Subchapter V of the Bankruptcy Code: A future restructuring option for cannabis companies

Imagine a small cannabis operator with a cultivation and production facility in California. The company owns a farm and adjoining warehouse, has $4 million of debt secured by all its real and personal property, and $3 million of unsecured notes. The secured debt comes due in 30 days and discussions with the secured lender have made it clear that it plans to foreclose on its collateral unless it is paid off. The company does not have the means to pay off the debt and is unable to refinance the debt in today’s economic environment (inflation and high interest rates) and with the headwinds facing the California cannabis industry in general (depressed flower prices and thriving illicit market). The owners and management believe the company is worth more than the debt as a going concern and do not want to lose control of the company’s assets and operations.

For cannabis attorneys, this scenario is all too familiar – and the options today are limited. A state court receiver or assignment for the benefit of creditors does not accomplish the client’s goal of staying in control. And bankruptcy has historically not been available unless the company is willing to exit the cannabis industry. But there have been two recent developments that warrant revisiting whether bankruptcy is a constructive option – the legalization of delta-8 THC and the creation of subchapter V of the Bankruptcy Code.

First, the Ninth Circuit in AK Futures LLC v. Boyd St. Distro, LLC, 35 F.4th 682 (9th Cir. 2022), recently clarified that products that contain hemp-derived delta-8 THC with less than 0.3% of delta-9 THC are federally legal under the 2018 Farm Bill. The Ninth Circuit BAP has also held in Olson v. Van Meter (In re Olson), 2018 Bankr. LEXIS 480 (B.A.P. 9th Cir. Feb. 5, 2018), that a bankruptcy judge must make adequate findings of fact and stated legal conclusions indicating the grounds for dismissal of a bankruptcy case. In a concurring opinion, Judge Tighe explained further that, in the context of dismissing a bankruptcy case for inappropriate ties to the cannabis industry, a bankruptcy court must find that the debtor is violating the Controlled Substances Act. Together, these decisions should require the United States Trustee (or another party) to prove that a grower or processor in bankruptcy is producing cannabis with more than 0.3% delta-9 THC as a condition to dismissing the bankruptcy case on grounds that the debtor is violating the Controlled Substances Act. Accordingly, the critical question for our hypothetical cannabis operator is whether, prior to filing bankruptcy, their future harvests can comply with the 2018 Farm Bill.

Second, the Small Business Reorganization Act of 2019 (“SBRA”) enacted a new subchapter V of chapter 11 of the Bankruptcy Code. 11 U.S.C. §§ 1181 – 1195. The purpose of the SBRA is “to streamline the process by which small business debtors reorganize and rehabilitate their financial affairs.” H.R. Rep. No. 116-171, at 1 (2019). To that end, subchapter V modifies the chapter 11 process for debtors in several respects described below. Most notably, subchapter V leaves a debtor in control, allows equity to retain ownership, and reduces the time and expense of chapter 11.

No Absolute Priority Rule | 11 U.S.C. § 1191(b). Subchapter V eliminates the “absolute priority rule” and allows owners to retain their equity despite not paying all creditors back in full, provided the debtor pays its net disposable income to unsecured creditors for a three to five-year period.

No Committee of Unsecured Creditors | 11 U.S.C. § 1102(a)(3). A typical chapter 11 case allows for the appointment of a committee of unsecured creditors, whose professional fees are paid by the debtor’s estate. Subchapter V prohibits the appointment of a committee unless otherwise ordered by the court.

No U.S. Trustee Fees | 28 U.S.C. § 1930(a)(6)(A). Subchapter V exempts a small business debtor from paying U.S. Trustee fees, which are ordinarily a percentage of quarterly disbursements.

Appointment of a Subchapter V Trustee | 11 U.S.C. § 1181(a) and 28 U.S.C. § 586. Subchapter V provides for the appointment of a trustee that has a duty to “facilitate the development of a consensual plan of reorganization.” 11 U.S.C. § 1183(b) (7). Unlike their counterparts in other chapters, subchapter V trustees do not take possession of estate property unless the debtor is removed and are not required to investigate the debtor’s financial affairs unless the court orders it for cause. 11 U.S.C. §§ 1183(b)(2) and (5). The U.S. Trustee’s Handbook for Small Business Chapter 11 Subchapter V Trustees explains that “facilitation of a consensual plan is a principal duty of the trustee.” Accordingly, the subchapter V trustee is akin to a mediator and may be a useful resource in reaching a global resolution of the case.

Relevant to the hypothetical scenario above, on June 21, 2022, the President signed into law the Bankruptcy Threshold Adjustment and Technical Corrections Act, which restores the debt limit to $7.5 million for businesses electing treatment under subchapter V, making its unique features accessible to a much broader range of small to medium-sized businesses. [FOOTNOTE: Subchapter V’s debt limit requirement was temporarily increased from ~$2.75 million to $7.5 million as part of the CARES Act in March 2020, with an original sunset date of March 27, 2021, which was extended a year by the COVID-19 Bankruptcy Relief Extension Act.]

Unfortunately for our hypothetical cannabis operator, subchapter V does not alter the statutory framework for dismissal of a chapter 11 case. Pursuant to 11 U.S.C. § 1112(b), a bankruptcy court may dismiss a case “for cause” and bankruptcy courts have uniformly found “cause” exists when a company operates in violation of the Controlled Substances Act. See, e.g., In re Rent-Rite Super

Kegs West Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012). Considering the continued applicability of section 1112 of the Bankruptcy Code under subchapter V, a traditional cannabis operator’s restructuring options remain limited. However, when faced with a looming foreclosure sale or protracted state court litigation, some cannabis companies may seek temporary shelter in bankruptcy and utilize the subchapter V trustee as a short-term mediator before the bankruptcy case is dismissed. See, e.g., In re NuVeda LLC, Case No. 22-11249 (Bankr. D. Nev 2022); In re Master Equity Group, LLC, Case No. 22-00818 (Bankr. W.D. Mi. 2022). And if our hypothetical cannabis operator can modify its business plan to comply with the 2018 Farm Bill, it may very well seek protection under subchapter V of chapter 11 of the Bankruptcy Code, avoid a fire sale, and stay in control of its operations.

Cannabis attorneys are accustomed to adapting to new legal frameworks and discussing creative solutions with their clients. But until Congress clarifies that a company that operates in compliance with state cannabis laws is eligible for bankruptcy protection, subchapter V may only be a temporary option of last resort.

Jason Rosell leads the Cannabis Restructuring Group at Pachulski Stang Ziehl & Jones, and represents debtors and creditors in complex chapter 11 cases.