Recreational marijuana is legal in two states—Washington and Colorado—and medical marijuana is legal in another twenty-one states.  Colorado alone has over 500 marijuana dispensaries and that number is on the rise.  However, as the marijuana industry continues to grow, federal law still prohibits the use of marijuana.  So what happens when a marijuana business becomes insolvent? Does it have the right to avail itself of the protections of the Bankruptcy Code?

The United States Bankruptcy Court for the District of Colorado (the “Court”) says no.  In In re Arenas, 2014 Bankr. LEXIS 3642 (Bankr. D. Colo. Aug. 28, 2014), a husband and wife filed for chapter 7 bankruptcy.  The husband engaged in the business of producing and distributing marijuana on the wholesale level in Colorado. The husband carried on his business operations in one unit of a commercial building owned by the debtors.  The debtors also leased another unit in the building to another marijuana dispensary.  The wife was not involved in the business and her income derived solely from disability payments. 

About one month after the debtors filed for bankruptcy, the United States Trustee (“Trustee”) moved to dismiss their case.  The Trustee argued that the Court should dismiss the case because it should not enforce the protections of the Bankruptcy Code to aid violations of the federal Controlled Substances Act (“CSA”).  Moreover, the Trustee argued that the Court should not place him in the position of administering assets used in connection with marijuana-related businesses.  The debtors filed a pro se opposition to the motion as their counsel previously withdrew from the case because it and the debtors disagreed as to whether bankruptcy relief was available to the debtors.

The Court agreed with the Trustee and debtors’ counsel and held that the debtors could not receive bankruptcy protection while operating the marijuana business.  Specifically, while the Court found that the husband’s activities were legal under Colorado law, they still violated the CSA.  These violations of federal law created significant impediments to the debtors’ ability to seek relief under the federal bankruptcy laws in a federal bankruptcy court. 

In its decision, the Court referred back to its prior ruling in In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799  (Bankr. D. Colo. 2012).  In that case, the Court addressed issues concerning a chapter 11 debtor’s activities with respect to medical marijuana.  It held: “Unless and until Congress changes [federal drug] law, the Debtor’s operations constitute a continuing criminal violation of the CSA and a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”  Id. at 805.

The debtors in Arenas invited the Court to reexamine its decision in the Rent-Rite case, but it declined to do so.  The Court explained that the “fundamental bargain underpinning a chapter 7 consumer liquidation case is that a debtor turns over his non-exempt assets to a chapter 7 trustee so those assets may be liquidated for the benefit of creditors….  Here, the…Trustee cannot take control of the Debtors’ property without himself violating…the CSA.  Nor can he liquidate the inventory of marijuana plants…because that would involve him in the distribution of a…controlled substance in violation…of the CSA.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *10.  Therefore, the Court found that administration of the case under chapter 7 was impossible without involving the Court and the Trustee in ongoing criminal violations, and that impossibility constituted “cause” for dismissal under 11 U.S.C. § 707(a).

Moreover, the Court denied the debtors request to convert the case to a case under chapter 13 because any reorganization would be funded from ongoing criminal activity and would necessarily involve the chapter 13 trustee in administering and distributing funds derived from such activity.  The Court found that such circumstances would violate Section 1325(a)(3)’s requirement that a chapter 13 plan be “proposed in good faith and not by any means forbidden by law.”  Therefore, the Court denied the debtors’ request to convert and dismissed the case. 

In dismissing the debtors’ case, the Court noted that it recognized that dismissal would be devastating for the debtors, but that the legal analysis necessary for the resolution of the case was “relatively straight-forward.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *19.  The debtors have appealed the decision to the United States Court of Appeals for the Tenth Circuit.

The marijuana industry continues to grow and legalization efforts are ongoing throughout the nation.  However, the Colorado cases make clear that unless federal law changes, there may be nowhere to turn for insolvent marijuana-related businesses.