In re: The Hacienda Company, LLC – A Budding Change in Bankruptcy Law for Cannabis Companies?

*The authors would like to thank Noah Weingarten, associate at Loeb & Loeb LLP in New York, who provided input on this article.

There may be hope on the horizon for insolvent Canadian cannabis companies who wish to seek recognition proceedings south of the border. The United States Bankruptcy Court Central District of California Los Angeles Division (the “Court”) released the reasons for its decision earlier this year to deny the United States Trustee’s (the “Trustee”) motion to dismiss The Hacienda Company, LLC’s (“THC”) filing under the United States Bankruptcy Code (the “Code”).^[1] THC, who had been a wholesale manufacturer of cannabis products operating under the Lowell Herb Co. brand name (“Lowell”), ceased operations in February 2021. Shortly thereafter, THC sold its intellectual property to a Canadian company in exchange for shares of the purchaser. THC filed its Chapter 11 petition on September 21, 2022, to which the Trustee responded with a motion to dismiss for cause on the basis that THC, through its dealings via Lowell, violated the Controlled Substances Act (the “CSA”)^[2] which makes it illegal to manufacture, distribute or dispense a controlled substance, including cannabis. 

The Trustee’s motion to dismiss followed a long-standing line of past objections to bankruptcy filings by cannabis companies in states where such activity is legal. This line of objection rests on the reasoning that while the sale and manufacturing of cannabis may be legal within certain state borders, such activities remain illegal under U.S. federal law, including the CSA, which in turn prevents bankruptcy courts from granting cannabis companies protection under the Code. In the past, bankruptcy courts have tended to agree with this reasoning,^[3] thus rendering the Court’s January decision a fairly noteworthy departure from the norm.

In his reasons, the Hon. Neil W. Bason began by noting that there are many remedies for a debtor’s violation of non-bankruptcy law, such as the CSA, and that dismissal of a filing is on the extreme end of this spectrum. Judge Bason also reflected on the degree of discretion that courts are afforded in considering cause for dismissal, especially when there are no post-petition violations of non-bankruptcy law. With this background, the Court proceeded to consider the particular circumstances of THC’s filing and found the following:

1. THC’s passive ownership of stock in Lowell did not violate section 856(a) of the CSA, which makes it illegal to “profit from” a place used to manufacture, store, distribute or use cannabis. THC’s plan to liquidate the stock to pay its creditors, thus terminating any connection with cannabis, was rather the “opposite of an intent to profit from an ongoing scheme to distribute cannabis.”^[4] 
2. Similarly, because THC proposed to sell its Lowell stock, its ownership of such also failed to violate section 854 of the CSA, which prohibits a person who has received income derived from a violation of the CSA to “use or invest, directly or indirectly, any part of such income, or the proceeds of such income, in acquisition of any interest in, or the establishment or operation of, any enterprise [engaged in or affecting interstate or foreign commerce].”^[5] 
3. Contrary to the Trustee’s argument that any future trustee would have to violate the CSA if the filing were to be permitted, a future trustee could simply ask the federal authorities to dispose of the cannabis products and seek either declaratory relief to assure compliance with applicable law or a dismissal of the filing.^[6]
4. The facts surrounding THC’s filing meet the “unusual circumstances” test under section 1112(b)(2) of the Code given that (1) THC has divested itself of any connection to the cannabis industry and (2) a dismissal would undermine the realistic possibility of a considerable distribution to creditors.^[7]
   

The majority of the Court’s decision, and perhaps the most notable part, is focused on the finding that Congress did not adopt a “zero tolerance” policy that requires dismissal of any bankruptcy case involving violation of the CSA (or other activity that might be proven to be illegal).^[8] Judge Bason held that an expansive interpretation of “cause” for dismissal could be “extremely disruptive on other cases before this Bankruptcy Court” and that “[d]ismissing every case that had a connection with illegal activity would be contrary to Congress’ directives under the Bankruptcy Code.”^[9] With this, Judge Bason stated that:

“[T]his Bankruptcy Court interprets both § 1112(b) and the [Trustee’s motion to dismiss] as adopting a middle ground, under which this Bankruptcy Court must exercise its discretion to determine whether, given all of the facts and circumstances, a debtor’s connection to cannabis profits and any past or future investment in cannabis enterprises warrants dismissal of this bankruptcy case.”^[10]

While this case likely serves as good news for many U.S.-based cannabis companies, it could be equally as exciting for the Canadian cannabis industry, especially for those companies that have U.S. operations. Rejection of the “zero tolerance” approach may mean that Canadian cannabis companies have a leg to stand on when it comes to commencing Chapter 15 recognition proceedings under the Code, even if cannabis remains illegal on a federal level.

While it’s still likely that any such attempt would be met with opposition from the U.S. Trustee’s Office, the Court’s decision could, in time, signal the availability of both Canadian and U.S. legislative regimes for Canadian cannabis debtors. This could have a myriad of ripple effects, including the potential for greater realization on debtor assets, increased creditor distributions and smoother cross-border restructurings overall, without the likelihood of being forced to abandon any hope of Code protections for U.S. operations.

While this decision stands out, it could still be narrowly interpreted. The Court relied heavily on the fact that THC had terminated its connection to the cannabis industry. This could mean that any protection sought under the Code may be reserved for debtor corporations that are no longer operating and have structured their asset sales in a way so as to tangibly distance themselves from the cannabis market. In addition, there are a number of other questions that remain unanswered, including whether the U.S. bankruptcy courts will be wary about the proverbial landslide effect of opening Chapter 15 proceedings to foreign cannabis companies.

We expect that more light will be shed on the matter once the Court has made a determination on the Trustee’s second motion to dismiss, which was filed on May 31, 2023. In its motion, the Trustee contends that THC is a bad faith debtor and that the Chapter 11 plan will continue to violate the CSA and federal anti-money laundering statutes, as it requires paying creditors with proceeds generated by the Lowell stock.

For now, however, it will be interesting to watch the U.S. bankruptcy courts continue to delineate an answer to the question of how close a debtor can come to engaging in illegal activity before Code protections are off the table. Time will tell if THC’s case proves be a mere outlier, or if it will help forge the path towards additional restructuring options for U.S. (and Canadian) cannabis companies in distress.

[1] In re: The Hacienda Company, LLC, Case No. 2:22-bk-15163-NB, 674 B.R. 748 (Bankr. C.D. 2023) [“THC”].