Ruling reveals potholes in the road to Chapter 11 for cannabis businesses

To save a successful Chapter 11 restructuring from, in the words of the 9th U.S. Circuit Court of Appeals, going "up in smoke," and in a case of first impression, the 9th Circuit recently affirmed a Washington state bankruptcy court's order confirming a commercial landlord's Chapter 11 plan which received "at least indirect support" from a tenant in the cannabis business. Garvin v. Cook Investments, 2019 DJDAR 3689 (May 2, 2019). The tenant in question, Green Haven, used the premises it leased from the debtor to grow marijuana, and its lease provided that Green Haven would use the premises "exclusively as a marijuana establishment." This decision marks a significant step towards allowing access to the bankruptcy courts for cannabis businesses that are operating in accordance with state law despite that marijuana growth, manufacturing and sales continue to be illegal under the federal Controlled Substances Act, 21 U.S.C. Sections 801-971.

Garvin follows a series of cases in which bankruptcy courts first cracked open the courtroom doors to participants in the cannabis industry, then gently began to widen the opening, as chronicled in G. David Dean's and Katherine M. Devanney's May 30 article in the ABA Journal, "Marijuana's Journey From Greenhouse to Courthouse." All of these cases involved participants whose activities in the marijuana industry are legal under applicable state law despite that such business activities continue to be illegal under the CSA -- as was the case in Garvin.

In Garvin, the U.S. trustee argued that confirmation of a Chapter 11 plan should be reversed for its violation of one of the 16 requirements for confirmation set forth in the Bankruptcy Code, which requires that the "plan has been proposed in good faith and not by any means forbidden by law." 11 U.S.C. Section 1129(a)(3). The U.S. trustee argued that the plan contemplated income from a business that is illegal under federal law because payments to the debtor were to be made by the tenant that was operating in violation of the CSA. The 9th Circuit disagreed, and affirmed the district court which had affirmed the Bankruptcy Court.

As if anticipating the inclination to read more than intended into the decision, the 9th Circuit framed the dispositive issue presented as one of narrow statutory construction: whether Section 1129(a)(3) of the Bankruptcy Code "forbids confirmation of a plan that is proposed in an unlawful manner as opposed to a plan with substantive provisions that depend on illegality." This was a question of first impression within the 9th Circuit.

The 9th Circuit begins observing that "the phrase 'not by any means forbidden by law' modifies the phrase '[t]he plan has been proposed.'" The court concludes that the plan was indeed "proposed" by legal means, i.e., "consistent with the objectives and purposes of the Bankruptcy Code." The significance of the court's holding is highlighted by the fact that the debtor's own action of renting property to a tenant in the cannabis business is itself explicitly a crime under the CSA.

The facts of Garvin reveal potholes in the road to Chapter 11 restructurings that may derail other landlords who rent to cannabis businesses. In Garvin, the Chapter 11 cases of the principal's five real estate holding companies were consolidated and the debtor holding companies' Chapter 11 plan was confirmed over the objections of the U.S. trustee. Although the U.S. trustee had filed a motion to dismiss the cases for "cause" under 11 U.S.C. Section 1112(b), on the grounds of alleged "gross mismanagement," for renting to a cannabis business, the Bankruptcy Court had denied that motion "with leave to renew" the motion at the confirmation hearing. Bankruptcy courts have dismissed Chapter 11 cases for "cause" under Section 1112(b) for the debtors' lease of property to a cannabis business. See In re Rent-Rite Super Kegs W. Ltd., 484 B.R. 799, 811 (Bankr. D. Colo. 2012). The U.S. trustee, however, failed to renew that motion to dismiss at the confirmation hearing. Earlier, before confirmation, and in response to the U.S. trustee's motion to dismiss, the debtors had amended the plan to provide for the rejection of the Green Haven lease in an effort to "cure" and thereby address the U.S. trustee's mismanagement argument.

The debtors' Chapter 11 plan was a resounding success from the public policy perspective of the Bankruptcy Code, which is to achieve a restructuring of indebtedness for the benefit of creditors: The plan was supported by the creditors and provided for all creditors' claims to be repaid in full. The creditors voted to accept the plan, and since there was no stay pending appeal, the debtors commenced to perform and the unsecured claims were in fact paid in full by the time the appeal was argued to the 9th Circuit. The confirmed amended plan also provided that the secured creditor would be paid directly by various of the tenants who were not in the cannabis business; the secured creditor did not receive under the plan any payments from Green Haven, and funding of the plan's obligation was from sources other than Green Haven's rent. Despite that the amended plan provided for the rejection of the Green Haven lease, and that the plan's funding did not depend on income from Green Haven, the 9th Circuit acknowledged the debtor would indeed continue "to receive rent payments from Green Haven, which provides at least indirect support for the Amended Plan." (Emphasis added.)

Against this backdrop of a successful restructuring that paid creditors' claims in full, the court considered and rejected the U.S. trustee's request "that the Amended Plan go up in smoke because one of the Cook companies leases property to [Green Haven] which uses the property to grow marijuana."

Significantly, the court emphasized that the U.S. trustee had not renewed its motion to dismiss at the confirmation hearing, which resulted in a waiver of the argument on appeal. See Walsh v. Nev. Dep't of Human Res., 471 F.3d 1033, 1037 (9th Cir. 2006). Furthermore, and in addition to framing the matter before the court as one of narrow statutory construction, the court expressed its intention that its decision not be deemed an invitation to law violators. "We do not believe that [our decision] ... will result in bankruptcy proceedings being used to facilitate legal violations." The court went on to note that "confirmation of a plan does not insulate debtors from prosecution for criminal activity, even if that activity is part of the plan itself."

Notwithstanding the court's implicit remonstration that its decision was not passing judgment on the legality of the cannabis business that provided "at least indirect support" for the plan, and the corollary that the court's decision should not be read as opening the door to the cannabis trade as such, some would argue it obvious that the legality of the cannabis business under applicable state law provided at least a quantum of the thread woven into the fabric of the court's decision affirming the plan confirmation. It would strain credulity to suggest the court would have been prepared to affirm confirmation of a Chapter 11 plan that was supported, even indirectly, by an enterprise engaged in child sex trafficking or operation of a meth lab, for example. Thus, common sense indicates the court's conclusion that "Green Haven appears to be in compliance with Washington law" was a relevant factor if not determinative of the court's conclusions leading to affirmation of the order confirming the plan.

A compelling public policy argument may be made for taking into account that the activity in question, illegal under federal law, is legal under applicable state law. Arguments are being made in public policy debates across the country as these issues are being addressed in numerous contexts, as states continue to expand and develop their cannabis jurisprudence against the backdrop of the seemingly inert federal ban by way of the CSA. Even state bar associations have weighed in; some have issued guidance to lawyers analyzing the needs, constraints and benefits to the business community of lawyers rendering legal advice to clients who are participants in the cannabis industry, to the extent such businesses are operating legally in accordance with state law. The notion is that such state-legal businesses deserve to receive the benefit of legal counsel. For example, the new ethics rules adopted in California last year include a comment that "The fact that a client uses a lawyer's advice in a course of action that is criminal ... does not of itself make a lawyer a party to the course of action." California Rules of Professional Conduct, Rule 1.2.1, Comment [1]. New York goes further, explicitly stating in an ethics opinion that "the New York Rules permit a lawyer to assist a client in conduct designed to comply with state medical marijuana law." New York State Bar Association, Opinion 1024 (Sept. 29, 2014). And at least seven states -- not including California -- have amended their rules of professional conduct to address assisting clients with cannabis businesses.

Nevertheless, "proceed with caution," and strictly in compliance with applicable state law, would be the prudent lesson to take from the 9h Circuit's Garvin decision. As long as marijuana remains a crime under federal law in light of the extant CSA, uncertainty and risks of potential prosecution cannot be ignored or eliminated. 