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Federal Bankruptcy Court and Ancillary Cannabis Businesses in Colorado—A Difficult Combination

Cannabis sales in the United States is a peculiar phenomenon if viewed through the lens of the federal government and federal law. But what happens when a cannabis business, licensed and “legal” within a given state, faces bankruptcy? And to what extent are the bankruptcy court doors shut in the face of the state versus federal scheme? A recent decision out of the U.S. Bankruptcy Court for the District of Colorado is highly informative in addressing the closed-door policy and to what extent. [In re Way to Grow, 597 B.R. 111 (Bankr. D. Colo. Dec. 14, 2018).]

Background: U.S. Bankruptcy Law and Cannabis

The U.S. Constitution, at Article 1, § 8, Clause 4 authorizes Congress to enact uniform laws on the subject of bankruptcies throughout the United States. Congress has exercised this authority several times since 1801, including through adoption of the Bankruptcy Reform Act of 1978 (BRA), 11 U.S.C. § 101, et seq., and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Pub.L. 109–8, 119 Stat. 23, enacted April 20, 2005), which amended various portions of the BRA. Courts have described the BRA, at least with respect to Chapter 11 thereof, as “to assist financially distressed business enterprises by providing them with breathing space in which to return to a viable state.” In re Encore Prop. Mgmt., 585 B.R. 22, 29 (Bankr. W.D. N.Y. 2018).

Not surprisingly, the illegality of cannabis under the federal Controlled Substances Act of 1970 (CSA), 21 U.S.C. § 101, et seq., complicates this issue as the above-quoted bankruptcy concepts derive from federal law. And despite the fact that cannabis is legal to grow and use recreationally and medically in many states like Colorado, the U.S. Supreme Court definitively held in Gonzales v. Raich, 545 U.S. 1 (2005) that the CSA supersedes any state law contrary to it, such as is the case with state legalization of cannabis.

The Way To Grow Case

The recent case of In re Way to Grow, 597 B.R. 111 (Bankr. D. Colo. 2018), indicates that—not only is federal bankruptcy protection not available to actual cannabis companies—but such access may also be denied to businesses “ancillary” to the cannabis industry, including companies whose businesses, but for the sale of their products to cannabis companies, would not be illegal under state orfederal law. Such was the case in Way to Grow, 597 B.R. at 111.

InWay to Grow, the Bankruptcy Court held that a company in the business of selling indoor hydroponic and gardening-related supplies primarily to companies in the business of growing cannabis, under the particular facts of that case, was in violation of federal law and accordingly denied access to the federal bankruptcy courts pursuant to 11 U.S.C. § 1112(b) (providing bases for the dismissal of bankruptcy cases). Id.at 131-32.

Previous Decisions Addressing Cannabis and Ancillary Businesses in Bankruptcy

In analyzing this issue, the Way to Grow Bankruptcy Court first analyzed two earlier cases from the Colorado Bankruptcy Court addressing Chapter 11 bankruptcy in the context of an ancillary business doing business with cannabis companies, as well as a bankruptcy cases in which the bankruptcy trustee would have been required to administer marijuana-related assets. Id. at 117-18.

The first case, In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012), involved a debtor that derived 25 percent of its revenue from leasing warehouse space to cannabis businesses. Id.at 810. In that case, the Colorado Bankruptcy Court found that the activity violated the CSA and dismissed the debtor’s Chapter 11 case pursuant to 28 U.S.C. § 1112(b). Id.at 805.

Not long thereafter, the Colorado Bankruptcy Court confronted a Chapter 7 case where the debtor’s bankruptcy estate contained cannabis-related assets. In re Arenas, 514 B.R. 887 (Bankr. D. Colo. 2014). In that case, the court dismissed the case because the bankruptcy trustee would be required to administer assets in violation of federal law. TheArenas court reasoned that:

“. . .the Debtors’ chapter 7 trustee cannot take control of the Debtor’s property without himself violating § 856(a)(2) of the CSA. . . .The Court finds that administration of this case under Chapter 7 is impossible without inextricably involving the court and the Trustee in the Debtors’ ongoing criminal violation of the CSA.” Id. at 891.

The Court’s Decision

TheWay to Grow court then turned to the issue before it—whether debtor Way to Grow, Inc. (WTG) could proceed with a Chapter 11 bankruptcy given that: 1) it was not in the business of growing or selling cannabis but 2) 95 percent of its growing supplies were sold to companies in such businesses. The Way to Grow court answered this question with a definitive “no” and dismissed the case pursuant to 11 U.S.C. § 1112(b). Id.at 128-132. The court reached this conclusion by analyzing whether WTG’s activities violated the CSA and concluded that they did. From there it was an easy step for the court to dismiss WTG’s Chapter 11 case. Id.at 131-32.

The court first analyzed WTG’s liability for aiding and abetting violations of the CSA, pursuant to 21 U.S.C. § 841(a)(1) and 16 U.S.C. § 2. After analyzing the issue, the Way to Grow court held that WTG was not aiding and abetting violations of the CSA. Id. at 124-27. The court did find, however, that the WTG violated another provision of the CSA, 21 U.S.C. § 843(a)(7), and this was sufficient for dismissal of its Chapter 11 bankruptcy case. Section 843(a)(7) of the CSA makes it a federal crime to “manufacture” or “distribute” any:

“. . .equipment, chemical, product or material which may be used to manufacture a controlled substance . . . knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance.” Id.at 827.

To determine whether WTG ran afoul of § 843(7), the Way to Growcourt analyzed a factually-developed record and determined that WTG was in violation of the statute because, among other things, it credited testimony that:

“As much as 95 [percent] of the customers in a WTG store used WTG’s products to grow cannabis; An investor deck prepared on behalf of WTG specifically referred to “marijuana as ‘the catalyst for hydroponic R&D’”; WTG had participated in cannabis industry promotional events and had given away promotional materials at industry events that were strongly associated with cannabis use.”

On this factual record, the court concluded that WTG’s conduct was in violation of § 843(7) of the CSA and dismissed its Chapter 11 case under 11 U.S.C. § 1112(b).Id.at 128-32.

Conclusion and Implications

This should raise a clarion call of caution for those ancillary businesses (and investors therein) that currently rely on the fact that their businesses do not touch the actual cannabis plant and/or that they are not directly involved in the manufacture or sale of cannabis to insulate them from lack of access to federal processes such as the federal bankruptcy system or, even criminal liability (not the subject of this article), if the federal enforcement of such potential crimes is increased from its current level and the criminal courts were to follow the analysis of the Way to Growcourt.

(Eric Liebman)