On The Case

Another risk for marijuana biz: no bankruptcy protection, even for tangential players

(Reuters) - A headline in Westlaw’s daily briefing for bankruptcy lawyers – "Business booted from Chapter 11 over medical marijuana ‘entanglement’" - caught my eye this morning. The story described a ruling from earlier this month in a Chapter 11 bankruptcy case in Detroit, granting a motion by the U.S. trustee to dismiss the case because the debtor’s sole shareholder had leased property to a marijuana dispensary.

What I learned from the ruling, written by U.S. Bankruptcy Judge Thomas Tucker of Detroit, is that there’s pretty solid precedent – with one big exception - backing the proposition that businesses in the marijuana industry are not entitled to federal bankruptcy protection, even if they’re operating in states where pot is legal and are involved only tangentially with marijuana. Judicial consensus, at the moment, is that as long as marijuana remains a controlled substance under federal law, businesses in the industry can’t avail themselves of the safe harbor of bankruptcy.

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In the case in Detroit, a custom cabinetmaker filed for Chapter 11 days after a state court in Detroit ordered the company to act in accordance with a real estate contract it had signed with a state-licensed marijuana dispensary. The details are complicated, but essentially, the dispensary had a deal to lease space from the owner of the cabinetmaking company, with the cabinetmaker acting as the landlord. The dispensary also had an option to buy the property. According to the U.S. trustee, the cabinetmaker has plenty of expected revenue under its deal with the dispensary and went into bankruptcy only because its owner wanted to get out of the original real estate agreement and renegotiate a more favorable deal.

Either way, the trustee said, the dispensary’s business is illegal under federal law. Presiding over the debtor’s bankruptcy, the trustee argued, “places the court in an impossible position, to assess and assign the value to the estate of illegal activity.”

The debtor, represented by the Metro Detroit Bankruptcy Law Group, said it had been duped into the real estate deal with the dispensary and that it didn’t want to be involved in the pot business. It claimed it filed for Chapter 11 to reorganize its custom cabinetry operation and was legitimately seeking protection from creditors. I emailed debtor’s counsel Stuart Sandweiss to talk about the case but didn’t hear back.

Judge Tucker sided with the trustee, concluding that the cabinet maker’s owner pushed his company into Chapter 11 to evade the state court decision compelling him to comply with the real estate deal he’d entered with the marijuana dispensary. And the evidence from the state court proceeding, the judge said, indicated that the cabinet maker’s owner wanted to make a more profitable deal based on selling pot, perhaps even through his own dispensary.

“The actual purpose of filing and prosecuting this bankruptcy case is for the debtor and its 100% shareholder to use this bankruptcy court, and the bankruptcy code, to assist them in obtaining a result that is contrary to federal criminal law under the Controlled Substances Act, and therefore contrary to federal public policy,” Judge Tucker wrote. “This federal court cannot allow itself to be used in this way.”

Nor is the Detroit cabinetmaker the only business tangentially linked to marijuana to be tossed out of bankruptcy because the pot trade is illegal under federal law. In 2012’s In re Rent-Rite Super Kegs, apparently the first ruling to confront this question, U.S. Bankruptcy Judge Howard Tallman of Denver dismissed the Chapter 11 bankruptcy of a company that earned 25% of its revenue from leasing space to a marijuana grower. The judge held that because the debtor knew of its tenant’s activities, it had unclean hands and was “unworthy of the equitable protection of bankruptcy court.” Similarly, in 2018, U.S. Bankruptcy Judge Michael Romero of Denver dismissed the Chapter 11 bankruptcy of Way to Grow, a hydroponic and gardening equipment company whose future growth was tied to the cannabis industry. After a four-day hearing, Judge Romero held that allowing Way to Grow to operate under bankruptcy protection would essentially countenance the violation of federal law.

Way to Grow appealed the decision to federal district court, but in January 2019, U.S. District Judge William Martinez of Denver refused to stay the dismissal of the Chapter 11 case, finding that the debtor was unlikely to succeed in showing the bankruptcy judge misconstrued the Controlled Substances Act.

In short, almost every judge to have considered bankruptcy for businesses tied to the pot trade has agreed with a rhetorical question-and-answer in 2015’s In re Arenas from the U.S. Bankruptcy Appellate Panel for the 10th Circuit: “Can a debtor in the marijuana business obtain relief in the federal bankruptcy court? No.”

The only exception – and it’s potentially a big one – seems to be a case decided earlier this month by the 9th U.S. Circuit Court of Appeals. In Garvin v. Cook Investments, the 9th Circuit refused to overturn the confirmation of a Chapter 11 reorganization plan for a group of real estate holding companies, one of which leased property to a marijuana grower in Washington state. Although the plan confirmed by the bankruptcy court excluded the lease to the marijuana grower, which pays its revenue to the owner of the real estate holding companies rather than to the companies’ creditors, the U.S. trustee argued that plan should be rejected because it failed to meet the statutory requirement that reorganization plans not be proposed “by any means forbidden by law.”

The 9th Circuit found the statutory language referred exclusively to the proposal of the plan – not, as other courts have found, to the substance of the plan. Otherwise, the appeals court said, bankruptcy judges will end up as roving ombudsmen, forced to scrutinize proposed reorganization plans for potential illegalities.

Who knows? Maybe the issue of bankruptcy protection for businesses that rely on marijuana revenue will someday go the U.S. Supreme Court.