J&J Bankruptcy Ruling Knocks Money Deal in ‘Texas Two-Step’ (1)

The Third Circuit’s decision to create a new “financial distress” standard for bankruptcy eligibility creates legal uncertainty for profitable companies eyeing Chapter 11 to head off mass tort liability.

A US Court of Appeals for the Third Circuit panel ruled Monday that Johnson & Johnson unit LTL Management LLC wasn’t in financial distress when it filed for bankruptcy because of a funding agreement it had with J&J that allowed it payment rights to the tune of $61.5 billion. A unanimous three-judge panel rejected the bankruptcy bid.

The decision has upended J&J’s attempt to consolidate and resolve more than 40,000 lawsuits alleging that its baby powder and other talc-containing products caused cancer without jury trials or other civil court proceedings. The company created LTL and transferred the talc liability to it. LTL then filed for Chapter 11 protection, in a move known as the Texas Two-Step.

The decision is a blow to the controversial technique, because the Third Circuit undercut the funding agreement between J&J and LTL, which is a key element of the Texas Two-Step strategy. But the court also left the door open for what it called “creative crafting” to pass the distress test.

“There’s no undoing it for this case, but the question is ‘what if anything can work?’” said University of Georgia law professor Lindsey Simon. “Will this opinion just drive the next layer of creativity?”

‘Catch-22'

The Third Circuit found that J&J’s agreement to fund LTL’s liabilities made J&J the subsidiary’s ultimate financial safeguard. That funding backstop was “not unlike an ATM disguised as a contract,” the court said. The agreement undercut arguments that LTL was truly insolvent, the court said.

The funding agreement was meant to guarantee that a trust set up to compensate victims can receive adequate money to pay claims, while also attempting to avoid fraudulent conveyance claims.

Without funding agreements, it’s unclear if strategies like the Texas Two-Step can exist, according to Samir Parikh, a bankruptcy law professor at Lewis & Clark Law School.

“The strong financial backstop that moots a fraudulent transfer claim also makes the debtor appear to lack financial distress. It’s a little bit of a catch-22,” Parikh said.

The Texas Two-Step maneuver involves a company spinning off a unit and transferring its tort liability to that unit, usually via a Texas corporate law that allows so-called divisional mergers. The spinoff is then put into bankruptcy to manage that liability without putting the assets of the original company into play.

Financial Distress

While the opinion was cheered on by tort claimants, bankruptcy experts say it also leaves big questions in its wake.

The opinion implies that Texas Two-Step maneuvers can be used for insolvent subsidiaries but aren’t permissible for solvent subsidiaries where there is enough money to pay claims in full, said Anthony Casey, a business and corporate bankruptcy professor at the University of Chicago Law School.

“To me that is a rule that gets things backwards,” Casey said.

While the opinion makes the Third Circuit a less attractive venue to bring Texas Two-Step cases, corporations were already gravitating to a different courthouse. LTL’s case was moved from the Western District of North Carolina’s bankruptcy court to New Jersey in November 2021 over the company’s objections.

The bankruptcy court in Charlotte, N.C., which follows more debtor-friendly precedent set by the US Court of Appeals for the Fourth Circuit, is likely to remain a magnet for such cases. Companies want a jurisdiction that allows broad litigation releases and “solvent filings,” Casey said.

He noted that the opinion’s “financial distress” requirement for solvency is new, but may not be viewed as a direct split with any other ruling that would make it ripe for US Supreme Court review.

The court’s financial distress requirement is “likely to lead to one of two bad outcomes,” including increased litigation costs as courts attempt to determine “financial distress” for each individual case, Casey said. Courts may interpret it as an insolvency requirement, which would be “akin to requiring someone to wait until their house has burned down before they call the fire department,” he said.

Still, the Third Circuit’s opinion leaves open the “theoretical opportunity” for a company to fund an agreement enough to avoid a fraudulent transfer challenge while ensuring that the bankrupt unit remains in financial distress, said Negisa Balluku, a Bloomberg Intelligence litigation analyst.

But that won’t be easy, she said.

“Balancing those two considerations via a Texas Two-Step would be difficult, if even possible,” Balluku said.

Still Stepping

Several Texas-Two Step mass tort asbestos bankruptcies that pre-date LTL’s bankruptcy are alive and pending in the US Bankruptcy Court for the Western District of North Carolina. That district has become attractive for such cases, including subsidiaries of major manufacturers like Georgia-Pacific LLC and Trane Technologies PLC.

The Third Circuit’s opinion isn’t binding in North Carolina or the Fourth Circuit. But it’s influence may still be felt.

Some of the bankruptcies winding through North Carolina bear similar hallmarks as the LTL case. Paper product maker Georgia-Pacific placed its Bestwall LLC unit into bankruptcy more than five years ago to limit asbestos liabilities. The case is ongoing, but Georgia-Pacific, which has not filed for bankruptcy, disclosed in court papers earlier this month that it’s paid out roughly $5.39 billion to its own parent, Koch Industries Inc., since Bestwall filed for Chapter 11.

And even in the Fourth District, certain elements of the Texas Two-Step strategy face uncertainty.

The Fourth Circuit recently heard arguments over whether Georgia-Pacific should be protected against ongoing asbestos litigation while Bestwall works through bankruptcy. Separately, a motion to dismiss the case brought by a tort claimants committee is pending in the federal district court.

Last year, a North Carolina bankruptcy judge called the Texas Two-Step into question, allowing a group of asbestos victims to continue a lawsuit seeking to undermine a reverse merger in a strategy called a “substantive consolidation.”

Charles Tatelbaum, a lawyer who specializes in business-restructuring cases, said that businesses facing mass tort liability in bankruptcy in Western North Carolina may continue to move forward with their cases. More companies could even decide to file there in the future, he said. But the risks have increased with Third Circuit’s opinion, he said.

“If I’m advising a company,” Tatelbaum said, “am I going to want to risk being thrown out by adopting the strategy?”

The case is In re: LTL Management LLC, 3d Cir., No. 22-02003, opinion 1/30/23.