Chapter 420, Part II: Closing the Book on Cannabis-Adjacent Bankruptcy
In a previous article, I discussed the potential impacts of a then-forthcoming decision in the case of In re United Cannabis Corporation, which had the potential to widen access to federal bankruptcy relief to cannabis-adjacent hemp businesses.
However, the In re United Cannabis case ended not with a bang, but with a whimper. On January 12, 2021, after approximately eight months of consideration, Bankruptcy Judge Joseph G. Rosania, Jr. of the District of Colorado issued a one-page ruling dismissing[1] the bankruptcy petition “pursuant to 11 U.S.C. § 1112(b) and . . . finding good cause.” In so doing, he snuffed out any hope that the District of Colorado could become a hub for hemp businesses that dabble in cannabis to successfully pursue chapter 11 bankruptcy.
Because the ruling does not provide any substantive reasoning for the decision, industry observers are left to speculate. One can only assume that the court found the evidence offered by the U.S. Trustee—namely, that the debtor was not nearly as removed from the cannabis arena as it purported to be based on the debtor’s website and marketing materials—credible enough to justify dismissal on the grounds that a plan of reorganization could not be untainted by federally illegal cannabis money. In so doing, the court left the fundamental question of how the 2018 Farm Bill’s legalization of hemp affects the availability of bankruptcy to businesses that have toes in both the cannabis and hemp pools. For the time being, the safer route—and the route perhaps favored by conventional wisdom—for businesses is to completely segregate their cannabis and hemp businesses, both on a practical and corporate/legal level.
The Bankruptcy Court for the District of Colorado’s declination to decide the issue raised by Way to Grow only illuminates other quirks in the current state of affairs for bankruptcy in the cannabis context. In particular, the ruling in United Cannabis displays the tension between how different bankruptcy courts have construed section 1112 vis-à-vis section 1129(a)(3).
Section 1129(a)(3) provides that a bankruptcy plan shall only be confirmed where, inter alia, “[t]he plan has been proposed in good faith and not by any means forbidden by law.” On its face, this statute would seem to preclude plans funded by federally illegal cannabis, given that those funds would be derived from a “means forbidden by law.” However, the Ninth Circuit disagreed in Garvin v. Cook Investments NW, SPNWY, LLC, 922 F.3d 1031 (9th Cir. 2019). In that case, the Ninth Circuit affirmed the Bankruptcy Court for the Western District of Washington’s confirmation of a chapter 11 plan for reorganization over the U.S. Trustee’s objection that one of the debtors was renting real property to a cannabis growing operation. Id. The Ninth Circuit parsed the language of section 1129(a)(3) quite narrowly, holding that that subsection “directs bankruptcy courts to policy the means of a reorganization plan’s proposal, not its substantive provisions.” Id. at 1033. The Ninth Circuit applied that interpretation to the case at bar, and found that although income funneled into the plan would ultimately be derived from a federally illegal source—the cannabis grower tenant—that had no bearing on whether the plan had been proposed in good faith. See id. at 1035-36. Importantly, the Ninth Circuit refused to rule on the argument that section 1112(b) mandated dismissal of the petition, concluding that “the Trustee waived the argument by failing to renew its motion to dismiss” after the Bankruptcy Court’s initial dismissal of a previous motion to dismiss with leave to renew at the plan confirmation hearing. Id. at 1033-34.
This literal interpretation of section 1129(a)(3) has been explicitly criticized in courts within other circuits. Indeed, the Bankruptcy Court for the Eastern District of Michigan sharply critiqued Garvin in dicta for its de facto affirmation of illegal conduct pursuant to a bankruptcy plan:
This Court does not necessarily agree with the Garvin court’s holding about § 1112(a)(3). And, respectfully, one might reasonably question whether the Garvin court should have refused to decide the § 1112(b) dismissal issue. That refusal, on waiver grounds, arguably is questionable, because it allowed the affirmance, by a federal court, of the confirmation of a Chapter 11 plan under which a debtor would continue to violate federal criminal law under the [Controlled Substances Act].
In re Basrah Custom Design, Inc., 600 B.R. 368, 381 n.38 (Bankr. E.D. Mich. 2019).
Moreover, the District Court of Colorado in In re Way to Grow, the very case that seemingly left the door open for United Cannabis in the first place, also criticized Garvin for unduly focusing on the “means forbidden by law” clause of section 1129(a)(3), rather than the “good faith” portion of the same. 610 B.R. 338.
As a result, there is an embryonic circuit split on the issue of interpreting section 1129(a)(3) as applied to cannabis business petitioners, with the Ninth Circuit in the minority and the Sixth and Tenth Circuits in the presumptive majority.
As fascinating as this may be on an academic level, for businesses in the cannabis industry, this circuit split will likely have little bearing on the ultimate issue of whether businesses that dabble in cannabis can obtain the benefits of federal bankruptcy. Reason being, section 1129(a)(3) is just one ground for dismissal on the basis of illegality. Garvin itself noted in its final paragraphs that there are plenty of other reasons to dismiss cannabis bankruptcies—not the least of which is section 1112(b). Garvin, 922 F.3d at 1036. Indeed, running an illegal business as part of a bankruptcy plan could conceivably run afoul of any number of the listed bases for “cause” under section 1112(b)(4), including but not limited to the “gross mismanagement of the estate” prong name checked by the court in Garvin.
The unceremonious dismissal of the petition in United Cannabis raises more questions than answers. Unless and until cannabis is descheduled, or some other form of federal reform occurs, the Bankruptcy Courts will be left to continue to battle it out over interpretations of section 1129(a)(3), comfortable in the knowledge that section 1112 provides a backstop for dismissing cannabis-funded petitions and plans. However, the issue raised in United Cannabis—whether a company that has cannabis-derived revenue can have a chapter 11 plan approved if the plan doesn’t require that revenue—remains tantalizingly unanswered for now.
[1] Curiously, the court styled the order as one “granting” the U.S. Trustee’s “Motion to Dismiss Chapter 11 Cases pursuant to 11 U.S.C. § 1112(b).” However, the U.S. Trustee never filed a Motion to Dismiss. Rather, the U.S. Trustee filed a response to the court’s own Order to Show Cause why the petition should not be dismissed—although, that response did raise section 1112(b) as a reason for dismissing the case.
