Oil and Water: Marijuana and Bankruptcy Law

Oil and Water: Bankruptcy Law and Marijuana

Across the country, we have witnessed a monumental societal attitude shift towards both medical marijuana and recreational marijuana use. With legalization of recreational use in Massachusetts we have also witnessed the birth of a new business industry. As of 2019, 33 states have enacted medical marijuana statutes, and 11 states have legalized recreational use. While marijuana dispensaries are the face of the cannabis industry, it also involves individuals from the legal, business, banking, media and real estate fields.

Not wanting to be a Debbie Downer, it is our nature as attorneys to also point out the cons of investing in the cannabis industry, and presently, the biggest con is the lack of bankruptcy protection for anyone involved in the cannabis industry.

One huge obstacle in the cannabis industry is financing. As marijuana is illegal at the federal level, obtaining the necessary start-up capital can be difficult. If a start-up cannot walk into a local bank and obtain a traditional commercial loan, they must turn to private equity sources. This includes private equity companies, family, friends and anyone looking to make an initial investment for a big return. Not wanting to be a Debbie Downer, it is our nature as attorneys to also point out the cons of investing in the cannabis industry, and presently, the biggest con is the lack of bankruptcy protection for anyone involved in the cannabis industry.

With any new business venture there is often the unfortunate failure and the need to file bankruptcy. As the Bankruptcy Code is federal law, there is direct conflict with state legalization of medical and recreational marijuana use. Under the Federal Controlled Substances Act (“CSA”) of 1970, (21 U.S.C.A., sec 801, et. seq.) sec. 812, all parts of the marijuana plant and any compound or mixture containing any part of the plant is considered a controlled substance. Section 856 deems it illegal to knowingly lease, rent, use, maintain, manage or control any place as an owner, lessee, agent, employee, occupant or mortgagee, any property for the purposes of distributing any controlled substance. Making matters worse, under Section 881, any products, equipment, cars, trucks or real estate used by a violator in furthering the storage, transport or sale of a controlled substance is subject to federal forfeiture, and any person violating the CSA “shall be” sentenced for a term not more than 20 years or fined no more than $500,000.00 or both.

Bankruptcy trustees fall under the aegis of the U.S. Department of Justice. A Department of Justice memo dated April 26, 2017 and issued to all Chapter 7 and 13 Bankruptcy trustees stated:

In recent months we have noticed an increase in the number of bankruptcy cases involving marijuana assets. This is to reiterate and emphasize the importance of prompt notification to your United States Trustee whenever you uncover a marijuana asset in a case assigned to you. Our goal is to ensure that trustees are not placed in the untenable position of violating federal law by liquidating, receiving proceeds from, or in any way administering marijuana assets. It is the policy of the United States Trustee Program that the United States Trustees shall move to dismiss or object in all cases involving marijuana assets on grounds that such assets may not be administered under the Bankruptcy Code even if trustees or other parties object on the same or different grounds.

So if a landlord leases space to a marijuana product company/dispensary, or an individual operates or invests in a marijuana company and derives income from it, or an individual works as a clerk in a marijuana dispensary, which accounts for the sole source of their income, and any of these individuals find themselves in a financial position whereby they need to file for bankruptcy relief, what happens?

The first major bankruptcy case involving the cannabis industry, was naturally in Colorado, In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 90 A.L.R. Fed. 2d 777 (Bankr.D.Colo. 2012). In this case, a Chapter 11 Debtor admitted in its schedules that it derived about 25% of its revenues from leasing its sole real estate asset to parties who grew marijuana for distribution. As the debtor freely admitted he was violating federal law and would continue to do so as the Bankruptcy Plan was based on the continued leasing of the property to the present tenants, the federal forfeiture statute came into play. As the property was mortgaged, the debtor’s mortgagee filed a motion to dismiss the bankruptcy as a possible forfeiture put its collateral at risk. The Court dismissed the bankruptcy holding that: 1) due to the federal law, a violation of the unclean hands doctrine applied to the debtor; 2) due to the debtor’s intent to continue to lease the property to the tenants, it would willfully continue to violate federal law, and under 11 U.S.C. 1112(b)(4)(B), the debtor would engage in gross mismanagement of the Estate; and 3) exposing its real estate asset to possible federal forfeiture was not in the best interests of the debtor’s creditors, as the mortgagee would lose its mortgage interest.

In re Arenas, 535 B.R. 845 (2015) was another Colorado case where the debtors grew marijuana for wholesale in one unit and leased a second unit to a marijuana dispensary. Their Chapter 7 filing was dismissed as it would require the Chapter 7 trustee to take possession of and sell marijuana assets in violation of federal law, thus exposing the bankruptcy trustee himself to potential criminal action. When the debtors attempted to convert to a Chapter 13, the conversion was also denied as they had insufficient income apart from the marijuana related income to support a Chapter 13 Plan.

The majority of cases follow the holding in the In re Rent-Rite case – i.e. a debtor engaged in the cannabis industry cannot take advantage of the benefits of bankruptcy. Other cases have additional twists.

For example, in the matter of In re Jerry L. Johnson, 532 B.R. 53 (2015) the Court ordered the debtor to make a choice – either continue his medical marijuana business and face dismissal, or terminate his business in order to take advantage of the benefits of Bankruptcy. The debtor doesn’t even have to be a medical or recreational dispensary to be found in violation of the CSA. In the case of In re Medpoint Mgmt., 528 B.R. 178 (Bankr.D.Ariz. 2015) the debtor licensed intellectual property to marijuana industry businesses, and the debtor in In re Way to Grow, Inc. 597 B.R. 111 (Bankr.D.Colo. 2018) sold hydroponic gardening/growing equipment to various business, some of which were marijuana related. Both the debtor and creditor in Basrah Custom Design, Inc. 600 B.R. 368 (Bankr. E.D.Mich. 2019) were found to be in violation of the CSA, and not wanting to benefit the creditor who also had unclean hands, the Court dismissed the case.

The recent case of Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (2019) should be seen as an exception, not necessarily the start of a turning of the tide. In Garvin, the bankruptcy trustee sought to dismiss a Chapter 11 Plan under 11 U.S.C. sec. 1129 (a)(3) which requires that a debtor “has proposed a plan in good faith and not by any means forbidden by law.” As the debtor rented property to a cannabis company, both pre and post filing, the Trustee moved to dismiss claiming that the rental to a company operating in violation of federal law meant the plan was proposed by a means forbidden by law. The Bankruptcy Court held that procedurally, the Plan was properly proposed under the Bankruptcy Code and that the phrase “not by any means forbidden by law” did not refer to the potential illegality of the debtor’s income to be used to fund the Plan. As the debtor had other sources of income and the Plan proposed to pay all creditors in full, the Court saw dismissal as prejudicial to creditors. The District Court affirmed and in May, 2019 the U.S. Court of Appeals for the Ninth Circuit again affirmed, noting that if the Trustee had a finding of illegality or had sought dismissal under 11 U.S.C. 1112(b)(4)(B) for gross mismanagement of the Bankruptcy Estate, there may have been a different outcome.

We previously witnessed the collision of state and Bankruptcy law when Massachusetts legalized same-sex marriage. Because it was illegal on the federal level, same-sex couples could not file a joint bankruptcy proceeding until same-sex marriage was legalized on the federal level. While the Supreme Court decided legalization of same-sex marriage on a discrimination basis, resolving the conflict with state’s rights to legalize medical or recreational marijuana versus the federal government’s policy to fight the proliferation of illegal drugs is a matter that will need to be decided by Congress.

No one anticipates the necessity to file a future bankruptcy, but unless and until Congress decides to act, companies and individuals seeking to become involved in any aspect of the cannabis industry need to understand that bankruptcy protection is not currently available to them.

Laura White Brandow Condo Law Blog

If you have any questions, you can email Laura at lbrandow@mbmllc.com or any of our other attorneys at Moriarty Bielan and Malloy LLC at 781-817-4900 or info@mbmllc.com.

Laura White Brandow