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The Cannabis Conundrum: Can Cannabis Companies File Chapter 15?

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by Catherine Jun and Colin Davidson, Attorneys at Sheppard Mullin

Recreational cannabis is now legal in 19 states and Washington D.C., driving the growth of legal cannabis sales estimated at $33 billion this year—up 32% from 2021—and expected to reach $52 billion by 2026.[1] This movement signals that financial investment in cannabis is not abating but accelerating notwithstanding the impact of the lingering COVID-19 pandemic. This growth in the cannabis industry, of course, also means that operators and their investment partners face commercial risk, including insolvency.

It has, however, become axiomatic that cannabis companies are barred from relief under the U.S. Bankruptcy Code.[2]  A line of court opinions, in fact, has held that cannabis companies cannot seek a chapter 11 restructuring or chapter 7 liquidation. The reasoning is, stated simply, marijuana is a schedule 1 controlled substance under the federal Controlled Substances Act (the “CSA”)[3]and, therefore, it is illegal under federal law “to manufacture, distribute, or disperse, or possess with intent to manufacture, distribute, or dispense, a controlled substance”[4]—notwithstanding any contrary state law.  Given its criminalized acts, a marijuana business that intends to continue to operate as such cannot propose a chapter 11 plan of reorganization “in good faith,” which has led bankruptcy courts to routinely dismiss such cases for “cause” pursuant to section 1112(b)(1) of the Bankruptcy Code.[5]  Nor can cannabis companies avail themselves of chapter 7, as any appointed bankruptcy trustee would then be required to sell marijuana and marijuana-related assets of the liquidating company and, in so doing, violate federal law.[6]

Compare this to Canada. In Canada, the federal Cannabis Act (2018) legalized cannabis nationwide, while the provinces maintain certain regulatory powers related to the distribution, sale and use of cannabis. For cross-border cannabis operators then, a potential avenue for bankruptcy relief is for the company to first commence an insolvency proceeding in Canada and then seek recognition of that foreign proceeding in a U.S. bankruptcy court under chapter 15 of the Bankruptcy Code. Upon recognition as a “foreign main proceeding,” the automatic stay, the power to continue to operate the debtors’ business, and a number of other bankruptcy protections become available to that debtor company regarding assets located in the United States.[7] If a bankruptcy judge determines that the Canadian proceeding is “non-main” rather than “main,” the rights provided in the foreign proceeding are not automatically available, but may still be requested by the foreign representative and granted at the bankruptcy judge’s discretion.[8]

While direct access to bankruptcy relief in the United States remains closed to cannabis and cannabis-adjacent companies, chapter 15 could potentially open the proverbial side door—i.e., the company first seeks insolvency protection in Canada and then seeks recognition of the Canadian proceeding in the U.S. bankruptcy court. That’s because chapter 15 sidesteps the hurdles that have historically barred bankruptcy relief to cannabis companies. In a chapter 15, no bankruptcy estate is created that a chapter 7 trustee must administer, and no chapter 11 plan of reorganization is proposed. Nor are traditional grounds for dismissal in a chapter 11 or 7 proceeding such as “bad faith” applicable in a chapter 15 proceeding.[9] That said, a cannabis company’s access to chapter 15 may turn on whether a bankruptcy court invokes the so-called “public policy exception”—which, while very rarely invoked, allows a court to abstain from acting under chapter 15 if doing so would be “manifestly contrary” to U.S. public policy.[10]

The public policy exception is found in section 1506 of the Bankruptcy Code and reads:

Nothing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.[11]

Courts have concluded that Congress’ use of the word “manifestly” substantially limits the exception’s scope to “the most fundamental policies of the United States.”[12]  Accordingly, courts applying the public policy exception have read it narrowly and applied it sparingly.[13]

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In order to determine whether an action is manifestly contrary to U.S. public policy, courts ask two questions:  (i) whether the foreign proceeding is procedurally unfair, and (ii) whether recognition of the foreign proceeding would severely impinge a constitutional or statutory right, or frustrate a bankruptcy court’s ability to carry out the fundamental purpose of such constitutional or statutory right.[14]

Most courts that have considered public policy arguments have declined to apply the exception. In fact, bankruptcy courts administering chapter 15 have only invoked the public policy exception four times.[15] Moreover, case law on this issue reveals three salient points, which should be important to cannabis operators:  first, the existence of a conflict between foreign and U.S. law is a prerequisite to applying the public policy exception; second, even if the relief sought in a chapter 15 petition gives rise to a violation of a criminal statute, it is not clear that such violation alone would trigger application of the public policy exception; and third, once a bankruptcy court grants recognition of a foreign proceeding, the court’s subsequent denial of requested relief based on the public policy exception does not nullify recognition—theoretically keeping the door open to other bankruptcy relief.

First, not all chapter 15 relief, and the protection that the foreign debtor needs, is created equal.  How narrowly a cannabis operator tailors the relief it seeks through its chapter 15 proceeding will likely determine whether the requisite ex anteconflict with U.S. law exists.[16] For example, a chapter 15 proceeding that merely seeks the protection of the automatic stay to bar collection activity against a cannabis company’s property and assets in the U.S. arguably does not give rise to a violation of the CSA.[17]  Without a conflict with U.S. law, no public policy inquiry is triggered.  This means that cannabis operators should carefully analyze the prohibited acts contained in the CSA to determine whether the relief sought in their chapter 15 petition gives rise to a conflict with U.S. law.

Even if relief sought in the chapter 15 petition would result in a violation under the CSA—for example, if the foreign representative seeks authority to liquidate a cannabis operators’ inventory and repatriate the proceeds back to the foreign jurisdiction free and clear of liens, claims and encumbrances for distribution to creditors under a foreign scheme of arrangement—it is possible that a bankruptcy court may not automatically conclude that this statutory conflict is “manifestly contrary” to U.S. public policy,[18]as precedent informs us that the analysis needs to consider whether the relief would “severely impinge a constitutional or statutory right,” or frustrate a bankruptcy court’s ability to carry out “the most fundamental policies and purposes” of such constitutional or statutory right.[19]

In 2011, the United States Bankruptcy Court for the Southern District of New York in Toft demonstrated this relationship. The case involved an orthopedic surgeon who had sought bankruptcy relief under the German Insolvency Code. During the German proceeding, the debtor refused to cooperate with the administrator by hiding assets and purportedly relocating them to some unknown country outside of Europe. In accordance with what was understood to be common practice in Germany, the German court entered a “Mail Interception Order,” authorizing the foreign representative, as administrator of the debtor’s estate, to intercept the debtor’s postal and electronic mail. The foreign representative then initiated a chapter 15 petition in New York and asked the bankruptcy court to recognize and enforce the Mail Interception Order that would empower the representative to intercept and monitor the debtor’s mail.  The New York bankruptcy court denied recognition of the German proceeding based on the public policy exception, explaining that the relief sought would result in criminal liability under the Wire Tap Act, and“directly compromise privacy rights subject to comprehensive scheme of statutory protection, available to aliens, built on constitutional safeguards incorporated into the Fourth Amendment as well as the constitution of many states.”[20]  In the case of cross-border cannabis, it is not readily apparent that there is any constitutional or statutory right the CSA ultimately seeks to safeguard.  Perhaps the CSA seeks to “protect the public health from the dangers of controlled substances”[21]—and one could imply a statutory right to one’s health and wellbeing. However, bankruptcy courts have yet to extend the public policy exception to such implied rights.

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Finally, courts that have exercised the public policy exception in the context of an application for relief after entry of the recognition order, have declined to revisit prior court orders granting recognition.  For example, in Qimonda AG, the bankruptcy court for the Eastern District of Virginia had already recognized the chapter 15 proceeding before denying the foreign representatives’ requests for subsequent relief on public policy grounds.

Qimonda was a German producer of computer microchips. Prior to its insolvency, Qimonda had entered into a series of cross-licensing agreements with various international electronics companies, allowing them to use its U.S. patents to manufacture and sell semiconductors in the U.S. and abroad.  In 2009, Qimonda commenced insolvency proceedings in Germany and soon thereafter filed a petition for chapter 15 recognition in the Virginia bankruptcy court. After holding a hearing on the petition, the bankruptcy court issued an order recognizing the German proceeding as a foreign main proceeding, and a second order granting discretionary relief to Qimonda, including section 365(n) of the Bankruptcy Code, which provides third-party IP licensees the option to retain its rights under the license.

Shortly after entry of these orders, the foreign representative filed a motion seeking to eliminate the protections of section 365(n) to conform with the German Insolvency Code and allow the debtor/foreign representative to reject patent cross-licenses. The bankruptcy court ultimately denied the motion, concluding that to except the application of section 365(n) under the circumstances of the case would “‘severely impinge’ an important statutory protection accorded licenses of U.S. patents and thereby undermine a fundamental U.S. public policy promoting technological innovation.”[22]  Notably, in invoking the public policy exception as a basis to deny the additional relief requested, the bankruptcy court did not reconsider its recognition of the foreign proceeding—the automatic stay and other provisions of the Bankruptcy Code remained in place. This and the preceding observations suggest that recognition under chapter 15 may not be wholly fantastical for insolvent cross-border cannabis operators, and that upon scaling the hurdle of recognition, denial of certain relief under the public policy exception does not foreclose all bankruptcy relief accessible through chapter 15.

Chapter 15 is based on principles of comity—i.e., giving recognition of, and deference to, a foreign ruling largely based on efficiency, international cooperation and collaboration.  As the global trend towards legalizing recreational cannabis continues, it is likely just a matter of time that a cross-border cannabis company will seek chapter 15 recognition of its foreign insolvency relief—and will unwittingly test the value of comity against the limits of the public policy exception.

About the Co-Author

 

Colin Davidson is an associate in Sheppard Mullin’s Finance & Bankruptcy practice group and is based in the firm’s New York office. He can be reached at cdavidson@sheppardmullin.com.

 

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[1]  See 10 Best Marijuana Stocks to Buy Now, Kiplinger(https://www.kiplinger.com/investing/stocks/stocks-to-buy/601667/best-marijuana-stocks).

[2]  Title 11 of the United States Code (the “Bankruptcy Code”).

[3]  21 U.S.C. § 812, Schedule 1(c)(10).

[4]  Id.§ 841(a)(1).  It is also illegal under the CSA “to manufacture, distribute, export, or import . . . any equipment, chemical, product, or material which may be used to manufacture a controlled substance or list chemical, knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance.”  Id.§ 843(a)(7).

[5]  See In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 809 (Bankr. D. Colo. 2012).

[6]  In re Medpoint Mgmt., 528 B.R. 178, 184 (Bankr. D. Ariz. 2015), vacated in part on other grounds, 2016 Bankr. LEXIS 2197 (B.A.P. 9th Cir. 2016).

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[7]  11 U.S.C. § 1520.  Once recognized, a foreign representative may also seek additional relief from the bankruptcy court or other state and federal courts and is authorized to bring a full (as opposed to ancillary) bankruptcy case.  11 U.S.C. §§ 1507, 1511.

[8]  Some or all of these powers may be available to the foreign representative upon a showing that the relief is necessary to protect the assets that should be administered through the foreign nonmain proceeding.  See 11 U.S.C. § 1521(c).

[9]  See, e.g., In re Manley Toys Ltd., 580 B.R. 632 (Bankr. D. N.J. 2018).

[10]See In re Rede Energia S.A., 515 B.R. 69, 91 (Bankr. S.D.N.Y. 2014).

[11]11 U.S.C. § 1506.

[12]In re ABC Learning Ctrs. Ltd., 728 F.3d 301, 309 (3d Cir. 2013) (quoting H.R. Rep. No. 109-31(1) at 109 (2005)reprinted in U.S.C.C.A.N. 88, 172.

[13]See, e.g.,In re Fairfield Sentry Ltd., 714 F.3d 127, 139 (2d Cir. 2013) (“The statutory wording requires a narrow reading.”); In re Vitro SAB de C.V., 701 F.3d 1031, 1069 (5th Cir. 2012) (“[section] 1506 was intended to be read narrowly[.]”); In re Iida, 377 B.R. 243, 259 (B.A.P. 9th Cir. 2007) (“This public policy exception is narrow[.]”); In re Ashapura Minechem Ltd., 480 B.R. 129, 139 (S.D.N.Y. 2012) (“While Title 11 does not define what is ‘manifestly contrary’ to U.S. public policy, case law prescribes that this public policy exception should be construed narrowly.”).

[14]See ABC Learning Ctrs., 728 F.3d at 309;Ashapura Minechem, 480 B.R. at 139; In re Toft, 453 B.R. at 195; see also In re Qimonda AG, 462 B.R. 165, 183 (Bankr. E.D. Va. 2011) (“[T]his court must determine . . . whether the application of foreign law or the recognition of a foreign main proceeding would ‘severely impinge’ a U.S. statutory or Constitutional right in a way that would offend ‘the most fundamental policies and purposes’ of such right.”).

[15]See In re Toft, 453 B.R. 186 (Bankr. S.D.N.Y. 2011) (“Toft”); In re Gold & Honey, Ltd., 410 B.R. 357 (Bankr. E.D.N.Y. 2009); In Vitro SAB de CV, 473 BR 117, 132 (Bankr. N.D. Tex.), aff’d, 700 F.3d 1031 (5th Cir. 2012); see also In re Qimonda AG Bankr. Litig., 433 B.R. 547 (E.D. Va. 2010), aff’d, Jaffe v. Samsung Elecs. Co. Ltd., 737 F.3d 14 (4th Cir. 2013) (“Qimonda AG”).

[16]  See, e.g.,  In re Irish Bank Res. Corp. (In re Special Liquidation), No. 13-12159, 2014 Bankr. LEXIS 1990 at *64-65 (Bankr. D. Del. Apr. 30, 2014).

[17]See CSA, 21 U.S.C. §§ 841(a)(1) and 843(a)(7).

[18]SeeIn re Special Liquidation, 2014 Bankr. LEXIS 1990 at *69 (“[T]he mere identification of a contrary statute or policy of the United States is insufficient, such conflict must be ‘manifestly contrary’ to U.S. policy.”); ABC Learning Centers, 728 F.3d at 309; In re Ephedra Prods., 349 B.R. 333, 335 (S.D.N.Y. 2006).

[19]Qimonda AG, 433 B.R. at 570.

[20]In re Qimonda AG, 462 B.R. at 198.

[21]  Congressional Research Service, “The Controlled Substances Act (CSA): A Legal Overview for the 117th Congress,” updated Feb. 5, 2021, referencing 21 U.S.C. §§ 801(1), (2).

[22]In reQimonda AG, 462 B.R. at 185.  On appeal, the Fourth Circuit affirmed the bankruptcy court’s decision based on its analysis of section 1522(a), not on public policy grounds in section 1506—but the Fourth Circuit noted: “[B]y affirming the bankruptcy court’s application of section 365(n) following its balancing analysis under section 1522(a), we also indirectly further the public policy that underlies section 365(n).”  Aff’d Jaffe v. Samsung Elecs. Co. Ltd., 737 F.3d 14, 32 (4th Cir. 2013).

 

The post The Cannabis Conundrum: Can Cannabis Companies File Chapter 15? appeared first on Cannabis Business Executive – Cannabis and Marijuana industry news.

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