The Ninth Circuit pushed back against the idea that a chapter 11 plan cannot be confirmed if there is a whiff of marijuana.

Still, the appeals court left the door open to dismissing a case if the debtor is involved with the production or sale of marijuana. As Circuit Judge Margaret McKeown explained in her May 2 opinion, the U.S. Trustee waived its appeal from the bankruptcy court’s order early in the case denying a motion to dismiss.

An individual owned five companies engaged in the ownership and management of real estate. One property had two tenants. One of the tenants grew marijuana, which is legal in the State of Washington but violates the federal Controlled Substances Act.

Early in the case, the U.S. Trustee filed a motion to dismiss, on the theory that having a tenant in the marijuana business amounted to gross mismanagement under Section 1112(b). Bankruptcy Judge Brian D. Lynch of Tacoma, Wash., denied the motion to dismiss, but with leave to renew at confirmation.

The debtor proposed a conventional reorganization plan paying creditors in full, unsecured as well as secured. The U.S. Trustee lodged the only objection to confirmation.

The U.S. Trustee argued that continuing to receive revenue from the marijuana tenant meant that the plan was not proposed in good faith, thus violating a condition to confirmation in Section 1129(a)(3).

Significantly, the U.S. Trustee did not renew the motion to dismiss at confirmation, and Bankruptcy Judge Lynch confirmed the plan. The district court denied the U.S. Trustee’s motion for a stay pending appeal and likewise upheld confirmation. The district court also denied the appeal from denial of the motion to dismiss because the U.S. Trustee had not renewed the motion at confirmation.

Appealing to the Ninth Circuit, the government brought out the big guns, but to no avail. The government was represented in the circuit by the Acting U.S. Attorney and an assistant attorney general from the Civil Division of the Department of Justice in Washington.

Judge McKeown quickly dispensed with the appeal from denial of the motion to dismiss. Like the district court, she said that the government waived the argument by failing to renew the dismissal motion at confirmation.

The marijuana appeal, Judge McKeown said, raised an issue of first impression: Does Section 1129(a)(3) only preclude confirmation of a plan that is “proposed” in an unlawful manner or, more broadly, a plan with substantive provisions that depend on illegal activity?

As one of the conditions to confirmation, Section 1129(a)(3) says that the plan must have been “proposed in good faith and not by any means forbidden by law.” In substance, Judge McKeown upheld confirmation based on the plain meaning of the statute.

Like the First Circuit Bankruptcy Appellate Panel in dealing with Section 1129(a)(3), Judge McKeown said that “courts look only to the proposal of a plan, not to the terms of the plan.” The statutory text and the “weight of persuasive authority,” she said, require the courts to examine only the proposal of the plan.

Judge McKeown conceded that “some bankruptcy courts” have adopted the U.S. Trustee’s approach by dismissing bankruptcies where significant income was derived by marijuana. To apply the same analysis at confirmation, she said, “would require us to rewrite the statute completely” because Section 1129(a)(3) calls on the court to inquire whether the plan was proposed by any means forbidden by law, not whether any of the “substantive provisions . . . depend on illegality.” In the case at bar, the debtor employed no illegal means in proposing the plan.

Judge McKeown said the circuit’s opinion would not allow bankruptcy to be “used to facilitate legal violations.” Confirmation, she said, does not insulate anyone from criminal liability.

Significantly, Judge McKeown insinuated that the result may have been different if the U.S. Trustee had renewed the motion to dismiss. Were there no waiver of the dismissal motion, she said that “courts may consider gross mismanagement issues under Section 1112(b).”