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Dancing Around the Law: Texas Two-Step's Controversial Role in Mass Tort Bankruptcy



Confronted with more than 50,000 asbestos related claims linked to its baby products, Johnson & Johnson’s (J&J) recent legal maneuvers have brought into focus the intricate dance between corporate solvency and mass liability. Despite prevailing in the majority of these claims, the prospect of facing another $2.1 billion verdict looms large. Consequently, J&J has put forth an $8.9 billion settlement offer, aiming to resolve all current and future claims and bring closure to this asbestos saga.


J&J contends that the traditional route of litigating such a vast number of claims could span decades (if not centuries) consuming precious time and resources. In response, it has opted to utilize the Texas Two-Step, a divisive merger strategy that leverages Chapter 11 to manage these claims more efficiently. This move, however, has sparked controversy with claimants accusing J&J of misusing bankruptcy law to delay and minimize payouts. Central to this issue is the recurring question: which court is more suitable for resolving such extensive tort claims—the traditional state and federal trial courts, or the bankruptcy courts?


History of the Texas Two-Step Strategy in Bankruptcy

Section 1.002(55) of the Texas Business Organizations Code has laid the groundwork for what is now known as the Texas Two-Step. This provision, established in 1989, authorizes corporations to effect a “divisive merger” by which a single entity becomes two or more. Through this process, assets and liabilities can be strategically divided amongst the newly formed entities allowing companies to tailor corporate structure to specific business needs or legal strategies. Following Texas’ lead, states like Arizona, Delaware, and Pennsylvania have since incorporated similar provisions into their corporate laws.


Despite its availability, the application of the Texas divisive merger in the bankruptcy context is a fairly new trend. In fact, four applications beginning in 2017 have been pioneered by the same attorney dubbing it “the greatest innovation in the history of bankruptcy.” While the process itself is straightforward, it inherently raises concerns regarding fraudulent transfers. These concerns stem from situations where a debtor moves assets around to hinder, delay, or defraud creditors. However, establishing a funding arrangement between the entities involved can help mitigate such fears and ensure legitimacy of the divisive merger. Notably, this strategy has been used by large companies like Georgia Pacific, Saint Gobain, Trane Technologies, and J&J, all of which faced mounting asbestos-related claims.


The relevancy of the asbestos-bankruptcy connection can be traced back to the landmark bankruptcy of Johns Manville in the 1980s. This case spurred Congress to enact Section 524(g) in the Bankruptcy Code, a specialized provision allowing for “channeling injunctions” that were first used in the Manville case. These injunctions effectively redirect all current and future asbestos claims away from the bankrupt entity to a specially created trust. The logic underlying this stems from the prolonged latency period associated with asbestos-related illnesses, which can take decades to manifest after exposure. By setting up a trust, companies can manage the uncertainty of future liabilities while providing a solution for current and future claimants.


A Step Too Far?

Earlier this year, the Third Circuit dealt a blow to the Texas Two-Step by reversing a ruling of the New Jersey Bankruptcy Court. This reversal led to the dismissal of the bankruptcy filing by LTL, a newly formed J&J entity specifically created to hold its asbestos-related liabilities. In its decision, the court emphasized that valid bankruptcy filings must be grounded in good faith. To meet this requirement, the debtor must demonstrate, as a preliminary matter, that they suffer from financial distress at the time of filing.


Financial distress, however, is not easy to quantify. It requires a fact intensive inquiry utilizing the totality of the circumstances. As such, courts must strike a delicate balance in determining the proper timing of bankruptcy claims. Filing too soon can risk undervaluing claims while filing too late may result in a hopeless situation. Although complete insolvency is not required, a premature bankruptcy filing must be scrutinized to ensure the bankruptcy process fulfills its intended purpose.


The Fourth Circuit’s Spin

The Fourth Circuit, by contrast, uses a more rigorous two-pronged test that shifts the burden onto those challenging the bankruptcy. Under this approach, a bankruptcy filing may only be dismissed as a bad faith filing if it meets two criteria: (i) the reorganization is objectively futile, and (ii) the filing is made in subjective bad faith.


Due to this heightened threshold, the Fourth Circuit has become the preferred forum for Texas Two-Step bankruptcy filings. LTL, in fact, originally filed for bankruptcy in North Carolina citing the favorable Fourth Circuit dismissal standards. However, the court, noting a trend of Texas Two-Step cases with similar characteristics, transferred the case to the more proper New Jersey Bankruptcy Court.


A Funding Conundrum

In its dismissal, the Third Circuit ultimately found that LTL was not in financial distress because it had a funding arrangement with J&J “not unlike an ATM” through which it could satisfy any of its current and future obligations. J&J’s strong financial standing, with its AAA rating and $400 billion plus in equity, effectively served as a financial safety net for LTL. As such, the court saw minimal risk of LTL failing to satisfy its debt obligations.


Simply eliminating the funding arrangement, however, would not adequately alleviate the issue. This arrangement, as mentioned above, is instrumental in addressing concerns related to fraudulent transfers with respect to a Texas Two-Step. With it, LTL is likely shielded from financial distress. However, without it, J&J could be potentially exposed to fraudulent transfer claims. This situation seems to lead to a paradoxical catch-22. On one hand, companies on the brink of insolvency—with limited means to address asbestos claims—may take advantage of this scheme. On the other hand, companies with financial backing—offering generous protections for claimants and the capacity to satisfy claims in full—are precluded from this arrangement.


Despite these complexities, the court did not entirely rule out the Texas Two-Step method. Noting lawyers' penchant for creative drafting and experimentation with novel solutions, the court indicated a willingness to consider such approaches under the right circumstances.


Aftermath

Merely hours after the Third Circuit struck down LTL's bankruptcy, the company promptly refiled in the New Jersey Bankruptcy Court. This time, J&J altered the funding arrangement by introducing an additional holding company, aiming to create a clearer separation between itself and LTL. However, in its review, the court found little trouble determining that this revised funding arrangement did little to alter the calculus. Financial distress was still lacking.


Even with this basis for dismissal, the court recognized the need to weigh the interests of claimants who might actually benefit from the bankruptcy process. The court voiced concerns about the sluggish speed and delays inherent in the tort system while highlighting the benefits of lower evidentiary and causation burdens in bankruptcy court. These differences could potentially provide claimants with a swifter and more certain resolution than traditional litigation in the tort system. Nevertheless, the overriding lack of good faith and financial distress in the filing could not be overcome.


Despite this second rejection, J&J has hinted at a possible third bankruptcy attempt.


Conclusion

In the realm of corporate restructuring, the Texas Two-Step divisive merger has emerged as a legal strategy with profound implications not only for the companies who employ it, but also for claimants, many of whom are in poor health and eagerly seek their day in court. In light of growing concerns, the Senate Judiciary Committee held a hearing titled: "Evading Accountability: Corporate Manipulation of Chapter 11 Bankruptcy." As of now, it remains uncertain whether this heightened congressional scrutiny will translate into legislative action. However, regardless of the immediate outcomes, this ongoing debate is poised to bring about significant shifts in the landscape of both bankruptcy law and mass tort litigation.


*The views expressed in this article do not represent the views of Santa Clara University.

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