On June 9, 2011, in In re McGinnis, 453 B.R. 770 (Bankr. D. Or. 2011), the U.S. Bankruptcy Court for the District of Oregon addressed certain issues arising from a Chapter 13 debtor’s proposed debt adjustment plan.

The court declined to confirm the debtor’s proposed plan as it violated both state and federal law, and because it failed to meet the "feasibility" requirement of 11 U.S.C. § 1325(a)(6). Specifically, the court addressed the validity of a plan that relied largely on income from the debtor’s medical marijuana operations. In making his case for feasibility, the debtor urged the court to consider the Obama administration’s recent pronouncements that the federal government would not interfere with such operations that comply with state law. Important to the court’s reasoning was the fact that these operations were nonetheless still illegal under federal law.

The Facts

Michael Lee McGinnis filed for Chapter 13 bankruptcy protection in January 2011. According to Schedule A, attached to his petition, McGinnis owned a commercial property in Arizona that was worth $1 million and was encumbered by secured debt of $6,922. Schedule A also reflected real property adjacent to McGinnis’ residence worth $250,000 and encumbered by secured debt of $35,000. Unsecured claims, meanwhile, totaled $62,192. According to his Schedule B, McGinnis also owned a 1959 El Camino that he indicated was "in pieces, no value"; curiously, McGinnis soon thereafter sold the vehicle for $22,500. When the court directed McGinnis to hold and not spend the proceeds, McGinnis revealed that he had already spent $14,079 of the $22,500 on his "marijuana warehouse operation."

On February 1, 2011, McGinnis filed a pre-confirmation amended plan, which proposed a series of monthly payments at gradually increasing amounts and listed the anticipated sources of funding for the payments. Among these sources of funding were two business ventures owned by McGinnis, including a medical marijuana growing operation. The plan projected a gross annual income of $72,000 from the operation which, after $15,600 for expenses, would result in net annual income of $56,400. McGinnis’ other business venture was Medical Growers LLC, which involved the leasing of warehouse space to other medical marijuana growers.

Since 1998, Oregon state law has permitted the cultivation, possession and use of marijuana by people suffering from specified medical conditions and who have a valid prescription for marijuana use. In addition, under the Oregon Medical Marijuana Act, certain people authorized to possess, deliver or produce marijuana for medical use are exempted from Oregon’s general drug laws.

However, at an evidentiary hearing on confirmation of the plan in March 2011, the court expressed "some doubt as to whether a plan could be confirmed which relied on the cultivation and sale of a product (marijuana) which is still … illegal under federal law." Accordingly, before issuing a ruling, the court invited the Chapter 13 trustee and McGinnis to brief the issue. In response to the court’s skepticism, McGinnis’ primary argument was based on statements by "the current federal administration … that it will generally not interfere with medical marijuana operations that are in compliance with state law."

The Court’s Analysis

Under § 1325(a)(3), a plan must be "proposed in good faith and not by any means forbidden by law," which the court interpreted to mean "in compliance with not only Title 11, but other applicable federal and state law."

The court first addressed whether McGinnis’ proposed plan violated federal law. The court acknowledged that "a medical marijuana grower who is in compliance with state law may find the risks acceptably small and of little deterrence to his operation." The court also observed, however, that marijuana is designated as a "Schedule 1 controlled substance," and that federal law sets forth certain prohibited acts and penalties with regard to such controlled substances. Ultimately, the court concluded that the federal government’s policy not to interfere with medical marijuana operations otherwise compliant with state law did not change the fact that such enterprises were still technically illegal under federal law. In a revealing footnote, the court made it clear that its decision was based solely on applicable statutes, rather than what it termed "the transient policies of agencies charged with enforcement of the criminal laws."

The court also considered the legality of the plan under state law, concluding that it was likewise "forbidden by law" under Oregon’s ostensibly permissive medical marijuana statute, regardless of any conflict with federal law. In particular, the court found that the plan relied heavily on profits that were impermissible under Oregon law. The act permitted medical marijuana users to reimburse an authorized marijuana cultivator only for the costs of supplies and utilities associated with marijuana production, but stated that "no other costs … may be reimbursed." Even more explicitly, the act provided that it was still illegal for individuals, including those authorized to possess, deliver or produce marijuana for medical use, to deliver marijuana for consideration, even to individuals with valid prescriptions.

Accordingly, in his medical marijuana growing operation, McGinnis could only legally be reimbursed for the $15,600 apportioned under the plan to cover supplies and utilities. In essence, the plan was still "forbidden by law," insofar as the act prohibited McGinnis’ projected $56,400 net profit on which the plan depended. The court was not persuaded by McGinnis’ testimony that he had been lobbying the Oregon legislature for a change in the law to allow such profit from the sale of medical marijuana.

The court also expressed doubt as to viability of the plan’s ancillary business enterprise, involving the leasing of warehouse space to medical marijuana growers. The court reasoned that, unless rental expenses could be included as a "cost of supplies and utilities," McGinnis’ prospective tenants would be unable to recoup the costs of renting the space for growing, thus rendering McGinnis’ business economically untenable.

Finally, the court addressed the notion of feasibility, stating that § 1365(a)(6) requires, as a condition to confirmation of a plan, that the debtor "will be able to make all payments under the plan and to comply with the plan." Because federal law, on its face, still prohibited the source of McGinnis’ projected income, the court disagreed that this income stream was "reasonably certain to produce sufficient income to fund the plan," even despite the pronouncements by the federal government regarding medical marijuana operations.

Future Implication

The question of whether a proposed plan is "forbidden by law" for purposes of the Bankruptcy Code is often a clear-cut issue. However, in the context of real-world economics, the legality of a particular business enterprise can become considerably more complex — especially in light of conflicting state and federal laws, and the federal government’s ambiguous approach to enforcement of its own laws. McGinnis is an indication that, when faced with such quandaries, bankruptcy courts will err on the side of enforcing the letter of the law, rather than attempt to accommodate a party’s appeal to economic and practical realities. •

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

James G. Schu Jr. practices in the area of business reorganization and financial restructuring at the firm. He also has experience with premises liability, products liability and class action litigation.