9th Circuit Considers Availability of Bankruptcy to Cannabis-Related Businesses

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

Cannabis businesses and those who deal with them should note Garvin v. Cook Investments Northwest, an appeal now pending in the U.S. Court of Appeals for the 9th Circuit. In that case, the Office of the United States Trustee (an arm of the U.S. Department of Justice) is fighting to keep a landlord from confirming a plan of reorganization under chapter 11 of the Bankruptcy Code because the landlord leases property to a tenant engaged in the cannabis business. If the U.S. trustee is successful, it could keep people who do business with cannabis companies from seeking relief in bankruptcy.

The debtor in bankruptcy is a landlord that owns 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.

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.

The bankruptcy court also confirmed the revised plan of reorganization, and on appeal by the U.S. trustee, the district court affirmed. The matter is now being considered by the 9th Circuit.

A company that seeks relief under chapter 11 of the Bankruptcy Code 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.” See 11 U.S.C. § 1129(a)(3). The U.S. trustee argues 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, argues that the phrase “any means forbidden by law” modifies “proposed,” meaning section 1129 only requires the debtor to follow a lawful procedure for proposing a plan.

Each side of the argument cites cases for their proposed reading, but none identifies 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” under 11 U.S.C. § 1112(b)(4)(B). The U.S. trustee argues 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 points out that other arms of the federal government do not prosecute cannabis businesses that are licensed under state law, so there is no meaningful risk of a criminal forfeiture.

The bankruptcy court and the district court agreed with the landlord. That is good news for the cannabis industry because the decisions of those courts may be cited as persuasive (but not binding) authority in other jurisdictions. The bankruptcy court and the district court rejected the U.S. trustee’s efforts to fashion the bankruptcy court into an instrument of anti-drug policy, and there are good reasons to believe the 9th Circuit will do the same.

The results of the case will be important for cannabis businesses and those dealing with them. Other courts have already held that cannabis businesses cannot file for bankruptcy themselves, but the U.S. trustee’s push to stop companies that work with cannabis businesses seems especially aggressive. If the 9th Circuit agrees with the U.S. trustee and overturns the rulings of both the bankruptcy court and the district court, then companies entering into transactions with cannabis businesses may also find the doors to the bankruptcy court closed to them.

This advisory is a publication of Davis Wright Tremaine LLP. Our purpose in publishing this advisory is to inform our clients and friends of recent legal developments. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations. Manufacturing, cultivation, distribution and possession of cannabis remains illegal under federal law and under certain state laws, and is strictly regulated in those states which have legalized medical or recreational cannabis.