Newest Opinion May Pave Way for Cannabis Industry Bankruptcy Protection

By Ava Schoen

Continued federal prohibition of cannabis poses a significant road block for individuals and businesses who seek to file for bankruptcy protection, which is governed by federal law.

Although more and more states, including Oregon, have chosen to regulate cannabis for medicinal and/or recreational purposes, the use, cultivation, or distribution of cannabis remains illegal under federal law pursuant to the Controlled Substances Act. The implications go far beyond who will be criminally prosecuted and into who can avail themselves of federal legal protections like bankruptcy.

To date, courts have generally ruled that debtors who work in the cannabis industry or derive income from cannabis activity directly or indirectly cannot use bankruptcy. These court rulings are often in response to the U.S. Trustee’s office (the arm of the Department of Justice that monitors bankruptcy cases) filing motions to dismiss bankruptcy cases where the debtor has a direct or tangential connections to the cannabis industry.

A recent opinion from the Ninth Circuit Court of Appeals, Garvin v. Cook, however, suggests a possible course change. The Cook case involved five real estate holding companies that filed Chapter 11 reorganizations in Washington, a state that regulates cannabis rather than prohibiting it. One of those five debtors leased property to a company that used the land to grow cannabis in compliance with Washington state law.

The U.S. Trustee’s office first filed a motion to dismiss the Chapter 11 cases asserting that the lease allowing cannabis to be grown on debtor’s land constituted “gross mismanagement” such that the bankruptcy cases had to be dismissed for cause. The bankruptcy court denied that motion, but gave the U.S. Trustee’s office the chance to reassert its motion at the time the debtors were seeking to confirm their bankruptcy plan.

At the time of plan confirmation, the U.S. Trustee did not renew its objection based upon “gross mismanagement” and the Ninth Circuit, in turn, found that such an objection was waived. The U.S. Trustee did, however, object to plan confirmation arguing that the plan was “proposed…by…means forbidden by law.” The Ninth Circuit disagreed and confirmed the plan.

In reaching its conclusion, the court held that it was not faced with a conflict between federal and state drug law but, rather, a straightforward question of statutory interpretation. The court found that the Bankruptcy Code does not require courts to police substantive provisions of a bankruptcy plan. Rather, the court held that it is charged with deciding if the plan was proposed in an unlawful matter. The Ninth Circuit conducted that analysis and found that the plan was not proposed by any means forbidden by law.

While the Cook case suggests an opening for courts to allow debtors involved with the cannabis industry to utilize the bankruptcy process, many questions remain as to whether businesses and individuals who are connected to the cannabis industry will be able to successfully go through the bankruptcy process.

For example, what would have happened had the debtors in Cook needed to rely upon the cannabis-related revenue to repay their creditors? And what would have happened had the U.S. Trustee’s office renewed its argument that the case had to be dismissed for “gross mismanagement,” which it is most likely to do in future cases?

Will other courts follow the Ninth Circuit’s decision? Notably, within just weeks of the Cook decision, the Bankruptcy Court for the Eastern District of Michigan dismissed a cannabis-related bankruptcy case and expressly rejected the Ninth Circuit’s ruling in Cook.

While the Ninth Circuit’s decision in Cook suggests a possible course change, there remains significant uncertainty and tension between state regulation of cannabis and federal prohibition. But given the growing number of states that have chosen to regulate cannabis and the resulting exponential growth in the cannabis industry – and the inevitable economic failure of some of those businesses – there is no doubt that questions such as these will be answered in future bankruptcy cases.

Contact Ava SchoenAl Kennedy, Tim Conway, or Mike Fletcher, if you have questions on the debtor-creditor options available to businesses in the cannabis and hemp industry or reach out to your contact at Tonkon Torp.

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