Article by: Zuber Lawler Counsel Tomas Ortiz

As the end of 2022 quickly approaches, where are we on a federal cannabis program?

Federal legalization remains frozen in time – re-scheduling versus de-scheduling, the SAFE Act, the MORE Act; none of these important cannabis initiatives is settled.

Biden’s pardon gave people something to talk about, but did it go far enough? Or, did it reinforce the old- fashioned constructs of talking about cannabis as a law and order issue, rather than one of business and industry? Was it forward thinking, in a time when cannabis businesses are struggling from lack of access to banking, limited financing and onerous taxation?

There was some hope in the courts, as crazy as that hope may have been.

The year brought us two pending bankruptcy cases involving cannabis and cannabis-related businesses, offering some hope that perhaps a bankruptcy court or a trustee may have a different approach, a more progressive mindset, and perhaps building that bridge toward bankruptcy protection.

Great Lakes Cultivation, LLC

The first of these bankruptcy cases was filed In June, 2021, by Great Lakes Cultivation, LLC, a Michigan-based medical marijuana company. The company sought Chapter 7 protection – an administered and controlled wind-down and liquidation of its assets to pay off its creditors.

The company grew and sold medical marijuana pursuant to a license issued in 2019 by the State of Michigan. The company operated out of a leased building and all of its equipment was used in the manufacture of marijuana and its income derived solely from the sales of medical marijuana. A short time after it acquired its license, Michigan decriminalized marijuana, which increased competition, and caused the business to fail.

At the time of the bankruptcy filing, the company estimated its assets at approximately $171,500. These consisted of marijuana plants, a security system, office furniture and other office equipment, and the security deposit for its lease. The company reported unsecured debts of approximately $837,000– most of it owed to its landlord, minority owners, and other persons who helped fund the business.

Soon after it was filed, the trustee moved to have the bankruptcy case dismissed on two arguments: (1) courts have consistently recognized that “cause” to dismiss a bankruptcy case, including under Chapter 7, exists where a failure to dismiss would require the Chapter 7 trustee to administer assets that are illegal under the Controlled Substances Act (“CSA”); and (2) the company was engaged in ongoing criminal activity.

The bankruptcy court agreed and dismissed the case on three grounds: 1) the private trustee could not administer the company’s assets consisting of marijuana and equipment used to manufacture and distribute marijuana, without violating the CSA; (2) because its business was illegal under federal law, public policy does not support using federal law to benefit marijuana businesses; and (3) the company’s violations of the CSA constituted bad faith, making it ineligible for bankruptcy relief.

The company appealed the dismissal to the federal district court arguing the trustee could administer the estate without violating the CSA because the marijuana plants had been abandoned by the trustee and because the remaining assets were not illegal by nature (e.g., the office equipment ) and were purchased with “non-marijuana” funds. The district court disagreed.

First, the district court denied that the trustee had in fact abandoned the plants. There was no evidence or procedural record of such an abandonment. Not a good start for the company. Second, as to the non-plant assets, the district court cited that the test is not where the money came from to purchase the equipment, office supplies, and furniture, but rather were they used in the cultivation and sale of cannabis, and the district court found that they had indeed been used in that activity. The district court turned to a seminal marijuana bankruptcy case, In re Arenas, 514 B.R. 887 (D. Bankr. Colo. 2014), for the proposition that bankruptcy protections and processes are not available for assets “that are used for, or generated by, a business prohibited under the CSA.”

Conclusory Comments on Great Lakes Cultivation.

Curiously, the district court dedicates a notable portion of its opinion to the suggestion that a Chapter 7 might not be necessary to liquidate the company in a fair and orderly manner, suggesting assets were limited and creditors were few. The company’s response was that Chapter 7 benefited one of its minority shareholders. This begs the question whether the same result would have occurred had this been a larger cannabis business, with a larger amount of money on the line, with large institutional creditors, and competing claims.

Master Equity Group, LLC

The second bankruptcy is also a Michigan based case filed in 2022 by Master Equity Group, LLC. This case, however, sought Chapter 11 protection under Subchapter 5, not Chapter 7. The company sought to reorganize, not liquidate.

In court filings, the company described itself as a “holding and management company for several related-entity businesses operating in the cannabis industry.” In this role, Master Equity Group buys or leases property to sublease to cannabis businesses along with providing accounting, payroll and other centralized functions. Court filings reflected that the company earnings came from — albeit indirectly —marijuana-related businesses.

It is this last point that the trustee seized upon in moving to dismiss. The trustee argued that all of the company’s “earnings, cash flow and income” came from the “growing, processing and retail sale of recreational and medical marijuana.” The trustee further argued that the “only possible way” for the company to fund any Chapter 11 plan of reorganization is to use the proceeds of criminally illegal activity. The company apparently agreed, because it soon stipulated to a voluntary dismissal of its Chapter 11 filing.

Conclusory Comments on Master Equity Group.

As with Great Lakes Cultivation, there were other issues with the company, including its ongoing litigation with one of its landlords, which appeared to make any plan financially impossible. Master Equity Group, LLC, like Great Lakes Cultivation, LLC, was not the perfect “cannabis” debtor with the perfect profile to be that “great hope” for movement toward federal normalization of cannabis businesses, at least with respect to bankruptcy filings.

Conclusions.

The takeaway on both Michigan cases is that cannabis will have to wait a while for bankruptcy protection. It may have to wait until federal legalization or, perhaps, until larger institutional lenders are brought into the mix, either via the SAFE Act or otherwise.

Until then, any hope of entering the bankruptcy courtroom for a cannabis business is going to require the perfect case – perfect debtor with highly-valued  assets, large debts and claims, larger creditors who want an organized and controlled reorganization or liquidated distribution, and an insurance company or two with something on the line thrown in, just to make things interesting.

Well, maybe next year.