In re Way to Grow and the Impact on Downstream Businesses with Marijuana Connections

It is a commonly accepted rule across the country that if a debtor has direct connections with marijuana – for example, cultivating the plant or leasing space to a dispensary or grow facility – that the debtor cannot seek relief under the U.S. Bankruptcy Code.[1]  In instances where the debtor has direct contact with marijuana, “the [d]ebtor’s operations constitute a continuing criminal violation of the [federal Controlled Substances Act (“CSA”)[2]], and a federal court cannot be asked to enforce the protections of the Bankruptcy Code[.]”[3]  However, when a business lacks direct contact with marijuana but still profits from the marijuana industry, it is unclear whether that business can seek the protections afforded by the Bankruptcy Code.

The Colorado bankruptcy court considered the issue of “downstream” marijuana related business in In re Way to Grow, Inc.[4]  Way to Grow (“WTG”) was a Colorado-based gardening supply store that specialized in high-end gardening supplies and indoor gardening products, including supplies for growing plants in a hydroponic environment.  Prior to the bankruptcy filing, the original owner of the company, Corey Inniss (“Inniss”), sold WTG to a parent company, Pure Agrobusiness, Inc. (“Pure”) for a combination of cash, stock, and a secured promissory note. Following a default under the promissory note, and on the eve of appointment of a receiver, WTG, Pure, and another affiliate (“GDA”) each filed petitions for relief under chapter 11 of the Bankruptcy Code.

Shortly after the cases were filed, Inniss filed a motion to dismiss or abstain (the “Dismissal Motion”), asserting that the debtors were ineligible for relief under the Bankruptcy Code because the debtors’ connections with the marijuana industry constituted aiding and abetting in violation of 18 U.S.C. § 2.  Both the debtors and Inniss agreed that the debtors did not manufacture or sell any marijuana, and did not own real property that was leased to a marijuana grower or manufacturer.  Instead, Inniss asserted that the debtors’ sale of hydroponic equipment to marijuana growers constituted aiding and abetting violations of the CSA or amounted to a conspiracy with their customers to engage in a violation of the CSA.[5]  In response, the debtors argued that because GDA and WTG were selling indisputably legal gardening supplies and not drug paraphernalia, and had no direct connections to marijuana such as selling or distributing marijuana, WTG and GDA were not in violation of any federal law,. According, the debtors argued, they were entitled to utilize the protections afforded by the Bankruptcy Code.[6]

In granting the Dismissal Motion, the bankruptcy court held that the debtors were neither engaged in conspiracy, nor were they aiding and abetting a violation of the CSA.[7]  Instead, the bankruptcy court granted the Dismissal Motion on the basis that the debtors in violation of 21 U.S.C. § 843(a)(7), a statute raised for the first time in dismissal order. According to the bankruptcy court, the debtors knew that they were distributing gardening supplies, knowing or having reasonable cause to believe that the products were being used to grow marijuana.[8]

In ruling on the Dismissal Motion, the bankruptcy court expressly held that the debtors were not aiding and abetting a violation of the CSA, nor were the debtors engaged in a conspiracy to violate the CSA.  However, the court held that there was ample evidence that the debtors had reasonable cause to believe its products were being used to grow marijuana.[9]  The court relied on evidence at trial that demonstrated: 1) a product mix tailored to the marijuana industry that was cost prohibitive to other horticulture industries; 2) use of customer aliases for loyalty accounts; 3) prior promotions with cannabis growers; 4) managers’ knowledge of what their customers were growing; 5) investor decks that indicated the continued expansion of the business was closely tied to the marijuana industry; and 6) an email from a store manager instructing all employees to remove anything “MJ related” from the stores.[10]  The bankruptcy court held:

 Even though the Court concludes Debtors do not share their customers' specific intent to violate the CSA, Debtors certainly know they are selling products to customers who will, and do, use those products to manufacture a controlled substance in violation of the CSA. Debtors tailor their business to cater to those needs, tout their expertise in doing so, and market themselves consistent with their knowledge. There is no evidence this business model has materially changed post-petition.[11]

As a result, the bankruptcy court held that the debtors’ conduct violated section 843(a)(7). Dismissal was therefore mandated.[12]

The debtors subsequently appealed the bankruptcy court’s decisions to the Colorado district court.[13]  In affirming the decision of the bankruptcy court, the district court held, “the Code is not blind to criminal behavior . . . it is frankly inconceivable that Congress could have ever intended that federal judicial officials could, in the course of adjudicating disputes under the Bankruptcy Code, approve a reorganization plan that relies on violation of federal criminal law.”[14]  Relying on the bankruptcy court’s findings, the district court agreed that the debtors’ were in violation of 21 U.S.C. § 843(a)(7), and the bankruptcy court did not err in dismissing the cases.[15]

The decision in Way to Grow leaves a question as to how connected to the marijuana industry a business can be before it loses the ability to reorganize under the bankruptcy code.  As more states continue to legalize marijuana, bankruptcy courts may be required to engage in a fact intensive analysis early in the case to determine whether the debtor has any connections to the marijuana industry, and the degree of those connections.  In cases where the debtor’s operations involve supplying equipment, providing management services, or deriving some form of income from a dispensary or a grow house, such as a company providing security services, the bankruptcy court will likely be required to determine if the debtor’s conduct is in fact criminal in nature, versus being a passive participant that has not engaged in criminal conduct.  Questions will also arise as to the percentage of income the debtor is receiving from marijuana-based operations and whether the debtor could reorganize absent its connections to the marijuana industry.  Until clear cut lines are determined at a district court or circuit court level, it will likely be up to a fact intensive inquiry by the bankruptcy court to determine where the line is drawn, and what degree of connection to the marijuana industry is permissible for those business that do not touch the plant directly.