The ability to obtain a discharge of a person's debts in bankruptcy—either through a reorganization of his or her affairs or liquidation proceeding administered by a court-appointed trustee—is a fundamental benefit of filing for bankruptcy. When a debtor's prepetition actions involve fraud, concealment, or other examples of a lack of good faith, bankruptcy courts dismiss such "bad faith" filings, thereby denying debtors the protections and benefits of the federal bankruptcy law. Usually bad faith involves fraud, concealment, or other types of white-collar criminal activity. Debts arising from other types of tortious conduct are also excepted from being discharged.
In recent years, there has been movement to legalize the production, sale and use of marijuana in certain states, first for medicinal purposes, but more recently for recreational use as well. Most notably, Colorado has legalized the production and sale of marijuana under certain circumstances notwithstanding that such production and sale remains illegal under federal law. One must wonder how this strange legal web plays out.
Recently, the issue was presented whether marijuana producers, fully licensed and in compliance with all laws of the state of Colorado, could avail themselves of the federal courts by filing for bankruptcy. In a decision rendered by the U.S. Bankruptcy Appellate Panel of the Tenth Circuit (BAP), dated Aug. 21, in In re Arenas, BAP No. CO-14-046, the BAP held that because the debtors were engaged in business in violation of federal law, and the bankruptcy trustee would have to administer assets derived from federally illegal activities, the debtors were not eligible for federal bankruptcy protection.
Dispute with Distributor Tenants Leads to Bankruptcy
The opinion recites the facts involving Frank and Sarah Arenas (the debtors) and the circumstances surrounding their bankruptcy filing, which were not in dispute. At the time of the opinion, Frank Arenas was licensed in Colorado to grow and dispense medical marijuana. He and his wife, Sarah Arenas, owned a building consisting of two units in Denver. Frank Arenas grew and wholesaled marijuana in one unit, and leased the other unit to Denver Patients Group LLC (DPG), which, in turn, dispensed the medical marijuana to the public. The couple brought an eviction action against DPG that resulted in a judgment against the Arenases for $40,000 in attorney fees. The Arenases, unable to pay the $40,000 or defend $120,000 in additional counterclaims brought against them by DPG, filed a Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the District of Colorado.
According to their schedules, Sarah Arenas, who was disabled, received approximately $2,977 in monthly pension benefits and Social Security disability benefits. The couple also had $4,265 in monthly income stemming from rental income and Frank Arenas' marijuana business. In light of their $7,235 in monthly expenses, their monthly net income was $7. Their two non-exempt assets were the rental property and 25 marijuana plants.
After the court-appointed trustee made inquiries to the Office of the U.S. Trustee regarding whether a federal court-appointed trustee could, or should, administer the profits of a marijuana business, the U.S. trustee filed a motion to dismiss the case, arguing that it would be impossible for a Chapter 7 trustee to administer the assets without violating federal law. The Arenases objected to the motion, and also moved to convert the case to a Chapter 13 reorganization proceeding. The bankruptcy court dismissed the debtors' motion to convert the case, and granted the trustee's motion to dismiss. The debtors appealed, and the parties consented to a direct appeal.
Marijuana Producers Cannot be Debtors
The opinion begins by noting the tension created by marijuana's legal status under the laws of certain states and its continued illegality under federal law by writing: "Possessing, growing, and dispensing marijuana and assisting others to do that are federal offenses. But like several other states, Colorado has legalized these acts and heavily regulates them, triggering a flourishing marijuana industry there." The court described the pivotal issue as whether engaging in marijuana trade, legal under Colorado law but a crime under federal law, constitutes "cause" that disqualifies otherwise-eligible debtors from bankruptcy.
Beginning with the debtors' motion to convert, the court noted that while Section 706 of the U.S. Bankruptcy Code permits a Chapter 7 debtor to convert its case to a Chapter 13 "at any time," the debtor must be eligible for Chapter 13 relief. The opinion then cites a U.S. Supreme Court decision that held that a Chapter 7 debtor who had made false statements and concealed assets from the trustee could not exercise his right to convert his case to a Chapter 13, because his lack of good faith rendered him ineligible for Chapter 13 relief. "Good faith" is a prerequisite for confirmation of any Chapter 13 plan, and the debtor's lack of good faith meant that he could not propose a Chapter 13 plan in good faith.
In this case, there was no fraud, concealment, or false statements. The decision notes that the Tenth Circuit test for determining if a bankruptcy petition should be dismissed for lack of good faith is subjective and utilizes a list of 11 factors courts consider. Here, only a few were arguably relevant, including the debtor's employment history, ability to earn and likelihood of future increases in income, the burden the plan's administration would place on the trustee, and the debtor's motivation and sincerity in seeking Chapter 13 relief.
The court reasoned that these factors weighed in favor of dismissal and concluded that the debtors could not propose a feasible plan. Their monthly income from non-marijuana sources was not enough to fund a plan. Even with the marijuana-based income, there was less than $8 per month, which the court stated would yield a "nominal dividend." The court described the burden of administering the debtors' plan, writing, "Short of exposing him to physical harm, nothing could be more burdensome to the trustee's administration than requiring him to take possession, sell and distribute marijuana assets in violation of federal criminal law. There would be no way the trustee could administer the plan without committing one or more federal crimes." The court noted that the bankruptcy court had found the debtors to be sincere and credible, and found that their motives in seeking bankruptcy relief were not improper, but stated good faith contains an objective component. If the debtors could not propose a confirmable plan, it was objectively unreasonable to seek Chapter 13 relief, regardless of the kindliness and sincerity of their subjective intentions.
The court went further. Not only were the Arenases precluded from converting their case to a Chapter 13, but the court held they could not remain in Chapter 7. Under Section 707 of the Bankruptcy Code, a court may dismiss a Chapter 7 case for cause, including unreasonable delay by a debtor that is prejudicial to creditors. The court wrote that while "cause" is not defined in the Bankruptcy Code, it is within the court's discretion. A court's analysis should include possible prejudice that dismissal might cause to the estate's creditors.
In this case, the bankruptcy court concluded it would be impossible for a Chapter 7 trustee to administer the estate's assets because selling and distributing the proceeds of the marijuana assets would constitute federal crimes. As such, the debtors would receive a discharge and creditors would receive nothing. The debtors argued that the bankruptcy court could have directed the Chapter 7 trustee to abandon the marijuana assets. The BAP rejected this argument, noting that it is not clear that a bankruptcy court can order a trustee to abandon assets sua sponte. Even if it could, the outcome would be the same. The debtors would retain their marijuana assets as a result of the abandonment and receive the benefit of a discharge, and creditors would receive nothing. The court described that outcome as "the epitome of prejudicial delay." The court ultimately affirmed the bankruptcy court's denial of the debtors' motion to convert their case to a Chapter 13 and dismissal of the Chapter 7 case.
Reliance on State Law not Same for Federal Bankruptcy
This case presents an example of how the strange legal web involving marijuana legalization under state law while still being illegal under federal law can play out. Simply put, the BAP concluded federal courts and federally appointed fiduciaries supervised by federal courts should not be utilized to perpetuate violations of federal law. Even here, where a clearly financially distressed elderly couple, one of whom is disabled, sought relief without any false or fraudulent conduct, the decision was clear that one cannot take advantage of a federal court and benefits of federal law while engaging in ongoing violation of other federal law.
In recent years, there has been movement to legalize the production, sale and use of marijuana in certain states, first for medicinal purposes, but more recently for recreational use as well. Most notably, Colorado has legalized the production and sale of marijuana under certain circumstances notwithstanding that such production and sale remains illegal under federal law. One must wonder how this strange legal web plays out.
Recently, the issue was presented whether marijuana producers, fully licensed and in compliance with all laws of the state of Colorado, could avail themselves of the federal courts by filing for bankruptcy. In a decision rendered by the U.S. Bankruptcy Appellate Panel of the Tenth Circuit (BAP), dated Aug. 21, in In re Arenas, BAP No. CO-14-046, the BAP held that because the debtors were engaged in business in violation of federal law, and the bankruptcy trustee would have to administer assets derived from federally illegal activities, the debtors were not eligible for federal bankruptcy protection.
Dispute with Distributor Tenants Leads to Bankruptcy
The opinion recites the facts involving Frank and Sarah Arenas (the debtors) and the circumstances surrounding their bankruptcy filing, which were not in dispute. At the time of the opinion, Frank Arenas was licensed in Colorado to grow and dispense medical marijuana. He and his wife, Sarah Arenas, owned a building consisting of two units in Denver. Frank Arenas grew and wholesaled marijuana in one unit, and leased the other unit to Denver Patients Group LLC (DPG), which, in turn, dispensed the medical marijuana to the public. The couple brought an eviction action against DPG that resulted in a judgment against the Arenases for $40,000 in attorney fees. The Arenases, unable to pay the $40,000 or defend $120,000 in additional counterclaims brought against them by DPG, filed a Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the District of Colorado.
According to their schedules, Sarah Arenas, who was disabled, received approximately $2,977 in monthly pension benefits and Social Security disability benefits. The couple also had $4,265 in monthly income stemming from rental income and Frank Arenas' marijuana business. In light of their $7,235 in monthly expenses, their monthly net income was $7. Their two non-exempt assets were the rental property and 25 marijuana plants.
After the court-appointed trustee made inquiries to the Office of the U.S. Trustee regarding whether a federal court-appointed trustee could, or should, administer the profits of a marijuana business, the U.S. trustee filed a motion to dismiss the case, arguing that it would be impossible for a Chapter 7 trustee to administer the assets without violating federal law. The Arenases objected to the motion, and also moved to convert the case to a Chapter 13 reorganization proceeding. The bankruptcy court dismissed the debtors' motion to convert the case, and granted the trustee's motion to dismiss. The debtors appealed, and the parties consented to a direct appeal.
Marijuana Producers Cannot be Debtors
The opinion begins by noting the tension created by marijuana's legal status under the laws of certain states and its continued illegality under federal law by writing: "Possessing, growing, and dispensing marijuana and assisting others to do that are federal offenses. But like several other states, Colorado has legalized these acts and heavily regulates them, triggering a flourishing marijuana industry there." The court described the pivotal issue as whether engaging in marijuana trade, legal under Colorado law but a crime under federal law, constitutes "cause" that disqualifies otherwise-eligible debtors from bankruptcy.
Beginning with the debtors' motion to convert, the court noted that while Section 706 of the U.S. Bankruptcy Code permits a Chapter 7 debtor to convert its case to a Chapter 13 "at any time," the debtor must be eligible for Chapter 13 relief. The opinion then cites a U.S. Supreme Court decision that held that a Chapter 7 debtor who had made false statements and concealed assets from the trustee could not exercise his right to convert his case to a Chapter 13, because his lack of good faith rendered him ineligible for Chapter 13 relief. "Good faith" is a prerequisite for confirmation of any Chapter 13 plan, and the debtor's lack of good faith meant that he could not propose a Chapter 13 plan in good faith.
In this case, there was no fraud, concealment, or false statements. The decision notes that the Tenth Circuit test for determining if a bankruptcy petition should be dismissed for lack of good faith is subjective and utilizes a list of 11 factors courts consider. Here, only a few were arguably relevant, including the debtor's employment history, ability to earn and likelihood of future increases in income, the burden the plan's administration would place on the trustee, and the debtor's motivation and sincerity in seeking Chapter 13 relief.
The court reasoned that these factors weighed in favor of dismissal and concluded that the debtors could not propose a feasible plan. Their monthly income from non-marijuana sources was not enough to fund a plan. Even with the marijuana-based income, there was less than $8 per month, which the court stated would yield a "nominal dividend." The court described the burden of administering the debtors' plan, writing, "Short of exposing him to physical harm, nothing could be more burdensome to the trustee's administration than requiring him to take possession, sell and distribute marijuana assets in violation of federal criminal law. There would be no way the trustee could administer the plan without committing one or more federal crimes." The court noted that the bankruptcy court had found the debtors to be sincere and credible, and found that their motives in seeking bankruptcy relief were not improper, but stated good faith contains an objective component. If the debtors could not propose a confirmable plan, it was objectively unreasonable to seek Chapter 13 relief, regardless of the kindliness and sincerity of their subjective intentions.
The court went further. Not only were the Arenases precluded from converting their case to a Chapter 13, but the court held they could not remain in Chapter 7. Under Section 707 of the Bankruptcy Code, a court may dismiss a Chapter 7 case for cause, including unreasonable delay by a debtor that is prejudicial to creditors. The court wrote that while "cause" is not defined in the Bankruptcy Code, it is within the court's discretion. A court's analysis should include possible prejudice that dismissal might cause to the estate's creditors.
In this case, the bankruptcy court concluded it would be impossible for a Chapter 7 trustee to administer the estate's assets because selling and distributing the proceeds of the marijuana assets would constitute federal crimes. As such, the debtors would receive a discharge and creditors would receive nothing. The debtors argued that the bankruptcy court could have directed the Chapter 7 trustee to abandon the marijuana assets. The BAP rejected this argument, noting that it is not clear that a bankruptcy court can order a trustee to abandon assets sua sponte. Even if it could, the outcome would be the same. The debtors would retain their marijuana assets as a result of the abandonment and receive the benefit of a discharge, and creditors would receive nothing. The court described that outcome as "the epitome of prejudicial delay." The court ultimately affirmed the bankruptcy court's denial of the debtors' motion to convert their case to a Chapter 13 and dismissal of the Chapter 7 case.
Reliance on State Law not Same for Federal Bankruptcy
This case presents an example of how the strange legal web involving marijuana legalization under state law while still being illegal under federal law can play out. Simply put, the BAP concluded federal courts and federally appointed fiduciaries supervised by federal courts should not be utilized to perpetuate violations of federal law. Even here, where a clearly financially distressed elderly couple, one of whom is disabled, sought relief without any false or fraudulent conduct, the decision was clear that one cannot take advantage of a federal court and benefits of federal law while engaging in ongoing violation of other federal law.
