In re: The Hacienda Company, LLC – The Budding Change in U.S. Bankruptcy Law Starts to Flower

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

While gaining recognition of Canadian insolvency proceedings south of the border used to be wishful thinking for an insolvent Canadian entity having involvement in the cannabis industry, such proceedings are now seemingly becoming a potential option. The United States Bankruptcy Court Central District of California Los Angeles Division (the “Court”) recently dismissed the United States Trustee’s (the “Trustee”) second motion to dismiss in The Hacienda Company, LLC’s (“THC”) bankruptcy proceedings.

Earlier this year, the Court denied the Trustee’s first motion to dismiss THC’s bankruptcy application, brought on the grounds that THC had violated the Controlled Substances Act (the “CSA”)^[1] which makes it illegal to manufacture, distribute or dispense a controlled substance, including cannabis classified as “marihuana.”^[2] THC had been a wholesale manufacturer of cannabis products operating under the Lowell Herb Co. brand name (“Lowell”), but ceased operations in February of 2021 after selling Lowell’s business to an unrelated public company, renamed Lowell Farms, Inc. (“Lowell Farms”), in exchange for shares in the capital of Lowell Farms. THC planned to sell its stock in Lowell Farms, thereby severing its connection to the cannabis industry.

In denying the Trustee’s motion, the Honorable Neil W. Bason found that THC was not actively violating the CSA; THC was not distributing cannabis and there was no showing by the Trustee that (i) THC would invest any remaining assets in cannabis enterprises, and (ii) that a future bankruptcy trustee, if appointed over THC, would have to engage in illegal activity, given THC’s involvement in the cannabis industry.^[3]

Judge Bason also found that U.S. Congress did not adopt a “zero tolerance” policy which requires the dismissal of any bankruptcy case involving a violation of the CSA, or any other illegal activity.^[4] In fact, he found that such an approach would be “extremely disruptive on other cases before this Bankruptcy Court” and contrary to the objectives of the United States Bankruptcy Code (the “Code”), which is to foster the need to restructure and preserve value of challenged businesses.^[5] For further information on the January 20, 2023, decision, please refer to our prior article on these proceedings: In re: The Hacienda Company, LLC – A Budding Change in Bankruptcy Law for Cannabis Companies?

The Trustee appealed this holding and, on September 20, 2023, Judge Bason doubled down, dismissing the appeal in a detailed 20-page decision. He began by noting that all THC is trying to do is pay its creditors and that, post-petition, it will not be fostering cannabis sales or contributing to a cannabis-related enterprise.^[6] However, Judge Bason noted this wasn’t always the case and also found (i) that the Trustee had established “probable” violations of the CSA, given THC’s stock in Lowell Farms, and (ii) that THC had “probably” not withdrawn from the alleged conspiracy to violate the CSA.^[7] This finding was in light of THC’s admission that it did not intend to sell the Lowell Farms stock immediately, but rather in instalments over time.

What did this mean for THC’s bankruptcy application? As it turns out, not much. In his reasons for the decision, Judge Bason re-emphasized his finding that Congress did not adopt a zero-tolerance policy for any illegality,^[8] and went on to make the following observations with respect to the U.S. bankruptcy system in general:

1. The Federal Court’s approach to illegal contracts is not inflexible. There is a distinction between private party contracts and a bankruptcy case. In the latter, Congress has demonstrated an intent to not “punish” a debtor when the victims of such punishment would be innocent creditors.^[9]
2. Violations of criminal law do not automatically necessitate a dismissal of a bankruptcy application. There are many instances in which a debtor company is non-compliant with legislation (see, for example, the PG&E and Enron bankruptcy cases). The Trustee had not shown that THC’s stock in Lowell Farms offends the principles of the Code.^[10]
3. The “unusual circumstances” test under section 1112(b)(2) of the Code^[11] remained satisfied in the circumstances given (i) THC’s divestment of any connection to the cannabis industry and (ii) that a dismissal would undermine the realistic possibility of a considerable distribution to creditors.^[12]
4. THC was not in violation of any money laundering statutes as argued by the Trustee and, if they were, this would be the case for many bankruptcy proceedings of businesses who, for example, owe “back taxes,” operate Ponzi schemes or pay their employees under the table, given some portion of their assets for distribution are often derived from violating state or federal laws in one way or another.^[13]
   

Judge Bason concluded his reasons by noting that while the Court is not condoning illegality, it will also not condone an outcome that, based on the present facts, denies “creditors, debtors, employees, equity investors, and other constituencies the benefits and protections of bankruptcy […].”^[14] While the Court should defer to prosecutors on how to address violations of bankruptcy law, dismissal should not be used as a blunt tool against the best interests of the creditors and the debtor’s estate.^[15]

This decision reinforces the prospects, not only for U.S. cannabis companies using the Code for creditor protection, but also for Canadian cannabis companies with assets in the U.S. seeking Chapter 15 recognition proceedings under the Code. While it remains unclear how far this reasoning will extend, both with respect to other Chapter 11 cases and Chapter 15 proceedings, the recent dismissal of the Trustee’s appeal strengthens the likelihood of Code protections becoming available to cannabis-industry companies.

The deadline by which the Trustee had to appeal the September 20^th holding was October 6, 2023. The Trustee did not file any such appeal and, accordingly, Judge Bason’s approach and reasoning in this case stands.

If you require legal counsel regarding insolvency or recognition proceedings, please contact the authors or members of our Financial Services Group.