(Seth McConnell, Denver Post file)

Court appeal: Bankruptcy cases caught in Catch-22 over pot assets

The federal government cannot passively allow a billion-dollar marijuana industry to flourish by not prosecuting certain crimes and then later deny its participants bankruptcy protection, a new court filing says.

By refusing to allow marijuana-derived assets to be protected in bankruptcy in the same way other assets are, the government is passively prosecuting the crimes it had earlier said it would not, “a Catch-22” of the U.S. Department of Justice’s own making, according to an appeal filed by a Denver couple whose bankruptcy was dismissed because much of their income was derived from a medical marijuana business.

Attorneys for Frank and Sarah Arenas of Denver argue in a 43-page brief that a bankruptcy judge erred when he dismissed their petition in August because their assets were derived from activity that is illegal under federal law.

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“The (Arenases) should not be faulted, or more importantly lose the right to a discharge of their debts, for playing by rules created by the same agency that seeks to dismiss their bankruptcy case for breaking those rules,” attorney Daniel Garfield wrote, arguing the court could simply refuse certain assets and allow the case to continue.

“The federal government has deliberately and actively allowed a legal marijuana industry to flourish in Colorado and not to prosecute participants in that industry,” Garfield wrote. “The federal government has made a conscious decision to allow (the Arenases’) otherwise illegal business to operate.”

If the U.S. Bankruptcy Appellate Panel of the 10th Circuit upholds the lower court ruling, the ramifications could be substantial. Bankruptcy petitions by individuals or businesses whose income was derived from marijuana — whether an employee of the shop or a business that supplies one — would be denied.

The potential impact would reach into at least 23 states where marijuana sales are legal in some form.

The Arenases’ bankruptcy is the latest in a series of cases in which federal and state laws governing marijuana have clashed.

The federal government in February said it would not prosecute legal marijuana businesses in states that approved its sale as long as the businesses did not violate certain conditions, such as selling to children or trafficking across state lines. Banks were also required to step up oversight of any accounts they held.

The Arenases filed for personal bankruptcy protection in February, listing among their assets a building at 28th and Larimer streets.

Frank Arenas, 58, grew and sold medical marijuana in one part of the building as FSA and leased the other half to a different medical dispensary, Denver Patients Group.

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During the bankruptcy, DPG offered to purchase the building, but that added to the concern that marijuana income would taint the case.

Sarah Arenas, 52, suffered a stroke in 2011 and has since been disabled, reliant on disability and pension payments. That income is not considered tainted in the bankruptcy case, only that which is tied to the marijuana businesses.

Other factors eventually pushed the Arenases to seek bankruptcy protection. Neither Sarah nor Frank would comment for this story.

Bankruptcy laws under Chapter 7 liquidation require a trustee to be named and assets sold. That puts the U.S. trustee’s office in a position of having to sell an illegal product for the benefit of creditors, or to sell assets derived from money that comes from the illegal product.

The conflict, U.S. Bankruptcy Judge Howard Tallman said, is between a federal law that deems marijuana illegal and a state law that allows for its sale.

“Any (bankruptcy) plan proposed by the debtors would necessarily be executed by unlawful means,” Tallman wrote in his nine-page opinion in August. “Administration of this case … is impossible without inextricably involving the court and the trustee in the debtors’ ongoing criminal violation of the (Controlled Substances Act).”

Tallman in an earlier case determined bankruptcy laws would not extend to those with pot-derived assets, but the case sidestepped the issue by dumping the tainted assets.

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Thomas and Susan Wright, owners of Rent-Rite Super Kegs West, in 2012 sought Chapter 11 reorganization, hoping to pay creditors and resume their enterprise, which included a building on East 48th Avenue.

But a venture-capital group that held the rights to a $1.7 million note on their commercial mortgage petitioned the court, saying bankruptcy could not protect an illegal business — the Wrights leased a portion of the building to three marijuana-related businesses.

“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,” Tallman wrote in the Wright case.

The Wrights relinquished the building to the venture capital group and their bankruptcy was allowed to continue.

David Migoya: 303-954-1506 or dmigoya@denverpost.com

This story was first published on DenverPost.com