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When State Law Conflicts with Federal Law, Bankruptcy Debtors May Lose

The United States is a nation of laws, many, many laws. We have city laws, county laws, state laws, and federal laws. The enforcement of each law is constrained by a jurisdiction. Federal laws typically apply everywhere within the United States; state laws only within the state borders. So, what happens when a state allows certain conduct within its borders that is illegal under federal law? And, more important as a practical matter, is a person or company entitled to the benefits of the federal bankruptcy laws when engaged in a permitted state activity that is a federal crime?

This uncommon situation has been addressed in several recent bankruptcy cases involving medical marijuana operations. Currently, 23 states have legalized medical marijuana, six have decriminalized marijuana use, and the states of Colorado and Washington have legalized recreational cannabis use. This despites the federal law that makes marijuana use illegal for any reason, even with a medical prescription. The Supreme Court held in the 2005 case of Gonzales v. Raich that Congress has the right to outlaw medicinal cannabis, thus subjecting all patients to federal prosecution even in states where the treatment is legalized.

This tension between state permission and federal prohibition makes the “legality” of marijuana very murky in many states. Regarding enforcement of the federal drug laws concerning marijuana, President Obama has said, “We’re going to see what happens in the experiments in Colorado and Washington. . . The Department of Justice … has said that we are going to continue to enforce federal laws. But in those states, we recognize that … the federal government doesn’t have the resources to police whether somebody is smoking a joint on a corner.” In other words, the feds will not actively enforce in states that allow marijuana production, sale, and use – for the time being.

However, this “blind eye” approach does not extend to other federal processes. Five bankruptcy court rulings from Colorado, California, and Oregon have turned away debtors who seek to restructure financial obligations connected with a marijuana business, whether the debtors are warehouse landlords, dispensary owners, or caregivers. Most recently, a federal judge dismissed the bankruptcy case of a Colorado marijuana business owner, stating that while he is in compliance with state law, he is breeching the federal Controlled Substances Act. The debtor, a marijuana distributor and producer, sought Chapter 7 bankruptcy protection and listed $556,000 in unsecured debt. He also identified roughly 25 marijuana plants, each valued at $250, which could have been liquidated to pay creditors, but the trustee could not take control of the plants without breaking federal law. The bankruptcy judge stated that that the case could not be converted to a Chapter 13, because the bankruptcy plan would be financed “from profits of an ongoing criminal activity under federal law.” The judge added, “Violations of federal law create significant impediments to the debtors’ ability to seek relief from their debts under federal bankruptcy laws in a federal bankruptcy court.”

Each bankruptcy case implicates both federal and state laws. If you are contemplating restructuring your debts through bankruptcy, speak with an experienced attorney to discuss your situation.

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