Medical Marijuana: What Happens in Bankruptcy (Not Much)

In re Arenas, 514 B.R. 887 (Bankr. D. Colo. 2014)

The U.S. trustee sought to dismiss “for cause” a chapter 7 case filed by a marijuana grower and his wife. The debtors countered by moving to convert to a chapter 13 case. The case turned on the impact of the federal Controlled Substances Act.

Mrs. Arenas was disabled. She had monthly income of ~$3,000 from disability and pension benefits. The remainder of the family’s monthly income of ~$4,000 came from Mr. Arenas’ operation of a medical marijuana production and distribution business and lease of a portion of their property to a marijuana dispensary.

The operations of both Mr. Arenas and the tenant were in compliance with state laws. However, he did not have any license or permit from the federal Drug Enforcement Administration that would allow him to lawfully operate his business under the federal Controlled Substances Act (CSA). Consequently, the debtors were liable for criminal penalties under federal law.

In a prior Chapter 11 case the court held that a federal court cannot give bankruptcy protection to a debtor whose operations constitute a continuing federal crime. The debtors invited the court to reconsider its analysis based in part on a law review article that discussed the conflict between state and federal law.

The law review author commented that this conflict frequently involves preemption of state law by federal law. However, that is not the case with medical marijuana since Congress has not chosen to preempt state law. Consequently, states are allowed to legalize and regulate the use of medical marijuana – at least as long as they do not actively assist marijuana users and growers. In other words, a state can look the other way when its citizens violate federal law.

The law review article noted that marijuana users and suppliers typically feel confident that they will not be prosecuted. However, that is not because the activities do not constitute a crime under federal law, but rather that the federal government lacks the resources to enforce. So, states can look the other way, but they cannot require the federal government to do the same.

As an interesting footnote the opinion describes a memorandum issued by the U.S. Department of Justice providing guidance to U.S. Attorneys: The memorandum identified eight enforcement priorities, including “[p]reventing the distribution of marijuana to minors;… [p]reventing revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels; [and] [p]reventing the diversion of marijuana from states where it is legal under state law in some form to other states.” Although the federal government retains the authority to enforce the law, U.S. Attorneys were advised to rely on state and local law enforcement for marijuana-related activities as long as the identified priorities were adequately protected.

With this as background, the court concluded that the case must be dismissed. As it explained: “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. In return, the debtor receives a discharge of his dischargeable debts.”

In this case the chapter 7 trustee could not take control of the debtors’ property, nor could he liquidate the inventory of marijuana plants without getting involved in the debtors’ ongoing criminal activities. Since the trustee would not be able to administer the debtors’ assets, to allow the debtors to proceed would give them the benefit of a discharge without requiring them to give up their assets. The court found that this constituted cause for dismissal.

The debtors alternatively tried to convert to a chapter 13 case. Under Section 1325(a)(3) a plan must be proposed in good faith and “not by any means forbidden by law.” Although the debtors argued that this simply meant that the process of proposing a plan must be legal, the court concluded that this requirement was broader.

Since their expenses exceeded $7,000 per month, the debtors could not propose a confirmable plan without using their illegal profits. Thus the reorganization would necessarily have been funded from profits of an ongoing criminal activity. Since this would constitute cause for dismissing the chapter 13 case – which the court found was equivalent to a finding that the debtors were ineligible – they were not permitted to convert.

While acknowledging that “the result is devastating for the Debtors,” the court found the legal analysis to be straightforward: The court could not force a chapter 7 trustee to administer assets where that would involve committing a crime, and the court could not confirm a plan funded by activities that constitute a federal crime. Consequently, the debtors’ case was dismissed.

Although one might sympathize with the debtors, it is hard to argue with the court’s analysis.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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