Colloquially known as the Texas Two-Step, the contentious bankruptcy strategy faces an uncertain future following divergent rulings in the Third and Fourth Circuits. The practice has gained popularity following J&J’s use of the Two-Step to avoid tort liability for the devastating effects of talc powder on thousands of claimants.[1] The Texas Two Step requires a two-part process: First, a company or corporation restructures using the divisive merger statute under Texas law. This law allows companies to legally undergo a merger, while dividing into two or more entities. Following the merger, the assets of the original company may be divided between the entities, with legal liability going to one, and debt to the other. Second, the newly formed entity that holds the liability of the original company goes into Chapter 11 proceedings which halts litigation, and, through a channeling injunction, can get third party releases that releases the claims of non-debtors who would otherwise bring costly suits.[2]
The process is possible under Texas law which considers divisive mergers (a company separating into two or more entities) and mergers of companies, legally similar. Under Texas law, dividing entity may allocate liabilities and obligations between the two new entities according to the terms of its “plan of merger” filed with the Secretary of State.[3] Following the divisive merger, each entity is only liable for the allocated debt or obligation.[4]
Currently, Texas is the only state besides Delaware that permits divisive mergers, and many lawyers are hesitant to employ the practice in chapter 11 bankruptcies because it’s not clear if the practice is even legal.[5] Other states consider transactions dividing entities in this manner to constitute a fraudulent transfer which can be avoided by a bankruptcy court.[6] However, under Texas Law, a merger can occur “without any transfer having occurred”. [7]
In the case of J&J, the company faced numerous lawsuits based on the allegation that there were trace amounts of cancer-causing asbestos in the talc used in its baby power formula.[8] Consumers suffering from mesothelioma and ovarian cancer brought lawsuits against J&J and Old Consumer (a wholly owned subsidiary of J&J). Old Consumer employed the divisive merger to divide itself into two new entities.[9] One, New Consumer, holds all the debts of Old Consumer. The Second, LTL Management LLC (LTL), holds all the liabilities of Old Consumer. J&J agreed to provide LTL with funding under the “LTL Funding Agreement” which would cover the cost of LTL’s liabilities.[10] After the restructuring made possible by Texas business law, LTL filed for relief under chapter 11 of the bankruptcy code in North Carolina. The case was later transferred to New Jersey and appealed to the Third Circuit.
On appeal, the Third Circuit dismissed the bankruptcy petition under section 1112(b), finding that the petition was not filed in good faith.[11] Good faith requires that the petition be filed for a valid bankruptcy purpose and not to gain a litigation advantage. LTL’s access to resources via the LTL Fund Agreement rendered its claims of insolvency moot. Because the entity filing for bankruptcy is considered independently, LTL’s assets were considered independently of Old Consumer of J&J. Because it had adequate resources through the Fund Agreement, the filing was held to be in bad faith. This ruling does not come as the big win that critics of the process would like, however, because it still leaves open the possibility that, were the entity filing for reorganization under chapter 11 in financial distress without access to a pool of resources as large as J&J, the procedure itself might not be an issue.[12] The Third Circuit admitted as much in its ruling, still, it denied the petition to rehear the case en banc, which may result in an appeal to the Supreme Court.
Conversely, the bankruptcy court for the Western District of North Carolina, which is in the Fourth Circuit, applied a much more stringent test in determining what constitutes bad faith filings. In North Carolina, a filing is not considered to be in bad faith unless the plan is (1) objectively futile and (2) filed in subjective bad faith.[13] Because of North Carolina’s extremely high bar for getting a case dismissed as bad faith, it is where all the Texas Two Step cases have been brought, despite the entities having minimal contacts in the state. The bankruptcy judge in North Carolina did not take issue with the available funds through J&J’s trust, rather, they applauded the feasibility of the plan and confirmed the plan on the grounds that there was real hope for rehabilitation.[14] Under § 524(g), the plan for reorganization was valid and therefore, the debtor had a realistic chance to reorganize which was sufficient to pass muster under the Fourth Circuit standards. [15]
Importantly, neither court rejected the practice outright, and its legality is still in question under Texas law. With competing standards between circuits and the potential for appeal to the Supreme Court, the Texas Two Step faces an uncertain future. Claimants continue to win in court against J&J but cannot collect on the millions awarded by juries while the bankruptcy is underway.[16] Many lawyers are hesitant to advise clients to employ the Texas Two Step, given its uncertain future and ongoing legal concerns.[17] Critics claim it is simply a bad faith attempt to avoid tort liability. While the Texas Supreme Court has not ruled on the issue, two circuits have weighed in regarding whether the practice evidences a bad faith bankruptcy filing with opposite results.[18] While North Carolina will likely remain the favored venue for debtors utilizing Texas law in this way, commercial debtors may need to consider the Third Circuit’s requirement that they be in actual financial distress to avoid a bad faith dismissal.
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[1] https://news.bloomberglaw.com/bankruptcy-law/j-j-bankruptcy-ruling-undercuts-central-move-in-texas-two-step
[2] https://www.nortonrosefulbright.com/en-us/knowledge/publications/c1a2664a/the-fate-of-texas-two-step-in-the-us-dealt-setback-in-appellate-ruling
[3] Id.
[4] Id.
[5] Scherbeh, Jamie M., The Texas Two-Step: How Divisive Mergers turn Plaintiffs’ Litigation Into a Nationwide Honkytonk. Tex. L. R. Vol. 41 at 279 (2022).
[6] Id.
[7] Tex. Bus. Orgs. § 10.008(a)(2)
[8] https://news.bloomberglaw.com/bankruptcy-law/j-j-jurys-cancer-verdict-adds-new-wrinkle-to-bankruptcy-vote
[9] https://www.nortonrosefulbright.com/en-us/knowledge/publications/c1a2664a/the-fate-of-texas-two-step-in-the-us-dealt-setback-in-appellate-ruling
[10] https://www.abajournal.com/news/article/jj-tries-once-again-to-settle-talc-claims-through-texas-two-step-bankruptcy
[11] In re LTL Management
[12] https://www.nortonrosefulbright.com/en-us/knowledge/publications/c1a2664a/the-fate-of-texas-two-step-in-the-us-dealt-setback-in-appellate-ruling
[13] In re Dunes Hotel Assoc., 188 B.R. 162 (Bankr. D.S.C. 1995).
[14] In re Bestwall
[15] Id.
[16] https://news.bloomberglaw.com/bankruptcy-law/j-j-jurys-cancer-verdict-adds-new-wrinkle-to-bankruptcy-vote
[17] Supra n. 3
[18] Supra n. 3.