Distressed Issues and Alternatives to Bankruptcy for Cannabis Businesses
April 11, 2023
Bankruptcy Remains Closed to Cannabis Businesses
Cannabis businesses and owners remain (mostly) barred from filing for federal bankruptcy protection, but as more states legalize and as more “ancillary” businesses seek to file, courts continue to grapple with court supervisions of distressed cannabis businesses.
It remains the case that businesses and individuals which “touch the plant,” that is, which grow or sell marijuana (aka marijuana regulated businesses, or “MRBs”), are unable to seek bankruptcy protection, whether or not such businesses or owners are in compliance with state marijuana laws. Until Congress legalizes marijuana or takes some other action to make marijuana legitimate federally (for example, the proposed STATES Act, where marijuana would be legal federally to the extent legalized under state law), the federal courts and the United States Trustee’s Office (which acts as a sort of ombudsman in bankruptcy cases) seems unlikely to change.
Almost every bankruptcy court that has considered the matter has dismissed a bankruptcy case where it could not proceed without the MRB debtor or the trustee having to administer an estate with assets consisting of marijuana or the proceeds of marijuana. See, e.g., In re Arenas, 535 B.R. 845 (B.A.P. 10th Cir. 2015); In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012); In re Johnson, 532 B.R. 53 (Bankr. W.D. Mich. 2015); In re Medpoint Mgmt., 528 B.R. 178 (Bankr. D. Ariz. 2015). Additionally, the United States Trustee’s Office has a policy to dismiss marijuana-related cases. Letter from Clifford J. White, Executive Office for the United States Trustee, dated April 26, 2017 (“It is the policy of the U.S. trustee program that the U.S. trustees shall move to dismiss or object in all cases involving marijuana assets on grounds that such assets may not be administered under the Bankruptcy Code . . . .”).
More recently, courts have started to grapple with non-MRB’s which knowingly do substantial business with MRBs. The case that has received the most “notoriety” is In re Way to Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018). This case provides a detailed discussion of the current state of case law concerning MRB debtors.
Given that the cannabis industry continues to have economic difficulties despite growing revenues for various reasons (e.g., the retrenchment of Canadian cannabis companies from acquisitions in the United States; Section 280E of the Internal Revenue Code; high excise and other state taxes bolstering the black market; oversupply in more mature markets such as California, Colorado, and Oregon), legal practitioners looking to restructure their MRB clients or to advise their MRB-creditor clients will be forced to do so under the various state debtor-creditor laws.
Alternatives to Bankruptcy
While the lack of access to the federal bankruptcy system remains problematic for the cannabis industry, the sustained drop in bankruptcies over the last few decades means that stakeholders and professionals are quite comfortable with out of court restructurings and other alternatives to bankruptcy, which often allow for less costly, less complex, more certain, and more flexible, albeit more ad hoc, solutions. One important difference for MRB’s and others in the industry is that the threat of bankruptcy is nonexistent (but not in Canada). Additionally, all out of court restructurings suffer from an inability to stop actions by creditors unless they are part of the restructuring or if a state court appoints a receiver (which only has limited powers). The following is not a comprehensive list of alternatives to bankruptcy, but lists the alternatives most useful for a going concern.
Lender Workouts
A lender workout is a bilateral or multilateral restructuring through which a financially distressed company and its (usually secured) lender(s) reach an agreement for adjusting the company’s debt obligations. Adjustments are unique to the circumstances, and might include (a) deferral of interest or principal, (b) maturity extensions, (c) covenant relief, and (d) debt-for-equity swaps. Given that almost all MRB’s do not have traditional bank debt, debt-for-equity swaps, or other grants of equity (such as warrants or options), are quite common. Such transactions might call for (a) asset dispositions, (b) grant of additional collateral), (c) operational benchmarks, (d) financial reporting requirements, etc. Taking collateral in cannabis inventory should be considered almost worthless by secured creditors as almost all inventory will be sold (or worse) by the time a secured creditor is able to begin foreclosure proceedings. A lender workout is best when a business is in moderate or episodic distress and lenders maintain a reasonably high level of confidence in management/ownership.
Exchange Offers
An exchange offer is a transaction to recapitalize or reorganize a business’s capital structure. The business typically offers to exchange one or more types of debt or equity security for another security, including debt with a different priority. Often this leads to creditors taking control with sufficient equity or an unsecured creditor becoming a secured creditor and/or a convertible debt holder. Moreover, new debt typically is stripped of covenants and events of default as much as possible, in exchange for higher priority, cash payment, and/or an interest rate increase.
Generally, an exchange offer is used to eliminate a class(es) of securities, due to an impending maturity date (e.g., debt or mandatorily redeemable preferred stock), to cure a default, to satisfy financial covenants, or to comply with minimum equity capital requirements of regulators (which is required of some MRBs).
An exchange offer is often used when there is a simple capital structure with a small number of stakeholders and majority consent is not an issue. Such a transaction typically requires sufficient time to execute, and is not helpful in situations where operations or third-party debt are a problem. Additionally, an exchange may require SEC registration or otherwise comply with securities laws.
Composition Agreements
A composition agreement is an agreement between a debtor and its creditors (usually unsecured), whereby the creditors agree to accept a less favorable claim in order to reorganize and rehabilitate the debtor. To be enforceable, the agreement requires consideration and only binds those who agree to it. It is best utilized when the business is viable and worth saving as a going concern (or in the case of a MRB, has a viable license worth saving), there is a small creditor body with which to negotiate, the debtor has a strong established relationship with its creditors, and the terms of the agreement are not overly onerous to the debtor. Typical provisions include (a) a background on the debtor’s condition, (b) the terms of the compromise, the percentage of creditors require for the agreement to be effective, (c) a provision to deal with disputed claims, and an agreement not to litigate, absent certain triggers, (d) the designation of an escrow agent and creditors’ committee, (e) a reservation of rights in the event of default, and (f) subordination of insider debt. See Committee on Bankruptcy & Corporate Restructuring, N.Y. City Bar, Non-Bankruptcy Alternatives to Restructurings and Asset Sales (Nov. 2010).
Friendly Foreclosure and Article 9 Sales
A “friendly foreclosure” is akin to a Bankruptcy Code § 363 sale. It is friendly in that the debtor cooperates with a secured lender to facilitate a foreclosure sale.
UCC § 9-610 provides that a secured party may sell or otherwise dispose of its collateral, but foreclosure must be “commercially reasonable.” A disposition of collateral is “commercially reasonable” if it is made, in the usual manner on a recognized market, at the price current in any such market at the time of disposition, or otherwise conforms with reasonable commercial practices among dealers in the type of property that was the subject of the disposition. Under UCC § 9-627(c), a disposition of collateral is presumptively commercially reasonable if it has been approved in a judicial proceeding, by a bona fide creditors’ committee, by a representative of creditors, or by an assignee for the benefit of creditors.
Collateral may be sold at a public or private sale. Under UCC § 9-610(c), in a private sale, a purchase may be permitted only if the collateral is of a specific type, “of a kind that is customarily sold on a recognized market or the subject of widely distributed standard price quotations.” Accordingly, almost certainly, a foreclosure sale of a MRB or its significant assets should be via a public sale.
A friendly foreclosure might be most successful: (a) where managers and employees want to remain part of the going concern, (b) where the secured lender wants to retain a high degree of control over the turnaround, (c) or when the debtor recognizes that (i) pledged assets must be sold, (ii) reorganization prospects are dim, (iii) potential unsecured claims are known and simple, and (iv) there is no need for a court order disposing of assets free and clear of existing liens.
Receivership
A receivership is an equitable remedy under state law (or federal law, but not for MRBs) in which a court-appointed fiduciary (the receiver) takes charge of, preserves, and manages property that is or might be the subject of an ongoing dispute. In some states, an ongoing dispute is not necessary. Generally, absent consent from affected parties, a court will only appoint a receiver upon a showing of waste, fraud, gross mismanagement, or other special circumstances. Financial distress is often sufficient to meet this standard. The power to appoint a receiver rests in the equitable power of the court or pursuant to statute.
Typically, a receiver controls all the assets of the debtor, operates the business with the intent to either sell the assets as a going concern or liquidate the assets of the business, and displaces management. The petitioning plaintiff may select any person or entity it believes is best suited to manage the receivership assets, subject to court approval. It is important to select a receiver who is familiar with the type of business that is in receivership.
A receiver is not autonomous and is an officer of the court. The receiver’s duties run only to the court/receivership estate. The receiver’s duties are derived solely from the order appointing receiver, which interested parties often negotiate. The receiver can have ex parte conversations with the court.
Lenders and others should consider special receivership provisions. These are standard in deeds of trust and mortgages, but not so standard in security agreements for tangible and intangible personal property, other than general provisions allowing the secured party to enforce all remedies under law or equity.
Assignment for Benefit of Creditors (ABC)
Fewer than half of the states have what is known as an assignment for the benefit of creditors (“ABCs”). The statutes vary considerably by state, and in most states, ABCs are rare (California is a notable exception), and particularly difficult for MRBs. Generally, a debtor that has decided to liquidate its business operations may make a general assignment for the benefit of all of its creditors. The assignment is accomplished by the execution of a deed in favor of the assignee, chosen by the debtor, which is filed with the clerk and recorder of the county of the debtor’s residence or principal place of business. Upon the recordation of the assignment, the assignee holds the assigned property in trust for the benefit of the debtor’s creditors. The debtor retains only those assets exempt under applicable law. The debtor must deliver to the assignee a complete inventory of the property assigned; the estimated value thereof; and a list of all creditors and the amounts due.
The relevant court has full power and complete jurisdiction over all the property of the assignment, regardless of its location. All sales of real estate, and all sales of personal property, not in the ordinary course of business of the debtor, must be approved by the court before they are valid.
There are disadvantages to a general assignment. In particular, cooperation of a secured creditor cannot be coerced, and there is no provision authorizing the use of cash collateral for the recovery of liquidation costs from the proceeds received, or authorizing a sale free and clear of liens and encumbrances. Thus, an assignment will work best, either when significant assets are unencumbered, or where the secured creditor consents. Liquidation through an assignee may benefit a secured creditor which is unable to liquidate its collateral effectively, or is concerned about the risk of lender liability claims if it forces a liquidation. Similarly, a going concern sale can be structured consensually with a lender to preserve the going concern value, while eliminating burdensome unsecured debt.
ABC’s are apt to be difficult for MRBs as the assignee cannot take possession of a licensed business without the approval of the relevant governmental authorities, and the best aspect of an ABC is its speed (the initial assignment can be often effected in a matter of days). However, unlicensed entities who might otherwise be ineligible for bankruptcy (e.g., landlords and IP holding companies) in the appropriate situation might be able to use an ABC. See generally Geoffrey L. Berman, General Assignment for the Benefit of Creditors: The ABCs of ABCs (American Bankruptcy Institute 2d ed. 2006); Robert Richards and Nancy Ross, Practical Issues in Assignment for the Benefit of Creditors, 17 ABI L. Rev. 5 (2009).