By Daniel Bugbee & Dominique Scalia
Every new business owner confronts the possibility of failure, even if it only ends up being theoretical. For marijuana businesses, future prospects may seem even less certain in the face of unresolved questions about the ever-changing relationship between state and federal drug laws. As several recent bankruptcy court decisions have shown, that unsettled relationship creates risks for marijuana businesses that extend even beyond the potential for liability under the federal Controlled Substances Act.
The federal bankruptcy courts in the United States provide an important safety net for individuals and businesses that take entrepreneurial risks, ensuring that one can move past insolvency by obtaining a discharge of debts through either reorganization or a liquidation of assets. As Washington and Colorado embark on the next frontier of marijuana legalization, the promise of the bankruptcy discharge is being denied to entrepreneurs investing in these new businesses.
A 2014 decision by the United States Bankruptcy Court for the District of Colorado highlighted this risk. Frank and Sarah Arenas operated their marijuana business as a sole proprietorship, and when they became unable to meet their personal financial obligations, they filed for individual bankruptcy relief (with regards to Frank Anthony Arenas and Sarah Eve Arenas, 514 B.R. 887, Bankr. D. Colo. 2014). The court dismissed their case, denying the couple the ability to obtain a discharge, based on findings that their business activities violated federal law, and that some of their assets consisted of marijuana plants.
This was not the first bankruptcy dismissed on similar grounds. In 2011, an Oregon bankruptcy court denied relief to the owner of a medical marijuana business because his income came from a business that violated both federal and state law (with regards to McGinnis, 453 B.R. 770, D. Or. 2011). The McGinnis case is distinct in some respects because it involved a business that violated state law, which would not be the case with a state-licensed business in Washington or Colorado. That said, in 2012, a Colorado landlord was denied the right to reorganize his business through a bankruptcy court because one of the debtor’s tenants grew marijuana (with regards to Rent-Rite Super Kegs West, Ltd., 484 B.R. 799, D. Colo. 2012).
These cases impose unique legal challenges on insolvent marijuana businesses and their owners; challenges that should be considered by owners at the outset, when forming a state-licensed marijuana business. At the minimum, it is critical to operate the business through a separate legal entity such as a limited liability company or standard corporation. Owners of businesses facing potential insolvency should look to state-law remedies for the entity — like a state court receivership — that may allow for either ongoing business operations or asset liquidation, and should consider federal bankruptcy courts unavailable. Once state-law remedies are exhausted, business owners still saddled with personal debts such as commercial guarantees may be able to find some relief through bankruptcy, but it is not clear how the cases described above will impact outcomes for those individuals. Business owners should consult counsel knowledgeable with debt relief protections at the earliest possible stage when facing insolvency of the business or personal financial challenges arising from guaranteed debt.
Daniel Bugbee and Dominique Scalia are attorneys with Garvey Schubert Barer Law Firm who specialize in bankruptcy, creditors’ rights, commercial litigation and real estate transactions.