in In re Rent-Rite Super Kegs West Ltd.,⁷ the debtor — itself not a producer, distributor or seller of marijuana — leased space in its warehouse to a marijuana-growing business. After the debtor filed for chapter 11 protection, the debtor’s mortgage lender filed a motion to dismiss the case under the “clean hands” doctrine.

The bankruptcy court found sufficient cause to dismiss the case or convert it to chapter 7 liquidation due to “gross mismanagement of the [bankruptcy] estate.” The court reasoned that the debtor’s actions in leasing space to a business engaged in illegal activity could subject the warehouse to forfeiture, and that the debtor could not confirm a chapter 11 plan, which must be proposed “in good faith and not by any means forbidden by law.”

In a similar but more recent case dismissed in the U.S. Bankruptcy Court for the Eastern District of Michigan because the debtor’s principal had, in this name of the debtor corporation, leased property to a medical marijuana dispensary business.⁸ In his opinion, Hon. Thomas J. Tucker wrote:
The actual purpose of filing and prosecuting this bankruptcy case is for the debtor and its 100 percent shareholder to use this bankruptcy court, and the Bankruptcy Code, to assist them in obtaining a result that is contrary to federal criminal law under the Controlled Substances Act, and therefore contrary to federal public policy. This federal court cannot allow itself to be used in this way.

Given that marijuana-related businesses, and those who derive income from them, appear to be barred from federal bankruptcy courts, they must find an alternative when a turnaround is no longer possible.

ABC as a Bankruptcy Alternative

One of the most viable and effective alternatives to bankruptcy for marijuana businesses is an assignment for the benefit of creditors (ABC). An ABC is an insolvency proceeding governed by state law rather than federal bankruptcy law. In some states, the right to pursue an ABC is rooted in the common law, and in others it is governed by statute.⁹

In an ABC, a company (the assignor), transfers all of its rights, titles and interests in its assets to an independent fiduciary (the assignee), who holds the assets in trust. While the process varies by state, the approval of a company’s board of directors and shareholders is required to move forward with an ABC. Unlike in a chapter 7 case, in which a trustee is appointed by the court, in an ABC the company selects the assignee, often in consultation with the company’s secured lenders.

In some states, the transfer of assets by contract to the assignee is all that is required to initiate an ABC proceeding. In other states, an assignee or assignor must register the ABC with a state court of appropriate jurisdiction.

For example, in Delaware, a business must file a petition to the court of chancery providing notice to the court that the business has made an assignment of its assets to an assignee.¹⁰ The assignment is typically memorialized in a “General Assignment for the Benefit of Creditors,” which provides the assignee with the authority to sell off assets, pay debts and wind down the business through a going-concern sale or liquidation.

Once an ABC is properly initiated, the assignee will assess and execute a plan to maximize the value of the assets. In some cases, the company will remain operational for a period of time during the ABC proceeding to preserve its going-concern value. In other instances, an immediate winddown is implemented. The assignee will also take steps to collect any accounts receivable and pursue litigation to the extent necessary to collect outstanding debts.

Once a liquidation or going-concern sale of the business is complete, the assignee then distributes the net proceeds of the sale process to the company’s creditors. In an ABC, there are no required sale procedures equivalent to those found in § 363 of the Bankruptcy Code, so assets can be sold quickly. Some of the primary advantages of an ABC include the fact that the process is typically faster and less expensive than bankruptcy. The assignee controls the timing, there are few administrative costs or reporting requirements, and there is little court oversight.

While there are many advantages to ABC proceedings, there are some drawbacks (relative to bankruptcy). One of the main disadvantages is that, unless a court orders it, there is no automatic stay in place. Accordingly, existing lawsuits may proceed and new ones may be filed against a marijuana business pursuing an ABC. However, a judgment for an unsecured debt against an assignor whose assets have been transferred to the assignee and held in a trust is likely to be of little to no value; unsecured creditors rarely recover anything in an ABC. Another potential disadvantage is that asset sales in an ABC, unlike those in bankruptcy, are not made “free and clear” of all liens, claims and encumbrances. An ABC might not be a perfect solution for a distressed marijuana business, but since bankruptcy is not an option, it is often the best alternative.

What Is Next for the Marijuana Industry?

A number of factors will influence whether the marijuana industry will rise above today’s challenges. Access to capital might improve if the SAFE Banking Act, which would make it easier for banks to provide financing to marijuana businesses, becomes law. In September 2019, the U.S. House of Representatives passed the legislation, but the U.S. Senate has not yet voted on the legislation. The legislation was passed by the U.S. House of Representatives in September 2019, but has not yet been voted on in the U.S. Senate.

The total addressable market for legal marijuana sales might grow in the coming years. Currently, only approximately two-thirds of all states have legalized some form of marijuana sales, and many of the remaining states have initiatives underway to try to get legalization on the 2020 ballot.

Finally, efforts to crack down on illegal marijuana sales could help improve the fortunes of those participating legally in the industry. For example, in California, it is estimated that black-market sales outstripped legal ones by a nearly three-to-one margin in 2019, which is $3 billion versus $8.7 billion.

Unless and until the market turns around, struggling marijuana businesses and their investors must conserve cash and try to raise more. They must also consider their options to the extent that moving forward is no longer an option. When such a time arrives, given that they are barred from seeking bankruptcy relief, an ABC might be the best approach to wind things down in an orderly fashion that maximizes the value of their assets.