Up in Smoke: Bankruptcy by Contract in the Legal Cannabis Industry

Access to the federal Bankruptcy Code cannot be modified by contract. Without a collective, compulsory system, creditors would race each other to the courthouse to collect on the remaining assets of a dying company. This process would hasten the company’s demise, waste value, harm some creditors, and increase borrowing costs. As a result, use of the Bankruptcy Code, without alteration, is forced upon individuals and companies, who are not permitted to voluntarily waive their rights to file for bankruptcy or alter even part of its mandatory rules. While critics of this inflexibility argue that many debtors and creditors would benefit from contractual modifications to the Code’s one-size-fits-all approach, such agreements are rare because courts universally reject them.

Nevertheless, a legal anomaly provides one industry with an exception to this otherwise ironclad rule. The cannabis industry—legal on a state level in many jurisdictions but illegal on a federal level—is essentially entirely unable to access bankruptcy protection. Courts have universally rejected bankruptcy petitions by insolvent state-legal cannabis companies, reasoning that since marijuana businesses are federally illegal, the protections of the Bankruptcy Code cannot be used to further an illegal enterprise. However, as the door to the bankruptcy courthouse has closed, another door—contracting around bankruptcy—has opened in its place. Since cannabis companies are barred from accessing bankruptcy courts, no bankruptcy court would have an opportunity to invalidate a contract regarding insolvency for altering the rights that a contract counterparty would otherwise have under the Bankruptcy Code. Cannabis companies, therefore, provide a quasi-natural experiment through which to evaluate how companies respond when given the chance to contract around bankruptcy.

My article exploits this anomaly to investigate the question of how companies deal with this bankruptcy blank slate. Scholars have written for decades about the potential benefits and drawbacks of amending, modifying, or waiving some or all aspects of bankruptcy’s otherwise comprehensive and mandatory scheme—so-called 'bankruptcy contracting.' But, because access to bankruptcy cannot be waived, there have until now been few direct opportunities to test their propositions. Yet the blanket prohibition on bankruptcy protection for the legal marijuana industry has inadvertently granted companies freedom to create contractual alternatives to bankruptcy. My article attempts to fill this void in empirical testing by relying on a novel, hand-collected data set consisting of almost 75,000 pages from 1,167 publicly-filed documents disclosed by thirty-four publicly-listed cannabis companies that each has a market capitalization greater than or equal to $25 million. By examining the legal documents that govern relationships with investors, lenders, employees, suppliers, and other contract counterparties, my article sheds light on whether, and how, companies use this unique chance to contract around insolvency.

Somewhat surprisingly, the data demonstrates that parties largely ignore the opportunity to engage in bankruptcy contracting. Analysis of the data suggests five primary conclusions. First, industry participants are aware, and largely publicly disclose, that they cannot access the protections of the Bankruptcy Code. Around two-thirds of companies expressly discuss the fact that bankruptcy protection is unavailable to them, while the majority of the remaining one-third have plausible reasons for failing to disclose. Second, despite this awareness, the data suggests that companies are mostly unwilling or unable to include contract terms that might replace or improve upon correlated provisions in the Code. Only around 6.6% of contracts contain such provisions.

Third, despite this overall rarity, bankruptcy contracting is present in around 29% of secured lending contracts (a prevalence more than four times greater than present in the overall set of contracts). Case studies of individual contracts show that sometimes bankruptcy contracting is limited, modifying individual provisions that might otherwise be applicable in bankruptcy. In other contracts, however, lenders demand wholesale procedural and substantive departures from the Bankruptcy Code. These include grants to lenders of express control over the sales process of a bankrupt company and providing them with payment rights that would be unavailable to them if their borrower had filed for bankruptcy.

Fourth, instead of bankruptcy contracting, parties more frequently engage in what my article terms 'bankruptcy structuring.' This refers to two distinct approaches that a company could use to address the fact that bankruptcy protection is unavailable to the cannabis industry: either choosing not to directly buy or sell marijuana products in the United States (although such companies could still lend or sell to marijuana companies), or to use marijuana-specific variants of the tools of corporate and organizational law (such as using separate legal entities for each cannabis license or property or special treatment of marijuana fixtures or inventory) to limit the unpredictable consequences of a bankruptcy filing. Around 44.8% of documents examined include provisions to tailor capital structures or business operations in this manner, though only around 6.5% employed marijuana-specific strategies. Finally, despite predictions or suggestions by academics who support bankruptcy contracting, no company issues any form of exotic securities that would contractually automate parts of the insolvency process.

My article concludes by considering why bankruptcy contracting is rare, bankruptcy structuring is more common, and such strategies are concentrated in secured lending documents. Bankruptcy contracting could be more common in secured lending agreements because of lenders’ heightened negotiating leverage and sophistication, greater financial stakes, and longer-term relationship with the borrower. However, for most parties, it may be that informational and transactional costs make bankruptcy contracting inefficient. If bankruptcy contracting is seen as too costly, then parties will not engage in it; at the same time, if structuring is cheaper and provides some of the same benefits, parties may choose to use structuring instead. Relatedly, the gains from bankruptcy contracting may be marginal when compared with the overall uncertainty faced by industry participants across a whole host of dimensions—liens, policy enforcement, tax, intellectual property, contract, and, yes, insolvency. This, in turn, suggests that limited bankruptcy contracting and more frequent bankruptcy structuring form part of a broader strategy used by cannabis companies and their counterparties to reduce overall uncertainty. In an industry that faces as many legal and regulatory hurdles as the marijuana industry, any attempt to reduce overall uncertainty might be preferable to customized contracts. By showing how legal cannabis companies use, or fail to use, their freedom of contract to tailor results in insolvency, my article provides evidence of the limits and potential inequities of bankruptcy contracting.

The author's complete article has been published in Volume 98 of the American Bankruptcy Law Journal, available here.

William A. Organek is an Assistant Professor of Law at the Zicklin School of Business, and is the Managing Editor of the Harvard Law School Bankruptcy Roundtable.