NEW YORK (The Deal) -- Common sense says that if you play by the rules in business, you'll be fine.

Pay your taxes, and you'll keep the Internal Revenue Service from knocking at your door. Don't drop any hints to shareholders about company plans, and you'll avoid following in Martha Stewart's footsteps. Restrain yourself from dipping into the company coffers to buy a speed boat, and it should be smooth sailing.  

In short, do what you're supposed to, and the law will be on your side.

But what happens when you think you've been operating on the straight and narrow only to discover that there could be a very big difference between a state law and a federal one?

That's the predicament Frank and Sarah Arenas find themselves in. Frank, who operates a marijuana wholesaler -- legal under Colorado law -- is fighting the dismissal of his and his wife's Chapter 7 filing in the U.S. Bankruptcy Court for the District of Colorado in Denver, a result that even Judge Howard R. Tallman called "devastating" for the couple in his order throwing it out.

Because bankruptcy is a federal process, judges have ruled the violation of the federal Controlled Substances Act by distributing marijuana makes cannabis-related companies ineligible for bankruptcy. In the Arenases' case, a trio of bankruptcy justices -- Judges Tom R. Cornish, Robert E. Nugent and Dale L. Somers of the U.S. Bankruptcy Appellate Panel of the 10th Circuit in Denver -- underscored the point, asserting in an Aug. 21 opinion that "possessing, growing and dispensing marijuana and assisting others to do that are federal offenses. [...] Can a debtor in the marijuana business obtain relief in the federal bankruptcy court? No."

The Arenases aren't done yet, however. The appellate panel judges on Sept. 4 agreed to stay the dismissal of the Arenases' case while the couple appeals the decision to the Tenth Circuit Court of Appeals, making it the first time this debate will be considered at so high a judicial level. 

The stakes for the Arenases are very real, of course. Their counsel, Daniel Garfield of Foster Graham Milstein & Calisher, said, "They simply can't afford to pay the claims against them." 

But there's even more to it, given that marijuana-related businesses are sprouting up and gaining legitimacy nationwide. "At the most basic level, this is a legal business under state law, and they should be able to access the protection," Garfield said. "That's the main reason [they're pursuing this]."

Jurisdictional issues are not new to bankruptcy. The Federal Energy Regulatory Commission has clashed with bankruptcy courts when utility companies have been involved. Among the reasons that asbestos-related Chapter 11 filings are handled in the complex way they are is because of the involvement of the federal Environmental Protection Agency.

 

The clash of state law and federal law in the bankruptcy arena has also been prominent in recent years when it comes to municipalities. Many states, such as Pennsylvania, pointedly have laws that prohibit cities and towns from declaring Chapter 9, the part of the federal bankruptcy code designed specifically for government entities.

The challenge the marijuana industry poses will inevitably require some type of reconciliation of state and federal law, since the sector is expected to have $20 billion in revenue by 2020. It's legal to purchase marijuana in Alaska, Colorado, Oregon, Washington and the District of Columbia. Meanwhile, 29 states and the District of Columbia have legalized medical marijuana.

Proponents may not have to look any further than the gaming industry for support for their legal cause. Gambling isn't legal nationally but is on a state-by-state basis, and is becoming a larger and larger business presence. Those companies can and have filed for bankruptcy under Chapter 7 and Chapter 11.

"This is just one of the many issues that take place because of the ambiguity between state law and federal law," said David Dinenberg, CEO of KindManage's Kind Financial, which provides financial services to the cannabis industry. 

The Arenases are being circumspect.

"Appellants are under no illusions as to the likelihood of success on appeal, given the two judgments against them and that the bankruptcy courts in the District of Colorado and the District of Arizona have held similarly to this court," the debtors said in a Sept. 4 filing. (MedPoint Management, a medical marijuana dispensary, was put into Chapter 7 involuntarily but the U.S. Bankruptcy Court for the District of Arizona in Phoenix dismissed the case on April 6.) "However, only this court has considered the issue at the appellate level, no court of appeals has considered the issue, and novel and substantial questions of law would benefit from further appellate review at the circuit court level."

An inability to file for bankruptcy in a standard way isn't the only obstacle confronting marijuana enterprises. The U.S. Patent and Trademark Office has said it won't register cannabis product trademarks, and the Ninth U.S. Circuit Court of Appeals in July ruled in favor of the IRS on its stance that the federal tax code forbids cannabis businesses from deducting expenses.

"We're not treated as regular businesses," Dinenberg said. "There are no traditional loans and there are barely traditional banks for these businesses."

He said that most cannabis businesses are self-funded or receive financing from friends and family. Lenders that do make loans in this industry can charge "north of 18%, 19%, 25%" on them, and national banks don't get anywhere close to the sector, Dinenberg said. 

The most likely type of bank to take deposits from marijuana businesses are state-chartered banks or credit unions, he said. 

As a result, cannabis companies without the ability to protect themselves from creditors through a federal bankruptcy filing may find themselves vulnerable to lawsuits from those parties in multiple state courts seeking recoveries. 

"Without automatic stay, you could have a race to the [state] courthouse," said Christopher Ward, co-chair of Polsinelli's bankruptcy and financial restructuring practice, about creditor lawsuits.

Ralph Preite, a partner at Sichenzia Ross Friedman Ference, said that keeping marijuana-related business out of bankruptcy really causes complications for the companies.

"I think this poses a big obstacle for companies that need to restructure, reorganize or even liquidate," he said. 

Preite said in a liquidation, for example, a trustee would be tasked with selling the valuable assets of the estate, including drug-related ones, which would "saddle the trustee with personal liability."

A reorganization is also out of the question because not administering the most valuable assets in the estate would violate the absolute priority rule, and a plan can't be funded through nonfederally legal means.

"It really is a tough situation for the creditors, too, because they may have difficulty getting their debt satisfied because of the illegal nature, if you will, of the equipment and inventory of their borrower," he said. 

Priete did point out that the Bankruptcy Code does include a provision that bars certain types of businesses -- in Section 109 (b) 2. "Those industries [listed] generally have their own liquidation schemes," he said. (Banks for example, can't file for bankruptcy -- the Federal Deposit Insurance Corp. takes over as a receiver for those entities.)

Just because they aren't allowed into bankruptcy court, however, doesn't mean that marijuana-related organizations don't have options available to them.

Polsinelli's Ward said it will be interesting to see whether these companies explore other avenues for dealing with insolvency on a state level -- for example, through a receivership or an assignment for the benefit of creditors, also known as ABCs. In the first option, a receiver is tasked with taking over the company's affairs; in the second, typically an outside company or law firm is assigned to liquidate an insolvent business.

These state processes vary from state to state -- both options are available in Arizona, California and Colorado, three of the states where the federal vs. state law debate has recently cropped up in bankruptcy court. (Medical marijuana is legalized in Arizona and California.)

"Bankruptcy is one of several processes that debtors and creditors can use where the debtor cannot pay all of its bills," said Juliet M. Moringiello, professor of law at Widener University Commonwealth Law School in Harrisburg, Pa. "It's a federal process that brings all of the options to one court. The problem, of course, always arises when a company is indebted to a lot of creditors. It would be more efficient for everybody to resolve all of those debts in a single forum."

State remedies aren't conducive to a single clearinghouse for settling matters because five different creditors can sue the same debtor in five different states.

"The punchline is that there are state law remedies," Moringiello said. "It's just that bankruptcy provides a more desirable system where a debtor, like a [marijuana dispensary], can deal with these problems." 

Another big benefit, she said, is that in bankruptcy, a debtor is allowed to amend contracts. "A state process can't do that," she noted.

That lack of efficiency and protection is exactly the problem for the Arenases.

The Arenases kicked off their Chapter 7 case in Denver on Feb. 12, 2014. Frank, who is licensed in Colorado to grow and dispense medical marijuana, later sought permission to convert the proceeding to a Chapter 13, which is the section of the federal Bankruptcy Code specific to farms. He does business as FA Husbandry, FSA and Twenty Eighth Larimer, and owns and grows wholesale marijuana in one unit of a commercial building in Denver. He and Sarah lease the other unit to Denver Patients Group, a marijuana dispensary.

The couple filed for bankruptcy after they attempted to evict DPG in state court, which resulted in a $40,000 attorney's fee award against them, even before the state court addressed DPG's $120,000 counterclaim against them for damages.

DPG has indicated that it would seek judgment against the Arenases if stay protection was removed, a situation that would surely cause irreparable harm. (The appellate panel's decision to stay dismissal of the case pending appeal means the couple is still protected by the automatic stay.)

Frank said at a July 30 court hearing that he was told when he applied for his wholesale license that he did not need any other documentation to operate his business in Colorado.

Following a stroke that has left Sarah unable to work ever again, and his being laid off from Anheuser-Busch Inbev 10 years ago, Frank said that bankruptcy is the only option for the couple.  

"Without me filing, again, this will send us to financial ruin," he said. 

When asked if he could enter some other line of work, Frank said, "I really don't know. I'm not sure how many companies are hiring 57-year-old men [anymore], so it would probably be a struggle."

Sarah, who worked as a clerk and recorder for the City and County of Denver for more than 20 years, receives monthly pension and social security benefits totaling $2,977; the family's remaining monthly income of $4,265 comes from rental income and Frank's marijuana business, according to court papers. (The duo's expenses leave them with little left over.) The couple's nonexempt assets are 25 marijuana plants valued at $6,250 and property in which they have no equity.

In a March 1, 2014, motion, the U.S. Trustee for the Arenases' case, Richard A. Weiland, requested it be dismissed, asserting the debtors disclosed that they are engaged in the husbandry business and that they used a portion of their building to lease to DPG, a dispensary. The case eventually was dismissed on Aug. 28, 2014, because even though Frank's conduct was legal under Colorado law, it violated the federal Controlled Substances Act. 

Therefore, the debtors couldn't receive Chapter 7 relief because "engaging in federal criminal conduct demonstrated a lack of good faith that would bar confirmation of their Chapter 13 plan and was cause to dismiss their Chapter 7 case, too," according to the appellate panel opinion.

In a Dec. 31 opening brief filed with the appellate panel, the debtors asserted, "The federal government has deliberately and actively allowed a legal marijuana industry to flourish in Colorado.[...] Appellants should not be found at fault and [should be allowed] to access the bankruptcy system where the federal government has made a conscious decision to allow their otherwise illegal business to operate and the debtors otherwise qualify as 'honest but unfortunate debtors.'"

The debtors argued the bankruptcy court failed to consider whether the marijuana assets were burdensome to the estate or of inconsequential value and that "well-settled case law allows [Chapter 7] trustees to abandon problematic property with appropriate conditions set by a bankruptcy court." (Why, the debtors argue, can't the marijuana plants be abandoned and the building be liquidated in its case, for example?)

Nevertheless, though Frank and Sarah "have not engaged in intrinsically evil conduct," the appellate panel ultimately ruled a bankruptcy trustee can't administer the marijuana plants because the action would break federal law.

"In this case, the debtors are unfortunately caught between pursuing a business that the people of Colorado have declared to be legal and beneficial, but which the laws of the [U.S.] -- laws that every [U.S.] judge swears to uphold -- proscribe and subject to criminal sanction," the opinion read. 

The appellate panel also underscored the fact that any trustee that would have to deal with the assets of a bankrupt marijuana business would essentially be handling illegal goods.

"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," the opinion said.

Moreover, the appellate panel said without the marijuana assets, creditors would likely receive no recovery, while the Arenases would hang on to their business.

"If the Trustee abandoned the Assets, the debtors would retain their business after exposing the trustee to grave risk, provide the creditors with little or no recovery, and receive a discharge, protected all the while from their creditors' collection efforts by the automatic stay and then the discharge injunction," the opinion read. "That is the epitome of prejudicial delay [...] this bankruptcy estate, shorn of its marijuana assets, would likely yield no dividend to the creditors. The debtors would get a discharge and get to keep (via abandonment) their marijuana assets while being protected from collection activities."

The Arenases' case is not the first time a cannabis-related bankruptcy has been booted from bankruptcy court. Marijuana dispensary Mother Earth's Alternative Healing Cooperative had its case dismissed on Oct. 4, 2012, for engaging in an activity prohibited under federal law. 

Even the judge presiding over the Arenases' bankruptcy has kicked out other debtors. Tallman dismissed warehouse owner Rent-Rite Super Kegs West's Chapter 11 filing on May 1, 2014, after the company's secured lender made a similar unclean hands argument.

Other justices in the Denver bankruptcy court have dismissed marijuana-related filings, too. Judge Michael E. Romero of the Denver court on June 11, 2012, ousted pot grower CGO Enterprises from bankruptcy court after Weiland, the UST in that case, as well, highlighted that the test of good faith in Chapter 11 is whether a company can propose a legally and economically feasible reorganization plan. Weiland said that since any Chapter 11 plan would be proposed by a means forbidden by law -- funded by the sale of the marijuana plants -- it would be impermissible.

Sichenzia's Priete said the way it appears now is that bankruptcy judges are looking at this matter as black and white. 

"It really is a simple issue," he said. "If the activity is illegal under federal law, then the activity won't be allowed in bankruptcy."

Ward believes that just because there is an appellate panel opinion on this matter doesn't mean other dispensaries won't file. 

"But I think the precedent is pretty clear," he said.

Garfield, the Arenases' lawyer, worries that marijuana companies in a fledgling sector won't have the opportunity most other industries enjoy, to reorganize and catch their breath. 

"Bankruptcy exists in order for creditors to collect in one forum, and for individuals and consumer debtors it allows them a fresh start," he said.

If people in the cannabis industry aren't able to have a legal way to wipe the slate clean, Garfield feels it could have serious consequences for individuals when it comes to such things as wage garnishment, liens on homes and compromised bank accounts.

"Bankruptcy exists so people don't have to put up with these severe creditor remedies," Garfield said. 

At the July hearing, Frank said the couple is just looking for a new beginning.

"We're looking to repay our creditors, and again, just move forward," he said. "We're not looking to just go out the back door and never be seen again. We want to repay the creditors. We want a fresh start and we want to rebuild our credit. We just want the opportunity, that's all." 

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