Third Circuit Standard
As an initial matter, the Third Circuit set forth its standard to determine whether bankruptcy petitions are filed in good faith.
Chapter 11 bankruptcy petitions are “subject to dismissal under 11 U.S.C. § 1112(b) unless filed in good faith.” Section 1112(b) provides for dismissal for “cause.” A lack of good faith constitutes “cause,” though it does not fall into one of the examples of cause specifically listed in the statute. Because the Code’s text neither sets nor bars explicitly a good-faith requirement, we have grounded it in the “equitable nature of bankruptcy” and the “purposes underlying Chapter 11.” Once at issue, the burden to establish good faith is on the debtor….“ [T]wo inquiries . . . are particularly relevant”: “(1) whether the petition serves a valid bankruptcy purpose[;] and (2) whether [it] is filed merely to obtain a tactical litigation advantage.”
Opinion at 3536 (internal citations omitted). After evaluating the standard in light of the facts of LTL’s case, the Third Circuit concluded “a debtor who does not suffer from financial distress cannot demonstrate its Chapter 11 petition serves a valid bankruptcy purpose supporting good faith.” Id. at 36. “Good faith,” the court held, “necessarily requires some degree of financial distress on the part of a debtor.” Id. at 37. "[A]bsent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose.” Id. at 38.
LTL’s Lack of Financial Distress
The Third Circuit found that LTL was not in financial distress. The court noted that LTL's assets included the right to receive about $61.5 billion from J&J and New Consumer under a funding agreement executed at the time of the divisional merger. By contrast, in the five years preceding the bankruptcy filing, the aggregate costs of the talc litigation were approximately $4.5 billion, or less than 7.5 percent of LTL's assets, on the petition date. Likewise, J&J reported a calculation of its talc liability as of October 2021 at only $2.4 billion over the next 24 months and had entered settlement discussions seeking to resolve its talc liability in multidistrict litigation in the $4 to $5 billion range. Given that its assets far outweighed its potential liability as of the petition date, the Third Circuit held that LTL was not in “financial distress." The court, however, did not rule out the possibility of changing circumstances that might necessitate a future filing and specifically stated that additional time for litigation claims to get resolved would assist future fact finders in painting a clearer picture of LTL’s actual talc claim exposure.
J&J's carefully crafted bankruptcy plan for its legacy talc liabilities was ultimately undone by its attempt to comply with fraudulent transfer laws. Specifically, at the time of the divisional merger, J&J gave a $61.5 billion funding agreement to LTL. As a result, LTL held "assets having a value at least equal to its liabilities and had financial capacity sufficient to satisfy its obligations as they become due in the ordinary course of business, including any [t]alc [r]elated [l]iabilities.” Opinion at 53 (emphasis in original).
Perhaps to discourage practitioners from trying to avoid LTL's fate by creating divisive mergers without a sufficient funding agreement or other adequate backstop, the Third Circuit warned that “interested parties may seek to ‘avoid any transfer’ made within two years of any bankruptcy filing by a debtor who ‘receive[s] less than a reasonably equivalent value in exchange for such transfer’ and ‘became insolvent as a result of [it].’ 11 U.S.C. § 548(a).” Id. at 55, n. 18. Put differently, the Texas two-step strategy is subject to a catch-22: either the divisional merger results in the new entity holding assets worth at least as much as its liabilities, in which case there is no "financial distress," or the divisional merger leaves the entity insolvent or inadequately capitalized and vulnerable to a fraudulent transfer attack.
LTL's bankruptcy path was undone because LTL was solvent after the division merger and therefore not in financial distress. Had LTL been insolvent or inadequately capitalized, the Third Circuit probably would not have dismissed the case but the bankruptcy court could have unwound the divisive merger, leaving J&J in the same position as before the merger.
While the Third Circuit noted the “apparent irony” of the situation, namely that J&J’s unquestioned ability to backstop LTL’s liability for the talc claims led to the finding that LTL was not entitled to bankruptcy protection, the court at the same time encouraged lawyers to be “inventive” and for management to experiment “with novel solutions.” Opinion at 57. Lawyers will likely do just that, and while the music may have stopped for LTL, another company may strike up the band with a twist that can pass judicial scrutiny.