Be it the IRS, the Bureau of Reclamation, or the banks, the conflict between state and federal laws on marijuana can cause problems to those in the marijuana industry. You should now add filing for bankruptcy to the list.

When businesses go (or are near to going) under, they typically file for bankruptcy in a federal court to reorganize the business or to liquidate its assets. Bankruptcy can allow debtors to keep their necessary assets and property for day-to-day operations, and it also usually involves an asset distribution plan that keeps creditors from suing the business.

The problem with federal court bankruptcies, however, is that marijuana is illegal under federal law and according to a recent U.S. District Bankruptcy Court decision in Colorado, marijuana businesses cannot file for federal court bankruptcy so long as marijuana remains illegal under federal law.

Cue to the recent bankruptcy case of Frank and Sarah Arenas (case no. 14-11406 HRT). The Arenas own their own Colorado state-sanctioned commercial marijuana grow and they also rent space to a separately owned Colorado state-licensed dispensary. In other words, the Arenas are acting within Colorado state marijuana laws. The Arenas filed in federal bankruptcy court for personal bankruptcy but the federal bankruptcy court dismissed their proceeding on the basis that, because the Arenas are engaged in federally illegal activity, they are ineligible to take advantage of federal bankruptcy laws.

The bankruptcy court noted that though the Arenas’ business might be completely lawful under Colorado law, they put themselves in an “awkward position” by violating federal law regarding marijuana only to seek redress under another provision of federal law for the same activity. The court noted that things get especially awkward when “granting [relief to the debtor] directly involves a federal court … administering the fruits and instrumentalities of federal criminal activity.”

The bankruptcy court also noted that should the bankruptcy Trustee take into its possession, liquidate, and re-distribute the assets of the Arenas’ marijuana business (the plants, the marijuana, and the property that houses the marijuana businesses), the trustee would be violating the federal Controlled Substances Act. This court decision is ultimately likely to be detrimental to the Arenas since their creditors may now be free to pursue their claims against the Arenas (personally) and against their business for outstanding debts incurred by the business. In Marijuana Commercial Loans. Marijuana As Collateral Is THE Issue, we talked about how banks and other lending institutions could face the same sort of issue if they allow their borrowers to use marijuana as collateral for loans.

This federal bankruptcy decision should be a wake up call to legal marijuana businesses everywhere as they now need to realize that the bankruptcy laws probably do not apply to them. If your marijuana business or you, yourself, as an owner of a marijuana business are experiencing financial difficulties and you are contemplating filing for bankruptcy, you should also explore the possibility of winding down your business and seeking protection from creditors via a state court receivership action as an alternative to bankruptcy. It is however not clear that even a state court receivership will be allowed if it will require the state court receiver to take possession or assume title to any marijuana assets as many states prohibit anyone from possessing or owning large quantities without a license to do so.

This bankruptcy court ruling also highlights the importance of your marijuana contracts being drafted so as to avoid disputes being resolved in a federal court where you may not have any redress, which we wrote about in How To Draft An Effective Marijuana Contract. Consider this. What will happen if you sell someone $300,000 of marijuana and they fail to pay and you have no choice but to sue them in federal court? Will the federal court enforce that contract and require the buyer to pay you or will it rule that the contract is illegal and unenforceable? Our advice is to avoid this sort of situation entirely by making sure that the dispute must be resolved in a state court in which what you are doing is legal.

Even though marijuana is now legal in some states, it is still illegal Federally and you must operate accordingly.