Will Dealing with Cannabis Leave You Bankrupt?

If your business deals with cannabis, you no doubt are hoping the answer is no. However, as the saying goes, “be careful what you wish for.”

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 and fears 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.

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. The burgeoning cannabis industry has attracted the attention of existing and start-up companies, with many companies avoiding the costly and time-consuming licensing process by providing ancillary products to the cannabis industry — products such as pipes, bongs, hydroponics, apparel, hats and other accessories.

While all of these businesses 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 and, as many an unwary business has learned, it also is not an option for many businesses ancillary to the cannabis field.

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. Since bankruptcy courts are creatures of federal statutes, they must follow federal law, and the law is clear that bankruptcy relief cannot be provided to those involved in illegal activities. This result does not come as a surprise to those who have been involved with cannabis since before 1996 when California legalized marijuana for medical use. These old-timers are well aware of the dichotomy existing between state laws and federal law,and are also quite familiar with the 2005 decision in Gonzalez v. Raich, 545 U.S. 1 (2005), wherein the U.S. Supreme Court clarified that the federal government’s designation of marijuana as a controlled substance supersedes contrary state law.

While the dichotomy is well-known in the industry, many in the industry 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. In re Way to Grow, Inc., 1:18-bk-14330 (Bankr.D.Colo., Dec. 14, 2018). 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 and the ambiguity factor is low.
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 entity 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. To be found complicit, the law requires you provide knowing aid to a person committing a federal crime, with the intent to facilitate the crime. Moreover, 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. This rule ranks high on the ambiguity scale given case law is less than clear what specific conduct will be deemed complicit and what will not and, unfortunately, the Way to Grow decision provides no clarity. The court in Way to Grow summarily dismissed the complicity argument, determining that while the companies provided information and sold to cannabis operations, they also provided information and sold to other operations. 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, and failed to discuss the companies’ sale of other cannabis-related paraphernalia. In short, the Way to Grow decision’s failure to do so is perhaps the primary reason for the renewed concern among the ancillary businesses. Clarity is key, and the decision offers none to these businesses and raises the question: Which will be the first vehicle offering clarity, a cogent bankruptcy opinion addressing the issue, or the removal of the issue through the decriminalization of cannabis? Time will tell.