If finalized, the Drug Enforcement Administration’s (DEA) recent recommendation to reclassify cannabis from a Schedule I to a Schedule III substance has the potential to open important doors to businesses in the legal marijuana industry.

Unfortunately, they don’t include the doors to the federal bankruptcy courts.

Companies or individuals involved in the legal cannabis business will continue to face an uphill battle to gain access to bankruptcy courts until the Controlled Substances Act, which declares the manufacture, distribution and possession of controlled substances unlawful, is modified. In the simplest terms, that’s because the Bankruptcy Code generally forbids the use of bankruptcy system in the service of an illegal enterprise.

There is certainly some nuance, but until there are federal laws and regulations for companies to follow regarding cannabis, access to the bankruptcy courts will remain limited, even if there are signs of change on the horizon.

The Schedule Change

The proposed change would move cannabis to a less-regulated rung on the DEA’s Drug Schedules. Schedule III drugs are defined as drugs with a moderate to low potential for physical and psychological dependence. The list includes drugs like Tylenol with codeine, anabolic steroids, and ketamine. Schedule III drugs are less regulated than Schedule II drugs, which include drugs like Adderall and oxycodone. Scheduled drugs can only be prescribed by DEA registered practitioners.

Moving cannabis from Schedule I to Schedule III would not bring the legal medical or recreational cannabis industry into compliance with the federal controlled substances law. The manufacture, distribution and possession of cannabis would still be illegal under federal law even as a Schedule III drug until there is legislation that legalizes and regulates it. If cannabis is moved to Schedule III, presumably there will be future regulations allowing for research and possibly medical treatment. However, as Ziva Cooper, director of the UCLA Center for Cannabis and Cannabinoids told PBS, “It’s going to be really confusing for a long time.”

Smoke Signals from Recent Bankruptcy Court Opinions?

For the industry to obtain full access to bankruptcy relief, Congress or the executive branch would need to change the status of cannabis under the Controlled Substances Act (21 U.S.C. § 801 et seq.). The Controlled Substances Act makes it “unlawful for any person knowingly or intentionally to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.” 21 U.S.C. § 841(a)(1). The federal bankruptcy system may not be used as an instrument in the ongoing commission of a crime and plans of reorganization that permit or require continued illegal activity may not be confirmed pursuant to 11 U.S.C. § 1129 and debtors may face dismissal under 11 U.S.C. § 1112.

Section 1129 of the Bankruptcy Code requires that a bankruptcy plan must be “proposed in good faith and not by any means forbidden by law.” Moreover, the federal watchdog — the Office of the United States Trustee — has consistently and successfully taken the position that estate fiduciaries should not be required to administer assets in violation of federal law despite cannabis being legal on a state level, see Arenas v. U.S. Tr. (In re Arenas), 535 B.R. 845 (B.A.P. 10th Cir. 2015)

However, recent case law shows that some courts may be willing to overlook a debtor’s involvement with the cannabis industry, depending on whether the involvement is ongoing. In In re Hacienda Co., the U.S. Bankruptcy Court for the Central District of California denied the United States Trustee’s motion to dismiss a debtor who proposed, as part of a plan of reorganization, to sell equity it had in a publicly traded Canadian cannabis company. The court focused its analysis on whether the violations of the Controlled Substance Act were pre-petition or post-petition and also whether the possible conversion of the case to a chapter 7 would require a trustee to violate the Controlled Substances Act. The court noted that the bankruptcy code did not adopt a “zero tolerance” policy for illegal activities and instead explained that cases involving illegal activities still served important tenets of the bankruptcy code, including preservation of assets and fair distribution. The court supported this reasoning by referencing some of the largest business bankruptcy cases, including Enron and Bernie Madoff, which involved alleged or actual criminal activity but were not dismissed. The court ended by emphasizing that courts do have discretion to dismiss cases related to illegal activity, but only when it would compromise the integrity of the bankruptcy system.

In Burton v. Maney, the Bankruptcy Appellate Panel (BAP) for the 9th Circuit simultaneously affirmed a dismissal of a debtor who was involved in the cannabis industry while also holding that “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” Burton v. Maney (In re Burton), 610 B.R. 633, 637 (B.A.P. 9th Cir. 2020). The BAP focused, similarly to the court in Hacienda, on whether continuation of a case would require the court, trustee or debtor in possession to administer assets or proceeds that were illegal under the Controlled Substances Act. In this case, the BAP affirmed the bankruptcy court’s finding that the debtor’s interest in a cannabis company constituted an illegal business becoming part of the bankruptcy estate. This involvement was a bridge too far for the bankruptcy court, but the BAP reiterated this was a matter of the court’s discretion, indicating that dismissal was not a bright-light rule.

The Real Greenery: Rescheduling’s Effect on Tax Treatment

The cannabis industry may see an explosion of profitability if cannabis is rescheduled to Schedule III, but this is due to the tax treatment rather than access to bankruptcy. Currently, under 26 U.S.C. § 280E – a business engaged in the prohibited trafficking of Schedule I or II drugs may not take any deductions on its federal tax return. Changing cannabis to a Schedule III drug would mean cannabis companies could take deductions on their federal tax returns, a move that may drive up profits and investment interest. This change in tax treatment combined with the possible passing of the SAFER Banking Act, which would allow federally regulated financial institutions to provide banking services to a state-sanctioned marijuana business without being penalized, may heat up the cannabis industry.

Where there’s investor interest, there are entrepreneurs, and where there are entrepreneurs, there’s bankruptcy. Potential investors will want to keep in mind the restrictions the bankruptcy code places on cannabis companies. The rules and therefore risks are different, this will not change even if cannabis is rescheduled.

Key Takeaways

• The manufacture and distribution of cannabis continues to be illegal under federal law.
• The pre-petition violation of this law may not be a deal breaker when it comes to bankruptcy courts, but continued violations likely are. In other words, a cannabis company that wishes to continue as a cannabis company will not be able to seek bankruptcy protection.
• Rescheduling will likely increase profits and therefore investor interest.

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