North Carolina Judges Are Shaping ‘Two-Step’ Bankruptcy Future

A Charlotte, N.C., bankruptcy court has taken a leading role in interpreting an increasingly controversial litigation maneuver, paving the way for potential clashes at higher venues—including the US Supreme Court.

Two judges on the US Bankruptcy Court for the Western District of North Carolina over the last six years have answered key questions about the legality of the Texas Two-Step, the legal strategy that Jones Day pioneered when Georgia-Pacific placed its subsidiary, Bestwall LLC, into Chapter 11 in 2017. The maneuver aims to curb liability stemming from claims brought by people who say they became ill from using asbestos-containing talc products, such as baby powder and plaster.

Lawyers and political leaders have debated whether the strategy—also pursued by Johnson & Johnson and Trane Technologies Plc—too easily lets companies off the hook for products that harm people. So far, no company has successfully gotten a Chapter 11 restructuring plan approved via the maneuver, and creditors frequently push to get the bankruptcies dismissed. But companies using the strategy aren’t giving up: J&J appears likely to try it for a third time.

Judges in Charlotte have issued at least half a dozen decisions about central elements of the Texas Two-Step, and have on multiple occasions rejected motions by creditors to dismiss two-step bankruptcies. The judges have considered whether the liability transfer at the strategy’s core is fraudulent. They’ve ruled that the litigation stay applied to a bankrupt unit can be extended to a non-bankrupt parent. And they’ve decided that an entity can be in bankruptcy even if it isn’t necessarily financially distressed. The decisions have added up to a body of case law on the two-step that is unmatched by any other court in the country.

The handful of asbestos bankruptcies in Charlotte have allowed the court to take the leading role in developing the law around the two-step, Duke University bankruptcy law professor Jonathan Seymour said.

“It’s happening in some of these routine asbestos cases,” Seymour said. “And Charlotte is really the place.”

Whether the court’s influence is lasting rests on what happens at the US Court of Appeals for the Fourth Circuit, which the Charlotte judges have asked to take up two bankruptcy cases. If plaintiffs’ attorneys prevail in their latest efforts to get the Two-Step invalidated at the Fourth Circuit, the appeals court could suddenly be viewed as hostile to the tactic, leaving firms attempting the strategy on the hunt for a more favorable venue. If plaintiffs fail, it could set up a circuit split with the Third Circuit, emboldening them to take their effort to the Supreme Court.

“There’s going to be showdown depending on how the Fourth Circuit comes down,” asbestos attorney Mike Shepard, of Shepard O’Donnell PC, said.

Scope of Bankruptcy

Plaintiffs’ attorneys have attacked multiple bankruptcies filed by companies seeking to resolve their asbestos liability in Charlotte—all brought by Jones Day. Plaintiffs have labeled as fraudulent the transaction at the heart of CertainTeed LLC’s two-step attempt with unit DBMP. Plaintiffs allege they were exposed to asbestos in construction equipment CertainTeed made, such as cement pipes.

Plaintiffs have moved to dismiss Trane Technologies’ two-step attempt through its Aldrich Pump and Murray Boiler units. The plaintiffs say they were exposed to asbestos through components of Trane’s HVAC systems.

On three occasions, plaintiffs have tried—and failed—to dismiss the bankruptcy of Bestwall, a unit of Koch Industries-backed Georgia-Pacific, which they say made asbestos-containing drywall products that caused mesothelioma.

The core of opponents’ arguments is fairly simple: a company not in financial distress shouldn’t be able to take advantage of the benefits of bankruptcy.

“It does not appeal to a regular person’s sense of fairness,” said asbestos attorney Maura Kolb, of the Lanier Law Firm. “And our clients are regular people.”

The central case in many of these disputes is the Fourth Circuit’s 1989 decision in Carolin Corp. v. Miller, which established requirements for dismissing a case for lack of good faith—as plaintiffs’ attorneys want to do with Texas Two-Step cases. In Carolin, the Fourth Circuit determined “both objective futility and subjective bad faith be shown in order to warrant dismissals for want of good faith in filing.”

The court defined “objective futility” as “whether a reorganization is realistically possible.”

“I see this as a watershed moment for the bankruptcy courts,” Shepard, the plaintiffs’ attorney, said. “They either have to say the bankruptcy system is for companies that are financially distressed and that’s it—or we’re going to widen the scope of bankruptcy.”

After losing in Charlotte, two bankruptcies are headed to the Fourth Circuit to test what Carolin says about financial distress.

Plaintiffs holding asbestos claims in December lost their effort to toss Aldrich Pump’s and Murray Boiler’s Chapter 11 cases when Judge J. Craig Whitley determined they couldn’t be dismissed under Carolin because the bankruptcies weren’t objectively futile. By deciding Aldrich had a solid chance of reorganizing, Whitley didn’t have to rule on the second part of the Carolin test: whether the bankruptcy was subjectively filed in bad faith.

“While the Movants make a compelling argument that the objective futility prong should not apply in cases filed by solvent, nondistressed debtors,” it’s required by the Carolin test, Whitley wrote. “With the Carolin objective futility prong unmet, these cases may not be dismissed as ‘bad faith’ filings,” he said.

Appeal to Fourth Circuit

The two judges in Charlotte, Whitley and Judge Laura T. Beyer, have implored the Fourth Circuit to intervene since at least 2019, when Beyer certified a direct appeal asking the court to examine Carolin. The Fourth Circuit didn’t take it up.

Late last month, Beyer cleared the way for a similar appeal to go to the Fourth Circuit. She said she regretted that the court didn’t take up the issue in 2019.

“Judge Whitley and I have been clear about our desire for the Fourth Circuit to consider the good faith question in the context of these cases,” Beyer said from the bench.

In a December ruling in the Aldrich and Murray cases, Whitley hinted the Fourth Circuit should examine Carolin‘s applicability to two-steps. His ruling provided a discussion on how financial distress may play into bad faith “simply for the Fourth Circuit’s consideration.”

The plaintiffs fighting the Texas Two-Step did reach the Fourth Circuit last year on a non-Carolin matter, but the court ruled against them. Instead, the Fourth Circuit upheld a key component of the maneuver, ruling Beyer could allow Bestwall’s bankruptcy to also shield parent company Georgia-Pacific from asbestos litigation.

In a dissent, Judge Robert King said the two-step was a “manipulation of the bankruptcy code.”

Third Circuit Contrast

This time, plaintiffs want the Fourth Circuit to weigh in on companies’ need to be in financial distress if they use the Texas Two-Step.

“From our standpoint, all you have to do is read Carolin and apply the words in the order that they’re written,” Jonathan Ruckdeschel, of Ruckdeschel Law Firm, LLC, said.

But University of Chicago bankruptcy law professor Anthony Casey said it isn’t so clear. Carolin represents a tougher standard for dismissal than the Third Circuit’s, Casey said. The Third Circuit last year determined Johnson & Johnson affiliate LTL Management LLC couldn’t be in Chapter 11 because it wasn’t in financial distress.

LTL ended up in the Third Circuit after Whitley punted the case to New Jersey, concerned about the heavy burden on the two judges in Charlotte. Jones Day didn’t respond to a request for comment about its legal strategy.

The Fourth Circuit would risk overturning its own precedent if it rules in plaintiffs’ favor and against Bestwall, Casey said in an email.

“The court never requires financial distress, much less immediate financial distress,” Casey said. “This is in stark contrast to the Third Circuit requirement in LTL.”

Seymour, at Duke, said a Supreme Court fight could be on the table. The high court has in recent years taken up several bankruptcy cases, and will be ruling on at least two in the coming months.

“If the Fourth Circuit just says Carolin means exactly what the bankruptcy courts are saying it means, I think that becomes quite an attractive issue for the plaintiffs to try to take to the Supreme Court,” he said.