Ninth Circuit Warms to Cannabis Bankruptcy Cases

Insolvency Insights (Reeder Law Corporation) September 2019

It isn’t often that we get to watch a new multibillion-dollar industry grow up literally under our noses. Examples from the past, such as electric utilities, were accompanied by doubts regarding whether the model could really work. The meteoric rise of the tech industry was accompanied by  understandability problems (what do you do with those things?). By contrast, the cannabis trade is an old-fashioned buy-sell enterprise. The grower grows and harvests the product, places it in the steam of commerce, eventually the product finds its way to the retail level, the buyer comes in, makes a purchase, pays, goes on his his/her way, the taxing authorities swoop in for their portion, and, by most estimates, there should be a lot left for the cannabis business and its investors.

Like all things, there is a catch. Here, the main catch is that cannabis is listed as a Schedule I controlled substance under the federal Controlled Substances Act, 21 U.S.C. § 812 eq. seq. (the “CSA”) The consequence is that trafficking in cannabis, or benefiting from a cannabis enterprise, such as collecting rents from the leasing of property to a cannabis grower or distributor, is a criminal activity under federal law. Although federal prosecution for cannabis-related acts is not part of the current legal landscape, cannabis enterprises remain clearly illegal under federal law.

At last count, thirty-three states have legalized cannabis for medical use, and eleven more have authorized recreational use. At the same time, however, cannabis remains a Schedule 1 controlled substance under the CSA.

As with all enterprises, cannabis-related enterprises are at times in need of bankruptcy relief. To date, the bankruptcy courts have given cannabis cases a very chilly reception. Bankruptcy Courts have typically dismissed cannabis-based bankruptcy cases. The dismissals have always been, at heart, based on the illegality of the cannabis enterprise. The legal “hook” has usually been either that the case was not filed in good faith, or that any plan filed in the case could not meet the bankruptcy law requirement that the plan be “proposed in good faith and not by any means forbidden by law” See, 11 U.S.C. § 1129(a)(3); 11 U.S.C. § 1325(a)(3).

Further grounds on which courts have based dismissal of cannabis-related cases include that the involvement of cannabis in the case constituted gross mismanagement of the bankruptcy estate. See, 11 U.S.C. § 1112(b((4)(B). Even in chapter 7 cases, dismissals have been common since the very presence of cannabis, and its illegality, has been viewed as constituting “undue delay by the debtor that is prejudicial to creditors” 11 U.S.C. § 707(a)(1). Finally, courts have invoked the equitable doctrine of “unclean hands”, stating that a debtor who comes before a court of equity, such as the bankruptcy court, and seeking equity, while violating federal law, lacks the “clean hands” necessary to gain equitable relief. Thus, despite various states’ legalization measures, cannabis businesses have, until recently, been frozen out the bankruptcy system.

The Ninth Circuit Court of Appeals, however, recently issued an opinion affirming the confirmation of the chapter 11 plan of a cannabis related entity which rented space to, and received rental income from, a cannabis grower. Garvin vs. Cook Investments, NW. SPNWY, LLC, 922 F.3d 1031 (9 th Cir 2019). Garvin, however,suffers from a quirky procedural history, and probably does not signal the opening of the floodgates for cannabis cases, even in courts in the Ninth Circuit.

The case got off to an unusual start when the bankruptcy court denied the motion of the United States Trustee (“UST”) to dismiss the case. The UST had based its motion on the usually successful arguments deriving from the effects of the illegality of the cannabis component of the debtor’s operations, even though cannabis-related income was a relatively small portion of the debtor’s operations and revenues. After denying the motion to dismiss, the bankruptcy court “invited” the UST to renew its motion at a later point in the case. The UST failed to do so. At the hearing on the confirmation of the debtor’s chapter 11 plan, the UST objected based on the debtor’s failure to comply with one of the mandatory provisions which must be found in order for the plan to be confirmed, specifically “The plan has been proposed in good faith and not by any means forbidden by law”. 11 U.S.C. § 1129(a)(3). Sounds pretty straight forward. The lack of good faith by the debtor in operating outside of federal criminal law, has been a staple for the finding of cause to dismiss numerous cannabis cases. Why should this case be any different? Further, since the debtor’s violation of federal law was not contested, it certainly looked like the plan was proposed by a means forbidden by law.

The bankruptcy court confirmed the plan over the objection of the UST. On appeal to the Ninth Circuit, the UST sought reversal of the denial of its motion to dismiss, and reversal of the order confirming the debtor’s plan.

The Ninth Circuit wasn’t buying. The opinion telegraphed where the court was going by making an attempt at drug humor early on, perhaps the first ever by a U.S. Court of Appeals, stating: “But now, the United States Trustee asks that the amended plan go up in smoke …”. The Ninth Circuit determined that the UST had “waived” all of its bad faith arguments, even those pertaining to the plan, when it declined the bankruptcy court’s “invitation” to renew its dismissal motion at a later date. The UST did argue all of the bad faith facts and the law derived therefrom, in its appeal. The Ninth Circuit refused to address the merits of the bad faith arguments, and all legal principles that depended on a finding of bad faith, due the UST having waived the entire inquiry.

This meant that the only issue that the Ninth Circuit had to address was the “not [proposed] by any means forbidden by law” prong of 11 U.S.C. § 1129(a)(3). The Ninth Circuit “went textual”, finding that the statute’s plain meaning is that the only inquiry is whether the proposal of the plan is through a means forbidden by law. According to the Ninth Circuit, the court need look no further than the proposal of the plan, and does not need to look at the actual contents of the plan, but only at its proposal. Under this analysis, finding an example of a violations of 1129(a)(3) require a stretch of the imagination. Perhaps if threats of physical harm to creditors who do not accept that plan was included in the disclosure statement, then a court could find that the plan was proposed by a means forbidden by law.

The upshot of the Ninth Circuit’s ruling is that the “proposed by a means forbidden by law” prong 11 U.S.C. § 1129(a)(3) is no remedy to address true illegalities in the body of the plan. Thus, it appears that a plan could be based on extortion, or money laundering, and clearly say so, and it still would not be assailable under the “proposed by a means forbidden by law” prong of 11 U.S.C. § 1129(a)(3).

This author foresees widespread rejection of Garvin by other courts who are requested by debtors to follow Garvin and allow cannabis cases to
survive dismissal motions. Already the bankruptcy court for the Eastern District of Michigan has refused to give Garvin any persuasive weight. That court, in In re Basrah Custom Design, Inc., 600 B.R. 368 (Bankr. E.D. Mich. 2019) dismissed the debtor’s cannabis-related case, finding that the debtor lacked they clean hands necessary when one approaches a court of equity, such as a bankruptcy court. The court went on to criticize Garvin at length.

There is every reason to believe that Garvin does not signal the dawning of a new day for beleaguered cannabis enterprises seeking entry into the bankruptcy system, but instead will be viewed as a one-off, and little more.

David Reeder is the principal attorney of Reeder Law Corporation located in Los Angeles. His practices includes bankruptcy cases, business reorganization, and bankruptcy litigation. He is admitted to practice in California and New York, and has written and spoken extensively on bankruptcy and commercial law-related topics.