9th Circuit Declines to Dismiss a Marijuana-Related Chapter 11 Case, Affirms Plan Confirmation

Does a real estate company’s bankruptcy reorganization plan go up in smoke if a tenant uses the property to grow marijuana? Relying on the plain text of Bankruptcy Code Section 1129(a)(3)[1] and the particular facts and procedural history of the case, the United States Court of Appeals for the Ninth Circuit affirmed confirmation of the plan.[2]

Factual Background

Five real estate holding companies owned and managed by an individual (collectively “Cook”) filed chapter 11 bankruptcy petitions in 2016. Prior to the bankruptcy, one of the debtors (“Lessor”) had entered into a lease (the “Lease”) with a company (“Tenant”) that used the subject property to grow marijuana, an activity permitted under Washington state law but prohibited under federal drug law.

When Cook filed for bankruptcy, the United States Trustee (“US Trustee”) moved to dismiss the Lessor’s chapter 11 case, asserting that the Lease “constituted gross mismanagement and thus cause to dismiss under 11 U.S.C. § 1112(b). The bankruptcy court denied the motion to dismiss, but with leave to renew at the plan confirmation hearing.”[3]

Cook filed a plan of reorganization (the “Plan”) which provided for repayment of all creditors’ claims in full and for Cook to continue as a going concern. Under the Plan the Lease was rejected and structured so that obligations to creditors would be paid without revenue from Tenant (the Court presumes that rents were paid directly to Cook).

The Plan was confirmed by the bankruptcy court over the US Trustee’s objection. The US Trustee argued that the plan violated Bankruptcy Code Section 1129(a)(3), which requires that a plan be “proposed in good faith and not by any means forbidden by law.” Only the US Trustee objected, while all creditors – who were being repaid in full – supported the Plan. The US Trustee failed to renew its motion to dismiss at the confirmation hearing, so the district court affirmed the denial of the US Trustee’s motion to dismiss Lessor’s case. Following confirmation, the US Trustee moved for a stay, but the district court denied the request.

Analysis

The Ninth Circuit, like the district court, rejected the US Trustee’s appeal of the denial of its motion to dismiss. The US Trustee’s failure to renew its motion to dismiss or raise the “gross mismanagement of the estate” argument at the plan confirmation hearing meant, in effect, that the US Trustee had waived its right to raise such arguments.

The Court then turned to the question of confirmation. In order for a bankruptcy plan to be confirmed, the Bankruptcy Code specifies several requirements to be satisfied, including that “[t]he plan has been proposed in good faith and not by any means forbidden by law.”[4]

The US Trustee contended that, because Cook continued to receive rent payments from Tenant – and thus arguably in indirect support of the Plan – the Plan was proposed in a manner forbidden by law in violation of Section 1129(a)(3). This raised a question of first impression for the Ninth Circuit: does Section 1129(a)(3) forbid confirmation of a plan that is proposed in an unlawful manner as opposed to a plan with substantive provisions that depend on illegality?

The Ninth Circuit concluded that Section 1129(a)(3) directs courts only to look to the proposal of a plan, not the terms of the plan.[5] The Court determined that its conclusion accorded both with the plain meaning of the statute and the weight of persuasive authority.[6]

The Ninth Circuit noted that some bankruptcy courts had accepted the US Trustee’s interpretation of Section 1129(a)(3). For example, a Colorado bankruptcy court dismissed the case “[b]ecause a significant portion of the Debtor’s income [wa]s derived from an illegal activity.”[7]

However, the Ninth Circuit, like the First Circuit Bankruptcy Appellate Panel previously, concluded that such a decision conflicts with Section 1129(a)(3)’s “express focus on the manner of the plan’s proposal.”[8] Section 1129(a)(3) was satisfied because Cook had not employed any illegal means in proposing the Plan.

The Court observed that its opinion would not “result in bankruptcy proceedings being used to facilitate legal violations.”[9] For one thing, absent waiver (as in the case at hand), bankruptcy courts may consider the gross mismanagement issues under Section 1112(b). In addition, plan confirmation “does not insulate debtors from prosecution for criminal activity, even if that activity is part of the plan itself.”[10]

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