Marijuana: Should a Plan “Go up in Smoke” Because a Debtor’s Tenant Operates a Marijuana Establishment?

Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019) –

The U.S. trustee objected to a chapter 11 plan of reorganization proposed by a group of real estate holding companies on the grounds that a tenant of one of the debtors was involved in a marijuana growing operation that was illegal under federal laws. The bankruptcy court overruled the objection and confirmed the plan; the district court affirmed on appeal; and the U.S. trustee further appealed to the Ninth Circuit.

Five real estate holding companies under common ownership and management proposed a plan of reorganization that paid all creditors in full and provided for the companies to continue as a going concern in what the Ninth Circuit characterized as “by most standards a resounding success.” However, the trustee asked that the plan “go up in smoke” because a tenant of one of the companies used the premises to grow marijuana.

Although the tenant’s business complied with state law, the U. S. trustee argued that the lease itself violated federal drug law. The lease provided that the tenant would use the premises exclusively as a marijuana establishment. So, the lease violated the federal Controlled Substances Act, which prohibits “knowingly … leas[ing] … any place … for the purpose of manufacturing, distributing, or using any controlled substance.” See 11 U.S.C. § 856(a)(1). Accordingly, the U. S. Trustee argued that the plan was unconfirmable because it was “proposed … by … means forbidden by law.”

The Ninth Circuit began by noting that a plan may be confirmed only if it satisfies requirements set forth in section 1129(a), including the requirement in subsection (a)(3) that the plan “has been proposed in good faith and not by any means forbidden by law.” Only the second prong was at issue in this case. Since it appeared that the debtor continued to receive rent payments from the marijuana tenant that provided at least indirect support for the plan, the U.S. trustee asserted that the plan involved means forbidden by law.

The court took issue with the trustee’s analysis, characterizing the question as whether section 1129(a)(3) forbids confirmation “of a plan that is proposed in an unlawful manner as opposed to a plan with substantive provisions that depend on illegality.” The court concluded that this requirement applies only to the proposal not the terms of a plan. It described this approach as consistent with both the text of the statute and the weight of “persuasive authority.”

Although some courts agree with the U. S. trustee’s position, from the court’s perspective this ignores the statute’s focus on proposal of a plan, and is not consistent with the plain text. The court did not view this as allowing bankruptcy proceedings to be used to facilitate legal violations. It suggested that a bankruptcy court could consider gross mismanagement issues under section 1112(b), and confirmation does not insulate a debtor from prosecution for criminal activity, even if the activity is part of the plan.

There is thus 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.”

Accordingly, the Ninth Circuit agreed that the plan met the requirements of section 1129(a).

As noted in the opinion, not all courts agree with the Ninth Circuit. In some cases, particularly where the debtor is the one involved in the marijuana business, courts have dismissed the case to avoid having the bankruptcy court used to facilitate an illegal activity. On a side note, assessment of this issue will now require a more detailed understanding of the marijuana activities involved since the Agricultural Improvement Act of 2018 removed hemp from the Controlled Substances Act so that it is no longer an illegal substance. See Statement from FDA Commissioner Scott Gottlieb, M.D., on signing of the Agriculture Improvement Act and the agency’s regulation of products containing cannabis and cannabis-derived compounds (December 20, 2018).

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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