Dismissal of Chapter 11 Case Calls Into Question Bankruptcy Protections for Cannabis Companies

Despite a company’s claim that it deals only in legal hemp products, in January, a federal court denied the company’s access to relief under the Bankruptcy Code. U.S. Bankruptcy Court Judge Joseph Rosania, Jr., of the District of Colorado, dismissed United Cannabis Corporation’s (UCANN) Chapter 11 bankruptcy filing, a move that could cause concerns for cannabis companies that may be seeking bankruptcy relief, particularly in the midst of a global pandemic.

Bankruptcy Courts Struggle with Drawing the Line for Cannabis Industry Protections

While some states have legalized marijuana, federal law still prohibits its use. Specifically, the Controlled Substances Act (CSA) makes it illegal to “manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense” marijuana and certain drug compounds. Bankruptcy Courts have routinely excluded businesses that violate the CSA from protection under the Bankruptcy Code.

However, given the closeness and relationship between legal hemp products and CSA-prohibited marijuana, it may not always be clear whether a cannabis company’s business practices violate the CSA. In the absence of guidance from Congress or federal agencies, courts have struggled to ascertain when a company’s dealings constitute a CSA violation that prohibits access to bankruptcy relief.

Do UCANN’s Operations Violate the CSA?

In the Chapter 11 context, Bankruptcy Courts focus on whether a debtor plans to use marijuana-derived income to fund its proposed future reorganization.

The Court’s decision arose out of an order to show cause in which the Judge asked the parties why the case should not be dismissed based on it “appear[ing]” that the Debtor was “engaged in the marijuana industry.”  While UCANN acknowledged that it had previously profited from a patent license involving tetrahydrocannabinols (THC), the chemical compound primarily responsible for marijuana’s psychoactive effects and a CSA prohibited Schedule I Controlled Substance, UCANN asserted that its dealings with THC were in the past and ceased in 2017. In a May 11, 2020 court filing, UCANN argued that all of its “current operations relate to, and all revenues are solely derived from, the sale of legal CBD products that are made using CBD that is extracted from legal industrial hemp plants.” It emphasized that it does not presently violate the CSA or derive income from illegal activity. Further, UCANN maintained that its reorganization plans would not “rely in any way on income derived from criminal activity.”

In contrast, the U.S. Trustee countered that UCANN’s THC business dealings persist and continue to violate the CSA. Specifically, the UST pointed to UCANN’s 2019 Third Quarter SEC filing, which stated that UCANN owns “distinct intellectual property relating to the legalized growth, production, manufacture, marketing, management, utilization and distribution of medical and recreational marijuana and marijuana infused products.” The UST highlighted UCANN’s statement that it licenses its intellectual property to “businesses in the cannabis industry.” The UST underscored UCANN’s “significant interests” in five subsidiaries that deal in cannabis and are “not bankruptcy debtors.”  The UST also alleged that while UCANN was perhaps not directly violating the CSA, UCANN was aiding and abetting and conspiring with others to violate the CSA.  In support, the UST pointed to (a) UCANN’s investment in a medical marijuana supplier, (b) UCANN’s prepetition transfer of over $1 million to a related entity that “might also engage in activities that violate the CSA”, and (c) UCANN’s transfer to its CEO, on the petition date, of its 50% stake in a cannabinoid research company which leases 28 acres of land in Jamaica for cultivation and extraction.

Although Judge Rosania’s order dismissing the case did not set forth his reasoning, his order to show cause offers some insight – “[d]espite being legal under state law, activities associated with the marijuana industry are illegal under federal law and cannot be condoned by the bankruptcy courts.”

The full version of this article may be found here.

Rachel L. Goodman is an associate in Montgomery McCracken’s Litigation Department.

Georgette Castner is a partner in Montgomery McCracken’s Litigation Department and Co-Chair of the Cannabis Law Practice Group.

Edward L. Schnitzer is a partner in the Business Development and chair of Montgomery McCracken’s Bankruptcy & Financial Restructuring Group.

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