The following is a recent case update.
The U.S. Court of Appeals for the Ninth Circuit affirmed the confirmation of a chapter 11 plan in which one of the debtor’s tenants operated a marijuana business. Garvin v. Cook Invs., NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019). The court held that Section 1129(a)(3), which requires that the plan be proposed “not by any means forbidden by law,” is to be construed to mandate only that the court determine whether the plan is proposed in an unlawful manner; and not whether a plan may contain substantive provisions that “depend on illegality.” To read the full decision, click here.
Michael Cook owned five companies, each of which owned and managed real estate. All of the real properties were encumbered by a deed of trust in favor of Columbia State Bank. One of the companies (Cook Investments NW, DARR, LLC, hereafter referred to as the “Debtor”) owned property that was leased out to two tenants, one of which (“Green Haven”) grew marijuana. The marijuana business complied with Washington state law, but violated the federal Controlled Substances Act, which prohibits, among other things, “knowingly . . . leas[ing] . . . any place . . . for the purpose of manufacturing, distributing, or using any controlled substance.” 21 U.S.C. § 856(a)(1). Cook defaulted on his loan, and the bank obtained state court orders appointing receivers for Cook’s properties. At that point, all of the Cook companies filed chapter 11 bankruptcy petitions.
The U.S. Trustee promptly filed a motion to dismiss the Debtor’s case under Section 1112(b) on the grounds that it was gross mismanagement for the Debtor to operate in violation of federal law by leasing to a tenant that grows marijuana. The trial court denied the motion to dismiss, raising the question whether any gross mismanagement might be “cured,” and invited the U.S. Trustee to renew its motion at the confirmation hearing.
The lease with Green Haven was rejected by the Debtor, who proposed a chapter 11 plan, the amended version of which was structured so that there was no reference to the Green Haven lease, and the money to fund the plan came only from the other tenant of the Debtor. Although now under a rejected lease, Green Haven continued in possession under Section 365(h). “Cook’s counsel also explained at argument that, pursuant to the Amended Plan, Cook’s other tenants [including tenants in related Cook debtors] pay their rent directly to Columbia State Bank in satisfaction of its claim, while Green Haven rents were presumably paid directly to Cook.”
The plan paid creditors in full, and the only objection to confirmation was from the U.S. Trustee. The U.S. Trustee did not renew its motion to dismiss at the time of confirmation. The Ninth Circuit held that the U.S. Trustee had thereby waived its “gross mismanagement” argument, and therefore did not reach the question of whether that would have been proper grounds for dismissal.
The gross mismanagement argument relied upon a violation of Section 1129(a)(3), which provides that “[t]he plan has been proposed in good faith and not by any means forbidden by law.” The U.S. Trustee focused on the second prong: “Because it appears that Cook continues to receive rent payments from Green Haven, which provides at least indirect support for the Amended Plan, the [U.S.] Trustee asserts that [the plan] was “proposed . . . by . . . means forbidden by law.” 11 U.S.C. § 1129(a)(3).
The bankruptcy court overruled the objection and confirmed the plan. The district court affirmed, and the Ninth Circuit also affirmed.
The appeal raises an issue of first impression, described by the Ninth Circuit as: “[w]hether the Amended Plan was confirmable depends on 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 provided the following answer: “We conclude that § 1129(a)(3) directs courts to look only to the proposal of a plan, not the terms of the plan.” (emphasis added).
This conclusion was based upon (1) the express terms of the statutory text, which do not refer to the substance of the plan, and (2) “the weight of persuasive authority.” The Ninth Circuit cited to two cases: Irving Tanning Co. v. Me. Superintendent of Ins. (In re Irving Tanning Co.), 496 B.R. 644, 660 (1st Cir. BAP 2013) (proposed plan which may violate state laws governing self-insurance for workers compensation nevertheless did not violate Section 1129(a)(3)), and NS In re Gen. Dev. Corp., 135 B.R. 1002, 1007 (Bankr. S.D. Fla. 1991) (even if a chapter 11 plan’s proposed distribution of stock to certain municipalities may violate the Florida Constitution, the proposal of the plan nevertheless did not violate Section 1129(a)(3)).
The Ninth Circuit acknowledged that some bankruptcy courts have adopted the U.S. Trustee’s approach by dismissing cases where income was derived from marijuana. To apply the same analysis at confirmation, the court in Cook Investments said, “would require us to rewrite the statute completely” because Section 1129(a)(3) calls on the court to inquire only 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.”
As the court further noted, the decision in Cook Investments would not allow a bankruptcy to be “used to facilitate legal violations” because confirmation does not insulate anyone from criminal liability. Significantly, the court suggested that the result may have been different if the U.S. Trustee had renewed the motion to dismiss. The decision specifies that it is leaving the door open for courts to “consider gross mismanagement issues under Section 1112(b).”
This decision provides limited room for a chapter 11 debtor to confirm a plan notwithstanding some connections with marijuana assets. The reach of the decision may be limited since it does not address whether “gross mismanagement” would have been grounds under these circumstances for dismissal of the case under Section 1112(b)(4)(B).
The decision gives scant attention to the fact that the debtor rejected the “marijuana” lease, presumably because the rejection did not change much: the debtor remained in possession and “presumably” and “apparently” continued to pay rent, a right which is contemplated by Section 365(h). The debtor no doubt did its best to keep any information about the status of ongoing payment of marijuana rent out of the record, but the debtor did not deny that the lease payments were still being made (and said at argument that “presumably” the payments were being made), and the court treated the payments as if they were being made. It would appear that if a chapter 11 debtor intends to withstand a motion to dismiss under similar circumstances, the debtor should take all practicable steps to “cure” any “gross mismanagement” by not only rejecting the lease but taking steps to evict the tenant (although the tenant may retain the right to possession under state law) and reject the payment of rent.
Note that in this case a state bank obtained the appointment of a receiver over Cook’s companies. Under RCW 7.60.010 et seq., Washington courts are authorized to appoint a receiver over a marijuana business, which can then liquidate assets and distribute the proceeds to creditors.
The Cook Investments case is an outgrowth of the major conflict between state and federal law relating to marijuana. The Executive Office for United States Trustees has taken a hard line on seeking dismissal and objecting to confirmation of cases connected to marijuana. At the same time the Department of Justice remains under a Congressional appropriations rider which prohibits the use of any DOJ funds to prevent certain specific states, including Alaska, Arizona, California, Nevada, Oregon, and Washington “from implementing their own laws that authorize the use, distribution, possession, or cultivation of medical marijuana.” The Ninth Circuit, in United States v. McIntosh, 833 F.3d 1163 (9th Cir. 2016), ruled that the rider’s practical effect was to prevent the DOJ from using funds appropriated to it by Congress to prosecute defendants, if the defendants fully complied with state law while engaged in authorized medical marijuana activities. This rider is currently in effect until September 30, 2019. Note that this budget limitation on federal prosecution of “marijuana” crimes is limited to protection of a state’s medical marijuana laws, not adult use laws, such as those enacted in California, Washington, and several other states over the last decade.
These materials were prepared by ILC advisor Tom Phinney of Parkinson Phinney in Sacramento (email@example.com), with editorial contributions from ILC Co-Vice Chair Gary B. Rudolph of Sullivan Hill Rez & Engel in San Diego (firstname.lastname@example.org).