Does Involvement in the Cannabis Industry Preclude Your Business From Bankruptcy Protection?

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Despite the growing public acceptance of marijuana and the fact that a majority of states have legalized marijuana for medicinal purposes (37 states and the District of Columbia have enacted medical marijuana legislation), federal law still treats marijuana cultivation and sale as a criminal offense. See 21 U.S.C. § 801, et seq. As bankruptcy is only available under federal law, this dichotomy between state and federal law can result in actions that potentially preclude businesses and individuals from accessing the protections afforded under the U.S. Bankruptcy Code (the “Code”).

Under the Bankruptcy Code, both businesses and individuals can seek to obtain a discharge of indebtedness through either a liquidation or reorganization proceeding. Businesses can utilize Chapter 11 to complete a reorganization or a liquidation. Individuals can use Chapter 11 and, subject to income limitations, Chapter 13 to reorganize their financial situation through confirmation of a plan. Both businesses and individuals can also seek a discharge through a liquidation under Chapter 7 of the Code. These federal provisions are recognized as paramount in providing individuals and businesses relief from indebtedness that, in most cases, is an insurmountable obstacle to obtaining a fresh start financially.

Access to the bankruptcy courts and the relief provided under the Code is not an absolute right, as the courts are empowered to dismiss a case for cause. Bankruptcy courts have held that violations of federal law constitute cause for dismissal of a case, which in the context of the marijuana industry has created a segment of many states’ economies that are unable to access bankruptcy relief.

Federal Law and Marijuana Assets or Income.

Currently, marijuana is illegal under the Controlled Substances Act, 21 U.S.C. § 801, et seq. The statute provides that the manufacture, distribution, and use of marijuana is illegal. See 21 U.S.C. § 812. The statute specifically provides that it is unlawful “for any person knowingly or unintentionally to manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.” 21 U.S.C. § 841(a)(1).

In the bankruptcy arena, the United States Trustee Program (“USTP”) is the gatekeeper that oversees access to bankruptcy and the relief available under the Bankruptcy Code. The USTP has “taken the position that debtors with assets or income derived from marijuana may not proceed through the bankruptcy system.” See https://www.justice.gov/ust/consumer-information#:~:text=For%20Individuals%20or%20Businesses%20with,proceed%20through%20the%20bankruptcy%20system. The USTP’s position as to marijuana-related bankruptcies is guided by two objectives. First, bankruptcy is not available as a means to foster ongoing criminal activity and reorganization plans that permit or require continued illegal activity cannot be confirmed. Second, bankruptcy trustees should not be required to administer assets in violation of federal criminal law. See https://www.justice.gov/ust/file/abi_201712.pdf/download.

Courts have consistently barred companies or individuals that directly derive ongoing income from the cultivation or dispensing of marijuana from the protections of the Bankruptcy Code. See Arenas v. United States Trustee (In re Arenas), 535 B.R. 845 (10th Cir. B.A.P. 2015). However, the USTP has not limited its strict policy to marijuana cultivators and retailers alone. Rather, it has taken the position that there is no distinction under the Controlled Substances Act between cultivators and retailers and those businesses or individuals that provide goods, services, or other accommodations to marijuana businesses.  As such, the USTP is willing to apply its rationale to related parties that provide goods, services, or other accommodations to cultivators and retailers.

Under federal law, it is unlawful to “manage or control any place, whether permanently or temporarily, either as an owner, lessee, agent, employee, occupant, or mortgagee, and knowingly and intentionally rent lease profit from, or make available for use, with or without compensation, the place for the purpose of unlawfully manufacturing, storing, distributing, or using a controlled substance.” 21 U.S.C. § 856. As such, landlords leasing space to cultivators or retailers can be precluded from accessing the bankruptcy system to reorganize or potentially having all of their assets liquidated by a bankruptcy trustee. For example, a landlord that received approximately 25% of its income renting space to a cultivator faced the dismissal or conversion of its bankruptcy case. See In re Rent-Rite Super Kegs, 484 B.R. 799 (Bankr. D. Col. 2012). The Court reasoned that a reorganization was unavailable due to the receipt of illegal income by the landlord and a potential liquidation of assets (e.g., the building of the landlord debtor), which would not be a federal crime for a trustee to undertake, was a potential option for a Chapter 7 trustee.

Additionally, it is a federal crime to sell or offer for sale any “equipment, product, or material or any kind which is primarily intended or designed for use” in manufacturing a controlled substance. 21 U.S.C. § 863. The USTP’s position with respect to ancillary businesses violating this provision is highlighted in In re Mayer, 2:21-bk-06572-DPC (D. Ariz. 2022). In this case, the individual debtor derived income from a corporation of which he was a significant shareholder known as Rosinbomb. The company manufactures and sells extraction presses that can be used to generate rosin from cannabis resin. The process creates a concentrated form of marijuana, “commonly referred to as ‘dabs.’” Id. at note 20.

The Court determined that because Mr. Mayer derived his income from Rosinbomb, which was engaged in the manufacture and supply of equipment sold to the marijuana industry, Chapter 13 relief was unavailable. While Mayer argued his company’s presses could be used to extract oils from various materials other than cannabis, he could not evidence sales unrelated to the cannabis industry. Id.  Ultimately, the Court determined that the equipment constituted “drug paraphernalia” under federal law, and even if it did not, the fact that Rosinbomb knew its machines were used in the marijuana industry was also a violation of the Controlled Substances Act. Id. Despite the fact that Mr. Mayer was not personally selling the equipment, the fact that his sole source of income flowed directly from Rosinbomb’s illegal activities was sufficient to dismiss his bankruptcy petition.

Liquidation Alternatives.

In states where marijuana has been legalized, state law insolvency proceedings may be an alternative to bankruptcy to afford financial relief to a marijuana business denied access to the bankruptcy courts. One option would be to initiate a receivership where the entity’s assets would be placed in the custody and control of a court-appointed receiver for liquidation. Another alternative is an assignment for the benefit of creditors, where the assets of the entity or assignor are assigned to an assignee to be liquidated for the benefit of creditors.

Conclusion.

The point at which a debtor’s involvement in a business or sources of income that have a connection to the cannabis industry is sufficiently attenuated to avoid outright dismissal or a liquidation of assets in bankruptcy is unclear. For example, would the owner of a nursery that knowingly sells gardening supplies used by an individual for marijuana cultivation be precluded from bankruptcy? Would a landscape company working for a landlord that rents his entire building to a marijuana cultivator risk being barred from bankruptcy protection?  As the cannabis industry expands, individuals and businesses need to be cognizant that their economic relationships with industry participants that may put them at risk of being shut out of the only legal mechanism available to permit a business or individual to reorganize their financial interests.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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