Marijuana-Related Debtors' Case Survives Dismissal in Ninth Circuit - Cannabis Industry News Alert

Bradley Arant Boult Cummings LLP

A recent decision by a federal appeals court appears to open the doors of United States Bankruptcy Courts nationwide… or does it? The Ninth Circuit’s decision from Garvin v. Cook Investments provides a helpful roadmap for understanding the challenges and opportunities for marijuana-related businesses considering their access to bankruptcy courts.

Marijuana Businesses Generally Violate Federal Law

Although permissible under certain state laws, in general, marijuana businesses do violate federal law. But first, some context may be useful to understand the issue. This country’s relationship with marijuana is a complicated one. Under the federal Controlled Substances Act (CSA), marijuana is a Schedule I controlled substance. The federal government designates Schedule I drugs as the most dangerous with a high risk of abuse and lack of recognized or accepted medical use. The CSA prohibits a variety of marijuana-related activities, including using, selling, and manufacturing marijuana, as well as funding or leasing property to businesses that sell or manufacture marijuana or related paraphernalia.

Notwithstanding the federal CSA, in the mid-1990s individual states began passing laws allowing marijuana use for medicinal purposes. Today, medical marijuana is legal in more than 30 states. Additionally, beginning in 2012, more than 10 states have passed laws allowing recreational marijuana use, with initiatives at the forefront in multiple other states.

Although the growth, distribution, sale, and use of marijuana still unequivocally violate the CSA, in 2014 the Rohrabacher-Farr amendment was passed as part of a federal omnibus spending bill. The Rohrabacher-Farr amendment prohibits the use of federal funds to interfere with state laws permitting medical marijuana use. The Rohrabacher-Farr amendment is subject to annual review and has been regularly renewed since 2014.

In 2017 the United States Trustee Program (USTP), a component of the federal Department of Justice that is responsible for civilly prosecuting bankruptcy fraud and abuse, released a memorandum instructing bankruptcy trustees to report bankruptcy cases in which debtors derived income from marijuana business activities and indicating the USTP’s intention to seek dismissal of such cases. Although then Attorney General Jeff Sessions released a memorandum in 2018 rescinding prior marijuana-related memoranda from the Justice Department, it is unclear the extent to which the 2018 memorandum impacted the USTP’s 2017 instructions to bankruptcy trustees.

Bankruptcy Courts Traditionally Eject Marijuana Debtors

One of the first landmark bankruptcy cases regarding dismissal due to the debtor’s involvement in the marijuana industry is In re Rent-Rite Super Kegs West Ltd. In Rent-Rite, a secured creditor moved to dismiss the bankruptcy case of a landlord debtor that leased warehouse space to a tenant whose business involved growing marijuana. The court found cause to dismiss under section 1112(b) of the Bankruptcy Code due to the debtor’s gross mismanagement of the estate. Specifically, because the debtor leased space to a tenant for its marijuana business operations, which remained illegal under federal law, the debtor subjected the estate to federal seizure and forfeiture. Additionally, the court held that the debtor had unclean hands due to its continued marijuana business activities in violation of federal law. Finally, the court held that any Chapter 11 plan the debtor could propose would rely on income from a business activity illegal under federal law.

Another landmark marijuana debtor bankruptcy case is In re Arenas. Sustaining the United States Trustee’s (UST) objection, the court denied the debtors’ motion to convert the Chapter 7 case to a Chapter 13 case and found cause to dismiss the Chapter 7 case. On the debtors’ appeal, the Tenth Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s ruling on the basis of the debtors’ violation of the CSA and because a Chapter 7 trustee could not administer the debtors’ estate – which included a commercial building leased to the debtors’ marijuana wholesaling business and a marijuana dispensary – as distributing the proceeds from selling the debtors’ assets would violate federal law.

Bankruptcy courts have even dismissed cases when debtors have been connected only tangentially with the marijuana industry. For instance, in In re Medpoint Mgmt., the debtors licensed intellectual property to a business in the marijuana industry. The court dismissed the debtors’ involuntary Chapter 7 case for cause because, although the Department of Justice at that time lacked funding to seize the debtors’ assets for violating the CSA, the possibility that the Department of Justice might seize the debtors’ assets in future years could not be ruled out.

In In re Way to Grow, Inc., the debtors’ connection to the marijuana business was even more remote. The debtors manufactured equipment used to grow plants, including, but not limited to, marijuana. Nonetheless, the court found cause to dismiss the debtors’ bankruptcy case due to the debtors’ violation of the CSA.

A Crack in the Floodgate or a Random Blip?

Bucking prior trends from bankruptcy courts, the Ninth Circuit recently affirmed a bankruptcy court’s refusal to dismiss a case in which the debtors’ business conduct violates the CSA. The debtors in Garvin v. Cook Investments NW, SPNWY, LLC, owned and managed real property that they leased to a tenant that grew marijuana. During the bankruptcy case, the UST moved to dismiss the debtors’ case due to the debtors’ violation of the CSA. The bankruptcy court denied the UST’s motion at that time because, although the debtors’ first proposed plan relied on rental income from a tenant that grew marijuana, the debtors stated at oral argument that they could revise the plan to reject the lease and fund the plan from other income. However, the court granted the UST leave to renew its motion to dismiss at the confirmation hearing if the plan still assumed the problematic lease and relied on its income for funding.

The UST also objected under Bankruptcy Code section 1129(a)(3) to the debtors’ Chapter 11 plan, despite its full repayment of creditors’ claims, because the debtors’ conduct violated the CSA. The UST, however, failed to renew its motion to dismiss at the confirmation hearing, and the bankruptcy court confirmed the plan. After a contested confirmation hearing, with the UST as the sole objector to the debtors’ Chapter 11 plan and a secured creditor supporting the plan, the court overruled the UST’s objection and confirmed the plan.

At the confirmation hearing, the UST did not object to the debtors’ proffer that they were otherwise in compliance with Bankruptcy Sections 1129(a) and 1129(b), which, if fulfilled, would provide for the debtors’ plan to be confirmed. Rather, the basis of the UST’s objection was that the court should refrain from confirming any plan proposed by a debtor that is violating federal law, regardless of whether such illegal activity is necessary for the plan’s feasibility. The court rejected the UST’s argument and overruled its objection, reasoning that, in this case, the debtors did not rely on the income from the marijuana business to fund the plan, and the debtors specifically rejected the marijuana business’ lease. The UST appealed the bankruptcy court’s decision to overrule the UST’s objection to plan confirmation.

On appeal, the question facing the Ninth Circuit was whether the debtors’ plan was proposed by means forbidden by law and thus unconfirmable under section 1129(a)(3) of the Bankruptcy Code. The court’s analysis turned on whether the phrase “proposed … by … means forbidden by law” referred to the manner in which the plan was proposed or if the provision prohibited confirmation of a plan with substantive terms that call for unlawful activity, such as funding the plan through business activity that violates the CSA. The court adopted the former, stating that, although cases have been dismissed on the basis of funding a plan through illegal activity, courts cannot deny plan confirmation under section 1129(a)(3) on that basis. Considering the plain language of that section, the Ninth Circuit stated that debtors are prohibited from proposing plans in an illegal manner, but courts should not consider the legality of the substantive terms of the plan under section 1129(a)(3).

Finding that the UST had waived its motion to dismiss by failing to reassert it at the confirmation hearing, the Ninth Circuit’s decision was limited to the application of section 1129(a)(3). In circumstances where motions to dismiss are not waived, however, the Ninth Circuit noted that gross mismanagement of the bankruptcy estate could still provide a basis for dismissal of marijuana debtors’ cases under Bankruptcy Code section 1112(b).

The Takeaway

So what does the Cook Investments case mean for marijuana-related businesses? Are the doors of the bankruptcy courts now open? It is too soon to tell, and treating the case as a harbinger of greater access to bankruptcy courts is probably a stretch. Although the Ninth Circuit allowed the survival of the debtors’ bankruptcy case and plan confirmation, its holding relied on the UST’s waiver of its section 1112(b) motion to dismiss for gross mismanagement of the estate. Had the UST not waived its opposition to the plan under section 1112(b), the outcome might very well have been different. Accordingly, it seems that precedence still provides for the dismissal of marijuana-related bankruptcy cases based on gross mismanagement where the debtor’s marijuana ties potentially subject the estate to seizure for violating federal law.

As increasingly more states pass laws legalizing medical and recreational marijuana usage, more related businesses will likely seek bankruptcy relief. The issue of whether marijuana debtors may file bankruptcy cases capable of surviving motions to dismiss will likely be considered again soon.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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