Full stop at the intersection of marijuana and bankruptcy law

Here at Shenwick & Associates, we counsel our clients to avoid violating any laws and regulations. While our colleagues of the criminal defense bar may lose work from such advice, it keeps our disciplinary record clean, our malpractice insurance premiums low and our clients out of trouble.

However, that's not always possible when dealing with marijuana, which remains a Schedule I substance under the federal Controlled Substances Act (which means that the federal government considers to have a high potential for abuse, no currently accepted medical use in treatment in the United States and there is a lack of accepted safety for use under medical supervision. In contrast, 23 states and the District of Columbia have enacted medical marijuana laws, and two states ( Colorado and Washington State) have taxed and regulated marijuana for adult non–medical use. This November, Oregon, Alaska and the District of Columbia will be voting on the adult non–medical use of marijuana.

This fundamental conflict between federal law and state law has had unusual consequences for marijuana entrepreneurs. Due to an obscure provision of the Internal Revenue Code, marijuana businesses aren't able to deduct ordinary and necessary business expenses from their federal taxable income. And despite the issuance of new, highly restrictive guidelines by the Financial Crimes Enforcement Network in February on how banks can provide services to marijuana businesses without violating their obligations under the Bank Secrecy Act, marijuana businesses remain largely dependent on cash.

The latest example of the problems that the conflict between state and federal law can cause impacts one of main practices–bankruptcy and creditors' rights (we also have a residential and commercial real estate practice). In August, a United States Bankruptcy Judge in Denver dismissed the Chapter 7 case of Frank and Sarah Arenas. Mr. Arenas is in the business of wholesale marijuana production and distribution. The UST's motion to dismiss the case was based on Bankruptcy Judge Tallman's holding in a prior Chapter 11 Colorado bankruptcy case, In re Rent-Rite Super Kegs West Ltd.

In reviewing the United States Trustee's motion to dismiss and the Debtors' motion to convert the case to a case under Chapter 13 of the Bankruptcy Code, Bankruptcy Judge Tallman held that the Chapter 7 Trustee assigned to the case couldn't take control of Mr. Arenas' assets or liquidate his inventory without "directly involving [the Chapter 7 Trustee] in the commission of federal crimes." Similarly, the Debtors couldn't convert their case to one under Chapter 13 of the Bankruptcy Code (which would allow them to pay off debts over time) because the plan would be funded "from profits of an ongoing criminal activity under federal law" and involve the trustee in distribution of funds derived from violation of the law. Section 1325(a)(3) of the Bankruptcy Code requires that a bankruptcy court find that a plan is "proposed in good faith and not by any means forbidden by law" to be confirmable. Bankruptcy courts in California and Oregon have issued similar holdings.

In practice, this means that creditors of marijuana businesses should avoid involuntary bankruptcy filings against marijuana businesses, but may look to state law alternatives to bankruptcy, such as foreclosure under the Uniform Commercial Code, assignment for the benefit of creditors, composition and receivership.