By Columbia – Lexington Bankruptcy Lawyer Lex Rogerson
Bankruptcy jurisprudence involves a curious marriage of state and federal law. We got a vivid reminder of that in August when a bankruptcy judge dismissed the chapter 7 case of a Colorado pot grower, whose business was entirely legal under state law but violated the federal Controlled Substances Act.
Legal pot and the Arenas case
In 2012, Colorado legalized marijuana, even for recreational purposes. Frank Arenas of Denver obtained the required state permits and began growing and wholesaling the herb.
In February 2014, Arenas and his wife Sarah filed bankruptcy. The US Trustee, a justice department official, asked Judge Howard Tallman to dismiss the case. Pointing out that that marijuana trade is still a federal crime, the government argued Arenas could not seek relief under the Bankruptcy Code while violating another federal law. It relied on a 2012 opinion by Judge Tallman dismissing a chapter 11 case of a company that knowingly leased warehouse space to a tenant who grew pot under Colorado’s prior medical marijuana law.
Following precedent, Judge Tallman dismissed the Arenas’ case. It was not a matter of disliking pot producers. In fact, the court specifically found Arenas credible and regretfully noted that dismissal would be devastating to the couple. But Tallman found that the Code bars bankruptcy relief to illegal businesses.
In the first place, when a debtor files chapter 7, all his property becomes part of an estate under the control of a trustee. Arenas’ property included 25 marijuana plants and related paraphernalia. His trustee could not exercise control over this contraband without himself violating federal criminal law. So administering Arenas’ bankruptcy estate would have been illegal.
To salvage something from their bankruptcy filing, the Arenases tried to convert their case to chapter 13. This approach fared no better. Judge Tallman recognized that a chapter 13 plan must be “proposed in good faith and not by any means forbidden by law.” Because the Arenases would fund their plan with proceeds of an illegal operation, they could not satisfy this requirement.
The same requirement applies to chapter 11 plans. For this reason, and because Judge Tallman’s 2012 opinion arose in a chapter 11 case, we can expect a similar result if a marijuana-related business attempts to reorganize.
Federalism and the bankruptcy system
The Arenas decision represents one instance in in the field of bankruptcy where state law yields to federal law. By contrast, in some basic areas, the Bankruptcy Code defers to state law. It is well established, for example, that state law defines the essential rights of property ownership and therefore determines what property rights come into a bankruptcy estate. In addition, state exemption laws determine what property a chapter 7 debtor may protect. State exemption laws thereby indirectly affect how much a chapter 13 debtor must pay to his creditors.
South Carolina has a long history of testing the limits of state authority vis-à-vis the federal government. Recently our governor and attorney general announced that they will, in effect, ignore the Fourth Circuit decision ruling that state bans on same-sex marriage are unconstitutional. As we can see, the relationship between state and federal power continues to be adjusted generation by generation, and sometimes day by day.