Developments in Mass Tort Bankruptcies

The Texas Two-Step

The days of “Texas two-step” describing a country-western dance move are over. Lately, the term has taken on a new meaning in the world of mass torts and refers to a specific corporate maneuver, the divisional merger, which is permitted under the Texas Business Corporation Act and similar state statutes and allows an entity to split into two new corporate entities, one of which assumes all of the tort liabilities of the prior entity and the other of which continues to operate the business, now shed of its former tort liabilities. Typically, following an increasingly well-trod path, the entity that assumes the liabilities will then file for bankruptcy and endeavor to obtain releases and injunctions against present and future claims on behalf of itself and its corporate affiliates—including the newly formed operating entity, which gets the protections of bankruptcy without itself having to file for bankruptcy. Recent developments have cast the viability of this strategy into doubt.

LTL Management. The most well-known Texas two-step, though not the first, is less than two years old. On October 12, 2021, a wholly owned subsidiary of Johnson & Johnson (J&J), Johnson & Johnson Consumer Inc. (Old JJCI), was divided into two new companies, LTL Management LLC (LTL), which assumed responsibility for the talc liabilities of Old JJCI, and New JJCI, which assumed the operating businesses of Old JJCI. New JJCI and J&J executed a funding agreement pursuant to which both entities were obligated to backstop LTL’s talc liabilities, up to at least $61.5 billion. LTL could draw on the funding agreement but was not obligated to repay any amounts. On October 14, 2021, two days after it was formed, LTL filed for bankruptcy in In re LTL Management.

LTL initially filed its bankruptcy petition in North Carolina bankruptcy court, which ultimately transferred the case to New Jersey. Once the case was venued in New Jersey, the creditors’ committee representing the talc claimants moved to dismiss the bankruptcy case. That motion was joined by certain claimants and their lawyers. The bankruptcy court denied the motions based on what it found to be the Third Circuit standard of “good faith.” The bankruptcy court cited 11 U.S.C. § 1112(b) and concluded that a bankruptcy case is subject to dismissal for cause unless it is filed in good faith, based on the totality of facts and circumstances, which the debtor bears the burden to establish by a preponderance of the evidence. Evaluating the bankruptcy purpose underlying LTL’s decision to file for Chapter 11 relief, Bankruptcy Judge Lewis Kaplan concluded it was valid. He cited the “two main functions of the bankruptcy law,” to preserve going concerns and maximize property available to satisfy creditors, and concluded that

[w]hile the parties may debate whether as a result of the [Texas two-step], LTL continues as a “going concern,” this Court has little trouble finding that the chapter 11 filing serves to maximize the property available to satisfy creditors by employing the tools available under the Bankruptcy Code to ensure that all present and future tort claimants will share distributions through the court-administered claims assessment process.

Indeed, Judge Kaplan cited with approval J&J’s and LTL’s candor and transparency “about employing Debtor’s chapter 11 filing as a vehicle to address the company’s growing talc-related liability exposure and costs in defending the tens of thousands of pending ovarian cancer claims and hundreds of mesothelioma cases, as well as future claims.” Citing the case featuring the first Texas two-step maneuver, In re Bestwall, he explained that “the filing of a chapter 11 case with the expressed aim of addressing the present and future liabilities associated with ongoing global personal injury claims to preserve corporate value is unquestionably a proper purpose under the Bankruptcy Code.”

As the bankruptcy court explained at some length, the “bankruptcy courts have witnessed serious abuses and inefficiencies,” including “the approval of overly broad nonconsensual third-party releases,” and “[n]o one can deny that there are situations in which tools and strategies have been abused and warrant critical review.” However, the bankruptcy courts have also had “innumerable successes” and

successful case outcomes where large and small businesses are reorganized, productive business relationships are maintained, jobs preserved and, most importantly, meaningful returns distributed to creditors—all in situations where outside of the bankruptcy system there would be fewer if any identifiable benefits, and the parties left to expensive and time-consuming litigation.

At the conclusion of this discussion, Judge Kaplan rejected “the premise that continued litigation in state and federal courts serves best the interest of their constituency.” He then touched briefly on the debtor’s financial distress and, though he observed that “distress is patently apparent in the case,” considered it to be “of no moment that the Debtor, by virtue of the Funding Agreement, was not insolvent on the date of the chapter 11 filing.”

On appeal, the Third Circuit disagreed in a relatively simple ruling: LTL could not meet the good faith standard because only “a putative debtor in financial distress can do so.” The appellate court emphasized “Chapter 11’s ability to redefine fundamental rights of third parties,” and concluded that “only those facing financial distress can call on bankruptcy’s tools to do so.” The court determined that the funding agreement, which guaranteed LTL at least $61.5 billion in funding to pay talc liabilities and related defense costs, eliminated any financial distress on the part of LTL as of the petition date.

The court explained that the funding agreement provided LTL with a reliable “right to cash that was very valuable, likely to grow, and minimally conditional,” backed by highly creditworthy counterparties. As the court noted:

J&J had well over $400 billion in equity value with a AAA credit rating and $31 billion just in cash and marketable securities. It distributed over $13 billion to shareholders in each of 2020 and 2021. It is hard to imagine a scenario where J&J and [New JJCI] would be unable to satisfy their joint obligations under the Funding Agreement.

The Third Circuit also found that the bankruptcy court’s analysis of financial distress, which it described as “casual[]” and akin to “back-of-the-envelope forecasts of hypothetical worst-case scenarios,” omitted Old JJCI’s prior litigation successes. As summarized by the Third Circuit, Old JJCI settled approximately 6,800 talc-related claims for under $1 billion, obtained dismissals of about 1,300 ovarian cancer and over 250 mesothelioma claims without payment, and prevailed at trial in a majority of the completed trials (with some of the verdicts against Old JJCI later reversed on appeal).

In this context, the Third Circuit wrote, “LTL did not have any likely need in the present or the near-term, or even in the long-term, to exhaust its funding rights to pay talc liabilities” at the time it filed the Chapter 11 petition. Rather, costs of the past five years were less than 7.5% of the $61.5 billion funding agreement value (about half of which were attributable to one verdict in a single case consolidating 22 plaintiffs). The Third Circuit closed this discussion by observing that LTL itself acknowledged that there was not “any imminent or even likely need of [it] to invoke the Funding Agreement to its maximum amount or anything close to it” in its opposition to the petition for direct appeal. “We take J&J and LTL at their word and agree,” stated the Third Circuit. It then directed the bankruptcy court to enter an order dismissing the bankruptcy case.

The Third Circuit was careful to note that it did not decide whether “Texas two-steps” (a.k.a. “divisive mergers”) were per se improper. However, given the emphasis by the LTL bankruptcy court on the practicalities of mass tort litigation and the benefits of bankruptcy for resolving these liabilities, and the Third Circuit’s emphatic reversal, plaintiffs in other major mass tort bankruptcies are likely to see an advantage. Indeed, some have moved quickly in response.

Aearo Technologies. Four days after the Third Circuit issued its decision, the creditors’ committee representing the claimants in the In re Aearo Technologies bankruptcy, who allege hearing injury arising out of the use of Combat Arms earplugs, moved to dismiss that bankruptcy case, relying heavily on the LTL ruling. The Aearo debtors, who have the benefit of an uncapped financial backstop agreement from 3M and thus an arguably weaker argument for financial distress as of the petition date, defended their bankruptcy case by primarily relying on the contention that the Seventh Circuit has a different “good faith” standard than the Third Circuit and “does not require a company to be in financial distress before filing for chapter 11.” Rather, the debtors argued, the Seventh Circuit standard examines whether a debtor has reasonable prospects for confirming a plan of reorganization.

In addition, in an argument that the Third Circuit implicitly rejected, the Aearo debtors emphasized the benefits of bankruptcy to a mass tort debtor, including:

the breathing spell and centralization provided by the automatic stay, the information gathering and clarity provided by a bar date, the data analysis and rigor afforded by an estimation process, the efficiency and fairness facilitated by a claims trust (relative to traditional tort litigation), and, perhaps most of all, the ability to achieve a full and final resolution [under a plan].

The Aearo court therefore was confronted directly with the question identified by Judge Kaplan in LTL: whether to allow an essentially financially healthy entity access to a bankruptcy forum, because it means “productive business relationships are maintained, jobs preserved and, most importantly, meaningful returns distributed to creditors,” including “meaningful, timely recoveries,” because such is preferable to “situations where outside of the bankruptcy system there would be fewer if any identifiable benefits, and the parties left to expensive and time-consuming litigation.”

The Aearo debtors also argued that their financial distress is real (and orders of magnitude greater than LTL’s) based on the committee’s claims of trillions in damages. Indeed, the Aearo multidistrict litigation (MDL) is the largest in history, with over 230,000 cases that collectively account for over 30% of the total number of all cases pending in federal courts nationwide. The court conducted an evidentiary hearing that concluded on April 26, 2023.

On June 9, 2023, the bankruptcy court dismissed the bankruptcy cases. Judge Graham declined to adopt a multifactor test and instead examined the question of whether the bankruptcy serves a valid reorganizational purpose. A debtor’s need for bankruptcy relief “is central to that inquiry,” and the bankruptcy court noted many bankruptcy dismissals because “if a petitioner has no need to rehabilitate or reorganize, its petition cannot serve the rehabilitative purpose for which Chapter 11 was designed.” Judge Graham then discussed the LTL ruling at length and concluded that Aearo was financially healthy, with the 3M-backed funding agreement playing “an obvious and significant factor” in the court’s conclusion. Ultimately, noting that Aearo had consistently made clear that it initiated the bankruptcy cases to manage its MDL process, the bankruptcy court concluded that the “cases were and are a litigation management tactic and not a rehabilitative effort.” As such, the bankruptcy court found cause to dismiss the cases.

North Carolina asbestos bankruptcy cases. At the end of March 2023, the committee representing asbestos claimants in In re Bestwall, the original Texas two-step bankruptcy, moved to dismiss that bankruptcy case for lack of subject matter jurisdiction. The Bestwall case is pending in the Fourth Circuit, which according to some (including the LTL bankruptcy court) has a more stringent lack of good faith standard for dismissal. This is also the third motion to dismiss the bankruptcy case, the first two having been denied.

The committee’s current motion is based on a novel argument that the constitutional authorization for the Bankruptcy Code and the existing bankruptcy court system derives from the language “uniform Laws on the subject of Bankruptcies,” and the meaning of “bankruptcy” as accepted by the drafters of the U.S. Constitution was limited to debtors who were unable to pay their debts. Therefore, the committee argues, the bankruptcy courts lack subject matter jurisdiction to adjudicate cases where the debtor is fully able to pay its debts. The committee argues that Bestwall’s funding agreement, provided by its parent, Georgia-Pacific, unquestionably allows it to pay its asbestos debts in full, and thus the bankruptcy court does not have subject matter jurisdiction to proceed in the Bestwall bankruptcy case. While LTL does not explicitly underpin the committee’s third effort here, the body blows to the divisive merger procedure espoused in LTL and Aearo no doubt have emboldened another try.

In early April 2023, a group of mesothelioma claimants moved to dismiss the Aldrich Pump asbestos bankruptcy case on the ground that the debtors are not in “financial distress” and “not in need of resuscitation.” The motion builds on the LTL, Aearo, and Bestwall cases to argue that a debtor’s financial distress is the “jurisdictional touchstone” of the bankruptcy system, and that Fourth Circuit law is no different than the law elsewhere, including in the Third Circuit under the LTL ruling. In the motion, the Aldrich Pump claimants take on the argument that an entity is eligible to file for bankruptcy “so long as the numerator of the equation (i.e., the liability) is large, no matter how gargantuan the denominator (i.e., financial resources available to pay the liability).” Though the debtors point to “a numerator of $240 million” in total liabilities, the funding agreements available to the Aldrich Pump debtors mean the debtors “are not and have never been” financially distressed. Instead, the debtors’ nondebtor affiliates and funding agreement counterparties reported $16 billion of consolidated revenue, $1.2 billion in buybacks, and $620.7 million in declared dividends in 2022. The asbestos claimants therefore argue that the debtors’ asbestos liabilities are “more manageable than ever,” with affiliates “awash in surplus cash,” and it is a “sleight-of-hand” to claim financial distress on this basis.

A fourth Texas two-step bankruptcy, In re DBMP, has not yet seen a similar motion to dismiss, but the claimants have indicated intent to do so. In the meantime, the parties were recently ordered to mediate.

LTL renewed bankruptcy case. Scant hours after the Third Circuit denied LTL’s petition to rehear the case en banc, LTL filed a renewed petition for bankruptcy. LTL’s new petition is based on an $8.9 billion funding agreement from New JJCI and paired with an announced settlement with some of the talc claimants (what percentage these claimants represent of the overall is likely to be hotly contested going forward). LTL also released J&J and New JJCI from the prior funding agreement, prompting an attorney representing an ad hoc claimants’ group to term the deal “the largest intentional fraudulent transfer in United States history.” The case was assigned to Judge Kaplan again, who has said he will not dismiss it sua sponte despite the claimants’ requests that he do so. The Aearo debtors are also pursuing an appeal to the Seventh Circuit. Developments in LTL’s renewed bankruptcy case, the Aearo appeal, and the other Texas two-step cases will continue to be worth watching.

Nonconsensual Third-Party Releases

Included in the putative “abuses” described by Judge Kaplan in his LTL ruling were “overly broad nonconsensual third-party releases,” which themselves were the focus of a significant bankruptcy ruling in the Second Circuit, In re Purdue Pharma. Although the district court’s ruling threatened to upend a key protection that nondebtor plan supporters seek to take advantage of in a bankruptcy setting, on appeal to the Second Circuit, the validity of such releases was recently confirmed.

Purdue filed for Chapter 11 bankruptcy in September 2019. As described by the district court, the “intent was for a ‘Manville-style’ bankruptcy that would resolve both existing and future claims against the company arising from the prescription of OxyContin,” referring to the Chapter 11 filing by Johns-Manville Corporation 40 years ago to address its asbestos liabilities. The Manville case piloted an innovative plan structure, eventually codified in 11 U.S.C. § 524(g), that provided a path for other asbestos bankruptcies but, in recent years, has been utilized by debtors facing all manner of other mass tort liabilities. In nonasbestos bankruptcies, debtors rely on § 105(a) of the Bankruptcy Code, not § 524(g), to secure injunctions against future claimants and, often, protect an array of third parties beyond the debtor itself. These protections largely take the form of third-party releases incorporated into a plan of reorganization, which provides a discharge to the debtor and can afford broad injunctive relief to nondebtor affiliated entities.

In Purdue, the proposed beneficiaries of the disputed nonconsensual third-party releases were members of the Sackler family who served as officers and directors of Purdue and faced their own liability for opioid-related litigation. “[T]he Sacklers made it clear well before the [Purdue debtors] filed for bankruptcy that they would contribute toward Purdue’s bankruptcy plan only if they received blanket releases that would put ‘all of the litigation behind them.’” The issue presented in Purdue and other cases is whether such releases can be confirmed on a nonconsensual basis.

In analyzing the question, Bankruptcy Judge Robert Drain concluded that a bankruptcy court has “residual authority” to issue such releases based on “authority in the ‘necessary or appropriate’ power in Section 105(a) of the Bankruptcy Code coupled with Section 1123(b)(6)’s grant of power to ‘include any other appropriate provision not inconsistent with the applicable provisions of this title.’” On appeal to the U.S. District Court for the Southern District of New York, Judge Colleen McMahon reversed the confirmation order, finding that “there is no such thing as ‘equitable authority’ or ‘residual authority’ in a bankruptcy court untethered to some specific, substantive grant of authority in the Bankruptcy Code.” On appeal to the Second Circuit, the Second Circuit agreed with the bankruptcy court, relying on the “broad equitable power” provided to bankruptcy courts under § 105(a) and the authority granted by § 1123(b)(6) to “‘any other appropriate provision’ in a plan so long as it is ‘not inconsistent’ with other sections of the Bankruptcy Code.” Acknowledging that it had not previously explicitly answered the question, the Second Circuit now concluded that bankruptcy courts may impose third-party releases on a nonconsensual basis.

However, the Second Circuit explained, another important question concerned the nature of the claims and whether they were direct claims, i.e., causes of action brought to redress a third party’s direct harm to a plaintiff, or derivative claims, where the “real injury” is to the estate. It was “well-settled” that a bankruptcy court may approve nonconsensual third-party releases of derivative claims “because those claims really belong to the estate of the debtor.” The “controversial” part of the Purdue plan was the “likely” release of some direct claims against the Sacklers.

Having concluded that nonconsensual releases of direct claims were authorized by the Bankruptcy Code, the Second Circuit nevertheless cautioned that “‘third-party releases are not a merit badge that somebody gets in return for making a positive contribution to a restructuring,’ nor are they ‘a participation trophy’ or ‘gold star for doing a good job.’” Rather, such releases pose a “‘heightened’ ‘potential for abuse.’” The risk of abuse informed the pertinent factors to be considered in approving such releases, in particular, whether there is an identity of interests between the debtors and released third parties, whether claims against the debtor and nondebtor are factually and legally intertwined, whether the scope of the releases is appropriate and necessary in breadth, whether the releases are essential to the reorganization, whether the nondebtor contributed substantial assets to the reorganization, whether the impacted class of creditors overwhelmingly supports the plan with the releases, and whether the plan provides for the fair—though not necessarily full—payment of enjoined claims.

Concurring in the judgment, Judge Richard Wesley urged the U.S. Supreme Court to take up this “weighty issue that, for too long, has split the court of appeals,” observing that the provisions of the Bankruptcy Code relied on to reach the Second Circuit’s conclusion “say nothing about nondebtor releases, and [he was] not convinced that statutory footing is up to the task.” As with any case, though, the chances of a successful petition for certiorari are slim.

While the Purdue case was on appeal, a federal district court approved of the nonconsensual third-party releases included in the In re Boy Scouts of America (BSA) plan, which had been confirmed by Bankruptcy Judge Laurie Silverstein. The district court explained:

Section 105(a) empowers the court to adopt flexible remedies, consistent with its powers as a court of equity, as “necessary or appropriate to carry out the provisions of” the Bankruptcy Code; § 1123(a)(5) requires a plan to provide “adequate means” of implementation “[n]otwithstanding any otherwise applicable nonbankruptcy law” and provides a non-exhaustive list of potential mechanisms; and § 1123(b)(6) allows a plan to include “any other appropriate provision not inconsistent with applicable provisions of [the Bankruptcy Code].”

These provisions together comprise a bankruptcy court’s “residual authority” and, “under appropriate circumstances,” authorize nonconsensual third-party releases. The BSA district court then affirmed the challenged releases as both necessary to the reorganization and fair. The district court’s ruling is on appeal to the Third Circuit, which denied a stay pending appeal on April 11, 2023.

These rulings, which are consistent with existing practice in mass tort cases in the Second and Third Circuits, indicate that third-party releases are likely to continue to be a feature in many plans, notwithstanding concerns over potential abuse. The Fifth, Ninth, and Tenth Circuits have taken a different view, and it remains to be seen if the Supreme Court will resolve the split.

Insurance Neutrality and Cooperation

The recent plan confirmation ruling and affirmance on appeal in In re Kaiser Gypsum, a long-running asbestos bankruptcy, similarly resulted in mass tort liability being turned out of bankruptcy and returned to the tort system, though on a much different basis. The Fourth Circuit’s ruling on appeal may also be significant for so-called “insurance neutrality” going forward, limiting an insurer’s ability to challenge resolution on mass tort liabilities in bankruptcy.

In Kaiser Gypsum, the case concluded with a plan of reorganization that generally allowed all claimants to pursue recoveries in the tort system, so long as their alleged injuries fell within the policy periods of the debtor’s primary insurance, issued from approximately the 1960s to the 1980s by Truck Insurance Exchange (Truck). Thus, bankruptcy worked a limited solution to the Kaiser asbestos liabilities and mostly avoided issues relating to the scope of releases or financial distress. In the case, the Truck policies afforded general liability coverage for bodily injury, and certain years of Truck’s coverage were not subject to aggregate limits but only to per-occurrence limits of $500,000. As the district court noted in affirming plan confirmation, “the Debtors have effectively unlimited insurance.” Unusually, the plan mandated that claims triggering Truck’s policy periods be pursued in the tort system, with no recourse to the trust. The trust provided compensation only to those claimants whose alleged injuries did not trigger Truck’s coverage. As a result, 14,000 current asbestos claimants and unknown numbers of future claimants were returned to the tort system.

Truck argued that, under the circumstances, even claimants litigating in the tort system should have to provide presuit discovery, citing extensively to findings of settlement trust abuse in In re Garlock. It argued that because the debtor’s plan did not so provide, the debtor was in breach of the cooperation obligations under its policies—or, at least, that Truck’s ability to assert breach as a defense to coverage should be preserved. Instead, the bankruptcy court had confirmed the plan, including specific findings that Kaiser’s conduct in “drafting, negotiation, proposing, confirmation, and consummation of the Plan . . . does not and has not violated any Asbestos Insurer Cooperation Obligations contained in any Asbestos Insurance Policies, nor was such conduct a breach of any express or implied covenant of good faith and fair dealing.” Further, under the confirmation order, “applicable principles of res judicata and collateral estoppel” would apply against Truck “with respect to any issue that is actually litigated” in connection with plan objections. The district court affirmed this ruling as insurance neutral and, therefore, Truck lacked standing to object because its rights were preserved. The district court also specifically found that Truck’s complaints about the structure and funding of the trust were an attempt to assert the rights of third-party asbestos claimants, not its own rights.

On appeal to the Fourth Circuit, Truck asserted that the policy cooperation clauses encompassed the policyholder-debtor’s conduct during the bankruptcy itself, and the bankruptcy court’s findings—that negotiation and confirmation of the plan did not breach the debtor’s cooperation obligation—were therefore not insurance neutral.

The Fourth Circuit disagreed, interpreting the clauses under California law and concluding that the insured’s contractual obligation unambiguously requires cooperation only in the defense of individual suits, not in the context of a bankruptcy case. As a result, the plan confirmation findings could not alter Truck’s policy rights to cooperation, because Truck’s asserted rights did not exist in the first place. Further, the preclusive effect of the bankruptcy court’s finding was within the bankruptcy court’s authority under 11 U.S.C. § 105(a), because Truck’s policies were critical to the viability of the plan, and allowing Truck to “later raise the Debtors’ bankruptcy conduct as a coverage defense in individual suits across the country would defeat the reorganization’s entire purpose and create inequitable results for claimants.” The Fourth Circuit also disagreed that Truck was entitled to anti-fraud protections for the claims funneled into the tort system, because Truck’s policies specifically require it to defend claims and suits “even if such claim or suit is groundless, false or fraudulent.”

The claimants will now proceed to litigate their claims back in the tort system, with Kaiser as only a nominal defendant and recovery against it limited to the extent of insurance. Aside from the claimants’ being barred by the terms of the plan from recovering punitive damages, little will be different from pre-petition circumstances. It remains to be seen whether the Fourth Circuit’s ruling will have implications for insurance neutrality battles in other cases. The ruling may be interpreted as limited to the circumstances of an insurer arguably seeking measures beyond what it would have had the right to insist on in a nonbankruptcy context. Other jurisdictions may find that other circumstances warrant the conclusion that an insured’s actions in the bankruptcy case itself do breach its cooperation obligation, and that the insurer may continue to insist on such cooperation throughout a bankruptcy case.

Conclusion

It remains to be seen how the appellate courts and bankruptcy courts in other jurisdictions will rule on these pivotal issues, and whether the Supreme Court will wade in on future circuit splits. However, these significant developments are being closely watched and are undoubtedly influencing strategic decision-making for mass tort defendants.