When a Cannabis Business Fails, Things Can Get Messy

 

As support for Amendment 2 picks up across the state, many people are eager to get their hands in the medical cannabis industry game. But it’s become clear recently that the Republican-controlled Legislature might cap the number of dispensaries and limit the number of people who can cash in.

Consider California. When medical cannabis was first legalized there, dispensaries popped up everywhere. Voters decided to limit them, and many closed down, leaving would-be entrepreneurs in the dust.

But what happens when a medical marijuana business fails?

It depends on the type of business and where that business was in its life cycle, but generally speaking, it’s not pretty. The easiest cases tend to be businesses that fold pre-licensure, because less money has been spent and there is less to unwind. The hard ones are those with a slug of assets (including cannabis), employees, and debt. Because there is no such thing as bankruptcy for cannabis businesses, and because cannabis is a controlled substance, things can get messy.

As to bankruptcy, courts have ruled repeatedly that cannabis businesses are ineligible. Bankruptcy cases are handled exclusively in federal court, and the rationale is that it wouldn’t be possible for a US Trustee to control and administer a debtor’s assets (cannabis) without violating the federal Controlled Substances Act. That holding makes perfect sense given the state of the law, but it’s really a shame: Bankruptcy laws are designed to give a fresh start to honest but unfortunate debtors, while providing fair treatment to creditors. Without the bankruptcy process, everyone is sort of left hanging.

Because bankruptcy is not an option,cannabis business is left with two lousy options:

(1) liquidate (convert assets to cash) without court supervision, or

(2) explore something called “receivership.”

In option 1, the cannabis business tends to close up shop, pick the creditors it likes best, pay them whatever it can, and politely ask that nobody sue. If the business is doing things right, it will also reach out to the OLCC to determine what to do with any excess cannabis. With a dispensary, for example, the OLCC will allow transfer of product to a wholesaler, and ensure that the product is properly tracked. Sometimes the OLCC may also allow a secured creditor to liquidate the cannabis under agency supervision.

Option 2, the “receivership” model, is a bit more exotic. In Oregon, a receiver is the state-level equivalent of a bankruptcy trustee, more or less, in that the receiver is appointed by a court order to wrap up a failed business. If such an appointment is made, OLCC rules allow that receiver to sell thecannabis, like the secured creditor mentioned above. The big difference here is that the receiver is selling cannabis with judicial approval, and isn’t looking out for her own interest.

One might argue that the lack of standard dissolution options, like bankruptcy, not only makes it messy when cannabis businesses fail, but makes them more likely to fail in the first place. Lenders understand that if a cannabis concern goes belly up, recoupment options are limited. Therefore, they charge higher interest as risk compensation. Higher interest leads to more defaults. Defaults lead to closed doors. And so on. And, after all of that, things can truly start to get messy.

When a medical marijuana business fails, four court rulings from Colorado, California, and Oregon suggest it’s not pretty. Because medical marijuana still isn’t legal on a federal level and bankruptcy cases are handled in federal court, the government won’t let anyone involved with cannabis restructure his debt. To the feds, dealing with cannabis is still “illegal activity,” even if it’s perfectly above board to be a warehouse landlord, dispensary owner, or caregiver in your state.

Here’s how courts have ruled in the past:

– Oregon, June 9, 2011: A debtor tried to file Chapter 13 bankruptcy. He made his money from Oregon Medical Growers LLC, which leased a warehouse to people who grow cannabis as well as a tattoo parlor. Because part of the debtor’s income was derived from doing business with cannabis growers, a debt repayment plan was denied by the courts.

– California, November 29, 2011: Plaintiff Northbay Wellness Group was set up to sell medical cannabis. Its attorney told the owners not to pay state income taxes, a piece of bad advice that cost them hundreds of thousands of dollars later on. When the company tried to sue, the courts invoked the “clean hands doctrine” that “closes the doors of a court to one who is tainted relative to the matter in which he seeks relief, no matter how improper may have been the behavior of the defendant.”

– California, October 4, 2012: Mother Earth’s Alternative Healing Cooperative Inc. tried to file Chapter 11 bankruptcy. The court said no, because it was in violation of the Controlled Substances Act.

– Colorado, December 19, 2012: A landlord tried to file Chapter 11 without knowing that 25 percent of his income came from a tenant who grew cannabis. This violated a so-called “crack house” statute, which caused the courts to dismiss the case.