For the past several years, a series of debtors have used a controversial new bankruptcy strategy known as the “Texas two-step” to streamline the bankruptcy process in mass tort cases by insulating operating businesses from bankruptcy oversight while simultaneously taking advantage of bankruptcy trust and injunctive powers to distribute funds among claimants. Critics have alleged that the strategy was intended to obtain a discount on mass tort claims or to delay plaintiffs’ day in court. Despite several hotly contested cases, no circuit has ruled on the propriety of the strategy.
Since that decision, which is still under review, there has been substantial speculation as to the viability of the divisional merger and bankruptcy strategy known as the Texas two-step. The Third Circuit’s opinion was issued in the midst of a continuing controversy concerning the availability and form of bankruptcy relief for large, often solvent, companies facing mass tort liability but no meaningful operational concerns. Despite placing a significant roadblock in the path of such companies, the Third Circuit’s opinion does not spell the end of the Texas two-step. As is often the case, the extreme facts of the LTL case leave ample room for further development in future cases.
Mass Tort Bankruptcies
Moreover, despite jurisdictional limitations to resolving personal injury and wrongful death claims, several courts have commented that the Bankruptcy Code is the best option for the management and resolution of mass tort claims. Although Congress enacted 11 U.S.C. § 524(g) to standardize a process for the resolution of asbestos claims, bankruptcy courts have been quick to adopt the trust and voting procedures for use in other sorts of mass tort cases, including sexual abuse, silica, and talc.
Given these circumstances, several of the largest bankruptcies in recent years have been filed by cash-rich, arguably solvent, companies or their subsidiaries. In the past few years, household names have sought bankruptcy for cases involving opioids (Purdue Pharma), talc (LTL/Johnson & Johnson), and hearing protection (Aearo/3M). In each of these high-profile cases, the debtors sought injunctive relief to protect related third parties, such as corporate parents, affiliates, and individuals. Although claimants and their counsel have supported the bankruptcies of solvent companies in the past, recent filings have attempted to minimize the burdens of bankruptcy and the significant control that claimants often have in that process. Claimants and their attorneys have cried foul.
Purdue Pharma faced billions of dollars in alleged liabilities related to its opioid products and related public health claims. As part of its bankruptcy, however, it sought third-party releases to protect the Sackler family—the owners of Purdue Pharma. other creditors appealed.
Perhaps more significantly from a process perspective, the massive public debate around the Purdue Pharma bankruptcy sparked a renewed interest in the public policy enshrined in the Bankruptcy Code.The uncertainty of third-party releases led corporations subject to mass tort liabilities to look for alternative mechanisms to protect corporate assets. The Texas two-step was a creative way to utilize a state law process to ensure that a company could obtain a complete resolution of bankruptcy issues through a bankruptcy filing.
The Texas Two-Step
The Texas two-step bankruptcy strategy enables a corporate debtor to “merge” into two companies: one that will continue to hold operational assets and the other that will hold the targeted liabilities and specified fixed assets. This enables a company to streamline the bankruptcy process by keeping operating assets out of bankruptcy but still enabling the company to access the unique bankruptcy powers to resolve mass tort liabilities.
Under the Texas two-step, a company goes through a “divisional merger” (or “divisive merger”) under Texas law to create two separate legal entities. One of those entities retains the business of the company while the other acquires the potential liabilities for the mass tort and assets sufficient, in theory, to satisfy those liabilities.The theory behind the funding agreement is that if it is sufficient to pay all current creditors in full, the alleged injured parties could be fully compensated through a more efficient and cost-effective process.
The second step of the Texas two-step requires that the new entity (which holds the liability) file for bankruptcy. This action “shields some or all of the assets of one entity from creditors, while providing the liability bearing entity with the shield of the Bankruptcy Code’s automatic stay.The debtors in these cases have almost universally sought an extension of the automatic stay, or an independent preliminary injunction, extending the stay to the ultimate parent companies and other related entities.
Texas’s divisive merger statute consists of three related provisions in the Texas Business Organizations Code (TBOC).This redefining of “merger” to include “division” is the heart of the bankruptcy strategy. Finally, section 10.008(a)(4) states that Together, these provisions enable a business to move liabilities—with or without assets—to a separate entity.
The Texas two-step legal strategy has been employed in several asbestos bankruptcies in recent years.In 2019, CertainTeed Corporation effectuated a divisive merger that created CertainTeed LLC, which retained 97% of the company’s assets and non-asbestos liabilities, and DBMP LLC, which inherited the company’s asbestos liabilities. In 2020, In each of these cases, the plaintiffs’ bar has engaged in full-scale litigation to try to halt the use of the two-step tactic. The full-throated opposition to the two-step reached its zenith with the LTL bankruptcy, filed by a new Johnson & Johnson (J&J) subsidiary created through a divisive merger of Johnson & Johnson Consumer Inc.
Criticism of the Texas Two-Step
As with third-party releases and forum shopping, the two-step has garnered considerable criticism. To the plaintiffs’ bar, the Texas two-step is viewed as allowing profitable, solvent corporations to delay mass tort litigations and potentially secure bankruptcy “discounts.” But that is far from the only criticism.
This fear that bankruptcy doesn’t allow jury trials is somewhat misguided. Bankruptcy certainly can delay jury trials for a plaintiff, but only 10 cases a year (out of over 40,000) were being tried by J&J. In practice, even several years of bankruptcy would delay only a handful of actual trials. Although a few cases would go to trial in a normal year, most would ultimately settle. Trials, however, are one of the main forms of settlement leverage that plaintiffs have over a defendant company. For the vast majority of claimants, the concern raised about jury trials is more about settlement leverage than about access to a jury.
Critics also complain that the Texas two-step allows debtors to file without the concomitant obligations of a typical Chapter 11 bankruptcy. For example, the company designated to hold the operating assets does not file bankruptcy and so is not required to file schedules of its assets and liabilities, a statement of financial affairs, and monthly operating reports. Critics say this threatens the transparency of the bankruptcy process because there is minimal ability to look behind the funding agreement. Similarly, the operating company can incur debt—which might be senior in priority to the funding agreement—without bankruptcy court approval.
These arguments exist in tension with the reality that it is enormously wasteful for a large solvent company to operate in bankruptcy. The bankruptcy requirements necessitate the expenditure of significant legal fees and court approval for many routine transactions. Subjecting thousands of employees, customers, and contract counterparties to the expense and vagaries of a bankruptcy process is not necessarily in anyone’s interest.
Finally, critics contend that the Texas two-step is intended to delay resolution of cases.In practice, it is true that these cases have not resolved quickly, but that is at least in part due to the hotly contested nature of the existing cases. It is not a hallmark of the strategy itself.
There is not necessarily a right answer to these arguments, which continue to be heatedly debated.At the hearing, Whitehouse raised concerns regarding the Texas two-step, and the subcommittee heard testimony from asbestos lawyers, academics, and former judges. But the judiciary may resolve this controversy before Congress acts (if it ever does).
The LTL Decision
Although it refused to rule on the propriety of the Texas two-step,
Prepetition, J&J faced approximately 40,000 claims alleging that the claimants had developed mesothelioma, ovarian cancer, or other diseases due to exposure to asbestos or talc contained in J&J’s products.The Official Committee of Talc Claimants, along with several other parties, filed motions to dismiss LTL’s bankruptcy case pursuant to § 1112(b) of the Bankruptcy Code, on the basis that the case was not filed “in good faith.” Judge Kaplan also approved a broad injunction protecting J&J and its affiliates.
The claimants’ committee vehemently disagreed. Of course, in the tort system, many claimants would receive nothing, but a few were likely to obtain significant verdicts or settlements. A bankruptcy trust undoubtedly would have provided greater certainty and uniformity to the claims process.
Recognizing the controversy surrounding the Texas two-step, Judge Kaplan certified his decision for direct appeal to the Third Circuit. On January 30, 2023, the Third Circuit issued its decision. The court concluded that the state law divisional merger was binding and then proceeded to evaluate the propriety of LTL’s bankruptcy filing given its liabilities and assets (primarily the J&J funding agreement). Ironically, the Third Circuit tossed out J&J’s talc petition because the new entity, LTL, was given too much value when it was created. The funding agreement provided to LTL on its formation gave it the right to demand payment from J&J and its consumer products division up to the full cash value of the consumer products division (an estimated $61.5 billion) to satisfy any talc-related liabilities and costs.Without such financial difficulties, even a good faith desire to protect the J&J brand or to comprehensively resolve litigation did not suffice.
The Third Circuit noted that although nearly 40,000 plaintiffs have sued J&J contending that its products caused their ovarian cancer or mesothelioma, with some trials resulting in substantial verdicts, the defendant had prevailed in many of the cases and had settled nearly 7,000 cases for a total of less than $1 billion. J&J’s consumer products business was valued at over $60 billion,Thus, in the court’s view, the debtor could not have filed for bankruptcy in “good faith”—a bankruptcy law requirement—because it was not in financial distress.
The Third Circuit also did not address whether the Texas two-step might have succeeded if, in the first instance, J&J had only provided LTL with some value more closely tied to its estimate of its actual liability. The plaintiffs’ bar contends that any such transaction would necessarily be a fraudulent conveyance or would not be in good faith. But the answer to that question is far from clear. The value of contingent unliquidated tort claims often is a matter of considerable dispute. Moreover, multiple courts have recognized the usefulness of the bankruptcy process for resolving mass tort liabilities, even with respect to solvent corporations.
Is the Texas Two-Step Still a Viable Option?
While the Third Circuit dismissed LTL’s bankruptcy under a bad faith filing standard, focusing on LTL’s lack of financial distress, it identified another potentially significant obstacle for successfully implementing a Texas two-step: Does the divisive merger constitute a fraudulent conveyance? This question has yet to be answered by any bankruptcy court addressing a Texas two-step divisive merger. The outcome turns on how the bankruptcy court answers the following questions: (1) Was there a transfer by the debtor? (2) Does the “non-transfer” language of the TBOC control over the Uniform Fraudulent Transfer Act (UFTA) or § 548 of the Bankruptcy Code? (3) Did the debtor receive reasonably equivalent value for the incurrence of an obligation?
By way of example, consider the following hypothetical scenario. In a divisive merger, OldCo disposes of its assets and liabilities by allocating the former to GoodCo and the latter to BadCo. Much of the criticism of the Texas two-step process to date has focused on whether the transfer of assets thereunder constitutes a fraudulent conveyance. A fundamental problem with this criticism is that the debtor, BadCo, did not transfer assets. Rather, OldCo transferred its assets and then was dissolved, leaving only GoodCo and BadCo.
This language has been found At first blush, this provision also appears to preclude a fraudulent transfer claim because there was not a predicate transfer. And the legislative history explains that creditors’ rights should not be adversely affected by the divisive merger, and Indeed, in a July 7, 2022, oral ruling in a pending Texas two-step bankruptcy, In re DBMP, Judge Craig Whitley rejected the notion of section 10.008(a)(2)(C) negating fraudulent transfer analysis, Applying only the plain meaning of section 10.008(a)(2)(C) would lead to absurd results, leaving plaintiffs with “no recourse whatsoever” and potentially facilitating “wholesale fraud,”
From this perspective, section 10.901 and the related history therefore suggest that section 10.008(a)(2)(C) does not negate creditors’ rights to pursue fraudulent transfer claims. Rather, even in a divisive merger, creditors maintain their rights “under existing laws.” The UFTA, adopted by most states, and § 548 of the Bankruptcy Code are such existing laws affording protection to creditors’ rights.U.S. Supreme Court authority recognizes that, And in that context, the bankruptcy court will consider a transfer to be “each mode, direct or indirect, . . . of disposing of or parting with . . . property [or] —which arguably includes divisive mergers effectuated per the TBOC.
Section 544 of the Bankruptcy Code allows for use of state law fraudulent transfer statutes to challenge an alleged fraudulent conveyance within the bankruptcy case. While the right to do so lies primarily with the debtor, interested parties may secure derivative standing to pursue the fraudulent conveyance claim.In DBMP, the debtor received approximately $175 million of assets (not including a funding agreement) and over $1 billion of asbestos liabilities. As previously noted, the DBMP court rejected the debtors’ argument that section 10.008(a)(2)(C) negates an argument that the allocation of assets and liabilities under the TBOC constitutes a fraudulent transfer, and it is anticipated that the court will be called upon to answer that fraudulent transfer question if the case is not otherwise resolved consensually.
It stands to reason that § 548 will control challenges to a divisive merger and derivative standing will be granted to asbestos claimants’ groups to pursue the challenge. However, since the debtor does not “transfer” assets in a divisive merger, such challenges are likely to focus on that portion of § 548 that deems an obligation avoidable if there was not reasonably equivalent value and the debtor was insolvent at the time of the transfer or rendered insolvent thereby.
LTL was saddled with billions of dollars of asbestos liabilities but funded with only hundreds of millions of dollars (excluding the funding agreement). This seemingly fits the § 548 language pertaining to an incurrence of debt without reasonably equivalent value. Consideration must be given to the funding agreement, however. Recall that LTL was given rights to access at least $65.1 billion, subject to certain use obligations, for payment of its asbestos liabilities. The Third Circuit deemed the payment rights to be binding and sufficient to compensate the asbestos liabilities LTL faces—thereby demonstrating that LTL was not in financial distress when it filed its petition. It is difficult to square that conclusion with any suggestion that LTL did not receive reasonably equivalent value for the asbestos obligations it inherited through the divisive merger.
One of the obvious takeaways from the Third Circuit’s opinion is that the J&J/LTL combination was a bad set of facts. J&J was not only solvent, it was unquestionably solvent, and it put its full weight behind LTL. That doesn’t mean a two-step isn’t a viable option for a less well-heeled, though still cash-rich, company. Indeed, the relative benefits of carving the operating business out of bankruptcy are obvious. When a company is facing bankruptcy due to mass tort issues, it may have no operating issue that bankruptcy could help.
Even where a parent company has no immediate financial distress, the Third Circuit explicitly noted that the financial distress was to be measured as to the debtor, not its parent companies. J&J potentially could have avoided the Third Circuit’s dismissal order if it had more carefully tailored the funding agreement. From a bankruptcy perspective, most tort claims are contingent, unliquidated claims. A company considering a two-step could put a NewCo into bankruptcy along with a funding agreement that agrees to fund the current and future claims based on a rigorous estimation of those claims. This would necessitate an exacting pre-bankruptcy analysis of the claims sufficient to overcome any challenges that the transfer was fraudulent.
Alternatively, the parent company could provide a commitment to fund claims in a bankruptcy based on an estimation conducted pursuant to § 502(c).Such a funding agreement could be capped or have other features, but such features might give rise to additional litigation. Courts have permitted estimation of tort claims in connection with confirmation of a plan.
Estimation has been a hotly contested issue in bankruptcy cases, and there are several economic firms that could readily provide this service to a prepetition debtor. Although any such estimation could be subject to challenge, that structure would eliminate the financial distress hurdle raised by the Third Circuit. The Bankruptcy Code does not explain how a court is supposed to estimate such claims when their value—or even existence—is contested.Garlock’s experts Although the estimate was a “projection,” the court concluded that As a result, the court held that The debtors in several pending bankruptcies (including Bestwall, DBMP, and Aldrich Pump) are all attempting to conduct an estimation of current and future claims along the lines of Garlock. If the funding agreement were contingent on the outcome of such an estimation, the court could be satisfied that the funding amount was sufficient to avoid any fraudulent conveyance concern and that the debtor was in financial distress.
Although the LTL decision has placed a considerable roadblock before LTL, the fundamental structure of a Texas two-step remains viable for the right companies or where a funding agreement more closely aligns with the actual liability faced.