In In re: Roberts in September,[1] the U.S. Bankruptcy Court for the District of Colorado held that a debtor's alleged ownership interest in cannabis-related companies did not require a dismissal of the case and that a Chapter 7 trustee could administer the debtor's assets.

This represents a significant change from prior decisions from this court, which has usually dismissed any bankruptcy case with debtors involved in the cannabis industry, citing their ongoing violations of the federal Controlled Substances Act.

Background

In Roberts, the debtor, an individual investor, formed a limited liability company, PdC LLC, with two partners for the purpose of purchasing and developing real estate in Mexico.

Together, the three investors purchased four beachfront properties through their jointly owned company and its Mexican subsidiary between 2006 and 2012.

Two of the properties were purchased subject to an existing lien, and the investors negotiated a settlement agreement with the lienholder whereby the lienholder agreed to release the lien in exchange for $6.5 million.

Rather than pay the lienholder on behalf of the investors' shared company, the debtor fraudulently purchased the lien for himself and attempted to foreclose on the property by hiring armed guards to take physical possession of all four of the jointly owned properties.

In 2018, the debtor's two investment partners and their jointly owned companies filed cross-claims as well as a third-party complaint against the debtor in an ongoing lawsuit in the U.S. District Court for the District of Colorado.

The district court granted the creditors' request for a preliminary injunction enjoining the debtor from taking any further action with respect to the four properties. In complete derogation of this injunction, the debtor transferred his interest in the properties to two Mexican nationals.

During years of protracted litigation in the district court, the debtor repeatedly violated court orders and was held in contempt of court on two occasions. The district court ultimately found that the debtor had engaged in a fraudulent scheme to misappropriate the rights of his partners in the Mexican land venture and entered a default judgment in favor of the creditors.

In 2020 — just four days before a hearing on damages was scheduled to occur in the district court and while the debtor was jailed for contempt of court — the debtor filed for Chapter 11 bankruptcy in the bankruptcy court.

In the bankruptcy court, the creditors argued, among other things, that the debtor's bankruptcy case was filed in bad faith and moved for the bankruptcy court to convert the debtor's Chapter 11 case to a Chapter 7.

The creditors also argued that, in light of the debtor's prepetition litigation misconduct, the bankruptcy court should prohibit the debtor from remaining in control of his assets as a debtor-in-possession and immediately appoint a Chapter 7 trustee to administer the estate's assets.

The debtor argued that his bankruptcy filing was proper, and that, in the event that cause existed to dismiss or convert his filing, his filing should be dismissed because his assets included an ownership interest in two cannabis companies that would become property of the estate in a Chapter 7 case.

The debtor argued that his cannabis-related investments required dismissal of the case because those assets could not be administered by a Chapter 7 trustee.

The debtor alleged that his investments in two cannabis-related companies were worth approximately $2.2 million, but the nature of those companies' business operations was unclear.

Ruling

Under Section 112(b)(1) of the U.S. Bankruptcy Code, a bankruptcy court may convert or dismiss a Chapter 11 case for cause, including, for example, when a bankruptcy filing is made in bad faith.

The bankruptcy court analyzed a variety of factors — including the debtor's prepetition conduct, the likelihood of success of the debtor's reorganization, and the timing of the filing in the context of the district court action — and found that the present case presented a textbook example of a bad faith filing.

The bankruptcy court rejected the debtor's argument that his cannabis-related investments require that the case be dismissed, rather than converted to a Chapter 7, noting that the debtor voluntarily sought relief under Chapter 11 with knowledge of his interests in these companies.

Although the debtor alleged that he had an ownership interest in two companies that are involved in the cannabis industry, the specific nature of those companies' business and the extent of the debtor's ownership interest remained unclear.

The bankruptcy court explained that, although the debtor's conduct may have violated the Controlled Substances Act, "a bankruptcy court must be explicit in articulating its legal and factual basis for dismissal for cases involving marijuana," and the bankruptcy court found that it lacked adequate information on the record to explicitly articulate the factual basis for dismissal.

The debtor relied, in part, on In re: Arenas[2] to support the argument that his cannabis-related investments compel dismissal. In Arenas in 2014, the bankruptcy court granted a U.S. trustee's motion to dismiss a bankruptcy case due to the debtors' involvement in the cannabis industry.

Unlike the Roberts case, the Arenas debtors owned property that was being used for cannabis cultivation and leased space for use as a cannabis dispensary. The bankruptcy court found that the debtor's connection to the cannabis industry is far more attenuated than the debtors in Arenas, noting that "the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief."

The bankruptcy court also noted that, unlike in Arenas, the U.S. Trustee's Office had not objected to the conversion of the debtor's case.

However, the bankruptcy court left the door open for the case to be dismissed at a later date — presumably by motion by the Chapter 7 trustee — after more facts are developed about the nature of the debtor's involvement in the cannabis industry.

Conclusion and Commentary

The bankruptcy court granted the creditors' motion and ordered the swift appointment of a neutral third party to serve as the Chapter 7 trustee.

The Roberts decision may be a signal that a debtor's alleged investment in cannabis-related companies alone is not an automatic death knell to a debtor seeking bankruptcy relief or prevent a Chapter 7 trustee from administering estate assets, especially if the debtor's connection to the cannabis industry is attenuated.

The debtor has appealed, so the bankruptcy court's order may not be the final resolution of this matter.

The Roberts decision stands in stark contrast with the bankruptcy court's 2018 ruling in the case of In re: Way to Grow Inc.[3] In Way to Grow, the bankruptcy court dismissed the debtors' Chapter 11 cases, finding that the debtors' plan was not proposed in good faith as it relied on revenue partially derived from the cannabis industry.

Even though the debtors were tangentially removed from the cannabis industry, one of the debtors did, in fact, sell hydroponic gardening supplies to consumers, including cannabis growers. However, the debtors' future business plans included actively marketing to the cannabis industry.

The bankruptcy court found ample evidence that the debtors had reasonable cause to believe that their gardening equipment would be used to manufacture cannabis. Therefore, the debtors indirectly violated the Controlled Substances Act by knowingly manufacturing and distributing equipment that would be used to manufacture a controlled substance.

The Bankruptcy Court's ruling in Way to Grow was affirmed by the District of Colorado. The district court clarified that the relevant statute is Chapter 11 of the U.S. Code, Section 1129(a)(3), which provides that a bankruptcy court "shall confirm a plan only if ... [t]he plan has been proposed in good faith and not by means forbidden by law."

The district court held that

as long as marijuana remains a Schedule I controlled substance, a Chapter 11 debtor cannot propose a good-faith reorganization plan that relies on knowingly profiting from the marijuana industry.

Other courts, including the U.S. Court of Appeals for the Ninth Circuit, have taken a different approach when applying Section 1129(a)(3) to debtors involved in the cannabis industry.

For example, in Garvin v. Cook Investments NW in 2019,[4] the Ninth Circuit interpreted Section 1129(a)(3) to only require that a plan be proposed in a lawful manner, not that the substance of the plan comply with applicable law.

Based on this interpretation, the Ninth Circuit held that dismissal of the debtor's bankruptcy case was not warranted despite the fact that the debtor leased property to a cannabis dispensary.

Although the number of states who have legalized cannabis for medicinal or adult use continues to grow, cannabis remains a Schedule I controlled substance under the federal Controlled Substances Act. This disconnect between state and federal law will continue to be a thorny issue for bankruptcy courts to resolve.

If upheld on appeal, the Roberts decision would be a significant shift in the approach taken within the District of Colorado, which could be a signal that courts are becoming more willing to allow debtors with indirect connections or investments in the cannabis industry to reorganize

References 

[1] In re Roberts, No. 22-10521, 2022 WL 4592086 (Bankr. D. Colo. Sept. 23, 2022).
[2] In re Arenas, 535 B.R. 845, 845 (10th Cir. BAP (Colo.) 2015).
[3] In re Way to Grow, Inc., 597 B.R. 111 (Bankr. D. Colo. 2018).
[4] Garvin v. Cook Investments, NW, SPNNY, LLC, 922 F.3d 1031 (9th Cir. 2019).

Reprinted with permission of Law360.