As US Cannabis Industry Grows, Produces Distress, Bankruptcy Relief Remains Limited – Insolvency/Bankruptcy/Re-structuring

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:

    1. Prioritizing the investigation and prosecution of significant
      drug traffickers
    1. Clarifying that the use of federal funds to enforce the CSA
      against cancer patients or their caregivers may not be
      efficient
    1. 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
    1. Providing guidelines to financial institutions
    1. 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 on how to file 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.

Footnotes

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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