The Restructuring Report

The legalization of marijuana and the Bankruptcy Code continue to proceed on a crash course. A majority of states have legalized marijuana for medical use, and a growing number have legalized recreational use as well. As a result, the industry is rapidly expanding – national sales in legal markets have increased 34 percent in 2018 to $10.8 billion. This issue remains front and center in Minnesota, as well, with the Minnesota legislature legalizing limited medical use in 2014 and recreational use advocates continuing to work for broader legalization.

But marijuana remains a Schedule I controlled substance under the Controlled Substances Act of 1970 (CSA), which makes it a federal crime, among other things, to manufacture, distribute or dispense a controlled substance.

In a recent decision from the District of Colorado titled In re Way to Grow, Inc., the bankruptcy court dismissed the Chapter 11 cases of affiliated debtors that sold hydroponic gardening supplies because the debtors’ business model violated the CSA. 597 B.R. 111 (Bankr. D. Colo. 2018), stay pending appeal denied, No. 18-CV-3245-WJM, 2019 WL 669795 (D. Colo. Jan. 18, 2019). This is the latest in a line of opinions dismissing bankruptcy cases where debtors violated the CSA, or where a debtor’s reorganization efforts depended on the proceeds from operations that violate the CSA. But, importantly, the Way to Grow court depended on a different provision of the CSA than past decisions, which could have far-reaching effects.

In addition to directly prohibiting the manufacturing, distributing or dispensing of a controlled substance, the CSA also prohibits the possession or distribution of any equipment that may be used to manufacture a controlled substance if the person knows, intends or has “reasonable cause to believe” that the equipment will be used to manufacture a controlled substance.

Hydroponic gardening supplies can be used to grow all sorts of plants, and while some of the supplies carried by the Way to Grow debtors were specific to marijuana cultivation, the court’s ruling did not depend on that fact. Instead, the court analyzed the debtors’ business model, the identity of their largest customers, the debtors’ efforts to raise financing, the debtors’ marketing activities and the debtors’ reputation as being experts in “advising on cannabis growing and … in selling products that are geared towards cannabis.”

In short, there was “abundant evidence” that the debtors’ business model depended on selling otherwise-legal products to customers who the debtors knew would use those products to manufacture a controlled substance in violation of the CSA. The bankruptcy court found that the debtors had “actual knowledge they are selling equipment which will be used to manufacture a controlled substance.” The debtors’ knowledge and intent caused the operation of their gardening supply store to violate federal law and therefore disqualified the debtors for relief under the Bankruptcy Code.

As the marijuana industry grows, in Minnesota and across the nation, more and more businesses will supply the industry’s needs and may even specialize in doing so. As the Way to Grow decision highlights, such businesses may find the protections of the Bankruptcy Code are unavailable if their business model depends on the violation of federal law.