Bankruptcy Law Lacks Remedies for Business Operating in Violation of the Controlled Substances Act

Entrepreneurs start new businesses knowing they are taking certain financial risks. They recognize that their businesses may fail. Entrepreneurs also know that they can likely obtain some value from the sale, reorganization or liquidation of the failed business.  The Bankruptcy Code facilitates the ability of companies to recover the value from the assets and business operations for the benefit of the creditors and equity holders.  In this way, the Bankruptcy Code allows entrepreneurs to engage in risk-taking activities by protecting property rights of individuals and business entities.

However, this protection does not extend to businesses involved in the certain aspects of the cannabis industry, such as crop growth or production of goods with marijuana. The Bankruptcy Code does not offer any protection to businesses whose business purpose violates the Controlled Substances Act.  It does not matter that such a business is registered, licensed, and permitted in accordance with state requirements, the fact that the business is in violation of the Controlled Substances Act nullifies the ability to use the Bankruptcy Code to protect the business.  Such a limitation has far-reaching effects on creditors.

In the case of In re Arenas, 514 B.R. 887, 888 (Bankr. D. Colo. 2014), aff’d, 535 B.R. 845 (10th Cir. BAP (Colo.) 2015), two elder individuals, one of whom was disabled by a stroke, operated a marijuana farm and sold it to a dispensary that was a tenant on their land.  Id. at 889.  They had proper licenses and permits necessary to operate the business under Colorado law.  Id. They did not, however, have any license or permit issued by the United States government. Nor could they obtain any such license or permit from the federal government.

The Arenases filed bankruptcy under chapter 7 of the Bankruptcy Code to discharge their personal debts.  However, they had a problem: their marijuana farm and land were assets of the estate.  The Court held that the chapter 7 trustee could not administer the farm and land assets because the administration would violate the Controlled Substances Act. In this matter, administration of the assets would have meant that the trustee would be operating the farm, receiving rent payments from the marijuana dispensary and even selling the assets.   Because the trustee would be violating federal law by taking any of these actions, the trustee could do nothing.  Because the trustee had to keep his “hands off” the assets, the trustee moved to dismiss the case.

Realizing the impending dismissal of the chapter 7 case would bring them right back to where they started before they filed bankruptcy, the Arenases sought to convert the case to chapter 13 because Chapter 13would allow the Arenases to operate their businesses. A Chapter 11 proceeding would have permitted this as well.  The court denied this maneuver because the funds used to pay the creditors through the chapter 13 trustee would require the chapter 13 trustee to administer funds in knowing violation of the Controlled Substances Act.  Although not discussed in the case, a conversion to chapter 11 would have yielded the same result.  See In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 805–06 (Bankr. D. Colo. 2012), which involved a warehouse landlord who received about 25% of its rents from tenants involved in the cultivation of marijuana.  Under chapter 11, the Arenas would have been in the position of the trustee, and would be administering the assets, which were illegal under current federal law.  Further, they would not have been able to confirm a chapter 11 plan, which requires good faith and compliance with applicable laws for confirmation.

As a result, to obtain a discharge, the Arenases would have needed to destroy the marijuana plants and breach the lease agreement to evict the marijuana dispensary–essentially strip themselves of any value from the operations–before filing bankruptcy.  Of course, this action would have created other problems, such as fraudulent transfers, waste of assets, lack of good faith, any of which could be used to deny them a discharge.  The Arenases had no easy recourse.

What about the creditors who lent money or sold on credit to the Arenases or other companies that are involved in the cannabis industry?  They have no easy answer or recourse either.  They cannot use the threat of filing an involuntary bankruptcy to recover their debts.  See In re Medpoint Mgmt., LLC, 528 B.R. 178, 186 (Bankr. D. Ariz. 2015), vacated in part (as to denial of attorney’s fees only), 2016 WL 3251581 (B.A.P. 9th Cir. June 3, 2016) (creditors who filed an involuntary bankruptcy petition should have known that the debtor was a medical marijuana business that a chapter 7 trustee could not administer).

Those involved in the cannabis industry, as either owners or creditors cannot file suit in federal courts and cannot obtain available federal collection remedies.  They are limited to applicable state law collection remedies.  At this time, federal law does not allow for any exceptions to the operation of an illegal business under the Controlled Substances Act.

Thus, businesses in some states are currently operating in accordance with their state’s laws, but in violation of federal law, and as a result are not able to take advantage of federal bankruptcy protections.  Thus, to the extent federal law does not change, it may make some sense to analyze the rights of creditors under state law assignments for the benefits of creditors, and other state law collection remedies.  The Bankruptcy Code simply cannot fill the role most entrepreneurs and creditors are accustomed to for businesses in violation of the Controlled Substances Act.

As for Texas businesses, Texas law is currently more restrictive than federal law. This restrictive stance may change in the 2019 legislative session. Currently, only three medical marijuana licenses were granted under the Texas Compassionate Use Act. However, it is anticipated that the legislature may also expand the current Compassionate Use Act in the 2019 session as well.

If you are a business owner facing business bankruptcy or a creditor of business that has filed a bankruptcy case, call Ritter Spencer Cheng PLLC to discuss your commercial bankruptcy options at (214) 295-5070 or email today.