The Cannabis Dilemma: Low Cash Flow and Inaccessible Federal Bankruptcy Protections

By January 29, 2020 February 24th, 2020 Cannabis, Tax
Cannabis Bankruptcy Protection

As of January 1, 2020, eleven states and Washington D.C. have legalized recreational marijuana. The number of states with some form of legalization balloons when you account for the states that have legalized medicinal marijuana. And by the end of the year, it is possible that more than 40 U.S. states could legally allow some form of marijuana, including some deep red states like Mississippi and South Dakota. Momentum and excitement for the industry is high.

Just ask Illinois, where they began to legally sell recreational marijuana on January 1, 2020 and sold over $3.1 million in sales on that first day alone. After a week, sales numbers jumped to nearly $11 million.

Yet even with undeniable exuberance for the product and the business possibilities, cannabis companies are struggling. Mightily. Following the 2020 ICR Conference in Orlando, Florida, one of the largest investment conferences in the country, MKM Analyst Bill Kirk predicted that the next four to six months will be tumultuous for the cannabis sector.

Between mounting pricing pressure and the realization that about 50% of companies with Canadian licenses are filing for bankruptcy, investors and other financial players are less keen to share the same excitement as their consumer counterparts.

Where outwardly we see consumer excitement for the growing legality across the country, within the industry itself the overall picture is less positive. With a federal ban on marijuana still stringently in place, those operating in the cannabis space face a number of unique challenges. For instance, due to current federal laws listing marijuana as a banned substance, cannabis-related companies have a severe lack of banking options.

This stands at the state level as well, even in places like California where both forms of marijuana are legal. The absence of viable banking resources combined with other financial hindrances have left some companies out in the dust. This in turn leads to another problem that cannabis companies are beginning to encounter: a lack of bankruptcy protection.

Why is cannabis bankruptcy protection a hot topic in the cannabis industry?

As noted above, the legalization of marijuana has been spreading across the country and the potential for the industry seems infinite. However, the outlook today – at least on the inside – is not as bright as the reality of a difficult regulatory landscape continues to sink in.

Between March and December 2019, marijuana stocks plummeted by about two-thirds. Capital markets largely froze for all but the strongest of companies. And now a cash crunch is leaving some on the verge of going bust. Factor in an astonishing surplus of product – the equivalent of 1 billion joints in Oregon alone – and the problems only seem to grow. In fact, some leading industry executives suggested a number of companies – both publicly traded and privately owned – were two to four weeks away from missing payroll.

But the effects do not reserve themselves exclusively for smaller companies. In December 2019, Los Angeles-based MedMen Enterprises Inc. reduced corporate staff by more than 40% and issued $27 million of shares at 43 cents each, 14% below the December 10 closing price.

Yet, as the industry’s financial concerns seem to be colliding at the same time, the companies suffering the most will not have the ability to fall back on federal bankruptcy protections.

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Can cannabis-related companies file for bankruptcy?

As long as cannabis remains on the list of federally controlled substances, federal bankruptcy protection shall remain elusive. Unfortunately, compliance with state laws is of little benefit when it comes to federal bankruptcy, banking and tax codes. Instead, bankruptcy courts consistently dismiss Chapter 11 plans for any business “involved” with the cannabis industry.

The court rulings often come in response to the U.S. Trustee’s office – the arm of the Department of Justice that monitors bankruptcy cases – filing motions to dismiss bankruptcy cases where the debtor has a direct or tangential connection to the cannabis industry. Therefore, the denial of federal bankruptcy protection affects both those directly involved in the industry and those that derive their income indirectly from the industry.

The rulings are mostly consistent throughout the country. The Justice Department remains steadfast in the decision that companies affiliated with cannabis operations cannot receive federal bankruptcy protections.

They directly stated that the prohibition on handling cannabis assets goes beyond activities that directly touch the plant and also extends to other indirect connections like real estate leases and investments.

In 2017, Clifford J. White, director of the Justice Department’s Executive Office for U.S. Trustees, and John Sheahan, a trial attorney for the agency, wrote that, “[N]ot only would a trustee who offers marijuana for sale violate the law but so, too, would a trustee who liquidated the fertilizer or equipment used to grow marijuana, who collected rent from a marijuana business tenant, or who sought to collect the profits of a marijuana investment.”

We saw this in action in Colorado in the case of In re Way to Grow, Inc., Case No. 18-14330-MER, Dkt. No. 379 (Bankr. D. Co. Dec. 14, 2018).  The court dismissed the bankruptcy case due to illegal activity because the hydroponics equipment seller knew or had reason to believe that customers would use their equipment to grow marijuana.

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So what options exist for cannabis-related entities and individuals?

2019 did not necessarily bring the financial success that many cannabis investors and cannabis-related companies had hoped for. So as the new year sets in, cannabis industry insiders are bracing for a slew of bankruptcies as small and medium-sized companies low on cash struggle to raise funds. Without access to federal bankruptcy protections, those affected find themselves asking – what relief is actually available?

For companies based in the U.S., options for capital are limited from the outset in thanks to the cannabis banking crisis and the federal tax code which bars cannabis companies from taking tax deductions from normal business operations.

Cheaper debt is gradually becoming more available for marijuana companies, but mostly flows to those already yielding a profit. In states such as California and Oregon, upon legalization, they instituted unique provisions that gave cannabis creditors leeway to take over business operations or sell off inventory.

However, not all states included such provisions in their marijuana laws, making it harder for creditors to take ownership of assets.

Still, another alternative may sit across the northern border for U.S. cannabis companies that trade on Canadian stock exchanges. At this time, this strategy is merely in the exploratory stage.

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Is there any hope for the future?

The picture painted thus far is admittedly bleak. But there is reason for hope. Of course the most optimal outcome is the removal of marijuana from the controlled substances list; but, for now, that is not the case. So we must look elsewhere – like the case Garvin v. Cook Investments NW (2019).

To date, courts have generally ruled that debtors who work in the cannabis industry or derive income from cannabis activity cannot utilize bankruptcy protections. A recent opinion from the Ninth Circuit Court of Appeals however, suggests a reason to believe that change may not be entirely elusive.

The Cook case involved five real estate holding companies that filed Chapter 11 reorganizations in Washington – a state that allows cannabis business activities. One of those five debtors leased a property to a company that used the land to grow cannabis in compliance with Washington state laws.

Initially, the U.S. Trustee’s office filed a motion to dismiss the Chapter 11 cases, asserting that the lease allowing cannabis production on debtor’s land constituted “gross mismanagement” and warranted dismissal of the case. The bankruptcy court denied that motion, but offered the U.S. Trustee’s office the chance to reassert its motion at the time the debtors were seeking to confirm their bankruptcy plan.

At the time of plan confirmation, the U.S. Trustee did not renew its assertion and the Ninth Circuit, in turn, waived the objection. The U.S. Trustee’s office did, however, object to the plan confirmation, arguing that the plan was “proposed…by…means forbidden by law.” The Ninth Circuit disagreed and confirmed the bankruptcy plan.

Effectively, the court determined that the case was not a conflict between federal and state drug law but, rather, a straightforward question of statutory interpretation. The court found that the Bankruptcy Code does not require courts to police substantive provisions of a bankruptcy plan.

Rather, the court must decide if the plan proposed lawful considerations. The Ninth Circuit carefully analyzed the proposed bankruptcy plan and came to the conclusion that it did not involve any means forbidden by law.

The decision was good news for cannabis businesses and those dealing with them. It suggested an opening for courts to allow debtors involved with the cannabis industry to make use of the bankruptcy process.

However, it also left many questions in its wake. For instance, could businesses and individuals connected to the industry successfully go through the bankruptcy process? What would have happened had the debtors in Cook needed to rely upon the cannabis-related revenue to repay their creditors? And what would have happened had the U.S. Trustee’s office renewed its argument that the case had to be dismissed for “gross mismanagement,” which it will likely do in future cases?

And still there are further questions about how other courts will react to the Ninth Circuit ruling. It was mere weeks after the Cook decision when the Bankruptcy Court for the Eastern District of Michigan dismissed a cannabis-related bankruptcy case and expressly rejected the Ninth Circuit’s ruling in Cook.

The Cook decision offered some hope for those in the cannabis industry, but at the end of the day there is still notable uncertainty and tension between the state regulation of marijuana and the federal prohibition. Given the growing number of states that have chosen to regulate cannabis and the resulting exponential growth in the industry – as well as the failure we are beginning to see – there is no doubt that these questions must be answered in future bankruptcy cases.

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How can Squar Milner help?

The cannabis industry is constantly facing its own unique challenges that stem from the area of legal limbo that it currently exists within. In a world balancing state legality and federal criminality, the options available for cannabis-related companies can be far and few between.

This is why you need accounting and financial advisors by your side who understand the unique and specific hurdles facing you and your business. Squar Milner can be that partner.

We have a group of professionals dedicated to the cannabis industry and helping companies effectively and efficiently strategize and plan for their economic future. Our team is here and we are ready to help your company flourish.

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Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.