July 15, 2024
More than 75% of the U.S. population lives in states that have legalized cannabis for adult and/or medical use. Yet, cannabis remains federally illegal as a Schedule I drug. That may soon change.
Pursuant to a 2022 directive from President Joe Biden, a 2023 recommendation of the U.S. Department of Health and Human Services, and a scientific review released in January supporting the HHS’s recommendation, on May 13, 2024, the U.S. Drug Enforcement Administration proposed reclassifying cannabis as a Schedule III drug. Following review by the White House Office of Management and Budget, the proposed rule will be made available for public comment and reviewed by an administrative judge.
If the rule is finalized, there will be a seismic effect on cannabis regulation at the federal level, such as the elimination of punishing tax treatment and banking restrictions that are restraining the cannabis industry’s growth. Rescheduling may also have an effect on cannabis-related bankruptcy proceedings.
While the impact rescheduling will have on tax and banking implications for cannabis businesses is clear-cut, the effect on bankruptcy access is not.
Historically, bankruptcy courts have been closed for cannabis-related businesses. However, recent decisions in favor of cannabis-related businesses, coupled with the potential rescheduling of cannabis itself, could possibly change the landscape and, as such, are worthy of further exploration and analysis.
Bankruptcy and Cannabis
Despite the expansion of legalized cannabis in individual states throughout the country, bankruptcy courts are federal courts and, as such, are bound by federal law.
The U.S. trustee, in their role as the watchdog of the bankruptcy system and as part of the U.S. Department of Justice, will move to dismiss bankruptcy cases when relief cannot be granted consistent with the Bankruptcy Code and other federal law.
The trustee’s response to cannabis-related bankruptcy filings is guided by two principles. First, the bankruptcy system may not be used as an instrument in the ongoing commission of a crime and reorganization plans that permit or require continued illegal activity may not be confirmed. Second, bankruptcy trustees and other estate fiduciaries should not be required to administer assets if doing so would cause them to violate federal law.
So long as cannabis use remains federally prohibited, whether as a Schedule I or Schedule III substance, cannabis-related businesses will continue to struggle to satisfy requirements for bankruptcy reorganization.
Cannabis-Related Case Law
Until recently, bankruptcy courts followed a script in dismissing cannabis-related cases. The trustee would flag such cases via a motion to dismiss. Cannabis-touching operations would be seen as a violation of the Controlled Substances Act (“CSA”), and thus prevent the bankruptcy courts from providing relief that abided by federal law.
However, there have been some recent decisions from bankruptcy courts in Colorado and California holding that the mere presence of cannabis is not per se improper.
For instance, in the 2023 case of In re Hacienda, the U.S. Bankruptcy Court for the Central District of California twice denied the trustee’s motions to dismiss a cannabis-related debtor’s bankruptcy case, and instead confirmed the debtors’ plan to liquidate cannabis-related assets.
The debtor, an American business that was no longer involved in the cannabis industry, transferred its cannabis-related assets to a Canadian company in exchange for stock in the Canadian company. Through its bankruptcy plan, the debtor looked to liquidate these Canadian shares over time.
However, the Hacienda decision is in contrast to U.S. trustee guidelines, which expressly state that reorganization plans administering cannabis-related assets may not be confirmed.
Rescheduling cannabis to Schedule III might further sway bankruptcy courts on cannabis-touching entities attempting to participate in bankruptcy proceedings and further influence the trustee’s discretion in filing future motions to dismiss.
Conclusion
The recent development of bankruptcy case law surrounding cannabis businesses and the proposed rescheduling provide a cautious optimism for cannabis entities interested in utilizing the bankruptcy courts, albeit under certain limited circumstances.
Not only is 2024 an important year with the potential rescheduling of cannabis on the horizon, but bankruptcy courts and the trustee will also have to navigate how to treat cannabis businesses seeking bankruptcy relief with the increasing liberalization of cannabis use.
Lawrence J. Kotler is a partner at Duane Morris LLP and co-chairs the bankruptcy and fiduciary representations division of the firm’s business reorganization and financial restructuring group.
Seth A. Goldberg (LAW ’99) is a partner and co-chairs the firm’s cannabis industry group.
Ryan Spengler is an associate at the firm.