Bankruptcy Concerns for Hemp Companies

The current landscape for cannabis companies is confusing due to the divergence between federal and state law. Under federal law, particularly under the Controlled Substances Act (CSA),[1] cannabis is a Schedule 1 controlled substance, and cannabis activities from cultivation to sale are illegal. Yet more than 30 states now have laws making those activities permissible for medical use, recreational use or both. This divergence presents tremendous challenges for the cannabis business.

One commonly discussed example involves Internal Revenue Code (IRC) § 280E, which bars businesses involved with cannabis from taking ordinary and necessary business deductions typically available for tax purposes, with the exception of the company’s cost of goods sold. Another is the benefit and protection allowed under the U.S. Bankruptcy Code, as we will explore in this article. Additionally, we will discuss the issues that still may exist despite the recent passage of the Agricultural Improvement Act of 2018.[2]

The Bankruptcy Code and Case Law Precedent

The Bankruptcy Code generally permits businesses in financial difficulty to liquidate or to reorganize their debts. However, § 1129(a)(3) of the Bankruptcy Code mandates that a plan of reorganization can be confirmed only if “the plan has been proposed in good faith and not by any means forbidden by the law.”[3] In at least one case, the U.S. Trustee took the position that a bankruptcy case brought by a landlord that leased property to a cannabis business should be dismissed on this basis.[4]

In addition, at least one bankruptcy court has held that where a debtor leases a substantial portion of its building to a cannabis business, the bankruptcy petition must be dismissed, since such use of estate property constitutes gross mismanagement of the estate under § 1112(b)(4)(B) of the Bankruptcy Code.[5] Further, courts have found that no trustees appointed in chapter 7 or 11 cases can be requested to distribute funds derived from an illegal business. Thus, such cases must be dismissed on that basis as well.[6]

For any of the previous three reasons discussed, U.S. Trustees have argued, and the federal courts have thus far consistently held, that cannabis businesses cannot avail themselves of the protection afforded by the Bankruptcy Code, except in liquidations where the assets are no longer being used in federally illegal activities.[7] This will likely remain the case until there is a federal reclassification of cannabis under the CSA.

Changes to the CSA under the Agricultural Improvement Act of 2018

In December 2018, Congress passed the Agricultural Improvement Act of 2018 (known as the “Farm Bill”).[8] This act, among an abundance of other changes, modifies the CSA to exclude hemp from the Schedule 1-classified Delta-9 Tetrahydrocannabinol, or THC for short. For purposes of the Farm Bill, “hemp” is defined as any part of the plant Cannabis Sativa L, whether growing or not, that does not contain more than 0.3% THC on a dry-weight basis. Hemp, a form of cannabis that is naturally low in the volume of THC it contains, is a commodity in production and manufacturing. It has also become increasingly popular due to Cannabidiol, or CBD, which it contains in high volumes. It has been suggested that CBD can be used to relieve certain medical ailments such as epilepsy, inflammation and anxiety.

The hemp provisions of the Farm Bill now make it legal under federal law for operators to produce, sell and engage in interstate commerce CBD products containing 0.3% or less THC on a dry-weight basis, subject to rules to be developed by the FDA. Further, these hemp businesses are not subject to the deduction restrictions of IRC § 280E and should be able to avail themselves of protection under the Bankruptcy Code if the need arises. Still, issues remain.

Residual Issues under the Code for Hemp Businesses

The Farm Bill’s removal of hemp products containing 0.3% or less THC from Schedule 1 of the CSA would seem to eliminate the restrictions that have been applied to cannabis businesses with respect to the availability of protection under the Bankruptcy Code. However, not all hemp contains 0.3% or less THC, and hemp companies are producing products consistent with state law that have enacted hemp-legalization legislation, with THC levels that could go as high as 1%.[9]

So, what would the government’s position be if a hemp business has as its majority of production or sales of products containing 0.3% or less THC, but handles some products containing more than the 0.3% threshold? Will these companies be subject to the same restrictions noted above under the Bankruptcy Code with respect to cannabis businesses? What if they divested themselves of any offending activities prior to filing a bankruptcy petition?

Further, the Food and Drug Administration is charged with issuing guidance to the hemp industry on the distribution of food products. But that guidance might not be issued for some time, according to recent press.[10] Will the lack of FDA guidelines give pause to U.S. Trustees and bankruptcy judges if a hemp business seeks reorganization under the Bankruptcy Code?  The answers to these questions are, at best, uncertain at this time.

Looking Forward

The removal of hemp products with 0.3% or less THC content from the CSA under the Farm Bill is a welcome push forward for the hemp industry. However, the current landscape seems to suggest that there are still issues that hemp businesses may face if financial difficulties arise and they seek the protection of the Bankruptcy Code. Operators of lawful hemp businesses will have to wait for more guidance before the uncertainty is resolved.