The U.S. Bankruptcy Code provides relief to debtors to maximize value for the benefit of their creditors and other stakeholders. Such relief is extremely limited when debtors are state-legalized marijuana businesses, as they are denied access to Bankruptcy Courts because the manufacture, distribution, and dispensing of marijuana remain federal crimes under the Controlled Substances Act (CSA), 21 U.S.C Sections 801-971.1
Although the manufacture, distribution, and dispensing of marijuana is currently legal in many U.S. states on the state level, the federal government's designation of marijuana as a controlled substance supersedes contrary state law through application of the commerce clause.2
The Drug Enforcement Agency (DEA), a department of the Department of Justice (DOJ), is the primary federal agency that enforces the CSA and related federal laws. In the last decade a series of memorandums were issued to provide specific guidance and recommendations relating to CSA enforcement, which included, among other things:
- Prioritizing the investigation and prosecution of significant drug traffickers
- Clarifying that the use of federal funds to enforce the CSA against cancer patients or their caregivers may not be efficient
- Clarifying specific enforcement priorities involving the possession, production, and sale of marijuana relating to noncompliance of other state laws and threats to public safety and health
- Providing guidelines to financial institutions
- Rescinding previous guidelines on enforcement and directing federal prosecutors to use discretion and weigh all relevant factors in their investigations and prosecutions3
The Office of the United States Trustee, also a department of the DOJ, has taken the position that a marijuana-related business cannot seek relief under the Bankruptcy Code because the business itself violates the CSA, regardless of whether such business operations are legal under applicable state law.
The direct consequence to these limitations is that U.S. businesses and individuals involved in the cannabis industry and facing financial distress may not seek bankruptcy relief under the Bankruptcy Code, and if they try, they will face a prompt exit. Yet, as more states continue to legalize/decriminalize marijuana, it is likely that more marijuana-related businesses will enter this industry, where some will face distress but with few avenues to restructure, reorganize, and/or liquidate.
The tension between state laws that legalize or decriminalize marijuana on the one hand, and the CSA's enforcement of marijuana as a controlled substance on the other, can be understood by reviewing decisions made by U.S. Bankruptcy Courts when they have been faced with marijuana-related businesses or individuals who sought relief under Chapter 7, 11, or 13 of the Bankruptcy Code. Bankruptcy Courts generally find that because marijuana violates the CSA, businesses or individuals may not seek relief under the Bankruptcy Code, regardless of whether the state in which the business operates or the individual resides and regardless of whether the particular debtor is directly (such as cultivators and dispensaries) or indirectly (such as landlords) engaged in marijuana.
Decisions in the Plan Context
A number of courts have addressed this issue in the context of the plan process, where the courts found the plan filed by the applicable debtor, while statelicensed to grow/dispense marijuana, did not comply with the two Bankruptcy Code sections that required that the plan (i) be proposed in good faith and not by means forbidden by law, and (ii) be feasible.4 The courts found that because the applicable debtors were engaging in conduct that violated federal law and the funding of the plan would come from income generated from such illegal conduct, the requirements of Sections 1129(a)(3) and (11) would not be met. Both courts dismissed these cases.
Similarly, in In re Arm Ventures, 564 B.R. 77, 84 (Bankr. S.D. Fla. 2017), where the debtor was a commercial landlord with a tenant that had sought (but not yet obtained) federal and state approval to grow and sell marijuana, the Bankrupt Court found the plan was not feasible and was not filed in good faith, as the plan was based on funds that included future rents from this tenant.
Decisions Involving 'Unclean Hands'
Related to the good faith argument, some courts have concluded that a debtor that engages in an illegal business is not eligible for relief, as it enters the court with "unclean hands." For example, in In re Rent-Rite Super Kegs W. Ltd, the court found that the debtor's lease of warehouse space to tenants who were state-licensed to cultivate marijuana (representing one quarter of its rental income) was an ongoing criminal violation of the CSA and also put the debtor's secured creditor's collateral at risk, justifying the application of the unclean hands doctrine. 484 B.R. 799, 807 (Bankr. D. Colo. 2012).
These facts, coupled with the debtor's inability to satisfy Section 1129(a)(3) of the Bankruptcy Code—as any plan would rely on revenue from illegal activity—warranted "cause" for dismissal of the case, even though (i) the debtor's business was legal under its state law (Colorado) and (ii) the court recognized that federal prosecutors may exercise their prosecutorial discretion to decline to seek indictments under the CSA where the federal illegal activity is legal under applicable state law. Id. at 802-05.
Similarly, in In re Basrah Custom Design Inc., the court found that the debtor's lease of space to a statelicensed medical marijuana dispensary violated the CSA and thus triggered the application of the unclean hands doctrine that warranted "cause" for dismissal of the case. 600 B.R. 368, 382 (Bankr. E.D. Mich. 2019).
Decisions Regarding Estate Administration
Another basis for the dismissal of cases where the debtors were state-licensed to grow/dispense marijuana is the inability of a Chapter 7 or Chapter 13 trustee to administer the estate case or plan with assets that relate to illegal activity. See Arenas, 535 B.R. at 848. In contrast, the court in In re Write, (Not Located) rejected the U.S. Trustee's argument that Chapter 7 was unavailable to the debtors (state-licensed growers for sale to medical clinics), finding that the ability to liquidate an estate is not a prerequisite to a discharge.
Decisions Over 'Direct' vs. 'Indirect' Connections
While it is clear that the majority of courts do not allow individuals or businesses directly engaged in marijuana activities to seek relief under the Bankruptcy Code, some courts have recognized the distinction between direct and indirect marijuana activities. Direct engagement cases include (i) In re Arenas, where the debtor grew and sold marijuana and leased its property to a marijuana dispensary and (ii) Rent-Rite Super Kegs W. Ltd., where the debtor was a landlord that derived about 25% of its rental income from a marijuana grower.
Although the court in In re Way to Grow, Inc., 597 B.R. 111, 123 (Bankr. D. Col. 2018) dismissed the case as the debtors sought to expand their supply business in the cannabis industry in states where such operations were legal, it did find that the debtors were indirectly violating the CSA, as most of its current customers were not in the cannabis industry.
As some refer to as the "outlier case," the court in Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019) interpreted Section 1129(a)(3) to mean a plan must not be proposed in an unlawful manner. The court found that such provision did not preclude confirmation of the plan that contained substantive provisions that are premised upon illegality, such that a court only is required to look at the plan proposal and not the terms of the plan for purposes of plan confirmation. In Garvin, the court confirmed a plan that included a continuing lease to an entity growing marijuana. It is worth noting that the debtor was not engaged in the cultivation, production, or distribution of marijuana.
Decisions Advocating Flexibility
Despite the few bright-line rules that have emerged from decisions published to date, some courts have favored the need for flexible latitude to deal with variations, as opposed to bright-line rules. As advocated by the court in In re Burton, 610 B.R. 633, 638 (B.A.P. 9th Cir. 2020), a Bankruptcy Court should "be explicit in articulating its legal and factual bases for dismissal in cases involving marijuana"5 and not take the approach that the mere presence of marijuana automatically prohibits a debtor from bankruptcy relief.6
As explained in In re Olson, this articulation should include an evaluation as to whether and how the debtor was actually violating the CSA and/or why dismissal of the case was necessary. 2018 WL 989263 at *6 (Tighe, J., Concurring). The court in Olson also recognized the increasing need for courts to address the needs of litigants who are in compliance with state law while not excusing activity that violates federal law. Id. at *6.
Similarly, the court in In re Malul recognized the evolution of case law and that potential CSA violations will be highly factual and specific. 614 B.R. 699, 714 (Bankr. D. Col. 2020). Similarly, although it ultimately dismissed the Chapter 11 case, the court in In re CWNevada LLC recognized the possibility that Chapter 11 relief could be appropriate for an individual or entity directly involved with marijuana-related businesses. 602 B.R. 717, 747 (Bankr. D. Nev. 2019).
Bankruptcy Courts Are Sympathetic
While a majority of courts have dismissed cases where the debtor was involved in marijuana-related businesses, many have expressed empathy for debtors that are in need of bankruptcy relief but face little to no practical alternatives. Way to Grow, 597 B.R. at 132.
In In re Arenas, the court was sensitive to the fact that the joint debtors, licensed in Colorado to grow and dispense marijuana, "have not engaged in intrinsically evil conduct" but could not seek bankruptcy relief "because their marijuana business activities are federal crimes." 535 B.R. at 849, 850.
The court in Way to Grow, 597 B.R. at 132, acknowledged that the debtor did not seek bankruptcy in bad faith and "[b]ut for the marijuana issue, this would be a relatively run-of-the-mill Chapter 11 proceeding." 597 B.R. at 133. The court stated further that "if the result in this case is unjust, Congress alone has power to legislate a solution." Id.
The court in In re CWNevada LLC went further to state until Congress does so, "all parties engaged in or having a significant connection with the marijuana industry face a creeping absurdity" as they can rely on state law to expand businesses and investments, yet such businesses "expose all of them to possible federal criminal prosecution," as well as create uncertainty for states and local governments that receive taxes from such businesses. 602 B.R. at 739-40.
One court aptly summarized the dilemma as follows:
If the uncertainty of outcomes in marijuana-related bankruptcy cases were an opera, Congress, not the judiciary, would be the fat lady. Whether, and under what circumstances, a federal bankruptcy case may proceed despite connections to the locally "legal" marijuana industry remains on the cutting-edge of federal bankruptcy law. Despite the extensive development of case law, significant gray areas remain. Unfortunately, the courts find themselves in a game of whack-amole; each time a case is published, another will arise with a novel issue dressed in a new shade of gray. In re Mulul, 614 B.R. at 701.
What's a Marijuana-Related Debtor to Do?
While there may be creative ways for a debtor involved with state-legalized marijuana activities to be eligible for bankruptcy relief,7 on a practical level, alternatives to bankruptcy protection remain dismal. These limitations also harm creditors, as they, too, are denied their benefits of bankruptcy relief, including the maximization of asset value, equality, and transparency.
Many in the turnaround and restructuring industry appreciate how the Bankruptcy Code provides unique and powerful tools that are not otherwise available outside of the official bankruptcy process. Unless or until changes are made to federal law, distressed companies and individuals in the cannabis industry will continue to face uncertainty and limited bankruptcy relief.
1. The CSA governs the the manufacture, distribution, and dispensing of controlled substances in the U.S., defined as a "drug or other substance, or immediate precursor, included in schedule I, II, III, IV or V [of the CSA]." 21 U.S.C. Section 802(6). The CSA was amended by the Agriculture Improvement Act of 2018, Public Law 115- 334, to exclude hemp and THC found in hemp from the definition of marijuana.
2. See Gonzales v. Raich, 545 U.S. 1, 29 (2005).
3. See generally, Memorandum from David W. Ogden, Deputy General, to Selected United States Attorneys on Investigations and Prosecutions in States Authorizing the Medical Use of Marijuana (October 19, 2009), available at justice.gov/archives/opa/blog/memorandum-selected-united-state-attorneys-investigations-and-prosecutions-states; Memorandum from James M. Cole, Deputy General, for United States Attorneys on Guidance Regarding the Ogden Memo in Jurisdictions Seeking to Authorize Marijuana for Medical Use (June 29, 2011), available at justice.gov/sites/default/files/oip/legacy/2014/07/23/dag-guidance-2011-for-medical-marijuana-use.pdf; Memorandum from James M. Cole, Deputy General, to All United States Attorneys on Guidance Regarding Marijuana Enforcement (Aug. 29, 2013), available at justice.gov/iso/opa/resources/3052013829132756857467.pdf; Memorandum from James M. Cole,Deputy General, to All United States Attorneys on Guidance Regarding Marijuana Related Financial Crimes (Feb. 14, 2014) (available at justice.gov/sites/default/files/usao-wdwa/legacy/2014/02/14/DAG%20Memo%20-%20Guidance%20Regarding%20Marijuana%20Related%20Financial%20Crimes%202%2014%2014%20%282%29.pdf; Department of the Treasury Financial Crimes Enforcement Network, Guidance FIN-2014-G001 (Feb. 14, 2014), available at fincen.gov/sites/default/files/shared/FIN-2014-G001.pdf; Memorandum from Jefferson B. Sessions III, Attorney General, to All United States Attorneys on Marijuana Enforcement (Jan. 4, 2018), available at justice.gov/opa/pr/justice-department-issues-memo-marijuana-enforcement.
4. See Sections 1129(a)(3) and (11) of the Bankruptcy Code; In re Mother Earth's Alt. Healing Coop., Inc., Case No. 12- 10223-LT11 (Bankr. S.D. Cal) (Chapter 11 plan); In re Arenas, 535 B.R. 845, 847 (B.A.P. 10th Cir. 2015) (Chapter 13 plan).
5. The court in Burton concluded the Bankruptcy Court did in fact sufficiently articulate the legal and factual bases for dismissing the debtor's case because the continuation of the case would likely require the trustee or court to become involved with administering assets related to an ownership interest in an entity involved in litigation related to growing and selling marijuana.
6. Id. at 610 B.R. at 637-38 (citing In re Olson, 2018 WL 989263, at *6 (B.A.P. 9th Cir. Feb. 5, 2018) (remanding for the bankruptcy court to "articulate the findings that led it to determine that Debtor was violating the CSA and what legal standard it relied upon in dismissing the case"); In re Johnson, 532 B.R. 53, 59 (Bankr. W.D. Mich. 2015) (rejecting the notion that dismissal was a foregone conclusion and giving the debtor option to remain in bankruptcy by ceasing illegal activities); Northbay Wellness Grp., Inc. v. Beyries, 789 F.3d 956, 960-61 (9th Cir. 2015) (affirming bankruptcy court's confirmation of a Chapter 11 plan where the plan derived indirect support from rental income from a lessor engaged in a marijuana growing business).
7. For example, it has been suggested that a debtor could agree to discontinue involvement with marijuana-related activities business (see In re Johnson, 532 B.R. at 58 or the debtor proposes a plan that meets the requirements of the Bankruptcy Code where the funding of the plan comes from a source unrelated to marijuana activities. See In re McGinnis, 453 B.R. 770, 773 -74 (Bankr. D. Or. 2011).
Originally published by Journal of Corporate Renewal.
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