Alerts and Updates

Ninth Circuit Removes Important Restriction to Cannabis Bankruptcy Reorganizations, But Obstacles Remain

May 22, 2019

The court noted that the DOJ might prosecute cannabis-related businesses under the CSA, notwithstanding plan confirmation. Thus, Garvin may have foreclosed any future DOJ CSA-based noneconomic objections to cannabis reorganizations.

The Department of Justice (DOJ) contends that cannabis-related businesses cannot obtain federal bankruptcy relief.[1] In Garvin v. Cook Investments NW, SPNWY, LLC, No. 18-35119, 2019 WL 1945280 (9th Cir. May 2, 2019), the DOJ challenged plan confirmation of a real estate holding company because it leased one of its properties to a cannabis grower, even though the debtor’s plan did not rely on those rents. In the first ruling by a Court of Appeals on this issue, the United States Court of Appeals for the Ninth Circuit rejected the government’s position. The case’s limited holding cracks, but does not completely open, the door for cannabis-related bankruptcy reorganizations (cannabis reorganizations).

The Ninth Circuit Limits Section 1129(a)(3) to the Plan’s Proposal, Not Its Terms

The debtor in Garvin leased property to a cannabis grower in compliance with Washington state law. Before plan confirmation, the debtor rejected the lease to the cannabis grower. The debtor then proposed a plan paying creditors in full from noncannabis proceeds. Despite rejecting the lease, the debtor retained the rights to rent under state law. The plan allowed the debtor to use one bank account for its cannabis and noncannabis rents, permitting commingling of funds.

The DOJ objected to the plan, arguing that it violated the Controlled Substances Act (CSA), or at least “tacit[ly] promot[ed] ongoing criminal conduct.” The CSA makes it unlawful for any person to manufacture, distribute, dispense or possess any “controlled substance.” 21 U.S.C. § 841(a). Nor may any entity “knowingly open, lease, rent, use, or maintain any place, whether permanently or temporarily, for the purpose of manufacturing, distributing, or using any controlled substance.” 21 U.S.C. § 856(a)(1). The CSA classifies cannabis as a Schedule I substance, which the CSA defines as a substance that has a high potential for abuse and no currently accepted medical or safe use. 21 U.S.C. §§ 812(a), (b)(1).

The DOJ based its argument entirely on Section 1129(a)(3).[2] Section 1129(a)(3) precludes confirmation of plans that are not “proposed in good faith” or by “any means forbidden by law.” 11 U.S.C. § 1129(a)(3). The DOJ contended that Section 1129(a)(3) bars a court from confirming a plan that envisions or perpetuates illegal activity. Several lower courts had already adopted this interpretation, at least with respect to commercial cannabis businesses. See, e.g., Arm Ventures, LLC, 564 B.R. 77, 86 (Bankr. S.D. Fla. 2017); In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 809 (Bankr. D. Colo. 2012).

The district court rejected the DOJ’s “extremely broad interpretation.” The Ninth Circuit affirmed, concluding that “§ 1129(a)(3) directs courts to look only to the proposal of a plan, not the terms of the plan.”

Further, the Ninth Circuit expressed its preference to limit the role of bankruptcy courts. The Ninth Circuit stated, “There is no need to… convert the bankruptcy judge into an ombudsman without portfolio, gratuitously seeking out possible ‘illegalities’ in every plan,” a result that would be “inimical to the basic function of bankruptcy judges in bankruptcy proceedings.” Further dividing the realms of criminal prosecution and bankruptcy reorganization, the court noted that the DOJ might prosecute cannabis-related businesses under the CSA, notwithstanding plan confirmation.[3] Thus, Garvin may have foreclosed any future DOJ CSA-based noneconomic objections to cannabis reorganizations.

Certain Unresolved Issues

The court’s ruling is, necessarily, limited to the Ninth Circuit. Outside of the Ninth Circuit, which covers California, Alaska, Arizona and Hawaii, the DOJ can continue to argue that every cannabis reorganization violates the CSA, and so Section 1129(a)(3) precludes plan confirmation. However, only a minority of courts subscribe to the DOJ’s interpretation. See In re Irving Tanning Co., 496 B.R. 644, 660 (B.A.P. 1st Cir. 2013) (collecting cases).

As discussed below, even after Garvin, the DOJ can still argue that cannabis-related business debtors engage in “gross mismanagement of the estate.” 11 U.S.C. § 1112(b)(4)(B). The DOJ might also argue that the reorganization does not “provide adequate means for the plan’s implementation.” 11 U.S.C. § 1123(a)(5). Still, cannabis reorganizations might overcome these objections to confirm plans.

Gross Mismanagement of the Estate

Debtors must manage the estate with an aim to “protect and conserve property… for the benefit of creditors.” In re Devers, 759 F.2d 751, 754 (9th Cir. 1985). “[G]ross mismanagement of the estate” is cause to dismiss or convert a Chapter 11 bankruptcy case. 11 U.S.C. § 1112(b)(4)(B).

A person convicted under the CSA risks forfeiting all property and money obtained from violating the CSA or that the person intends to use in any manner to commit such violation. 21 U.S.C. § 853(a). Further, “the government is not required to show that property is owned by a drug trafficker, but rather that it has a substantial connection to a drug transaction.” United States v. A Single Family Residence & Real Prop. Located at 900 Rio Vista Blvd., Fort Lauderdale, 803 F.2d 625, 629 (11th Cir. 1986).

The DOJ has argued successfully that a bankruptcy debtor engages in gross mismanagement by risking asset forfeiture under the CSA. See In re Medpoint Mgmt., LLC, 528 B.R. 178, 184 (Bankr. D. Ariz. 2015). The Ninth Circuit declined to rule on this issue, noting the DOJ waived this argument by failing to raise it below. It remains an objection that cannabis reorganizations must overcome in future cases.

Preclusive Effect of Section 1123(a)(5) 

Plan funding in Garvin did not rely on cannabis-related proceeds. Hence, the Ninth Circuit did not address whether a debtor may confirm a plan that is funded by marijuana proceeds. Section 1123(a)(5)’s superseding scope might determine the answer.[4] Section 1123 requires a plan to have “adequate means” for its implementation, “notwithstanding any otherwise applicable nonbankruptcy law.” 11 U.S.C. § 1123(a)(5) (emphasis added).

Generally, “statutory ‘notwithstanding’ clauses broadly sweep aside potentially conflicting laws.” United States v. Novak, 476 F.3d 1041, 1046 (9th Cir. 2007). This would apply to the CSA even though the CSA is a criminal statute seeking to “conquer drug abuse and to control the legitimate and illegitimate traffic in controlled substances.” Gonzales v. Raich, 545 U.S. 1, 12 (2005). Notwithstanding clauses at least demonstrate “that Congress intended to supersede any previously enacted conflicting provisions.” Student Loan Fund of Idaho, Inc. v. U.S. Dep’t of Educ., 272 F.3d 1155, 1166 (9th Cir. 2001) (emphasis added). The CSA has such a relationship to Section 1123(a)(5) because Congress enacted the CSA in 1971, seven years before it enacted the Bankruptcy Code. Moreover, unlike other Bankruptcy Code provisions, Section 1123’s notwithstanding clause does not limit its scope to state laws or any specific federal law. See Cisneros v. Alpine Ridge Grp., 508 U.S. 10, 18, 113 S. Ct. 1898, 1903 (1993). Contrast 11 U.S.C. § 363(b)(2)(A). Thus, Section 1123 could supersede the CSA to prevent plan confirmation.

However, the Ninth Circuit limits Section 1123’s superseding scope to laws relating to “financial condition.” Pac. Gas & Elec. Co. v. California ex rel. California Dept. of Toxic Substances Control, 350 F.3d 932, 937 (9th Cir. 2003) (suggesting that Section 1123 extends to contrary federal law); but see In re Fed.-Mogul Glob., 684 F.3d 355, 364 (3d Cir. 2012) (rejecting the Ninth Circuit’s limitation as applied to federal preemption of state law). Thus, the DOJ might continue to object to cannabis reorganizations by contending that, because the CSA is not a law relating to financial condition, a plan cannot propose to generate income through activities that violate the CSA.

Conclusion

Garvin opens the door to cannabis reorganizations. Although its limited holding still allows the DOJ alternative grounds to object to cannabis reorganizations, such objections must be considered in light of the Ninth Circuit’s limitation of the bankruptcy court’s role.

Duane Morris attorneys will continue to monitor developments in this area and other related issues, and report on the key details for our clients and others in the industry.

For More Information

If you have any questions about this Alert, please contact Meagen E. Leary, James J. Holman, Jeff D. Kahane, Mohammad Tehrani, any of the attorneys in our Business Reorganization and Financial Restructuring Practice Group, any of the attorneys in our Cannabis Industry Group or the attorney in the firm with whom you are regularly in contact.

Notes

[1] The Controlled Substances Act no longer controls hemp. Garvin leased to a marijuana grower, not a hemp grower. Congress removed “hemp” from the Controlled Substances Act in 2018. 2018 Farm Bill, Pub. L. No. 115-334 § 10113, 132 Stat. 4490.

[2] References to “Section” refers to sections of Title 11 of the United States Code, 11 U.S.C. § 101, et seq (Bankruptcy Code).

[3] In fact, the DOJ can prosecute cannabis-related businesses even during bankruptcy. See 11 U.S.C. § 362(b)(1); In re Gruntz, 202 F.3d 1074, 1085 (9th Cir. 2000); see also In re Universal Life Church, Inc., 128 F.3d 1294, 1298 (9th Cir. 1997).

[4] Although sometimes referred to as “preemption,” preemption addresses conflicts between state and federal law. Section 1123(a)(5)’s language appears intended to also supersede other federal statutes.

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