Oops! My Parachute Won’t Open

Risk is the life blood of the entrepreneurial spirit, fueling the fire that turns the business engine. Taking chances is the key to success. Indeed, the history books tell us the success of many entrepreneurs were built on the bones of failure.

Henry Ford tasted bankruptcy before becoming the wildly successful auto magnate. Walt Disney fell victim to bankruptcy before becoming the father of the Happiest Place on Earth. Even, our sitting President has had more than a handful of his companies seek bankruptcy protection.

The point being, entrepreneurs don’t fear failure; a fact well-known to any attorney who has had the pleasure of advising an entrepreneur. Such confidence, however, is no doubt fed by the unspoken knowledge that bankruptcy is their safety net; their parachute.

However, if you are a cannabis entrepreneur, you may be operating without the safety net of the federal bankruptcy laws. If you are advising a cannabis entrepreneur, have you adequately counseled your client regarding this fact? If not, you may be doing your client a disservice.

Cannabis is a burgeoning field. From its embryonic start in 1996 following California’s passage of Proposition 215 , the industry has exploded. As of November 2018, 33 states have passed laws legalizing cannabis for medical use of some nature with 10 of those states legalizing cannabis for recreational use. This is a dramatic increase from 2012 when Colorado and Washington became the first states legalizing marijuana for recreational use.

Much like the Wild West of the 19th Century, the burgeoning cannabis industry is a magnet pulling entrepreneurs to it in every increasing numbers. While all of these entrepreneurs have entered the cannabis arena with high hopes and expectations, reality is often not so kind.

According to the Small Business Administration, approximately 30 percent of all new businesses fail during the first two years of being open, 50 percent during the first five years and 66 percent during the first 10. When businesses in the U.S. fail, bankruptcy often is the fallback savior, discharging debts the companies cannot afford to pay. However, bankruptcy is not an option for cannabis businesses. Perhaps more unnerving to entrepreneurs, it also may not be an option for businesses ancillary to the cannabis field.

A recent decision by the federal bankruptcy court in Colorado has implications for cannabis businesses across the country, including businesses peripheral to the cultivation, manufacture, distribution or sale of cannabis. Although consistent with existing bankruptcy law, the decision has rekindled concern, fear and confusion in the cannabis industry, while further highlighting the dichotomy between existing federal and state laws pertaining to cannabis. Bouts of fear and uncertainty will continue until this discord is harmonized.

The root of the discord lies with existing federal law. Because marijuana remains a Schedule 1 drug under the Controlled Substances Act, the cannabis trade remains illegal under federal law. This remains so even though the majority of states have legalized marijuana for medical use.

Since bankruptcy courts are creatures of federal statutes, they must follow federal law, and federal law is clear that bankruptcy relief cannot be provided to those involved in illegal activities. Indeed, as Judge Howard Tallman explained in his decision in In re Rent-Rite Super Kegs West Ltd., “That there is a sharp difference between state and federal law where the growing of marijuana is concerned does not make the controlling law unsettled or ambiguous.” Any doubt regarding this fact was removed in 2005 following the U.S. Supreme Court’s decision in Gonzalez v. Raich, 125 S.Ct. 2195 (2005), wherein the U.S. Supreme Court clarified the federal government’s designation of marijuana as a controlled substance supersedes contrary state law.

This result does not come as a surprise to many of those who entered the cannabis arena following California’s passage of Proposition 215 in 1996. These cannabis pioneers experienced first-hand the uncertainty created by the dichotomy existing between state laws and federal law. While the dichotomy is well-known in the industry, many in the industry still are surprised to learn an individual or business can be denied access to bankruptcy protection if that individual or business cultivates, manufactures, distributes or sells cannabis.

A far greater number are surprised and concerned to learn the prohibition could apply to individuals and entities providing products or services to cultivators, manufacturers, distributors or sellers of cannabis. This concern was brought to the forefront recently when a federal bankruptcy court judge in Colorado dismissed the bankruptcy petitions of Way to Grow, Inc. and related companies. The decision reaffirmed bankruptcy protection may not be available to those selling or leasing extraction, remediation, hydroponic or laboratory equipment to an individual or business cultivating, manufacturing, distributing or selling cannabis. Arguably, bankruptcy protection may not be available to those selling bongs, pipes, wearing apparel, hats or other accessories to a cannabis business.

The Way to Grow companies did not cultivate, manufacture, distribute or sell cannabis. Rather, the companies sold equipment for indoor hydroponic and gardening-related supplies. While such equipment is used for many types of crops, the companies acknowledged their future business expansion plan was tied to the growing cannabis industry. In his order, Judge Michael E. Romero, after conducting a survey of earlier decisions, explained while the debtors did not themselves manufacture, distribute or dispense cannabis, they marketed their products to the cannabis industry and sold hydroponic and other supplies knowing these products were being used by some of their customers to cultivate marijuana. The court further determined the debtors’ reorganization plans were inadequate if cannabis-related business was removed. While not applicable in Way to Grow, Judge Romero further explained bankruptcy petitions could be denied if it can be shown the debtors aided and abetted or conspired with the manufacture, distribution or dispensing of cannabis.

So, until federal law is changed, if you transact business with anyone tied to the cannabis industry, you better hope your business is a monetary success because filing for bankruptcy protection may not be an option. That said, understanding how the law presently is applied can assist a business in determining its risk.

To those familiar with the bankruptcy process, Judge Romero explained how present bankruptcy law relating to cannabis businesses operates from three fundamental tenets: (1) a party cannot seek equitable bankruptcy relief from a federal court while in continuing violation of federal law; (2) a bankruptcy court cannot proceed where the court, the trustee or the debtor-in-possession will necessarily be required to possess and administer assets that are either illegal under the Controlled Substances Act or constitute proceeds of activity criminalized by the act; and (3) the focus should be on the debtor’s marijuana-related activities during the bankruptcy case, not necessarily before the bankruptcy case is filed.

For those less familiar, the foregoing is as clear as mud, and offers little help in learning whether bankruptcy relief may be an available option for their cannabis-related business. For such souls, the following hopefully provides insight.

Firstly, if your business violates federal law, you will not be able to successfully petition the bankruptcy court for relief. This means that while marijuana remains a Schedule 1 drug under the Controlled Substances Act, and your business involves the cultivation, manufacture, distribution or sale of cannabis, you will not be able to obtain relief through the bankruptcy court. This is a pretty clear-cut rule.

Secondly, it is a violation of federal law (see, e.g., 21 U.S.C. Section 843(a)(7)) to knowingly or intentionally manufacture, distribute, export or import “any equipment, chemical, product, or material which may be used to manufacture” cannabis. This is the foundation for the Way to Grow decision denying Way to Grow access to bankruptcy protection.

The court found there were a substantial number of emails and other communications showing the companies knew their hydroponics equipment was and would be used for cultivation of cannabis and actively marketed toward this end. The companies paid for booths at cannabis industry trade shows, giving away promotional materials including lighters and rolling papers that are “strongly associated with marijuana use.” The companies also did cross-promotions with cannabis dispensaries and advertised on cannabis talk shows.

The takeaway is that if you manufacture or provide anything to business that likely will be used to assist in the cultivation or manufacture of cannabis, you may be in violation of federal law, particularly if you promote cannabis or advertise to the cannabis market. And, if you are in violation of federal law, you will not be able to avail yourself of the benefits afforded by bankruptcy laws. Again, this is a fairly straightforward concept with the biggest area for confusion resting on whether the business subjectively knew or objectively should have known its product was going to be used for cannabis manufacture.

Lastly, you can violate federal law if you are complicit regarding the cannabis industry. Specifically, if your business aids or abets another’s manufacture, distribution, dispensing or possession of cannabis with intent to manufacture, distribute or dispense, you are in violation of federal law and, again, you will not be able to avail yourself of the benefits afforded by bankruptcy laws. Unfortunately, while the law is clear, it is very difficult to predict how a court will rule because the outcome is highly dependent on the specific facts of the situation before the court.

To be found complicit, the law requires the offending party provide knowing aid to a person committing a federal crime, with the intent to facilitate the crime. Moreover, the party you must take an affirmative act in furtherance of the offense, which must be more than mere presence at the scene, knowledge of the offense or merely providing general information.

Case law is less than clear regarding what specific conduct will be deemed complicit and what will not and, unfortunately, the Way to Grow decision provides no clarity. Because it determined the companies violated federal law by selling the hydroponic equipment to cannabis cultivators, the Way to Grow court summarily dismissed the complicity argument. The court determined the companies did not “willfully associate themselves with their customers’ criminal ventures.”

Judge Romero held it was unclear whether the companies were merely providing general information to their customers which is useful and applicable to growing almost any type of crop, not just marijuana. He explained the companies serve “a broad customer base consisting of both commercial and individual horticulturists, growing a variety of legal crops.”
For its analysis, the court did not address the specific communications regarding the businesses’ intent to focus on the cannabis operations and completely ignored all the advertisements and marketing directly focused on the cannabis industry. The court also failed to discuss the companies’ sale of only pesticides approved for use on cannabis plants as well as the companies’ sale of other cannabis-related paraphernalia, including “bubble bags,” which are specifically used to make “water hash,” a concentrated cannabis derivative.

The failure of the Way to Grow court to discuss why these facts are not germane to the complicity discussion while, at the same time, relying on them to find the companies sold equipment for cannabis cultivation may be the primary reason for the renewed concern among the ancillary businesses. Clarity is key, and the decision offers none to these businesses. The decision also begs the question, “will clarity be reached through a future bankruptcy opinion cogently addressing the issue, or will the industry continue to wrestle with the uncertainty until the issue is removed by the reclassification of marijuana in the Controlled Substances Act.

Until there is resolution, many cannabis and cannabis-related businesses will be jumping without their bankruptcy parachute. However, while the uncertainty is creating concern, I believe the cannabis entrepreneurs will adapt. I fully expect to see some businesses double down while others modify their practices to increase the chance they will be able to seek bankruptcy protection should the need arise.

Some business will accept the fact they have no safety net, and will increase their focus on growing the cannabis market. Others will take guidance from Judge Romero’s comments about how providing general information or serving a broad customer base does not give rise to complicit liability. They will continue to work in the field but will try to broaden their business and marketing to encompass a customer base beyond cannabis.

Whatever road is chosen, the cannabis field will continue to be the new Wild West, not well suited for the faint of heart or the slow of foot.