In Burton v. Maney (In re Burton), 610 B.R. 633 (B.A.P. 9th Cir. 2020), the Bankruptcy Appellate Panel of the U.S. Court of Appeals for the Ninth Circuit affirmed the dismissal of a Chapter 13 case filed by two individual debtors who held ownership interests in a defunct medical marijuana company. Although the company was no longer operating, the Bankruptcy Appellate Panel agreed with the bankruptcy court that pending litigation stemming from the company’s marijuana business that could result in recoveries paid to the company and its members, including the debtors, was sufficient cause for dismissal.

Background

In April 2018, Brigham and Carly Rae Burton filed for bankruptcy protection under Chapter 13 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Arizona. The Burtons owned a majority membership interest in Agricann, LLC, a company engaged in cultivating and selling medical marijuana. Although medical marijuana is legal under Arizona state law, the growing and distribution of marijuana continues to be illegal under federal law.

One of the Burtons’ creditors filed a motion in the bankruptcy case arguing, among other things, that the Burtons filed the case in bad faith because Mr. Burton derived income from a marijuana business that was illegal under federal law. The bankruptcy court then issued an order directing the Burtons to show cause why their case should not be dismissed due to their ownership interest in a business involved in growing and selling marijuana.

The Burtons asserted that Agricann went out of business before their bankruptcy filing, and that Agricann had generated no income since then. They claimed that they were not deriving any income from any entity involved in the marijuana industry, and the sole source of funding for any Chapter 13 plan would be Mrs. Burton’s lawful employment income.

However, Agricann was a plaintiff in at least two pending lawsuits seeking recovery of damages for breach of various contracts pursuant to which Agricann was to serve as a cultivator, grower, holder, and seller of marijuana. Acknowledging this, the Burtons nevertheless asserted that they did not expect to receive any proceeds from such litigation due to a contingency fee arrangement and a litigation financing lien on any recovery in these suits.

The bankruptcy court found that dismissal of the Chapter 13 case was appropriate. Despite the Burtons’ assertion that their company was no longer in the medical marijuana business, the court noted that Agricann was still pursuing litigation which, if successful, would generate recoveries ultimately derived from the company’s illegal conduct. The court discounted the Burtons’ assertion that the Agricann litigation was of no value, and it concluded that any distribution of funds from Agricann to the Burtons would constitute revenue derived from operations illegal under federal law. Based on this reasoning, the court dismissed the Burtons’ Chapter 13 case.

The Burtons appealed the bankruptcy court’s dismissal to the Bankruptcy Appellate Panel of the U.S. Court of Appeals for the Ninth Circuit.

The Court’s Analysis

The Bankruptcy Appellate Panel affirmed the bankruptcy court’s dismissal of the Burtons’ Chapter 13 case. It agreed with the bankruptcy court that the Burtons had failed to demonstrate they would receive no proceeds from the Agricann litigation, noting that the Burtons had simply made a “foundationless” and “equivocal” statement that they expected to receive nothing from the litigation. The panel reasoned that “this statement was far from a categorical denial that the claims had value, and the Burtons provided no details or documentary evidence to support it. While we cannot agree with the bankruptcy court’s blanket assertion that Agricann’s pursuit of these claims was indicative, per se, that they had value …, we discern no evidentiary support in the record for the Burtons’ assertions that the litigation would not result in their receipt of any litigation proceeds.” Because of this failure of proof, the panel deemed it appropriate to preclude the possibility that the Burtons’ Chapter 13 estate receive any proceeds of a federally illegal business operation, and found that the bankruptcy court had not abused its discretion in dismissing the Burtons’ case.

The Bankruptcy Appellate Panel recognized that, while numerous states have legalized medical marijuana and the recreational use of marijuana, the manufacture and distribution of marijuana is still illegal under federal law. As a result, a bankruptcy case filed by an individual or entity with ties to the marijuana industry has raised difficult issues regarding how involved the debtor may be in that industry in the event it wishes to seek relief under the Bankruptcy Code. While there are few bright-line rules governing this subject, the Bankruptcy Appellate Panel distilled one principle from prior cases: “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.”

The Bankruptcy Appellate Panel also recognized other patterns that have developed in the case law dealing with the nature and extent of a debtor’s involvement in an illegal activity. Several courts have dismissed a bankruptcy case if continuation of the case would require the court, the trustee, or the debtor to administer assets that are illegal under the federal Controlled Substances Act or that constitute proceeds of activity criminalized under federal law. Other courts have found that a bankruptcy filing or a reorganization plan proposed by a debtor involved in an illegal enterprise is not made in good faith. Relatedly, courts have found that a debtor engaged in an illegal business comes into a bankruptcy case with “unclean hands” and is not eligible for relief under the Bankruptcy Code.

Ultimately, the Bankruptcy Appellate Panel concluded that courts’ reluctance to adopt bright-line rules requiring the immediate disposition of bankruptcy cases involving marijuana-related activity to be the correct approach. Rather than being held to bright-line rules, a bankruptcy court’s broad discretion in finding “cause” to dismiss a bankruptcy case, coupled with the “abuse of discretion” standard of review on appeal, give bankruptcy courts “appropriate latitude” to address such cases.

Turning to the facts presented in the Burtons’ Chapter 13 case, the Bankruptcy Appellate Panel found it to be irrelevant whether Agricann was actively engaged in growing or selling marijuana when the Burtons filed for bankruptcy. Instead, what mattered was that the Burtons held a majority interest in a corporate litigant seeking to recover damages consisting of profits lost as a result of breaches of contracts related to the growing and selling of marijuana. Any proceeds received from the litigation would therefore constitute profits from a business that is illegal under federal law, which profits would necessarily have been administered in the Burtons’ bankruptcy case.

The Bankruptcy Appellate Panel also recognized that a bankruptcy court has broad discretion in deciding whether to dismiss a bankruptcy case, and that in exercising that discretion some courts have permitted debtors with connections to the marijuana industry to remain in bankruptcy subject to certain conditions. That notwithstanding, the panel concluded that any particular court’s decision to allow a bankruptcy case to continue despite a debtor’s ties to the marijuana industry under certain circumstances “does not create a rule that all bankruptcy courts must, in every instance, permit a debtor with ties to the marijuana business to stay in bankruptcy.” Given all of the facts and evidence presented in the Burtons’ bankruptcy case, the Bankruptcy Appellate Panel found that the bankruptcy court had neither abused its discretion nor erred in deciding to dismiss the case.

Conclusion

This decision in Burton adds to the growing area of case law addressing the ability of a debtor involved with or connected to the marijuana industry to obtain relief under the Bankruptcy Code. The difficult issues raised by such bankruptcy cases will likely only continue as more states legalize medical and recreational marijuana and while marijuana remains a controlled substance under federal law. As exemplified by Burton, courts’ decisions in these bankruptcy cases likely will not be determined by any bright-line rules, but will instead be dependent on specific facts and subject to the broad discretion of the bankruptcy judge. Therefore, entities with ties to the marijuana industry—no matter how remote or contingent those ties are—that wish to obtain relief under the Bankruptcy Code should be aware of the risk that their attempt to obtain such relief may ultimately be unsuccessful.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Elisa Hyder, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.