Creditors Can Do Business with Cannabis Companies and Still Reorganize Under Chapter 11 (At Least in the Ninth Circuit)

The value of the legitimate cannabis industry in the U.S. (measured by annual sales) is rapidly approaching $10 billion and is expected by some to exceed $20 billion within the next five years. As the market grows, companies that do not grow or sell cannabis are nonetheless doing business with some that do. Media companies are running advertisements for dispensaries, agricultural-equipment manufacturers are selling machinery to cannabis growers and lawyers, and accountants and other professionals are providing services to clients directly involved in the industry.

Cannabis businesses and those that deal with them should note Garvin v. Cook Investments Northwest, a decision published by the U.S. Court of Appeals for the Ninth Circuit on May 2, 2019.[1] Importantly, the court decided that a landlord receiving rent from someone involved in the state-legal cannabis industry could confirm a plan of reorganization under chapter 11 of the Bankruptcy Code.

In Garvin, the debtor in bankruptcy was a landlord that owned real property. Before the commencement of its bankruptcy, the landlord rented the property to a cannabis business under a written lease. After filing for bankruptcy, the landlord continued to accept rent from the cannabis business. The landlord then proposed a plan of reorganization that would pay off its debts to creditors. The original version of the plan contemplated that at least some of the rent received from the cannabis business would contribute to the success of the reorganization.

The Office of the U.S. Trustee (an arm of the U.S. Department of Justice) objected to the plan, arguing that a landlord could not confirm a chapter 11 plan of reorganization because the landlord leased property to a tenant engaged in the cannabis business. After the U.S. Trustee objected, the landlord reformulated its plan. It used its authority under the Bankruptcy Code to reject the lease, then removed any references to the use of proceeds of the lease from the plan. The landlord noted that it expected to earn enough revenue from other sources to pay its debts. The landlord admitted that it would continue accepting rent from the tenant because the tenant had the right to remain in possession of the premises so long as it continued paying rent, and showed no interest in abandoning that right. (As an aside, the U.S. Supreme Court’s recent decision in Mission Product Holdings Inc. v. Tempnology LLC apparently confirms that a landlord in that situation cannot exercise eviction and other rights unless they are available under other applicable state or federal law.)[2]

The bankruptcy court confirmed the amended plan of reorganization. After an appeal by the U.S. Trustee, the district court affirmed, and the U.S. Trustee appealed again, this time to the Ninth Circuit.

A company that seeks chapter 11 relief is entitled to confirm a plan of reorganization if, among other things, it “proposed a plan in good faith and not by any means forbidden by law.”[3] The U.S. Trustee argued that a landlord renting property to a tenant engaged in the cannabis business cannot meet this test because the landlord derives income in the form of rent from an illegal enterprise. The landlord, by contrast, argued that the phrase “any means forbidden by law” modifies “proposed,” meaning that § 1129 only requires the debtor to follow a lawful procedure for proposing a plan. Each side of the argument cited cases for its proposed reading, but none identified a controlling precedent from the U.S. Supreme Court.

A bankruptcy court also has the discretion to dismiss a bankruptcy case if the debtor is guilty of “gross mismanagement of the estate.”[4] The U.S. Trustee argued that a debtor who continues to accept rent from a tenant engaged in the cannabis business is guilty of gross mismanagement because the landlord’s property could, as a result, become subject to forfeiture in a criminal prosecution. The landlord pointed out that other arms of the federal government do not prosecute cannabis businesses that are licensed under state law, so there was no meaningful risk of a criminal forfeiture.

In its opinion, the Ninth Circuit relied on the plain language of § 1129(a)(3) of the Bankruptcy Code, which states that a bankruptcy court shall only confirm a plan if the plan “has been proposed in good faith and not by any means forbidden by law.” The Ninth Circuit held that § 1129(a)(3) “directs courts to look only to the proposal of a plan, not the terms of the plan.... This reading accords with both the statutory text, which does not refer to the substance of the plan, and the weight of persuasive authority.”[5] Since, in this case, the plan itself had not been proposed by any means forbidden by law (such as procedural irregularities or other improprieties in the proposal itself), the plan did not violate § 1129(a)(3).

Although the Ninth Circuit relied on the plain text of the statute, it also observed that its interpretation was good policy. The Ninth Circuit rejected the notion that a bankruptcy court should be converted into “an ombudsman without portfolio, gratuitously seeking out possible illegalities in every plan.”[6] Its decision would not allow debtors to exploit the Bankruptcy Code to facilitate lawbreakers because debtors could still be prosecuted if they were deemed to have engaged in criminal activity, and bankruptcy courts retain the authority to consider whether estates are being grossly mismanaged by debtors, such as debtors’ participation in illegal activity.[7]

The Ninth Circuit rejected contrary authorities.[8] In 2012, for example, a bankruptcy court in Colorado dismissed the chapter 11 case of a debtor that received rent from cannabis businesses.[9] The bankruptcy court had held that the debtor could not confirm a plan because § 1129(a)(3) “forecloses any possibility of this Debtor obtaining confirmation of a plan that relies in any part on income derived from criminal activity.”[10] Although that decision may be persuasive authority in other jurisdictions, it is a dead letter within the Ninth Circuit because of Garvin.

The Ninth Circuit’s decision is good news for cannabis businesses and those dealing with them. It is binding on all federal courts within the Ninth Circuit and will hopefully pave the way for other sister circuit courts to follow in the Ninth Circuit’s footsteps.