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One Toke Over the Line

Marijuana Law Attorneys Diemer and Wei San Jose CAAs the legalized marijuana at the state level continues to thrive, bankruptcy courts flirt with marijuana’s place within the Bankruptcy Code. One principle begins to emerge: while presence of marijuana does not automatically call for dismissal, if the court and trustee have to participate in or condone the illegal conduct in any way, the case will be dismissed.

Background:

Since the legalization of marijuana has occurred in several states over the past several years, multiple courts have ruled that the continued illegality of marijuana on a federal level prevents debtors entrenched in the marijuana industry from garnering the benefits of bankruptcy protection. See In re Rent Rite Super Kegs W. Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012) (A debtor whose plan relied on roughly 25% of its income from renting property to marijuana growing operation was “cause” to dismiss case under 11 U.S.C 1112(b), constituted gross mismanagement of the estate, and debtor was not operating with “clean hands.”); In re Arenas, 514 B.R. 887 (Bankr. D. Colo. 2014) (prohibition against marijuana related activities extended to cases under Chapter 7 and Chapter 13).

However, as cases present a varying level of marijuana industry involvement, judges are forced to interpret the provisions of the code in a manner that complies with federal law, while still upholding the general spirit and purpose of bankruptcy protection.  

Garvin v. Cook Ivestments, NW, SPNYW, LLC (9th Cir. 2019) 922 F.3d 1031. - May 2019. 

Synopsis:

9th Circuit affirms the confirmation of a Chapter 11 plan funded indirectly on the marijuana industry, despite objection by the US Trustee that the plan was unconfirmable under 11 U.S.C. § 1129(a)(3) because it was not “proposed in good faith and not by any means forbidden by law.” The Court holds that 1129(a)(3) only requires inquiry into the means of the plan’s proposal, and not the substance of the underlying plan.

Facts:

Debtor consisted of five real estate holding companies, all owned and managed by Michael Cook. One of the five companies owned commercial real estate whereby leasing a property to “Green Haven”, a marijuana establishment in compliance under Washington state law. The lease provided that Green Haven was to be used exclusively as a marijuana establishment, putting Mr. Cook in violation of the Controlled Substance Act, 21 U.S.C. § 856(a)(1), which prohibits the leasing of property for the purpose of manufacturing, distributing, or using any controlled substance.

The plan, which called for the repayment of all creditors in full, was solely objected to by the trustee. The Trustee filed a motion to dismiss under 1112(b) for “gross mismanagement of the estate” and objected to the plan under 11 U.S.C. § 1129(a)(3) because it was proposed by “means forbidden by law.” Notably, the Trustee’s motion to dismiss was denied but left open for renewal at the plan confirmation hearing. The trustee never renewed the motion.

At the hearing, the Court confirmed the plan, noting that it satisfactorily provided for all creditors repayment. The Court also noted that the plan’s monthly obligations did not include rent from Green Heaven, which was to be paid to Mr. Cook directly. In contrast, the other tenants pay their rent directly to the secured creditor, CS Bank. By the time of appeal, all the unsecured creditors had been repaid, and the unsecured creditor was in the process of being repaid.

Upon appeal, the 9th Circuit directed its attention to interpreting the meaning of 1129(a)(3). Specifically, whether the code section forbids confirmation of a plan that is proposed in an unlawful manner, as opposed to a plan which contains provisions that depend on illegality. See, 11 U.S.C. 1129(a)(3) (“The court shall confirm a plan only if all of the following requirements are met… The plan has been proposed in good faith and not by any means forbidden by law.”).

The Court took a literal approach to interpretation, finding that the phrase “not by any means forbidden by law” modifies the phrase “the plan has been proposed.” In doing so, the court refused to look to the contents of the plan, stating that to do so would “convert the bankruptcy judge into an ombudsman without portfolio, gratuitously seeking out possible illegalities in every plan…”

The court ended its analysis by excluding any inquiry into “gross mismanagement”, poking at the trustee’s failure to renew the motion to dismiss under 1112(b)(4)(B), and finally noting that mere confirmation does not insulate debtors from prosecution for criminal activity.

Takeaway:

Despite the Court’s narrow holding, the case appears to present some respite to cannabis companies existing legally under state law.

However, there are some important aspects to note:

  1. Cook’s plan was structured so that his monthly obligations would be satisfied without the revenue from Green Haven.
  2. The rents from Green Haven diverted the debtor’s estate entirely, being paid to Mr. Cook. No trustee or court involvement in the illegal activity!
  3. The trustee failed to renew their motion to dismiss, and the court accordingly refused to look into “gross mismanagement” under 11. U.S.C. 1112(b).
  4. Creditors were to be paid in full!

Hypothetical:

If Trustee had renewed motion to dismiss for gross mismanagement, would court have agreed to look into the contents of the plan? Would we see a decision similar to that in Rent Rite Super Kegs?

In re: Way to Grow, Inc. (Dist. Colorado 2019) 2019 U.S. Dist. LEXIS 207846 – September 2019.

Synopsis:

District Court of Colorado affirmed the denial of a debtor’s Chapter 11 plan which relied upon a business model that marketed its stores as high-end gardening and hydroponic retail stores for the marijuana industry. In doing so, the Court found that debtors plan could not be proposed in good faith while knowingly profiting from the marijuana industry, and this was cause for dismissal under 11 U.S.C § 1112(b)(1).

Facts:

Debtors, a collective of affiliated retail corporations in Colorado and California, marketed and sold high-end gardening and hydroponic equipment. Much of their marketing was directed toward the marijuana industry, which managers of stores testified made up anywhere from 65% to 95% of their overall business.

Debtors filed a chapter 11 plan in which their future business expansion relied heavily upon the cannabis industry, legal under California and Colorado state law. 

A secured creditor filed a motion to dismiss the petitions for “cause” under 11 U.S.C § 1112(b), because the plan could not be proposed in good faith under 1129(a)(3). See, 11 U.S.C. 1129(a)(3) (“The court shall confirm a plan only if all of the following requirements are met… The plan has been proposed in good faith and not by any means forbidden by law.”). The bankruptcy court dismissed the petition for cause, holding that the debtors could be held in violation of 21 U.S.C. § 843(a)(7), which prohibits selling goods with knowledge that they will be used to manufacture controlled substances.

In affirming, the District Court criticized the 9th Circuit’s ruling in Garvin, and refused to opine on what it means for a plan to be “proposed … not by any means forbidden by law.” Instead, the Court grounded its holding in 1129(a)(3)’s good faith requirement, find that because profit from the marijuana industry was such a large portion of Debtor’s business, there was no way effective reorganization could occur whilst stripping away that market.

The Court put a particular emphasis on debtors’ ties to the marijuana industry, noting the following: (1) testimony that 65-95% of the business derived from marijuana growers; (2) stores sold specific products that were either too cost prohibitive to be used in any other market, or were specifically designed for marijuana cultivation; (3) debtors engaged in cross promotions with cannabis dispensaries, and participated in cannabis trade shows; (4) three days after the motion to dismiss was filed, debtor’s vice president instructed store managers via email to remove anything marijuana related and to not discuss marijuana directly with any customers; (5) testimony that it was common for customers to bring in plants or pictures of their marijuana plants for advice, to which the store would recommend them products based upon. 

Takeaway:

The Ninth Circuit’s decision in Garvin was heavily criticized by the Way to Grow Court, both Courts looking at opposite parts of 1129(a)(3)’s duality: The plan has been proposed (1) in good faith and (2) not by any means forbidden by law.

Hypothetical:

If debtor was simply an honest gardening shop whose business model didn’t target the marijuana industry, but still inadvertently made the majority of its sales to marijuana growers, would the court still deny confirmation? 

The debtor themselves also proposed an interesting hypothetical to the court. In arguing against the court’s use of 21 U.S.C. § 843(a)(7) to deny confirmation, the debtor argued that the court did not have direct evidence of any specific transaction in which they sold equipment to a marijuana grower. “Section 843(a)(7) could serve to turn any business into a criminal with a single transaction. If an individual walked into a home depot and the cashier had reasonable cause to believe the shovel would be used in a marijuana growing operation based on statements by the customer, by virtue of selling that individual a shovel, the Home Depot will have committed a criminal act… The Home Depot would not even need to know the customer’s name, nor whether the shovel was actually used to grow marijuana.” The court rejected this hypothetical, and pointed at the evidence that debtor had knowledge that 65% to 95% of its business was from marijuana growers. Is the court’s interpretation of § 843(a)(7) too broad?

In re Andrick (Bankr. Colorado 2019) 604 B.R. 577.  – July 2019

Synopsis:

Bankruptcy Court for the District of Colorado denies confirmation of chapter 13 plan which proposed $900 monthly expenditure for medical marijuana, for failure to provide for the payment of all disposable income under 11 U.S.C § 1325(b).

Facts:

Individual debtor proposed a chapter 13 plan which proposed monthly payments of $681 over a sixty-month period, totaling $40,860 in payments, $33,794 of which were to go to unsecured creditors. The allowed unsecured claims totaled $88,076. Debtor’s plan proposed to pay approximately 38% of such debt.

The trustee objected to the plan for lack of good faith and failure to provide payment of all disposable income pursuant to 11 U.S.C § 1325(a) and (b). The plan disclosed that debtors spent $900 per month on medical marijuana, legal under Colorado state law. Debtors also disclosed they spent $210 per month on cigarettes. Debtors argued that the wife suffers from a painful medical condition for which marijuana is the only effective remedy, and that her use was for pain control rather than recreation. Debtor held a Colorado medical marijuana license.

The Court discussed at length the disposable income requirement of chapter 13, noting that should the $1,110 per month of income spent on medical marijuana and cigarettes be paid toward the plan, unsecured creditors would be paid 100% ($1,710 monthly payments would fully satisfy after 60 months). The Court only discussed the effect of the illegality of marijuana on the plan as it applied to debtor’s claimed special circumstances deduction for the marijuana. The court found that such a deduction for an illegal drug, on the federal level, cannot be allowed either for a medical expense deduction or under the special circumstances deduction.

The court held the plan unconfirmable because the plan did not propose to contribute all projected disposable income as required by 11 U.S.C § 1325(b)(1)(B).

Takeaway:

While the court stated it was sympathetic, the plan, which called for more monthly payment to a medical marijuana dispensary than its unsecured creditors, clearly did not pass muster under 1325(b)(1)(B).

The court took notice that upholding the plan would essentially subsidize the purchase of illegal drugs, because unsecured creditors were not being paid in full.

Hypothetical:

If debtor’s medical marijuana expenses were more reasonable, say $200 per month, similar to her expense on cigarettes, would the court have taken such offense?

In re Burton (9th Cir. B.A.P 2020) 610 B.R. 633 – January 2020.

Synopsis:

9th Circuit BAP affirms dismissal of a chapter 13 in which debtors own majority interest in an entity engaged in growing and selling marijuana, legal under Arizona law. Debtor’s argument that the entity, Agricann, was no longer operating or relied upon to fund chapter 13 plan was insufficient. Court found that because debtors were plaintiffs in at least two state lawsuits related to the Agricann business, and any recovery would likely require the court and trustee to become involved in such illegal conduct, court must dismiss.

Facts:

Debtors’ third amended plan proposed to pay some $458.80 of monthly net income, derived entirely from Ms. Burton’s wages. Mr. Burton was unemployed during life of bankruptcy case. Debtors owned majority interest in Agricann, an entity involved in cultivating and selling marijuana, legal under Arizona state law. Debtors asserted that Agricann was no longer operating and was not being relied upon to fund the Burton’s chapter 13 plan.

Debtor filed two post-petition lawsuits in Arizona state court for breach of contract, resulting from their business, Agricann, both of which had unknown value.  Debtors stated that they did not expect to receive any proceeds from such litigation due to a contingency fee agreement and a financing lien on any potential recovery.

Creditor, who had a 2.4 million dollar unsecured claim which debtors conveniently failed to include on their schedules, filed a motion to convert to a chapter 7 due to: (1) the fact that debtors debts exceeded chapter 13 limits, and (2) alleging bad faith due to income derived from the marijuana business.

At preliminary hearing, the Court issued an order to show cause as to the value of the litigation and debtor’s interest in the cannabis entity. Debtor’s filed a motion to compel abandonment of the Agricann interest, and produced a “one page self-serving spreadsheet” which the court noted did not support the Burton’s assertion that they would receive nothing from the litigation. The spreadsheet showed a net figure of over $3 million, and further unverified projections. 

The court dismissed the chapter 13 for “cause” under 1307(c), holding that the debtor’s assertion that the litigation was valueless was not credible, and that the nature of Agricann’s business would necessitate the Court and Trustee’s involvement in condoning the illegal activity.

The 9th Circuit BAP affirmed, noting the Circuit’s reluctance to define a bright line rule about disposition of cases with marijuana present. Instead the courts possess “appropriate latitude” in dealing with the range of debtors’ involvement in marijuana. The Court analyzed recent decisions, stating that “the mere presence of marijuana near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” (Citing In re Olson (9th Cir. BAP 2018) 2018 Bankr. LEXIS 480; Garvin v. Cook Ivestments, NW, SPNYW, LLC (9th Cir. 2019) 922 F.3d 1031. However, the Court also found that a case must be dismissed “if the continuation would require the court, trustee, or debtor in possession to administer assets that are illegal under the CSA or that constitute proceeds of activity criminalized by the CSA.” (Citing In re Arenas (10th Cir. BAP 2015) 535 B.R. 845, 853; In re Way to Grow, Inc. (Dist. Colo. 2018) 610 B.R. 338.

The 9th circuit put particular emphasis on an unwillingness to allow the trustee or the court to become involved in administering proceeds from the Agricann litigation, which was “tainted as proceeds of an illegal business.” The court also pointed to the debtors’ failure to produce adequate evidence of the litigation being valueless, stating that debtors only provided foundationless and conclusory statements to support this. The court ended its argument by pointing to other reasons that they must affirm the dismissal, even without looking into the marijuana connections, such as the 2.4 million dollar proof of claim which was not listed in debtors schedules, and the case pending for over a year without a confirmable plan.

Takeaway:

The court was clearly not enthused with Debtor’s inability to evidence the purported lack of value in the litigation, which the court all but stated was a lie by the debtors.

A quick search of debtors produced an article discussing the fact that debtors were arrested in 2019 for a laundry list fraud and theft charges, among them was unlawful use of food stamps. Perhaps the court caught on to the debtors’ dishonesty. https://www.idiosyncraticwhisk.com/2019/05/brigham-burton-and-carly-burton-have.html

The court did further cement the principle that mere presence of marijuana in a bankruptcy did not automatically prohibit a debtor from relief. Instead, courts within the 9th circuit have “appropriate latitude,” use discretion on a case by case basis.

Hypothetical:

Without the pending litigation, and assuming debtors were more forthright with the court, would they have gotten a plan confirmed?

Where do we go from here?

Burton seemed to support two principles: (1) Mere presence of marijuana in a bankruptcy case does not automatically disqualify the debtor; (2) however, if the trustee and court must get involved in the illegality, then the case must be dismissed.

Of interest is Burton’s discussion and use of the unpublished case Olson v. Van Meter (In re Olson) (9th Cir. BAP 2018) 2018 Bankr. LEXIS 480. In Olson, the debtor was a 92 year old blind woman who owned commercial real estate in which a marijuana dispensary was a tenant. In Olsen, the debtor declared, "I wish only to terminate any dealings with [a marijuana dispensary tenant] and to sell my property and pay my creditors in full." The BAP vacated the bankruptcy court’s dismissal and remanded, requesting that the bankruptcy court further articulate its standard for dismissal. The concurring opinion by Judge Tighe stated that “the presence of marijuana near the case should not cause mandatory dismissal.”

Perhaps Burton has paved the way for the honest debtor, such as that in Olson, who wish to wind down or cease business with the marijuana industry entirely. It’s a tight line to walk for such a debtor, because one bad fact can inevitably lead to dismissal. If a debtor can manage to pre-petition cease all ties with the marijuana industry, preventing any involvement or condoning of illegal activity by the trustee and the court, then it appears that such a debtor may be able to attain bankruptcy relief.

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