As previously reported here, bankruptcy courts appear increasingly willing to allow debtors with businesses related to the cannabis industry to file for bankruptcy, as another bankruptcy court recently denied a motion dismiss a cannabis-related bankruptcy.

In In re Callaway (Bankr. N.D. Cal. 2024), the bankruptcy court refused to dismiss a Chapter 7 bankruptcy case in which the debtor owned LLC membership interests in cannabis-related business. The court determined that “administering the ownership interests of LLCs that engage in marijuana business is not necessarily equivalent to administering marijuana assets” and that a Chapter 7 trustee’s “own personal determination that he cannot lawfully administer the assets of this case is insufficient cause to dismiss the debtor’s case as there are other options for the trustee.” 

Background

The debtor owned and operated 100% of Caliverde, LLC (“Caliverde”) and 40% of Grassy Castro, LLC (“Grassy Castro”), which were both retail cannabis dispensaries in San Francisco, California. The debtor claimed that he was entitled to distributions from Grassy Castro “in the ballpark” of $700,000.

The U.S. trustee and a creditor filed separate motions to dismiss for “cause” because “the assets of the estate are comprised of or derived from cannabis.” The U.S. trustee more specifically argued the “debtor ‘possesses and controls an interest in cannabis assets and business ventures that are in violation of the Controlled Substances Act ["CSA"] . . . and which a Chapter 7 trustee cannot lawfully administer.’” Essentially, “[t]he Chapter 7 trustee cannot lawfully administer assets in violation of the CSA, and continuation of the case would force the Chapter 7 trustee into such a position.” 

The Chapter 7 trustee also joined in both motions and argued “although a Chapter 7 trustee would like nothing more than to be able to administer an asset case, it is clear that he would be subject to prosecution in any attempt to administer the assets of this particular estate.”

The Controlled Substances Act

The court observed that the Controlled Substances Act (the “CSA”) “is a statutory scheme that regulates nearly every facet of the manufacturing, distribution and dispensing of controlled substances.” The court further observed that “[f]or now, marijuana products remain a Schedule I controlled substance under the CSA, the most tightly regulated classification of controlled substances.”

“Cause” for Dismissing a Bankruptcy Case

However, despite the provisions of the CSA, the court recognized that “[t]here is a ‘stated reluctance in this Circuit to adopt per se bright-line rules requiring the immediate disposition of bankruptcy cases in which marijuana activity is present’” and that “Congress did not adopt a ‘zero tolerance’ policy that requires dismissal of any bankruptcy case involving violation of the CSA (or other activity that might be proven to be illegal.)" 

Distinguishing Chapter 7 from Chapter 11 Cannabis Cases

The court noted that many of the decisions dismissing cannabis cases “arise in Chapter 11 or Chapter 13.” In those cases, the courts dealt with “the actual or anticipated post-petition conduct expected of the debtor, the debtor-in-possession or the Chapter 13 trustee, almost entirely in the context of use of income or funds from businesses that are in violation of the CSA during Chapter 11 reorganization or administration of a Chapter 13 plan.”

A Chapter 7 case presents a “different and difficult issue:” “whether the bankruptcy court and the court appointed bankruptcy trustee should play a role in the continued administration of income derived from a marijuana business.”

Court’s Ruling

1. The debtor was distinct from the cannabis businesses.

The court began its analysis by finding a lack of cause for dismissing the case because the debtor did not: (i) “receive rental income from a marijuana business;” (ii) “personally cultivate marijuana;” nor (iii) “hid[e] his interests in marijuana business.” Moreover, there was no “indication that [the debtor’s] bankruptcy filing was part of a litigation strategy other than stemming the tide of a run-of- the-mill contract dispute . . .” 

2. The debtor was legally separate and distinct from the marijuana businesses. 

The court next recognized that the debtor was considered “separate from the entities that engage in the marijuana business,” and, therefore, “the trustee is not in danger of having to administer the actual tangible marijuana assets held by those businesses.” 

Specifically, under California law, corporate shareholders do not “own the corporate property nor the corporate earnings.” Rather, a shareholder “simply has an expectancy interest in each, and he becomes the owner [upon a liquidation action or declaration of a dividend].” 

3. The sale of the debtor’s equity interest in Caliverde.

As to the sale of Caliverde, the court found that the “sale of the ownership of Caliverde, including its name, goodwill customer list and other intangibles . . . do not on their face appear to implicate the CSA.”  

Rather, “any potential sale of a membership interest in an LLC is just that—the sale of an ownership interest whose rights are bundled in applicable articles of incorporation or operating agreements.” 

Accordingly, the “possible sales of interests in LLCs, enforcement of LLCs’ contractual rights and sale of other intangibles related to marijuana” are “not directly implicated by the language of the CSA [and] are not sufficient for this court to find cause to dismiss an otherwise eligible individual debtor’s Chapter 7 case.”

4. The distribution claims against Grassy Castro.

As for the distribution claims against Grassy Castro, the court observed that just like a sale of an LLC membership interest is not necessarily the proceeds of a marijuana business, so too, “a claim against fellow LLC owners for owed proceeds are not necessarily a claim for the profits of a marijuana business.” Rather, it is “a claim for the entitlements owed to the holder of ownership interests.”

The court also noted that “[w]hile it is true that realizing profits from a marijuana business is prohibited by the CSA, there is nothing presented by the parties, nor discovered by the court, that suggests that monetizing an intangible ownership interest is the equivalent of profiting from a marijuana business.“

The court analogized liquidating the intangible claim to monetizing the domain name of a marijuana business, observing: “no party has suggested, nor does the court know of a reason, why the trustee would violate the CSA or any other law were he to offer to sell, and actually sell, such intangible assets of the estate such as domain names.”

Options Available to Chapter 7 Trustee

The court opined that the Chapter 7 trustee had “many tools in the bankruptcy toolbox,” which include:

1. Blocking the discharge for debtors who “misbehave pre- or post-petition.”
2. Under 28 U.S.C. § 586(a)(2), if the Chapter 7 trustee chooses not to continue in that role, and no other private panel member will do so, the U.S. trustee could step in and act as case trustee.
3. The trustee could abandon assets, which frees the trustee from administering assets. 

Takeaways

While the Callaway decision came in the context of a Chapter 7, the court’s rationale may also be applicable in a Chapter 11 when a cannabis-related debtor seeks to liquidate or sell its business in bankruptcy. As the court noted, simply selling an interest in a cannabis-industry company does not in itself violate the CSA. Of course, the law in this area is not settled and there is no binding precedent on this issue. Accordingly, subsequent decisions could result in a very different outcome than Callaway.