Have you ever wanted to start your own marijuana cultivation and distribution business? Do you see billboards on the highway advertising pot-growing seminars and think, “Maybe I should go?” Does the grass seem greener on the other side? What was once a mere dream can be a reality now that several states have legalized the use, possession, distribution and cultivation of cannabis (a fancy term for marijuana) for medical or recreational reasons, and other states (such as my own state of Florida) will be voting on whether to legalize marijuana in the near future. Most people do not like to think about what would happen if things go awry with their perfectly-planned future business. But things do go wrong, businesses fail, and bankruptcy is regarded as a palliative means of bringing a failing business back to life or an orderly means of letting a business die with dignity. Before you quit your day job, however, and start spending the riches from your hypothetical marijuana business (or start thinking about the “joint-ly” administered cases you’ll file and “pot plan” you’ll propose should things go sour), read this cautionary tale.

#hashtag:thingsonedoesnotappeartothinkaboutwhenplanningtheirfuturemarijuanabusiness.

The Arenas Case

Frank Anthony Arenas had a wholesale business that produced and distributed marijuana in the state of Colorado. Earlier this year, Arenas and his wife filed for bankruptcy protection under chapter 7 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Colorado, presumably because business wasn’t growing. About a month later, the United States Trustee sought to dismiss the debtors’ chapter 7 case for cause pursuant to section 707(a) of the Bankruptcy Code. In his motion, the U.S. Trustee stated, “The Debtors appear to be engaged in the marijuana industry and the Court should not enforce the protections of the Bankruptcy Code to aid violations of the federal Controlled Substances Act.”

Section 707(a) contains a list of reasons a court may dismiss a chapter 7 case. Predictably (or maybe surprisingly?), “engaging in the marijuana industry” is not one of them. The list enunciated in section 707(a) consists of (1) unreasonable delay by the debtor that is prejudicial to creditors, (2) nonpayment of fees and charges required under 28 U.S.C. § 123, and (3) failure by the debtor to file its schedules within the time frames provided by the Bankruptcy Code or the bankruptcy court. Section 707(a)’s list of bases warranting dismissal of a chapter 7 case for cause, however, is not exhaustive, and that’s what the U.S. Trustee pointed out in his motion when he argued that the debtors’ case should be dismissed.

In the dismissal motion, the U.S. Trustee observed that the debtors owned commercial property, a portion of which was leased to a marijuana dispensary. In addition, although the debtors had not disclosed their interest in any marijuana plants or inventory in their schedules, they did list “growing lamps” and “air conditioning equipment” on their schedules. They also indicated they were engaged in the “husbandry” business. Finally, counsel for the debtors had advised the U.S. Trustee that the debtors used a portion of their building to grow marijuana. In light of this, the U.S. Trustee alleged that cause existed under section 707(a) to dismiss the Arenas’ chapter 7 case and that “[t]he Court should not enforce the protections of the Bankruptcy Code to aid violations of the federal Controlled Substances Act.” In further support of his position, the U.S. Trustee cited to an earlier case decided by the Colorado bankruptcy court, In re Rent-Rite Super Kegs West, Ltd., in which the bankruptcy court held that, in deriving approximately 25% of its revenue from the lease of warehouse space to tenants who were engaged in the business of growing marijuana (without a certificate of approval from the Drug Enforcement Agency), the debtor had violated the Controlled Substances Act, and cause existed to dismiss its bankruptcy case.

The Bankruptcy Court Revisits Its Prior Decision

Considering the U.S. Trustee’s motion, the court first observed that the debtors’ business operations were not illegal under the laws of Colorado and that the debtors had complied with applicable state regulations. But, the court noted, Mr. Arenas’s testimony also established that his business operations and the debtors’ control over their property violated federal law – the Controlled Substances Act, which is codified under 21 U.S.C. § 801 et seq.

Citing to Rent-Rite in which the bankruptcy court found violations of federal law, the court in the Arenas case also found that Mr. Arenas’s pot-growing business also violated federal law. Specifically, the court held that Mr. Arenas had violated 21 U.S.C. § 856(a)(2), which makes it 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” and 21 U.S.C. § 841(a)(1), which makes it unlawful to “knowingly or intentionally— (1) [] manufacture, distribute, or dispense, or possess with intent to manufacture, distribute, or dispense, a controlled substance.”

The court explained that, in a chapter 7 liquidation case, a debtor turns over non-exempt assets to a chapter 7 trustee for liquidation and administration for creditors. In exchange, the debtor is discharged. In the case before it, however, the debtors’ chapter 7 trustee would not be able to take control of the debtors’ property or liquidate it because that would involve the trustee in the management of property used for storing or distributing a controlled substance and would involve him in the distribution of a controlled substance, both in violation of the Controlled Substances Act.

Allowing the debtor to remain in chapter 7 and obtain a discharge, while preventing their trustee from administering their assets, would enable them to receive all the benefits of chapter 7 while avoiding the attendant burdens. Consequently, the court found cause to dismiss the chapter 7 case.

Chapter 7 Was Weeded Out, But Was Chapter 13 an Option?

In an effort to salvage their bankruptcy efforts, the debtors then sought to convert their case to a case under chapter 13 of the Bankruptcy Code. Chapter 13 allows individual debtors to propose plans and pay their creditors over a period of time. The bankruptcy court, however, nixed the debtors’ motion to convert their case. The court reasoned that although a chapter 7 case can be converted to a chapter 13 case at any time, here, there would be cause to dismiss the hypothetical chapter 13 case under sections 1307(c) and 1325(a)(3) of the Bankruptcy Code. That is because those sections would, collectively, require the debtor to propose a confirmable plan “not by any means forbidden by law.” That was the rub – the court reasoned that any plan that the debtors might propose would be “executed with income derived from the Debtors’ production and sale of a Schedule I controlled substance and from leasing space in their Property, which is used by their Tenant for distribution of a Schedule I controlled substance.” Because of this, the court reasoned it would never be able to find that any plan of the debtors would comply with section 1325(a)’s requirements. Consequently, the court found the debtors were not eligible for relief under chapter 13 and denied their motion to convert.

In a final postscript of sorts, the court recognized the debtors’ quandary. It observed that the debtors needed “the relief that would otherwise be available to them under the Bankruptcy Code” while noting that “[i]t is relief that, under the circumstances, the Court cannot provide.”   The debtors’ cases were dismissed. Well…maybe.

The Debtors Want to Rehash Their Arguments

Last month, the debtors appealed the bankruptcy court’s order and judgment dismissing their chapter 7 case and sought to stay the dismissal order pending the appeal. Arenas and his wife want to take their argument to a higher court. In their memorandum of law in support of their motion, the debtors raised additional arguments supporting their request for a stay. Among them is the fact that the Bankruptcy Code does not “explicitly prohibit” medical marijuana businesses from filing for bankruptcy protection, even though Congress could have excluded such businesses from the ambit of potential debtors. In further support of their position, they noted that section 362(b)(23) of the Bankruptcy Code excepts from the automatic stay efforts to evict a debtor from its residential property based on “the illegal use of controlled substances on such property.” The express reference to a debtor’s residential property (and thus the implied reference to individual debtors) in section 362(b)(23), the debtors in Arenas reasoned, was deliberate. In other words, section 362(b)(23) could have been worded more expansively so as to include the eviction of all debtors using controlled substances illegally, but it wasn’t. Consequently, the debtors argued that medical marijuana businesses should be permitted to be debtors. (The debtors, however, did not appear to explain the clear nexus between their new argument about medical marijuana businesses and their individual chapter 7 cases). Earlier this week, the U.S. Trustee filed a response to the Arenas’ motion to stay in which the U.S. Trustee indicated he did not oppose the stay of the dismissal pending the debtors’ appeal.

Two days ago, Arenas and his wife filed a statement of the issues on appeal noting five issues for appellate consideration. Predictably, Arenas and his wife questioned whether the bankruptcy court interpreted section 707(a) correctly – the root of the U.S. Trustee’s argument. But they also asserted that the bankruptcy court violated their fifth and fourteenth amendment rights. To put it bluntly, it looks as though the debtors’ marijuana saga will continue to climb its way through the federal court system in Colorado. At this point, however, it’s hard to gauge whether any or all of their arguments will succeed.

Conclusion and the Future of Marijuana in Chapter 11

It’s tempting not to make too much hay of the Arenas decision. After all, it’s just one individual debtor case, pending (for now) in one bankruptcy court, and marijuana continues to be illegal in most states. As we have been seeing, though, states are starting to, colloquially speaking, “change their minds” about marijuana, and Americans are nothing if not enterprising. As states begin to legalize marijuana (whether it’s for medical purposes only or for recreational use, too), it’s safe to assume that more marijuana businesses will begin to sprout. The question is whether the federal bankruptcy system will be those businesses’ safety net if they fail.

Although the Arenas decision dealt only with the debtors’ ability to stay in chapter 7 or convert to chapter 13, the decision presents equally troubling results for would-be chapter 11 debtors engaged in the marijuana business. First, precedent already exists – the Rent-Rite case cited in the Arenas decision – holding that a chapter 11 debtor’s revenue from marijuana activities constituted cause for dismissal of a debtor’s chapter 11 case. Second, section 109(d) of the Bankruptcy Code (not cited in either Rent-Rite or Arenas), provides that only a person that may be a debtor under chapter 7 (along with certain other expressly noted entities not relevant here) may be a debtor under chapter 11 of the Bankruptcy Code. So, a holding that a particular individual whose income is marijuana-based may not remain as a debtor in chapter 7 may have planted an important seed with respect to marijuana-based businesses that seek chapter 11 protection in the future.

#Stillthinkingofstartingyourownmarijuanabusiness?