The federal bankruptcy process, or even the looming threat of a bankruptcy, can be of enormous utility to a struggling business. In addition to the ability to restructure debt, the bankruptcy process affords businesses certain legal rights and protections that can be invaluable in securing sufficient time to attempt to turn things around or conduct an orderly liquidation of their assets. Because the process can be expensive and often time consuming, creditors are incentivized to attempt to come to an amicable resolution of their claims in order to avoid a filing.

Unfortunately, these valuable benefits are not available to cannabis enterprises. The classification of marijuana as a Schedule 1 drug under the Controlled Substances Act renders the cultivation, sale or use of marijuana for any purpose a crime. See 21 U.S.C. Sections 802, 813 (definitions of "controlled substance" and schedules). Further, enterprises that knowingly "aid and abet" the commission of a crime are also at risk of being prosecuted for conducting criminal activity. See 21 U.S.C. Section 841(h)(1)(B) (aiding or abetting distribution or manufacture under the CSA). They may also find themselves unable to access the federal bankruptcy laws to assist them in a restructuring or liquidation. Because the Bankruptcy Code is a federal statute, it is unavailable to enterprises that derive their revenues from activities that are in violation of federal law. Many cannabis companies—including some of the largest players—have recently begun showing signs of financial distress. Most, if not all, states have statutes that are available to companies or creditors of companies that are insolvent. This article deals with the following legal conundrum: with the most powerful avenue of relief closed to them, what is a financially distressed Pennsylvania cannabis company to do?

One option is the out-of-court workout. At first blush, this may seem to be a less likely option for a creditor to consider. After all, the creditor knows that their borrower cannot resort to the bankruptcy process for relief from its financial obligations. Why, then, would the creditor consent to a voluntary restructuring of debt rather than declaring a default and invoking its corresponding remedies? Without very much leverage existing on the other side of the negotiating table, it would appear that the cannabis enterprise would be at its creditors' mercy.

The answer largely lies in one statutory provision. The Pennsylvania Medical Marijuana Act (the MMA), 35 P.S. Section 10231.101 et seq., requires that a company secure a permit before it is allowed to serve as a marijuana grower/processor or dispensary. The process for obtaining a permit is difficult, expensive and uncertain to result in success. The MMA requires that applicants submit to lengthy background checks of their principals, employees and financial backers. The permits are geographically restricted, with Pennsylvania having established six distinct regions for permitting purposes. A single applicant may only hold up to five individual dispensary permits (each of which allows for operation of three dispensary locations in its designated region), and no more than one grower/processor permit. As of now, Pennsylvania has granted only 25 grower/processor permits and 50 dispensary permits, which are the maximum numbers currently permitted by Section 616 of the MMA. The permits were issued in two waves, dubbed "Phase I" and "Phase II."  According to the Pennsylvania Department of Health, there were 167 applications for dispensaries and 91 applications for growers/processors for Phase II permits. This was in addition to the 283 applications for dispensaries and 179 applications for growers/processors in Phase I. Once obtained, Section 603(b) of the MMA provides that such permits may not be transferred. The company's most valuable asset—the permit—is therefore essentially tethered to that company.

Because of the transfer prohibition, the permit cannot merely be executed upon and then appropriated by a creditor like any other asset. The creditor would seemingly need to apply for a permit of its own, and the approval process would entail potentially significant legal and administrative time and expense. It is possible that a creditor may be able to foreclose on the stock or limited liability interests of the debtor company (if the company has pledged its stock or limited liability interests), and thereby indirectly gain control of the permit by obtaining ownership of the company. In this scenario, the entity owning the permit would not change—only the control of the entity itself changes. However, as illustrated by Harvest Health's attempts to purchase CannaPharmacy in 2019, the Pennsylvania Department of Health (DOH) adamant that control of the permits remain with its approved applicant, and it is willing to rescind permits if it believes the owners thereof have abused the process. Harvest eventually opted not to consummate that transaction, so the question of whether the permit would have remained valid with new owners of the company was left unresolved. Harvest had also notably crossed swords with the DOH over exceeding the limit of allowed dispensary permits. It did so by entering into management services agreements with other dispensaries, reasoning that it had not been granted more permits than the MMA allowed. The DOH disagreed, which led Harvest to relinquish permits that exceeded the allowed limit. Therefore, foreclosing on the cannabis permit, or even the stock of the permit owner, may not provide the relief sought by the creditor—usually a recovery of its debt.

Any other assets that could be seized, such as the plant itself, would not be saleable without the requisite permit to operate the business. For example, if a creditor holds a mortgage on land used to grow cannabis, what value can be derived from foreclosing on the mortgage if the land may not be used for that same purpose? The value may be significantly lower than if the permit were transferrable to the new owner. With the relatively small number of state sanctioned growers and distributors in Pennsylvania, it may also be difficult to find a buyer and arrange a favorable sale of assets after execution. If the creditor holds a pledge of the stock of the company that owns the permit, the creditor may be able to foreclose on the stock. However, foreclosing on the stock then makes the buyer of the stock the owner of the entire business—its assets as well as its liabilities—and would not necessarily be a desired result. Faced with these limited options, the creditor may conclude that its best prospect of repayment is enabling the cannabis company to remain in business with the hope of an eventual turnaround.

There is another reason to consider avoiding the courts. In Pennsylvania, as in many states, laws designed to assist insolvent companies with regard to their creditors are often not as well developed as the federal bankruptcy statute. For most distressed companies, the preferred choice of relief is through the federal bankruptcy process; it is well developed, with numerous cases that resolve most questions arising under it and is administered by courts that are very familiar with the law. State laws that deal with similar issues are not as well developed and state court judges do not have nearly the same level of experience deciding disputes that arise under those statutes. Further, because the body of law in most states is not as well developed as is the Bankruptcy Code, individual judges have more flexibility on the types of relief that may be granted to both debtors and creditors. There is less precedent for the judge to be bound by, or for counsel to be guided by. The fact that state law remedies are not widely used also lends itself to the possibility that policy positions may influence how any court case is handled. This hazard seems especially pronounced in politically charged matters such as the treatment of cannabis enterprises. When the outcome of any case may be so uncertain, the parties may want to give added consideration to court involvement.

If an out-of-court workout is impracticable or if disputes are not able to be hammered out without litigation, then the choices essentially narrow down to two paths. The creditor's first option is to secure its judgment and then execute on it. As discussed above, in Pennsylvania, the benefit to be realized from this route is subject to several variables. The circumstances surrounding the creditor, the cannabis enterprise, the state administration and the medicinal marijuana market will all weigh on how this process plays out. Given the inconsistent and unpredictable results that may occur, a creditor may opt for the ostensibly safer alternative. This would be the appointment of a receiver.

A receiver may be appointed upon the filing of a complaint against an insolvent entity and the showing of equitable cause. In Pennsylvania, the standard for obtaining this relief over a debtor's objections is quite difficult to achieve. Even if a creditor can point to language in a contract that enables it to have a receiver appointed, courts usually view this as an extraordinary remedy that is available only in "emergencies," such as upon a showing of malfeasance or fraud by the debtor or its principals. If appointed, the receiver will act as a fiduciary of the entity, operating it in the interests of maximizing the value of its assets and ensuring that its creditors are paid. Its powers are dictated by the order entered by the court. In short, the receiver acts essentially in a similar manner as a trustee in bankruptcy. Superficially, this may appear to be the best course of action. The company may be preserved as a going concern, but with new management installed with a specific duty to maximize value for the company and its creditors, rather than only for the creditor itself.

While there are undoubtedly some benefits to the state court receivership, closer examination also reveals some less desirable considerations. Firstly, the standards for having a receiver appointed without the debtor's consent are difficult to meet. Further, given the nature of the business and the federal illegality of it, finding a receiver willing to serve as such may not be an easy task. To be effective, the receiver should have some familiarity with the industry in which the company operates. Because there is currently a scarcity of cannabis enterprises operating legally in Pennsylvania, there may be a shortage of suitable candidates available to operate a cannabis enterprise as a receiver. While persons involved in other cannabis enterprises may be available to serve in this capacity, they may be conflicted given their other business relationships. There is also the issue of compensation for the receiver, which would be a cost indirectly borne by the creditor because the company may have fewer funds from which to pay its debts. If the receiver is appointed without notice pursuant to Pa. R.C.P. 1533, then the moving party must also post a bond with the court, adding additional expense.

The issue of uncertainty is also of enormous concern. The Pennsylvania receivership law, 39 P.S. Section 35, has been infrequently invoked since adoption of the Bankruptcy Code. Its lack of a predictable outcome is a deterrent to many creditors. Cannabis-specific issues of uncertainty also exist. For instance, do the permit requirements for operating a cannabis company also extend to a receiver? Will the state consent to a person who was not involved in the permit process overseeing a cannabis business?  These are questions that, for now, have no clear answer.

While the options discussed above are primarily from the view of a creditor, this is only because there are very few alternatives for the company itself unless it can find funds to resuscitate its business. The company could consent to the appointment of a receiver, but this cedes control of its operations. The company could also offer to retain a chief restructuring officer in lieu of a receiver, but this would itself likely only be part of a broader workout plan, and the chief restructuring officer may need to be vetted by the state. Finally, the company could simply allow the creditor to foreclose. Given the time, expense and difficulty that goes into securing a permit to grow or sell cannabis in Pennsylvania, it is extremely unlikely that the enterprise would view this as a desirable outcome. The lack of the bankruptcy option for cannabis enterprises and the fact that some are already experiencing cash flow challenges indicates that debtors and creditors will need to work together if they want to try to salvage value. For the time being, at least, the best way to navigate this uncertain terrain may be cooperatively.

Claudia Springer is a leading restructuring and bankruptcy attorney at Reed Smith who has practiced law in this area for almost 40 years. Two years ago she started the cannabis law team at the firm, which she chairs. The team has over 40 lawyers firmwide and has represented numerous parties who have a variety of connections to the cannabis or CBD industry. 

James Britton is an associate in the firm's financial industry group. He focuses his practice on corporate restructuring and insolvency matters, helping creditors successfully navigate the bankruptcy process and ensure that their claims are paid.