Maryland Laws Update for Financial Services

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Ninth Circuit Affirms Confirmation of Chapter 11 Plan Despite Debtor's Receipt of Income from Cannabis Business

While states continue to expand the legalization of cannabis for medical or recreation use, cannabis remains a controlled substance under federal law. As a result, cannabis businesses and businesses that derive income from the cannabis industry (such as a commercial landlord renting to a cannabis business) often run into roadblocks when forced to interact with matters of federal law. Cannabis businesses are largely denied access to traditional banking services. The Bankruptcy Code, as a product of federal law, likewise has proven inhospitable to the cannabis industry. Because the cultivation and sale of cannabis remains a federal crime, bankruptcy courts generally are loath to extend the protections of the Bankruptcy Code to businesses involved in or benefiting from the cannabis industry. However, a recent case from the United States Court of Appeals for the Ninth Circuit bucked this trend by confirming a chapter 11 plan of reorganization over the U.S. Trustee’s objection. This confirmation was despite the fact that rental income from a cannabis business provided indirect support to the debtors’ plan.

A group of five real estate holding companies filed chapter 11 petitions and submitted a joint chapter 11 plan of reorganization proposing to repay all creditors’ claims in full and for the companies to continue to operate. One of the companies rented property to a cannabis business. In the plan, the debtors were careful to exclude any rental income from the cannabis business from the plan’s payments to creditors. The plan rejected the lease with the cannabis tenant and this tenant appears to have paid rent directly to the debtors’ owner instead of the debtors’ creditors. Under 11 U.S.C 1129(a)(3), a plan must be “proposed in good faith and not by any means forbidden by law.” The U.S. Trustee objected to confirmation on the basis that the plan violated Section 1129(a)(3) because the rental income derived from the cannabis business at least indirectly supports the plan. The bankruptcy court overruled the objection based upon a plain reading of this statute, and the district court and Ninth Circuit affirmed. In so holding, the Ninth Circuit reasoned that Section 1129(a)(3) only directs bankruptcy courts to review whether the plan was proposed in good faith and in a lawful manner, not whether the plan’s terms depend on illegal conduct. The Ninth Circuit rejected a reading of Section 1129(a)(3) that would require bankruptcy judges to scour plans for potential illegalities falling outside of the jurisdiction of the bankruptcy court.

Though this case may appear to demonstrate an avenue for businesses with ties to the cannabis industry to seek bankruptcy protection, there are two significant caveats. First, the Ninth Circuit noted that plan confirmation does not insulate debtors from prosecution for criminal activity. Second, the Court suggested that the outcome may have been different had the U.S. Trustee renewed a motion to dismiss the case under 11 U.S.C. 1112(b) for gross mismanagement of the estate at the confirmation stage. Earlier in the case, the bankruptcy court denied the U.S. Trustee’s motion to dismiss with leave to renew the motion at the confirmation stage. The U.S. Trustee failed to renew its motion to dismiss and, as a result, the Ninth Circuit held that the U.S. Trustee waived this argument on appeal. Many cannabis-related bankruptcies are terminated by similar motions to dismiss and, going forward, the U.S. Trustee’s Office will likely ensure that such motions become standard practice for cases involving the cannabis industry.

For further information, please contact Bryan M. Mull.