Debtors Doing Illegal Things

Introduction

The United States Trustee Program is part of the United States Department of Justice and oversees the administration of bankruptcy cases, including oversight of panel trustees. When a bankruptcy court grants a motion to appoint a Chapter 11 trustee, the United States Trustee (“UST”) is responsible for selecting and appointing the individual who will serve in such capacity. Thereupon, the Chapter 11 trustee assumes control of the debtor in possession and the UST remains a party in interest that continues to monitor the progress of the case and may be heard on any issue in the case. This monitoring role often prompts the UST to seek dismissal of a Chapter 11 case due to the debtor’s failure to abide by the rules, such as filing incomplete statements or schedules, failing to provide monthly operating reports, or failing to pay the UST’s quarterly fees. In certain instances, however, the UST will also seek dismissal when the debtor’s operations are deemed “illegal.” Yet, what or how much “illegality” is likely to trigger a UST motion to dismiss or convert reveals inconsistencies.

Duties of a Chapter 11 Trustee

The duties of a Chapter 11 trustee are set forth at 11 U.S.C. § 1106 (also incorporating certain provisions of 11 U.S.C. § 704). Like a debtor-in-possession, the trustee manages the debtor’s affairs and makes all decisions about property of the estate. The trustee owes a fiduciary duty to the creditors and parties in interest in the case.1 This duty requires the trustee to preserve the assets of the estate and to sell those assets to “maximize distributions to creditors.”2 In some cases – where a debtor’s wrongful, imperfect and, sometimes flatly illegal conduct precipitated the bankruptcy filing – the fulfillment of this fiduciary duty requires the trustee to reform and correct broken promises, contractual obligations and legal violations.3

Differences in How the UST Evaluates the Trustee or Debtor in Possession’s Exercise of these Duties

There appear to be inconsistencies in the UST’s view of the potential conflict between the statutory duties of a Chapter 11 trustee or debtor-in-possession and concern over the potential “illegality” of the debtor’s business. This conflict is sometimes, but not always, addressed by a motion to dismiss or convert the case. For instance, bankruptcy courts are a generally accepted forum to unwind Ponzi schemes, while debtor cases involving cannabis or other potentially illegal acts, are oftentimes promptly dismissed.

Motions to Convert or Dismiss Pursuant to 11 U.S.C. § 1112

In a Chapter 11 case, a party in interest may move the bankruptcy court for an order: (i) converting the case to one under Chapter 7 (i.e., 11 U.S.C. § 701 et seq.); (ii) dismissing the case; or, if the court determines it to be in the best interests of creditors and the estate, appointing a trustee or examiner under 11 U.S.C. § 1104(a).4

Conversion or dismissal pursuant to 11 U.S.C. § 1112(b)(1) must be “for cause.”5 Cause sufficient to justify conversion includes, among other things, substantial or continuing losses of the estate; gross mismanagement; failure to maintain insurance; failure to comply with court orders; failure to timely pay taxes and various defaults with respect to plan performance.6 The party moving for dismissal has the burden of establishing cause pursuant to 11 U.S.C. § 1112(b)(1)7 by a he preponderance of the evidence.8

In addition to the specific, statutory grounds set forth in 11 U.S.C. § 1112(b)(4), a bankruptcy court will also grant a motion to dismiss to preclude a debtor from engaging in illegal conduct while “operating under the protection of the bankruptcy court”9 and because “compliance with applicable non-bankruptcy law” is “generally required by statute.”10 Some examples include debtors engaged in ongoing violation of laws pertaining to toxic waste,11 debtors operating cannabis businesses that are illegal under federal law12 and debtors filing petitions in bad faith.13 Cases involving successful motions to dismiss generally involve one or more of the enumerated ‘for cause’ grounds.14

Ponzi Scheme Cases

Charles Ponzi borrowed money from investors to purchase postal coupons. Ponzi promised to sell the coupons at a 100% profit with investors receiving $150 for every $100 invested. This operation only worked because Mr. Ponzi used money from new investors to pay “returns” to previous investors while keeping a large portion of the funds for himself. Happy with their “profits,” investors would continue to invest with Mr. Ponzi. When the authorities investigated, Mr. Ponzi stopped soliciting investors, which meant he could not repay his investors. The entire scheme collapsed, Mr. Ponzi filed bankruptcy and this fraudulent scheme is now commonly called a Ponzi scheme.

The scheme and the entity behind the scheme were operating illegally. Once in bankruptcy, a trustee is usually appointed to take ownership and control over whatever assets exist, try to claw back other assets and provide a fund to distribute equally to parties harmed by the scheme. Yet, in these cases, the UST allows the trustee to proceed with litigation, even against claimants harmed by the scheme, to “undo” the fraud and maximize the return to all claimants. The UST encourages and supports trustees in these efforts even though Ponzi cases involved the illegal conduct of business. Rather than seeking dismissal of these cases,15 the UST understands the benefits to be gained from a transparent bankruptcy process having as its core objective the recovery of funds for victimized creditors. For debtors involved in other forms of illegal conduct, there may be an evolving approach on how to handle some of these cases.

Cases Involving Other “Illegal” Businesses

Many cases that have resulted in a UST’s motion to dismiss a bankruptcy case due to the “illegality” of the business, involve debtors engaged in or connected to the cannabis industry. A review of those decisions dealing with a debtor in the cannabis business, demonstrates that dismissal was required because the potential for continued illegal activity constituted a lack of good faith from the debtor,16 unclean hands17 or that the debtor was not entitled to the protections of bankruptcy.18

Recent decisions take a different tone, if not approach, to cases with a past or current connection to the cannabis industry. These cases recognize that many provisions of the Code permit a debtor to restructure or reorganize its affairs such that any issues with illegal activity can be resolved.19 In the 2015 case of In re Johnson, the Bankruptcy Court for the Western District of Michigan permitted a Chapter 13 debtor to file an amended plan based on his income following the closing of his cannabis dispensary and sale of related items.20 In 2018, the Ninth Circuit Court of Appeals affirmed the confirmation of a Chapter 11 plan over the UST’s objection and request to dismiss because a cannabis business was a tenant of one of the debtors.21 The Ninth Circuit noted that the confirmed Chapter 11 plan rejected the lease with the cannabis business and that no rent from the cannabis business was part of the Chapter 11 plan. The Ninth Circuit rejected the UST’s argument that section 1129(a)(3) required courts to determine that all actions under the plan would be legal. To require this of a judge at confirmation would turn them into an “ombudsman without portfolio, gratuitously seeking out possible ‘illegalities’ in every plan[.]”22

This new approach is currently being tested in the case of The Hacienda Co., LLC pending before Judge Neil W. Bason in the Bankruptcy Court for the Central District of California.23 The debtor had been involved in the cannabis industry, but it sold its assets to a Canadian cannabis company in exchange for stock in that company. The debtor proposed to liquidate these shares over time as the stock was thinly traded. The UST moved to dismiss the case, arguing ownership of this stock violated The Controlled Substances Act (“CSA”).24 The Court denied the Motion, finding the UST had failed to prove any ongoing violation of the CSA based on the debtor’s passive ownership of stock in a foreign cannabis company.25 The Court noted that the debtor’s plan would liquidate its stock in a company involved in cannabis to fund payments to creditors, but that the debtor would not be involved in cannabis production or sale.

On September 20, 2023, Judge Bason confirmed the debtor’s plan of reorganization and denied the UST’s second motion to dismiss. The basis for this motion to dismiss was the potential for the reorganized debtor to violate applicable CSA and money laundering laws. The Court issued a “to be published” decision denying the motion to dismiss. In this decision, the Court found that the UST had met its burden to show both the debtor’s pre- petition activity violated the CSA and that its post-petition actions likely violated the CSA because the debtor had not taken sufficient actions to withdraw from its relationship with the Canadian company such that a conspiracy to violate the CSA could still be alleged. However, the Court held that this did not mandate dismissal of the case finding that Congress did not adopt a “zero tolerance” policy for pre-petition or post-petition illegal actions when considering dismissal pursuant to 11 U.S.C. § 1112. Citing its earlier decision in the case, as well as the In re CWNevada case, the Court held that the general policy of courts not to enforce illegal contracts between private parties gives way when the dispute impacts non- parties to the contract in question.26 The Court rejected the UST’s argument that the distribution of the proceeds from the stock sale would violate money laundering statutes,27 despite assuming, for the purposes of the opinion, that the debtor’s distribution of proceeds from these stock sales outside of bankruptcy would violate the law. The difference is that the debtor was proposing to liquidate the stock under “a federal court’s supervision” which is a remedy available in the criminal statutes – seizure of proceeds of unlawful activity and distribution to any victim or to satisfy any civil judgment.28 Finally, the Court observed that rather than use the “blunt tool of dismissal” other actors, including prosecutors, could take direct, targeted actions regarding any violations of applicable law while the creditors of the debtor could benefit from an orderly liquidation.29

A recent case in the Central District of California, In re the Litigation Practice Group, P.C.30 provides an appropriate case study for a non-cannabis related debtor. The debtor was a law firm providing representation to consumers in debt collection and related matters. After the petition was filed, a creditor brought the motion to dismiss, convert or appoint a trustee, arguing that the case was filed in bad faith to avoid a receiver and transfer all the assets away from creditors’ reach;31 the US Trustee filed a supplement to the motion to dismiss or convert based on the typical grounds: lack of statements, schedules, financial records, etc.;32 the Court decided to direct the UST to appoint a Chapter 11 trustee.33 The UST selected Richard Marshack to serve as Chapter 11 trustee as of May 5, 2023, and that order was entered.34

Subsequently, on May 25, 2023, the Trustee filed an Adversary Complaint, Case No. 8:23-ap- 01046-SC (the “1046 Action”), seeking avoidance and recovery of fraudulent and preferential transfers of substantially all of the debtor’s clients and associated receivable income stream to alter ego law firms established to evade either the state court receiver or Trustee’s grasp.35 The Trustee recovered a large majority of these clients in the 1046 Action and, on July 7, 2023, proceeded to file a motion to sell this recovered property pursuant to 11 U.S.C. § 363, on shortened notice.36 On July 10, 2023, the court granted the Trustee’s application for an order shortening time and set the hearing on the Trustee’s sale motion.37 The UST38 and other amicus curie39 opposed the sale motion based on, inter alia, the alleged illegality of the debtor’s business. Specifically, UST and amici argued that the pre-petition legal services agreements between the debtor and its consumer clients violated applicable provisions of the telemarketing sales rule (“TSR”)40 among other state and/or federal statutes and could not be reformed by the Court or Trustee via the sale process. While the sale motion was pending, on July 13, 2023, the UST again filed a motion to convert pursuant to 11 U.S.C. § 1112(b),41 arguing that the continued operation or sale of the debtor’s business violated applicable federal and state law including, but not limited to, the aforementioned TSR, the Credit Repair Organizations Act,42 California Business and Professions Code § 17200 and the California Rules of Professional Conduct.

On July 21, 2023, the Court conducted a nearly eight-hour hearing on the Trustee’s sale motion, determining that “[t] hrough the continuing and persuasive insistence of this Court, Trustee and his professionals have engaged in an unrelenting and expensive process of converting Debtor’s business into a consumer protection compliant business” and that there “is no fair reason to discount or refuse to approve the sale based on the prior bad acts of Debtor when considering the current and future reformation of business practices.”43 In approving the sale motion, the Court noted “even when a debtor has engaged in an illegal business, bankruptcy courts have recognized that a debtor can transform its business, stop violating applicable law, and remain in bankruptcy.44 The sale will result in significant recoveries for the Estate, based on the purchasing law firm’s ability to successfully provide legal services to Debtor’s former customers. Had the sale not been approved or had the Court instead granted the UST’s motion to convert, there was virtually no likelihood of any substantial recovery for creditors or the consumers harmed by Debtor’s allegedly illegal pre-petition conduct. Following the entry of the sale order, the UST stipulated with the Trustee to withdraw its motion to convert.45

While bankruptcy courts in cases like In re Hacienda and In re Litigation Practice Group seem to take a more nuanced approach to handling cases involving alleged illegal activity, there are a substantial number of cases holding that dismissal is required for “cause” when a trustee or debtor-in-possession could violate the law in administering estate assets. While not a reported case, the case of Great Lakes Cultivation, LLC v. Vara (In re Great Lakes Cultivation, LLC) is informative. The court dismissed the debtor’s Chapter 7 case for cause despite the fact that (i) its cannabis plants had died and (ii) its remaining assets were comprised of assets like tools, dehumidifiers and air conditioning units. The court noted that while the plants may have died, the Trustee had not filed any motion to abandon assets and when he did so both the Trustee and court would become involved in administering illegal property. While a Chapter 7 trustee could normally liquidate working assets, the CSA’s prohibition on possession of “any equipment, chemical, product, or material [that] may be used to manufacture a controlled substance” essentially prevented the Trustee from selling equipment because it was once, and might again be, used illegally for the production of controlled substances. Given that abandonment and dismissal both return title to assets that

may violate the CSA to the debtor, holdings like this are hard to square with the Code’s focus on equality of creditor treatment. There seems to be no reason why a Chapter 7 trustee could not abandon property like specialized equipment or plants that may raise issues under the CSA while liquidating property like tools, tractors and office furniture that do not raise the same concerns. As Judge Bason noted, a less absolute approach would better protect creditors and allow some oversight over the disposition of these assets.

Conclusion

When the UST appoints a Chapter 11 trustee to take over the debtor’s operations, that trustee has fiduciary duties and must act in accordance with the bankruptcy code and law to fulfill these obligations. And, while the UST allows the chapter trustee’s deference in Ponzi scheme cases, in other types of “illegal” business cases, it generally files a motion to dismiss the case, not allowing the trustee to continue to administer the case in accordance with their statutory duties. Various courts looking at these motions to dismiss an “illegal” business are now acknowledging that the bankruptcy court might just be the best place for these cases to be reformed and not dismissed. In light of these new cases, it seems that the UST’s position in certain types of “illegal” cases will have to shift to be more like its position in Ponzi scheme cases, and allow the trustee, working hand in hand with the UST, to administer the case in an attempt to cure the illegal activity and provide some sort of return to harmed creditors. Only time will tell.

---

ENDNOTES:

1 In re Accomazzo, 226 B.R. 426, 429 (D. Ariz. 1998) (holding “a bankruptcy trustee owes a fiduciary duty to creditors of, and parties in-interest to, a bankruptcy estate.”)

2 Id. (citing In re Rigden, 795 F.2d 727, 730 (9th Cir. 1986))

3 Douglas Baird, Bankruptcy’s Uncontested Axioms, 108 Yale

L.J. 573 (1998); see also Elizabeth Warren, Bankruptcy Policy, 54 U. Chi. L. Rev. 775 (1987)

4 11 U.S.C. § 1112(b)(1)

5 Id.

6 11 U.S.C. § 1112(b)(4)

7 In re Rosenblum, 608 B.R. 529, 536 (Bankr. D. Nev. 2019)

8 In re Woodbrook Assocs., 19 F.3d 312, 317 (7th Cir. 1994)

9 In re Mattiace Industries, Inc., 76 B.R. 44, 47 (Bankr. E.D.N.Y. 1987) (granting New York State Attorney General’s motion to dismiss where the Debtor continued to operate, under protection of the bankruptcy court, a business engaged in the illegal dumping of toxic chemicals)

10 In re Hacienda Co., LLC, 647 B.,R. 748, 751 (Bankr. C.D. Cal.

2023) (citing 28 U.S.C. § 959)

11 In re Mattiace Industries, Inc. 76 B.R., supra.

12 In re Arenas, 535 B.R. 845 (10th Cir. BAP 2015) (granting motion to dismiss a Chapter 7 case under comparable provisions of 11 U.S.C. § 707 which also do not include ‘illegality’ or ‘bad faith’ among the enumerated grounds for dismissal)

13 In re Leavitt, 171 F.3d 1219, 1224 (9th Cir. 1999) (granting motion to dismiss a Chapter 13 case under comparable provisions of 11 U.S.C. § 1307 which also do not include ‘illegality’ or ‘bad faith’ among the enumerated grounds for dismissal)

14 In re Mattiace Industries, Inc., 76 B.R., supra at 48 (granting motion to dismiss based on a “continuing loss or diminution of the estate and absence of a reasonable likelihood of rehabilitation”, debtor’s inability to effectuate a plan, a case history evincing an “unreasonable delay by the debtor that is prejudicial to its creditors” and failure to propose a plan “within the time fixed by the court”); see also In re Arenas, 535 B.R., supra at 853 (granting motion to dismiss a Chapter 7 case under comparable provisions of 11 U.S.C. § 707 on the basis of debtor’s “unreasonable delay”.

15 For example, see In re Professional Financial Investors, Inc., No. 3:20-bk-30604 (Bankr. N.D. Cal.) and In re Professional Investors Security Fund, Inc., No. 3:20-bk-30579 (Bankr. N.D. Cal), both involving a Ponzi scheme involving a real estate investment company that filed for bankruptcy. Despite undisputed illegality, the UST did not file a Motion to Dismiss.

16 Arenas v. United States Tr. (In re Arenas), 535 B.R. 845, 851 (B.A.P. 10th Cir. 2015)(affirming dismissal of a chapter 7 case pursuant to 11 U.S.C. § 707 and denial of the debtors’ motion to convert to chapter 13 because the debtors could not propose and confirm a plan in good faith and that would not be “forbidden by law” when the source of income was a warehouse leased to companies involved with cannabis).

17 “The ‘unclean hands’ defense applies to conduct immediately related to the cause in controversy.” In re Everett, 364B.R. 711, 723 (Bankr. D. Ariz. 2007) (citation omitted). “[B]ecause of the clean hands doctrine a federal court should not, in an ordinary case, lend its judicial power to a plaintiff who seeks to invoke that power for the purpose of consummating a transaction in clear violation of law.” See Johnson v. Yellow Cab Transit Co., 321 U.S. 383, 387, 64S. Ct. 622, 624, 88 L.

Ed. 814 (1944).” In re Medpoint Mgmt., 528 B.R. 178, 186 (Bankr. D. Ariz. 2015).

18 In re Rent Rite Super Kegs W. Ltd., 484 B.R. 799 (Bankr. D. Colo. 2012) (finding cause to dismiss or convert a chapter 11 case involving rents from cannabis operations stating the court could not “enforce the protection of the Bankruptcy Code in aid of a Debtor whose activities constitute a continuing federal crime.”)

19 The Bankruptcy Appellate Panel for the Ninth Circuit summarized this outlook as recognizing that “the mere presence of cannabis near a bankruptcy case does not automatically prohibit a debtor from bankruptcy relief.” Burton

v. Maney (In re Burton), 610 B.R. 633, 637 (B.A.P. 9th Cir. 2020).

20 In re Johnson, 532 B.R. 53 (Bankr. W.D. Mich. 2015).

21 Garvin v. Cook Invs. NW, SPNWY, LLC, 922 F.3d 1031, 1036 (9th Cir. 2019).

22 Id. at 1035 quoting from In re Food City, Inc., 110 B.R. 808, 812 (Bankr. W.D. Tex. 1990).

23 The bankruptcy case number is 2:22-bk-15163. The decision discussed here is reported at In re Hacienda Co., LLC, 647 B.R. 748, 754 (Bankr. C.D. Cal. 2023).

24 21 U.S.C. § 801 et. seq.

25 While the Debtor’s asset was stock in a Canadian company whose shares were traded on the Canadian Exchange, the company apparently had operations in the United States where cannabis had been decriminalized.

26 See Order Denying Motion to Dismiss, Page 13 [Doc. No. 199 in Case No. 2:22-bk-15163] citing J. Lilly, LLC v. Clearspan Fabric Structures Int’l, Inc., 2020 WL 1855190 at *12 (D. Or. Apr. 13, 2020) and Sensoria, LLC v. Kaweske, et al., 2021 WL 103020 at *6 (D. Colo. Jan. 12, 2021)(holding that state court disputes involving cannabis matters are not immediately subject to dismissal if no future violation of the CSA is implicated. The decision also noted the Code’s refusal to punish or subordinate unsecured creditors in favor of fines, penalties, and forfeitures citing 11 U.S.C. §§ 551 and 724(a), 724(b), and 726(a)(4)).

27 18 U.S.C. § 1956(a)(2)(A) and (C).

28 18 U.S.C. § 1956(a)(1), (b)(4)(A), and (c)(9).

29 See Order Denying Motion to Dismiss, page 20 citing Burton

v. Maney (In re Burton), 610 B.R. 633, 637 (B.A.P. 9th Cir. 2020).

30 In re The Litigation Practice Group, 8:23-bk-10571-SC (Bankr. C.D. Cal. 2023) (Note: the authors are partners at Dinsmore & Shohl, LLP, Special Counsel for Richard A. Marshack, Chapter 11 Trustee of the Litigation Practice Group, P.C.).

31 Id., Docket Entry No. 44

32 Id., Docket Entry No. 50

33 Id., Docket Entry No. 58

34 Id., Docket Entry No. 65

35 Id. Docket Entry Nos. 1-8 (1046 Action).

36 Id. Docket Entry No. 191-192.

37 Id. Docket Entry No. 214.

38 Id. Docket Entry No. 296

39 Id. Docket Entry No. 288.

40 The TSR of 16 C.F.R. § 310, et seq., implements the Telemarketing and Consumer Fraud and Abuse Prevention Act of 15 U.S.C.

§§ 6101-6108.

41 In re The Litigation Practice Group, No. 8:23-bk-10571-SC (Bankr. C.D. Cal. 2023), Docket Entry No. 232.

42 15 U.S.C. Section 1679, et seq.

43 In re The Litigation Practice Group, No. 8:23-bk-10571-SC (Bankr. C.D. Cal. 2023), Docket Entry No. 320.

44 Id., citing Garvin v. Cook Invs. NW, SPNWY, LLC, 922 F.3d 1031, 1034 (9th Cir. 2019).

45 Id. Docket Entry No. 455.