The Texas Two-Step
Introduction and Background on the Texas Statute
In January 2023, the Third Circuit issued an opinion directing the US Bankruptcy Court to dismiss the Chapter 11 bankruptcy filing of LTL Management, LLC, a subsidiary of Johnson and Johnson (J&J). J&J attempted to employ the “Texas Two-Step” bankruptcy maneuver by transferring tens of thousands of talc-related personal injury lawsuits to their newly created subsidiary, LTL Management, so that the legal disputes could be addressed more forgivingly in bankruptcy court. A successful Texas Two-Step process allows corporations to manage mass tort liabilities such as the personal injury lawsuits challenging J&J today. To complete the maneuver, two key steps must be performed under two separate legal statutes––a Texas divisional merger followed by a Chapter 11 bankruptcy filing––giving rise to the “Texas Two-Step” name.
Typically, a corporate merger involves the fusion of two companies into one legal entity. However, The Texas Business Organizations Code (TBOC) defines a unique feature of mergers that goes beyond the typical definition. TBOC § 1.002(55) states that a “Merger” can mean “(A) the division of a domestic entity into two or more new domestic entities or other organizations or into a surviving domestic entity and one or more new domestic or foreign entities or non-code organizations” [1]. This idiosyncrasy of the statute gives rise to the divisional merger, where companies incorporated in Texas can divide themselves into multiple new entities.
Why would a company facing mass tort liabilities be incentivized to use this approach in the first place? The typical Texas Two-Step process involves companies reincorporating themselves in Texas, gathering and isolating their tort liabilities to a new entity, and subsequently using the divisional merger law to split off the new entity from the rest of the business. The split-off entity, riddled with liabilities, can then file for Chapter 11 bankruptcy. Typically, this brings two main benefits to companies: (1) They can deal more favorably with their tort liabilities through the bankruptcy process instead of numerous jury trials, avoiding potentially large jury verdicts, and (2) The original, liability-free entity can operate without its burden of tort liabilities, effectively shielding its assets from tort claims.
However, the legal maneuver is not without controversies. While ostensibly preserving business viability, the Texas Two-Step offers a legal loophole that undermines the ethical principles of corporate accountability and threatens the pursuit of legal justice for plaintiffs. The strategy not only exploits the bankruptcy system’s protections, but also sets a concerning precedent for corporate conduct that impacts the integrity of legal and ethical standards in handling tort liabilities.
How the J&J Case Sets the Precedent: Financial Distress and Good Faith
The US Bankruptcy statute does not actually require a company to be in financial distress when filing a Chapter 11 petition. In fact, 11 U.S. Code § 301 merely states that “A voluntary case under a chapter of this title is commenced by the filing with the bankruptcy court of a petition under such chapter by an entity that may be a debtor under such chapter” [2]. Indeed, the Texas Two-Step enables companies to file for bankruptcy when they are not in distress. In fact, the opposite is typically true; some of the largest companies with the markers of financial strength (revenue growth, billions of dollars in assets, low future financial risks) have exploited the process to evade lawsuits over tort liabilities. However, when filing for Chapter 11 bankruptcy, section 1129(a)(3) of the Bankruptcy Code mandates that “the plan has been proposed in good faith and not by any means forbidden by law.” The exact definition of “good faith” has been debated upon, and interpretations of the language have often determined whether bankruptcy cases proceed. As stated in the opinion of carbon product manufacturing company SGL Carbon’s Chapter 11 petition, whether a bankruptcy petition falls under the category of good faith requires an “intensive inquiry determining where [petitions] fall along the spectrum ranging from the clearly acceptable to the patently abusive” [3].
One key consideration of whether a company’s filing is in good faith is if the company is facing financial distress. In the Third Circuit’s opinion on LTL Management, the Court refers to J&J’s lack of financial distress as an indicator of a patently abusive filing: “Our precedents show a debtor who does not suffer from financial distress cannot demonstrate its Chapter 11 petition serves a valid bankruptcy purpose supporting good faith” [4]. The Court cited the SGL Carbon case, where they “rejected arguments that the suits seriously threatened the company and could force it out of business, suggesting the magnitude of potential liability would not likely render it insolvent” [5], as well as the Integrated Telecom case, where the debtor was “highly solvent and cash rich at the time of the bankruptcy” [6].
LTL was not a company in true financial or operational distress; instead, that distress was artificially created for the sole purpose of exploiting the bankruptcy courts and the protections of the Chapter 11 process. LTL’s bankruptcy petition required J&J to “enter a financing agreement with LTL, promising to cover any talc and bankruptcy-related expenses up to $61.5 billion” [7]. The Third Circuit cited this financing agreement as the key reason for LTL’s solvency, stating that “the Agreement provided LTL a right to cash that was very valuable, likely to grow, and minimally conditional. And this right was reliable, as J&J and New Consumer were highly creditworthy counterparties (an understatement) with the capacity to satisfy it” [8]. Additionally, without the talc costs, J&J’s consumer health business showed healthy revenue and adjusted income trends, indicating no significant future detrimental effects caused by the liabilities. Its balance sheet was also very strong at the time; with over $400 billion in equity value, J&J had more than ample proceeds for LTL’s obligations [9]. J&J’s continued operations and financial ability to support its subsidiary suggests that their declaration of Chapter 11 bankruptcy leaned heavily towards a “patently abusive” filing.
The precedent for the Texas Two-Step established by the Third Circuit should extend further than J&J’s case. Because of its onerous financial and legal challenges, only large corporations have the means to pursue the maneuver and provide financial backing to their liability-saddled subsidiaries. This limitation guarantees that future cases will involve large corporations that are financially solvent even if their engineered subsidiaries through the divisional merger are not. If the J&J precedent holds, similar Texas-Two Step attempts can be dismissed.
Beyond Good Faith: Ethics, Litigation Advantages, and Asymmetry of Power
The ethics of the J&J case extend beyond a “good faith” issue of whether solvent debtors can file for bankruptcy; the Texas Two-Step maneuver raises a broader ethical question of litigation advantages and creditor fairness. The Texas Two-Step enables large corporations to gain a litigation advantage over their creditors while incurring minimal risk, at a detriment to fair competition and at the expense of smaller corporations unable to pursue the maneuver. Typically, companies dealing with mass torts can either pursue traditional Chapter 11 bankruptcy or employ options outside the bankruptcy context such as case-by-case litigation, multi-claimant class action litigation, or negotiated settlement” [10]. Each has its costs and benefits, but the Texas Two-Step encourages corporations to subvert legal frameworks meant to hold companies accountable for their legal obligations by stripping tort liabilities away from the company. By moving liabilities to a new and separate entity eligible for bankruptcy protection, financial resources to satisfy claims are further restricted, and the creditors’ ability to receive full compensation becomes limited.
Large corporations (more than $1 billion in annual revenue) disproportionately wield the power to pursue such a maneuver, creating a cyclical power structure where large corporations only gain more advantages over smaller businesses unable to pursue the Texas Two-Step. Large corporations uniquely have the financial resources and legal infrastructure to navigate the more complex legal and financial processes required to complete the Texas Two-Step maneuver. In 2022 alone, J&J’s talc-related legal expenses were $3.9 billion, an easily financed cost when compared to J&J’s $95 billion in sales that year.[11] However, such costs present a significant obstacle to any company with less than $1 billion in annual revenue, preventing smaller companies from pursuing the Texas Two-Step. Smaller companies must instead choose between two unfavorable situations: (1) filing for Chapter 11 bankruptcy without the divisional merger, which will often lead to a long bankruptcy process that can damage public perception and company relationships, or (2) individually litigating the liabilities, which could potentially span a longer period and drain company cash flow.
Maneuvers like the Texas Two-Step often attract public and legal scrutiny, and large corporations have a greater ability to withstand this, another unfair advantage of the maneuver unable to be reaped by smaller businesses. The aforementioned analysis demonstrates how large companies are more likely to have the legal and financial resources to combat scrutiny, including lengthy legal battles or negotiations with creditors, claimants, and regulatory bodies. Additionally, the brands of large corporations have staying power that afford large companies more protection than small companies. For example, despite public headlines scrutinizing J&J, the mission-critical nature of its products, diversified revenue, and sticky customers have caused revenues to grow 7.3% from the 4th quarter of 2022 to the 4th quarter of 2023.[12] Due to the benefits of the Texas Two-Step that are only reaped by large corporations, access to the maneuver allows these corporations to unfairly better position themselves when compared to peers.
Conclusion
The Texas Two-Step bankruptcy strategy, exemplified by the J&J / LTL Management case, reflects both the creative use of legal statutes to manage liabilities and the ethical considerations of doing so. Johnson and Johnson is not the only company currently attempting to use the Texas Two-Step to its advantage, but its case is setting a new precedent for the maneuver through the Third Circuit’s good faith analysis. If such precedence is followed, other similar ongoing cases, like those of Georgia-Pacific / Bestwall, Trane Technologies / Aldrich Pump, and CertainTeed / DMBP, should be closely scrutinized, further highlighting the need for balance between legitimate financial restructuring and the protection of creditors’ rights.
Bibliography
[1] Tex. Bus. Orgs. Code Ann. § 1.002, accessed March 21, 2024. https://statutes.capitol.texas.gov/Docs/BO/htm/BO.1.htm.
[2] 11 U.S. Code § 301, Legal Information Institute, accessed March 21, 2024. https://www.law.cornell.edu/uscode/text/11/301#:~:text=Chapter%209%20cases%20will%20be,are%20other%20title%2011%20cases.&text=Section%20301%20specifies%20the%20manner,which%20he%20wishes%20to%20proceed.
[3] In re SGL Carbon Corp., 200 F.3d 154 (3d Cir. 1999).
[4] In re LTL Mgmt., LLC, No. 22-2003, 2023 WL 1098189 (3d Cir. Jan. 30, 2023).
[5] No. 22-2003, 2023 WL 1098189 (3d Cir. Jan. 30, 2023).
[6] Ibid.
[7] Charlie Hu. “Court Rejects Johnson & Johnson’s Use of the “Texas Two-Step” to Tackle Baby Powder Liability.” The University of Chicago Business Law Review Online Edition (2023). Accessed March 21, 2024. https://businesslawreview.uchicago.edu/online-archive/court-rejects-johnson-johnsons-use-texas-two-step-tackle-baby-powder-liability
[8] No. 22-2003, 2023 WL 1098189 (3d Cir. Jan. 30, 2023).
[9] Ibid.
[10] Adam Paul et al. “Resolving Mass Tort Liability Through Bankruptcy.” 37th Annual Southeastern Bankruptcy Law Institute (2011). Accessed March 21, 2024. https://sbli-inc.org/archive/2011/documents/BB_Paul.pdf
[11] Johnson & Johnson and Subsidiaries. 2022 Annual Report. https://www.investor.jnj.com/files/doc_financials/2022/q4/Johnson-Johnson-4Q2022-Form-10-K.pdf.
[12] Johnson & Johnson and Subsidiaries. 2023 Fourth-Quarter Press Release & Supplemental Schedules. https://www.investor.jnj.com/files/doc_financials/2023/q4/4Q23-Press-Release_Final-_With-Guidance-_With-Attachments-1.pdf.