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Pot Companies May Get Smoother Path Into U.S. Bankruptcy Courts

May 31, 2019, 10:41 AM

Cannabis companies are looking to a recent federal appeals court ruling as a sign that bankruptcy may be an option in the future should they go bust.

The Justice Department has resisted efforts by failing pot businesses to reorganize or liquidate under the federal Bankruptcy Code, which doesn’t provide relief to entities conducting illegal businesses.

Marijuana remains illegal under the federal Controlled Substances Act, even as state legalization of recreational pot has spawned a $10 billion industry. The federal prohibition has made it harder for cannabis businesses to operate or unwind, such as by limiting access to traditional banking services or bankruptcy courts.

The U.S. Court of Appeals for the Ninth Circuit became the first federal appellate court to say bankruptcy law doesn’t forbid a Chapter 11 plan involving a marijuana business from being approved in a May 2 ruling.

While it isn’t a complete victory, the case “opens the door” for bankruptcy relief for pot businesses that remain illegal under the Controlled Substances Act, Mark Salzberg, a partner with Squire Patton Boggs in Washington, D.C., said.

The possibility of federal bankruptcy relief is significant since the alternative is state remedies that offer fewer debtor protections and less transparency for creditors.

Washington State Case

In Garvin v. Cook Investments, the U.S. Court of Appeals for the Ninth Circuit affirmed a bankruptcy’s court’s approval of the Chapter 11 reorganization plan of a real estate firm that leased property to a marijuana grower in Darrington, Wash., which is allowed in the state.

Acting U.S. Trustee Gregory Garvin unsuccessfully sought to prevent the property owner, Cook Investments, from getting its reorganization plan confirmed by the court because of its business ties with the state-approved marijuana grower.

Cook Investments said its reorganization plan was legitimate because it chose to reject the lease to the marijuana grower and the plan didn’t depend on income from the lease, said James L. Day of Bush Kornfeld LLP in Seattle, who represented the party seeking bankruptcy protection in the Ninth Circuit case.

The reorganization was proposed in good faith and it’s not the bankruptcy judge’s job to determine the plan’s legality, the Ninth Circuit said.

Good Faith

The U.S. Trustee Program, a component of the Justice Department that oversees bankruptcy cases, has long taken a no-tolerance policy on marijuana and has sought to dismiss all marijuana-related bankruptcy cases.

The U.S. Trustee has relied on a section of the Bankruptcy Code that requires reorganization plans to “be proposed in good faith and not by any means forbidden by law.”

The Ninth Circuit decision takes away a “primary tool” used by the trustee’s office—the “forbidden by law” provision—to object to marijuana businesses’ bankruptcy reorganization plans, Day said.

Alternative Theory

The government now will have to find other ways to get marijuana-related cases dismissed in its no-tolerance approach, he said. The Justice Department may instead argue that estate fiduciaries shouldn’t be required to administer assets if doing so would cause them to violate federal criminal law, Day said.

This “gross mismanagement of the estate” argument would apply in virtually every marijuana-related case, but the trustee waived that argument in the lower court in the Garvin case and failed to renew it later on appeal.

But as long as the tension continues between which law is paramount—state legalization laws or federal drug prosecution laws—uncertainties will always remain in the bankruptcy courts for marijuana businesses.

The issue could eventually reach the U.S. Supreme Court if another circuit case is decided in the next few years with a different outcome, said James J. Holman, a partner at restructuring firm Duane Morris LLP.

In the interim, it isn’t the job of federal bankruptcy judges to resolve the conflict between state and federal law or to make a moral judgment on a company’s business purpose, Holman said. Instead, the bankruptcy court’s job is to determine whether the debtor’s plan is economically feasible and has a legitimate business purpose, he said.

Other Options

Without access to federal bankruptcy relief, marijuana businesses only have state law remedies such as receiverships and non-bankruptcy liquidation proceedings, said Laura N. Coordes, a bankruptcy law professor at Arizona State University’s Sandra Day O’Connor College of Law. “But they’re not as good,” she said.

State receiverships don’t offer as many debtor protections, compared to bankruptcy proceedings, and aren’t as transparent for creditors. Bankruptcy documents are all part of the public record and creditors can get access to all of the debtors’ financing information filed in the bankruptcy courts.

“There isn’t the same level of information in state court receiverships,” said Patricia Heer, a cannabis industry consultant and founder of legal reference site Cannabis Law Digest.

Most state receiverships don’t offer as many debtor protections available in bankruptcy court like the automatic stay, which gives debtors a “breathing spell” from creditors, Heer said.

“It’s a race to the courthouse by creditors to get priority to get paid distributions,” she said.

The case is Garvin v. BHS Cook Invs. NW, SPNWY, LLC, 2019 BL 158186, 9th Cir., No. 18-35119, 5/2/19.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bloomberglaw.com

To contact the editors responsible for this story: Roger Yu at ryu@bloomberglaw.com; Seth Stern at sstern@bloomberglaw.com