Tag Archives: dismissal

February 25, 2016

“Structured Dismissals” within the Tenth Circuit

  1. Introduction

The United States Bankruptcy Court for the District of Utah has published the first opinion within the Tenth Circuit analyzing and authorizing the “structured dismissal” of a chapter 11 case. See In re Naartjie Custom Kinds, Inc., 534 B.R. 416 (Bankr. D. Utah 2015) (Thurman, J.)  In Naartjie, Judge Thurman addressed two issues: first, whether the bankruptcy court has statutory authority to grant a “structured dismissal,” and second, whether the debtor met its burden of establishing cause for the court to grant such a relief.  Answering both of these questions in the affirmative, the court joined a growing number of jurisdictions, including the Third Circuit, where structured dismissals are now a viable alternative to traditional exit strategies from chapter 11 cases.  This article introduces the debate about the propriety of structured dismissals by comparing Naartjie to the Third Circuit’s decision in Jevic Holding Corp., 787 F.3d 173 (3rd Cir. 2015) decision – an opinion from the highest court to have weighed in on the debate.  It concludes with  ten “practice pointers” to consider when seeking or opposing an order authorizing a structured dismissal in the Tenth Circuit.

  1. Structured Dismissals Generally

Generally, “structured dismissals are simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth) that remain in effect after dismissal.” Jevic Holding, 787 F.3d at 181.   “Unlike old-fashioned one sentence dismissals order – ‘this case is hereby dismissed’ – structured dismissal orders often include some or all of the following additional provisions: ‘releases’ (some more limited than others), protocols for reconciling an paying claims, ‘gifting’ of funds to unsecured creditors and provisions providing for the bankruptcy court’s continued retention of jurisdiction over certain post-dismissal matters.’” In re Strategic Labor, Inc., 467 B.R. 11, 18 (Bankr. D. Mass. 2012) (quoting Norman L. Pernick & G. David Dean, Structured Chapter 11 Dismissals: a Viable and Growing Alternative After Asset Sales, 29 Am. Bankr.Inst. J. 1, 56 (June 2010)).  The most contentious features of some structured dismissals are provisions that authorize distribution of funds outside the priority scheme prescribed by § 507 of the Bankruptcy Code. 

III.       Structured Dismissals in Practice: Jevic and Naarjie

The recent decisions of the Third Circuit in Jevic and the Utah Bankruptcy Court in Naartjie illustrate the nature of and issues surrounding structured dismissals.

  1. Jevic and Structured Dismissals that Deviate from Section 507’s Priority Scheme

As of December of 2015, the Third Circuit was the highest court to have opined on the propriety of “structured dismissals” under the Code. In Jevic, the Third Circuit upheld the bankruptcy court’s order authorizing a dismissal of a Chapter 11 case pursuant to a settlement agreement that, among other things, included broad exculpatory clauses and authorized the distribution of estate assets outside the priority scheme of § 507 of the Code.

Jevic was a typical case with an atypical outcome.  In 2006, CIT Group financed Sun Capital Partners’ leveraged buyout of Jevic Transportation, Inc. See Jevic, 787 F.3d at 175.  Jevic was a trucking company in decline, and as part of the acquisition, CIT advanced an $85 million revolving credit facility to Jevic secured by substantially all of Jevic’s assets. Id. The acquisition did not alter Jevic’s fate, and by May of 2008, the company had been forced to enter into a forbearance agreement with CIT, which also required a $2 million guarantee from Sun. See id. On May 19, 2008, Jevic ceased business operations and notified employees that they would be terminated.   See id. at 175-176.  The next day, the company filed a petition for protection under Chapter 11 of the Code in Delaware. See id. at 176.  As of the petition date, Jevic owed $53 million to CIT and Sun.   See id. It owed also over  $20 million in tax and general unsecured claims. See id.

The court appointed a committee of unsecured creditors, which filed an adversary proceeding asserting fraudulent and preferential transfer claims against CIT and Sun. See Jevic, 787 F.3d at 176.  In essence, the committee alleged that “Sun, with CIT’s assistance, acquired Jevic with virtually none of its own money based on baseless projections of almost immediate growth and increasing profitability.” Id. Meanwhile, a group of truck drivers filed a class action against Jevic and Sun, alleging that the defendants had violated the Worker Adjustment and Retraining Notification (“WARN”) Act by failing to give the workers 60 days’ written notice of their layoffs. See id.

By March of 2012, the estate’s sole remaining assets consisted of $1.7 million in cash and the committee’s action against CIT and Sun. See Jevic, 787 F.3d at 176.  The $1.7 million were subject to Sun’s lien, and although the committee had partially succeeded in defeating a motion to dismiss the fraudulent and preferential transfer claims, it had concluded that the estate lacked sufficient funds to finance prosecution of its action.  Accordingly, the committee, Sun, Jevic, CIT and Sun reached a settlement agreement whereby: (1) all parties would exchange releases, (2) the committee’s fraudulent and preferential transfer action would be dismissed with prejudice, (3) CIT would deposit $2 million into an account earmarked to pay the estate’s administrative expenses, including the fees of the committee’s and the debtor’s professionals, (4) Sun would assign its lien in the remaining $1.7 million to a trust for the payment of tax and administrative creditors first, and the remainder to unsecured creditors on a pro rata basis, and (5) the chapter 11 case would be dismissed. See id. at 177.  Although the truck drivers participated in the settlement discussions, the parties could not agree on a settlement of the WARN Act claims, which the drivers valued at $12.4 million, inclusive of 8.3 million entitled to priority under § 507(a)(4) of the Code. See id. Consequently, the drivers were not included in the settlement presumably because Sun, who remained a defendant in their WARN Act lawsuit, did not want to fund litigation against itself. See id. The effect of the drivers’ exclusion from the settlement would be that the drivers would receive nothing from the estate, even on the $8.3 million wage claim, but all other general unsecured would receive about four percent of their claims. See id. at 177, 177 n.1.

The truck drivers and the United States Trustee objected to the proposed settlement, arguing, in part, that the proposed distribution violated the priority scheme prescribed by § 507 of the Code. See Jevic, 787 F.3d at 178.[1]   The drivers argued that the Code does not authorize “structured dismissals,” but rather only three ways for the debtor to exit chapter 11: (1) confirmation of a plan, (2) conversion to chapter 7, or (3) “plain dismissal with no strings attached.” See id. at 180.  The Third Circuit addressed these objections in reverse.

First, the Third Circuit affirmed the district court and bankruptcy court’s conclusion that while structured dismissals are not expressly authorized by the Code, they are not prohibited by the Code either. See Jevic, 787 F.3d at 181.  Specifically, the Third Circuit held that “though § 349 of the Code contemplates that dismissal will typically reinstate the pre-petition state of affairs by revesting property in the debtor and vacating orders and judgments of the bankruptcy court, it also explicitly authorizes the bankruptcy court to alter the effect of dismissal ‘for cause’ – in other words, the Code does not strictly require dismissal of a Chapter 11 case to be a hard reset.” Id.

Second, the Third Circuit rejected the argument that “even if structured dismissals are allowed, they cannot be approved if they distribute estate assets in derogation of the priority scheme of § 507 of the Code.” See Jevic, 787 F.3d at 182.  In essence, the drivers argued that § 103(a) required settlements in Chapter 11 cases to comply with § 507’s priority scheme. See id.[2] Although the Third Circuit acknowledged “some tacit support in the caselaw for the [d]river’s position,” it concluded that “neither Congress nor the Supreme Court has ever said that the [absolute priority rule] applies to settlements in bankruptcy.” Id. at 182-83.  The Third Circuit noted that the Fifth and Second Circuits “had grappled with whether the priority scheme of § 507 must be followed when settlement proceeds are distributed in Chapter 11 cases.” Id. (citing Matter of AWECO, Inc., 725 F.2d 293, 295-96 (4th Cir. 1984) (declining to approve a settlement agreement because unsecured creditor would be paid ahead of senior claims); In re Iridium Operating LLC, 478 F.3d 452, 463-64 (2nd Cir. 2007) (rejecting the AWECO ruling as too rigid because and finding that the absolute priority rule is not necessarily implicated in settlements outside of plans of reorganization)).  The Third Circuit agreed with the Second Circuit’s approach, and held that “bankruptcy courts may approve settlements that deviate from the priority scheme of § 507 of the Bankruptcy Code only if they have specific and credible grounds to justify the deviation.”   Id. at 184 (citation and quotation omitted). 

Having concluded that the bankruptcy court had authority to grant structured dismissals, and that the “structure” could include distributions outside the priority scheme of § 507, the Second Circuit found that although it was a “close call,” the bankruptcy court had “sufficient reasons” to approve the settlement in Jevic and overrule the Trustee’s and the truck drivers’ objections. See Jevic, 787 F.3d at 184-85.  The court emphasized that there was “no evidence calling into question the Bankruptcy Court’s conclusion that there was ‘no realistic prospect’ of a meaningful distribution to Jevic’s unsecured creditors apart from the settlement under review.”   Id. at 185.  Instead, it was apparent that if the court did not approve the proposed settlement, the unsecured creditors would not receive anything at all because the estate lacked sufficient funds to prosecute the fraudulent claims against Sun and CIT, both of which claimed they would not enter into the same settlement with a trustee were the case converted to chapter 7.  Thus, the court concluded, the movants had shown cause for approval of a structured dismissal that deviated from § 507, “[a]lthough this result is likely to be justified only rarely.”   Id. at 186.[3]

  1. Naartjie – a Simple Structure

Naartjie was a much narrower decision than Jevic. See Naartjie, 534 B.R. 416. 

Naartjie was a children clothing retailer that filed Chapter 11 intending to reorganized using pre-arranged financing. See id. at 418.  The financing fell through shortly after the petition date, and the debtor shifted to an orderly liquidation. Id. Over the next six months, the court approved multiple orders authorizing the debtor to sell significantly all of its assets pursuant to § 363 of the Code. See id. Following the proof of claim deadline, four principal creditor constituencies emerged: (1) a group of secured noteholders claimed a senior lien against virtually all of the debtor’s assets in the amount of $8.8 million; (2) a trade creditor of the debtor – Target Ease – asserted a $7 million claim, of which $2.1 was entitled to administrative priority and $2.6 million consisted of a reclamation claim;(3) a shipping company asserted a claim secured by a maritime line in the amount of $339,923.47; and (4) general unsecured creditors. See id.at 418-19.

The parties sought and obtained approval of a settlement agreement to distribute the estates’ assets as follows: (1) payment of all allowed administrative claims subject to a negotiated budget, and priority claims up to $382,000; (2) payment of $140,000 to the shipping company in satisfaction of its claim; (3) all remaining funds to be distributed among the secured creditors (45%), the trade creditor Target Ease (30.5%), and the unsecured creditors excluding Target Ease (24.5%). All parties agreed to mutual releases and to seek dismissal of the case or confirmation of a plan. See id. at 419. No one objected to the settlement proposal, and the court approved it pursuant to Rule 9019 and the factors set out in In re Kopexa Realty Venture Co., 213 B.R. 1020 (BAP 10th Cir. 1997).

After liquidating all assets, and consummating much of the settlement agreement, the debtor moved for approval of a structured dismissal under §§ 305(a) and 349 of the Code, whereby (1) all of the court’s orders would remain in full force; (2) the court would retain jurisdiction over the approval of professional fees and any disputes arising from the interpretation and implementation of an order approving the dismissal; (3) the court’s dismissal order would incorporate the exculpation clauses and releases negotiated through the settlement agreement; and (4) the debtor and committee of unsecured creditors would distribute all funds pursuant to the terms of the settlement agreement. See Naartjie, 534 B.R. at 420. 

No party with an economic interest in the estate objected, and the senior secured creditors, the committee and Target Ease supported the motion for approval of the structured dismissal. See Naartjie, 534 B.R. at 521.  The U.S. Trustee objected, however, arguing that the Code does not authorize the approval of “structured dismissals” because “there are only three ways to exit a Chapter 11 case: (1) by  confirmation of a plan pursuant to § 1129; (2) by dismissal of the case pursuant to § 1112(b); or (3) by conversion of the case pursuant to §1112(b).” See id.  

The court granted the debtor’s motion, holding that §305(a) authorized dismissals of any case if the interest of creditors and the debtor would be better served by such dismissal or suspension. Naartjie, 534 B.R. at 422.  The court then turned to the determinative question: “may the Court alter the effect of dismissal?”  Id.  Quoting § 349(b), the court held that “[t]his subsection describes the effect of dismissal, but it qualifies the effect by providing that the Court may, for cause, order otherwise.  It follows that, if cause is shown, a bankruptcy court may alter the effect of dismissal.  The statute is clear and unambiguous on this point.” Id. at 422-23.  Furthermore, analyzing § 349’s legislative history, the court concluded that “[t]he effect of dismissal is to put the parties, as much as practicable, back in the positions they occupied pre-bankruptcy.” Id. at 423.  “But, if cause is shown, such as when a structured dismissal will better serve the interests of the creditors and the debtor, the bankruptcy court may order otherwise and alter the effect of dismissal.” Id.

Having concluded that it had statutory authority to authorize a structured dismissal, the court found that the debtor had shown cause for dismissal under § 305(a) because (1) “it [was] clear that the proposed structured dismissal [was] the most efficient and economic[cal] way to administer” the case; (2) the parties’ rights were protected and preserved since the court’s orders would remain in full force and effect; (3) the parties would have access to a forum where they could enforce those orders (i.e, the bankruptcy court); and (4) the settlement agreement was an out-of-court workout that equitably distributed the assets of the estate. See Naartjie, 534 B.R. at 426 (applying factors adopted in In re Zapas, 530 B.R. 560, 572 (Bankr.E.D.N.Y. 2015), In re AMC Investors, LLC, 406 B.R. 478, 488 (Bankr.D.Del. 2009), In re RCM Global Long Term Capital Appreciation Fund, Ltd., 2000 B.R. 514, 525 (Bankr.S.D.N.Y. 1996), In re Picacho Hills Util. Co., No. 11-13-10742 TL, 2013 WL 1788298, at *9 (Bankr.D.N.M. Apr. 26, 2013)). 

The court found that the debtor had also met the standard for altering the effect of dismissal under § 349. Naartjie, 534 B.R. at 426.  In addition to the bases discussed above, it found that despite receiving notice of both the settlement motion and the motion for approval of a structured dismissal, “no economic stakeholder [] objected.”  Moreover, there was little for the debtor to do in the case, other than distributing the assets.  The court concluded that the motion was “not an attempt to work around the protections of § 1129; it is simply the rare case where cause is shown to alter the effect of dismissal.” Id. Thus, the court concluded, the movants had shown cause for alternating the effect of dismissal under § 349.

  1. Ten Factors to Consider When Proposing or Opposing a Structured Dismissal

As Judge Thurman noted in Naartjie, that case was part of a “growing trend of structured dismissals.” Naartjie, 534 B.R. at 421.  Given their perceived or actual benefits, including speed and lower cost, structured dismissals are likely to become more common over the next few months or, at least, are highly likely to be litigated more frequently.  In seeking approval of or opposing structured dismissals, practitioners should consider the following:

  1. Statutory Relief: Consider whether dismissal should be or is sought under §§ 305(a) or 1112(b). As Judge Thurman noted in Naartjie, “[s]ection 305(a)(1) is a narrower provision for dismissing a Chapter 11 case than § 1112(b).” Naartjie, 534 B.R. at 422. Under § 305(a), a court may dismiss a case if “the interests of creditors and the debtor would be better served by” the dismissal. 11 U.S.C. § 305(a)(1). By contrast, under § 1112(b), the court may appoint a trustee, convert or dismiss a chapter 11 case, “whichever is in the best interest of creditors and the estate.” 11 U.S.C. § 1112(b). Courts are less likely to grant relief under § 305(a) than 1112(b) particularly because the court’s decision under § 305(a) is not subject to appellate review pursuant to § 305(c) of the Code. Nevertheless, movants may be tempted to seek relief under § 305(a) over § 1112(b) to limit the range of potential relief – i.e., to avoid the possibility that the court may appoint a trustee or convert the case rather than dismiss it. Section 305(a) is particularly attractive where all parties with an economic interest in the outcome of the case have reached a settlement.
  2. Focus on “Cause” Under § 349: At this point, the debate on whether the court has statutory authority to grant a structured dismissal is largely academic. Even the courts that have denied motions for approval of structured dismissals have recognized that they have the statutory authority to alter the effect of dismissal under § 349(b) of the Code. Although “cause” for altering the effect of § 349 is a developing concept, the Naartjie opinion provides some guidance on factors that may be considered when determining whether the movant has met this burden. See Naartjie, 534 B.R. at 426 (considering the notice provided to the parties, objections filed, and whether movant was attempting “work around the protections of the Bankruptcy Code”).
  3. Anticipate the U.S. Trustee’s Objection: In virtually every reported opinion, the U.S. Trustee has objected to motions seeking approval of structured dismissals. The reasons for the U.S. Trustee’s distaste for structured dismissals are articulated in an article by the Associate General Counsel for Chapter 11 Practice at the Executive Office for the U.S. Trustee titled Structured Dismissals, or Cases Dismissed Outside of the Code’s Structure, 30 Am. Bankr. Inst. J. 20 (March 2011). Practitioners proposing or opposing structured dismissals can anticipate the U.S. Trustee’s position and address, to the extent possible, the concerns raised in this article.
  4. Timing: Movants should seek relief under § 349(b) as soon as it becomes significantly likely that confirmation of a plan is not a viable option, but after resolution of as many preliminary matters as possible. Correspondingly, opponents should highlight loose ends that may affect negatively the rights of creditors or other stakeholders. For example, the court may reject a structured dismissal motion where claim disputes are outstanding.
  5. Consider sub rosa Jurisprudence: Strictly speaking, a proposal constitutes a sub rosa plan where it dictates the terms of a reorganization plan. See Jevic, 787 F.3d at 188 (Scirica, J., dissenting); see also, In re Shubh Hotels Pittsburgh, LLC, 439 B.R. 637, 644-45 (Bankr. W.D. Penn. 2010) (“a transaction would amount to a sub rosa plan or reorganization if it: (1) specifies the terms of any future reorganization plan; (2) restructures creditors’ rights; and (3) requires that all parties release claims against the Debtor, its offices and directors, and its secured creditors”). Structured dismissals, by definition, do not implicate the confirmation of a plan, and thus are distinguishable from sub rosa plans. Structured dismissals, however, implicate the same policy concerns as sub rosa plans. Accordingly, practitioners should consult case law analyzing sub rosa plans and may rely on it by analogy particularly when opposing structured dismissals motions.
  6. 9019 Settlements and Asset Sales: Most successful structured dismissals follow approval of a settlement under Rule 9019, the sale of substantially all assets of the debtor under § 363, or both. The practical reason for this sequence is that by the time the court has to determine whether there is cause for altering the effect of § 349, all other major disputes in the case have been resolved. This is particularly true in cases like Naartjie, where all constituents with an economic interest in the case reach a settlement (or, at least, are represented during settlement discussions). Thus, in seeking structured dismissals, movants increase the likelihood of succeeding if they first obtain relief, were applicable, under § 363 and seek consensus from stakeholders in the form of a settlement under Rule 9019.
  7. But if no Consensus, Invoke Jevic: Failure to obtain consensus from all stakeholders with an economic interest in the case, however, is not a dispositive post Jevic. The effect of that opinion appears to be that so long as objecting creditors like the truck drivers in Jevic can vindicate their rights elsewhere or against another party, the court may approve a structured dismissal that violates the absolute priority rule. In other words, movants should seek consensus, but if they must, then they should abandon only creditors who can fend for themselves.
  8. Remain Vigilant: Opponents of structured dismissal motions should object to any Rule 9019 or §363 motion that sets up the dismissal motion. For example, in Naartjie, the Rule 9019 Motion that predated the structured dismissal motion contemplated a filing of the latter. In dismissing the case, the court noted that no party had objected to the earlier motion. See Naartjie, 534 B.R. at 426.
  9. Prove Efficiency: One of the primary justifications for granting a structured dismissal motion is the movant’s ubiquitous proffer that the structured dismissal will save the estate significant resources over an expensive plan confirmation process. Typically, however, the estate is not fully administered as of the date the court enters an order approving a structured dismissal. Thus, part of the “structure” will likely include process for wrapping up the case. Practitioners should be careful not to surprise the court with professional fees or administrative expenses incurred post-approval of a structured dismissal that disprove its professed efficiency.

10.       Equitable Mootness: The Jevic dissent points out that the doctrine of equitable mootness was not applicable to a court’s order approving a structured dismissal because that doctrine applies only where a plan of reorganization is confirmed. See Jevic, 787 F.3d at 186 (Scirica, J., dissenting) (citing In re Semcrude, L.P., 728 F.3d 314 (3d. Cir. 2013). It is unclear, however, whether Judge Scirica’s rationale holds true in the Tenth Circuit, specially when the structured dismissal is approved pursuant to a rule 9019 motion, or where the court dismisses the case under § 305(a). See e.g., Rindlebach v. Jones, 532 B.R. 850, 856-58 (Bankr. D. Utah 2015) (appeal from order approving settlement equitably moot).  Opponents of structured dismissal motions should therefore consider whether and when to ask a court to stay an order pending post-ruling motions.

 

[1] The drivers also claimed that the committee of unsecured creditors violated its fiduciary duties to the estate because the settlement it negotiated excluded the drivers. See Jevic, 787 F.3d at 178.

[2]               Section 103(a) provides, “[e]xcept as provided in section 1161 of this title, chapters 1, 3, and 5 of this title apply in a case under chapter 7, 11, 12, or 13 of this title, and this chapter, sections 307, 362(0), 554 through 557, and 559 through 562 apply in an case under chapter 15.” 11 U.S.C. § 103(a).

[3] Judge Scirica dissented, arguing that it was not clear that the only alternative to the settlement was a chapter 7 liquidation. See Jevic, 787 F.3d at 186. He emphasized that the settlement at bar was not substantially distinguishable from sub rosa plans, and emphasized that this was not a “gifting” case because the assets to be distributed were assets of the estate since the settlement resolved the estate’s fraudulent transfer claims. See id. at 187-88.

September 29, 2015

Another Marijuana Bankruptcy Case Bites the Dust as the Arizona Bankruptcy Court Dismisses an Involuntary Case Filed Against a Medical Marijuana Dispensary

Following its sister court in Colorado[1] the United States Bankruptcy Court for the District of Arizona recently held that the debtor’s operation of a business that it illegal under federal law mandates dismissal of an involuntary bankruptcy petition filed against the debtor.  In re Medpoint Management, LLC, 528 B.R. 178 (Bankr. D. Az. 2015).  Medpoint Management managed the operations of Arizona Nature’s Wellness (“ANW”), which held an Arizona Department of Health Services-issued Dispensary Certificate allowing it to operate a branded medical marijuana dispensary under the Arizona Medical Marijuana Act.  In its capacity as manager, Medpoint owned ANW’s name and trademark under which ANW sold its marijuana products.  When several of its creditors filed an involuntary bankruptcy petition against it Medpoint filed a motion to dismiss the petition.  In the context of the motion to dismiss, the court analyzed the issue as “whether [the court] can or should enter an involuntary order for relief against Medpoint despite the fact that Medpoint’s current and former business affairs are illegal under applicable federal criminal statutes.”

Medpoint argued that the case should be dismissed because the trustee could not lawfully administer the bankruptcy estate’s marijuana-related assets without violating the Controlled Substance Act, 21 U.S.C. § 801 et seq.  The petitioning creditors argued that an order for relief was not precluded under federal law because their claims against Medpoint were not related to it’s the actual proceeds of its marijuana sales, that Medpoint had received a federal tax identification number and maintained a bank account at an FDIC-insured bank, and that Consolidated and Further Continuing Appropriations Act (“Cromnibus Act”) prohibited the use of appropriated funds to “prevent Arizona from implementing its own law that authorizes the use, distribution, possession or cultivation of medical marijuana.”

The court decided to dismiss the case for cause.  It was persuaded by the opinions from the Colorado bankruptcy court dismisses two marijuana related cases.  The first, In re Arenas, held dismissal proper because the chapter 7 trustee could not take control of or administer the debtor’s assets without violating the Controlled Substance Act.  The court in In re Rent-Rite Super Kegs held that dismissal was proper in a case where the debtor owned real property that was rented to a marijuana entity and that the debtor’s continuing lease with that entity constituted gross mismanagement of the estate.  The Arizona court was persuaded by these decisions.  The court determined that the bankruptcy trustee would be placed in an untenable position, with the debtor’s assets subject to the prospect of possible forfeiture or seizure by the federal government under the Controlled Substance Act.  The fact that the Cromnibus Act prohibited the use of appropriations by the government under it to enforce the Controlled Substance Act did not persuade the court, as it noted the Department of Justice had other sources of funds from which it could prosecute violations of the Controlled Substance Act.  In short, the court held that entering an order for relief would result in the trustee necessarily violating federal law in carrying out his or her duties under the Code.  As a result, the court found cause existed to dismiss the involuntary petition.



[1] In re Arenas, 514 B.R. 887 (Bankr. D. Colo. 2014); In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012)

September 25, 2014

Nowhere to Turn for Insolvent Marijuana Businesses

Recreational marijuana is legal in two states—Washington and Colorado—and medical marijuana is legal in another twenty-one states.  Colorado alone has over 500 marijuana dispensaries and that number is on the rise.  However, as the marijuana industry continues to grow, federal law still prohibits the use of marijuana.  So what happens when a marijuana business becomes insolvent? Does it have the right to avail itself of the protections of the Bankruptcy Code?

The United States Bankruptcy Court for the District of Colorado (the “Court”) says no.  In In re Arenas, 2014 Bankr. LEXIS 3642 (Bankr. D. Colo. Aug. 28, 2014), a husband and wife filed for chapter 7 bankruptcy.  The husband engaged in the business of producing and distributing marijuana on the wholesale level in Colorado. The husband carried on his business operations in one unit of a commercial building owned by the debtors.  The debtors also leased another unit in the building to another marijuana dispensary.  The wife was not involved in the business and her income derived solely from disability payments. 

About one month after the debtors filed for bankruptcy, the United States Trustee (“Trustee”) moved to dismiss their case.  The Trustee argued that the Court should dismiss the case because it should not enforce the protections of the Bankruptcy Code to aid violations of the federal Controlled Substances Act (“CSA”).  Moreover, the Trustee argued that the Court should not place him in the position of administering assets used in connection with marijuana-related businesses.  The debtors filed a pro se opposition to the motion as their counsel previously withdrew from the case because it and the debtors disagreed as to whether bankruptcy relief was available to the debtors.

The Court agreed with the Trustee and debtors’ counsel and held that the debtors could not receive bankruptcy protection while operating the marijuana business.  Specifically, while the Court found that the husband’s activities were legal under Colorado law, they still violated the CSA.  These violations of federal law created significant impediments to the debtors’ ability to seek relief under the federal bankruptcy laws in a federal bankruptcy court. 

In its decision, the Court referred back to its prior ruling in In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799  (Bankr. D. Colo. 2012).  In that case, the Court addressed issues concerning a chapter 11 debtor’s activities with respect to medical marijuana.  It held: “Unless and until Congress changes [federal drug] law, the Debtor’s operations constitute a continuing criminal violation of the CSA and a federal court cannot be asked to enforce the protections of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”  Id. at 805.

The debtors in Arenas invited the Court to reexamine its decision in the Rent-Rite case, but it declined to do so.  The Court explained that the “fundamental bargain underpinning a chapter 7 consumer liquidation case is that a debtor turns over his non-exempt assets to a chapter 7 trustee so those assets may be liquidated for the benefit of creditors….  Here, the…Trustee cannot take control of the Debtors’ property without himself violating…the CSA.  Nor can he liquidate the inventory of marijuana plants…because that would involve him in the distribution of a…controlled substance in violation…of the CSA.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *10.  Therefore, the Court found that administration of the case under chapter 7 was impossible without involving the Court and the Trustee in ongoing criminal violations, and that impossibility constituted “cause” for dismissal under 11 U.S.C. § 707(a).

Moreover, the Court denied the debtors request to convert the case to a case under chapter 13 because any reorganization would be funded from ongoing criminal activity and would necessarily involve the chapter 13 trustee in administering and distributing funds derived from such activity.  The Court found that such circumstances would violate Section 1325(a)(3)’s requirement that a chapter 13 plan be “proposed in good faith and not by any means forbidden by law.”  Therefore, the Court denied the debtors’ request to convert and dismissed the case. 

In dismissing the debtors’ case, the Court noted that it recognized that dismissal would be devastating for the debtors, but that the legal analysis necessary for the resolution of the case was “relatively straight-forward.”  In re Arenas, 2014 Bankr. LEXIS 3642 at *19.  The debtors have appealed the decision to the United States Court of Appeals for the Tenth Circuit.

The marijuana industry continues to grow and legalization efforts are ongoing throughout the nation.  However, the Colorado cases make clear that unless federal law changes, there may be nowhere to turn for insolvent marijuana-related businesses.