Many companies in the cannabis industry currently face substantial financial distress caused by oversupply and pandemic-related stay-at-home and retail closure orders. Unfortunately, non-hemp cannabis companies cannot obtain bankruptcy relief under federal law. Due to the unique position of cannabis—legal under the laws of many states, but illegal under the federal Controlled Substances Act (“CSA”)—“a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a debtor whose activities constitute a continuing federal crime.” This position not only harms insolvent cannabis enterprises, but also harms their creditors by preventing a controlled, court-supervised wind-down or reorganization. Landlords that have helped expand the industry through sale-leaseback financing (“SLF”) stand to be particularly hurt by disorderly liquidations and they cannot rely upon the federal bankruptcy laws for guidance. Although the law on this subject remains hazy and the following suggestions are untested, savvy landlords can include specific provisions in their leases that could protect them if their tenants encounter financial difficulties.
Permitted uses
Bankruptcy judges have almost universally dismissed bankruptcy filings for businesses engaged in cannabis cultivation, distribution, or sale, finding that bankruptcy courts cannot be used to aid businesses operating in violation of federal law. Yet, cannabis SLF leases commonly restrict the use of leased property to just these uses, and no other purposes. A lease providing that a landlord can unilaterally change the permitted use of the premises upon a tenant default could provide a workaround that may be supported by case law and may be especially useful for retail locations.
Courts have noted that the question of dismissal turns on the debtor’s behavior during the bankruptcy case, rather than in the period leading up to the bankruptcy filing. Therefore, including language in a lease permitting the property to be used for any purpose upon default, and not merely for a purpose that violates the CSA, may allow a tenant-debtor that changes the nature of its business access to the bankruptcy court and improve outcomes for landlord and tenant. Of course, such a strategy may be more viable for a prominently located retail dispensary that could readily be used to sell other items than a remote cultivation facility, and any court will likely scrutinize the facts surrounding any conversion of the permitted use. Thus, landlords and tenants should make clear in the lease and in their course of conduct that the possible change of use is an essential part of the negotiated business deal between the parties.
Asset forfeiture
In addition to possibly precluding access to bankruptcy courts, a tenant’s ongoing violation of the CSA could subject its assets to civil forfeiture. Ownership of items such as cannabis grow systems, display cases, and other cannabis-specific personal property is often a heavily negotiated aspect of any cannabis SLF, since these items typically constitute a large part of the value unlocked through the transaction. Additionally, some cannabis leases permit landlords to seize such property upon a tenant default. However, mere possession of these items could subject the possessor, including the landlord, to federal forfeiture proceedings.
Landlords can implement several strategies to reduce these risks. Ideally, tenants would retain ownership of property that could be forfeited. Alternatively, if the business deal between the parties calls for the landlord to monetize, and take ownership of, the cannabis-specific property, then the landlord should be permitted to exercise a put option for a nominal sum to transfer ownership back to tenant upon a lease default. As further protection for a landlord, upon a tenant default a landlord should be permitted to dispose of any cannabis-specific property or inventory or force the tenant to sell such property to a licensed third party to satisfy its lease obligations. A landlord could even try to place a lien on the proceeds of the sale of any operating licenses held by a tenant for the premises. Tenants should also expressly agree that they are not entitled to reimbursement for property so removed or sold. Furthermore, the value of forfeited property, any property sold back to the tenant under the put option, and any costs incurred in enforcing these rights, should all be included as additional rent. Ultimately, these additional obligations should be expressly backstopped by any lease guarantor. Although the availability of some of these remedies may vary from state to state, in general these strategies should insulate an SLF landlord from both forfeiture risk and risk resulting from tenant’s inability to obtain bankruptcy relief.
Predetermined financial distress processes
Without bankruptcy protection, a tenant’s other creditors may quickly seek to foreclose on any viable tenant assets, possibly leaving a landlord without financial compensation following a default. Seeking to avoid such a “race to the courthouse,” some states have created receivership programs for cannabis companies. While inferior to federal bankruptcy law and varying greatly from state to state, these mechanisms can provide some protection for landlords, especially when coupled with protective lease provisions.
Upon a tenant default, a landlord should be permitted to place a tenant in state receivership and the tenant should agree in advance not to oppose the landlord’s receivership motion unless tenant can demonstrate that such a filing is manifestly inappropriate. In addition, any receiver should be selected by the parties in advance and have the appropriate state licenses needed to operate a cannabis business. Finally, tenants should be required to bear all costs for any such appointment and administration, including any bonds that might need to be filed to secure obligations under the receivership process and any additional costs needed to appoint a properly licensed receiver. As with asset forfeiture, all of these costs should be added to additional rent and secured by any lease guaranty. These additions should help mitigate some of the cost and uncertainty that a landlord may face in a state-authorized receivership process.
As long as non-hemp cannabis remains illegal under federal law, cannabis tenants may be unable to seek federal bankruptcy relief. Therefore, landlords must take steps to protect themselves in advance of tenant financial distress. Landlords can include lease provisions, like those suggested above, to either increase the likelihood that a cannabis tenant could file for bankruptcy protection, or to reduce the risks to its property and business if an alternative is used.
Claudia Springer is a bankruptcy partner and chair of the cannabis law team and William Organek is an associate with the law firm Reed Smith.
