Boot-Scootin' to Financial Freedom: Texas Two-Step Bankruptcy Tactics
By: Howard Silverman
Recently, several corporations have used a relatively new strategy to shirk liability and streamline the bankruptcy process. This strategy is known as the “Texas Two-Step.” The first step is a corporate restructuring maneuver, in which a parent company can reorganize and split into two subsidiaries. This process is allowed under Texas Law in the Texas Business Organizations Code as a divisional or divisive merger. Under this Code, the dividing organization must develop and follow a plan for merger, which specifies the distribution of assets and liabilities and a filing with the secretary of state. In a divisional merger[CA1] where the dividing organization does not survive, all of the dividing organization’s “liabilities and obligations are allocated to one or more of the … new organizations [CA2] in the manner provided by the plan of merger.” Thus, if a company devises a plan for a divisional merger in which one of the new organizations retains certain liabilities or obligations, and the other new organization retains the business, the new liability-bearing organization is exclusively liable for those liabilities and obligations.
Once an organization does this, the first step of the Texas Two-Step is complete. In the second step, the liability-bearing organization files for Chapter 11 bankruptcy. Once bankruptcy is filed, the organization running the business and holding the assets is protected from all or most creditors because the liability has shifted to the liability-bearing organization. The liability-bearing organization is protected from all creditors because of the U.S. Bankruptcy Code’s automatic stay, which “places an immediate freeze on all adverse actions that creditors could take against the liability bearing organization.” Usually, debtors will seek an extension of the automatic stay or an independent preliminary injunction in order to extend the stay to the ultimate parent company.
In Re LTL[CA3] : The Most Recent Attempt of the Two-Step
The use of the Texas Two-Step is quite controversial. Companies like Johnson & Johnson (“J&J”) or Georgia-Pacific facing mass tort claims have used the Texas Two-Step to evade liabilities and decrease their settlements. However, this dance is not simple. Most recently, J&J has attempted and failed to use the Texas Two-Step. J&J is facing 40,000 tort claims due to the presence of talc, a toxic, cancerous chemical, used in their baby powder. J&J used the Texas Two-Step strategy to create two new entities: LTL Management, a company containing all talc-related liabilities and funding meant to settle talc-related claims, and J&J Consumer (“New Consumer”), a company containing the rest of J&J’s productive assets. Two days after this divisive merger, LTL Management (“LTL”) filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Western District of North Carolina, shielding them from liability. That court then transferred the case to the U.S. Bankruptcy Court for the District of New Jersey.
The talc claimants [CA4] moved to dismiss LTL's bankruptcy case, contending that LTL’s filing was conducted in bad faith and was merely a way to evade full liability. LTL argued that they implemented the Texas Two-Step to “produce an equitable resolution of both current and future talc claims by means of a settlement trust, established pursuant to § 105 or § 524(g) [of the Bankruptcy Code], that can promptly, efficiently, and fairly compensate claimants.” The bankruptcy court denied the claimant's motion to dismiss. The court held that LTL's filing served a valid bankruptcy purpose, and that LTL was in financial distress considering the costs of the talc litigation faced by J&J[CA5] . Highlighting the benefits of LTL’s filing in creating a trust for talc claims as opposed to mass tort litigation in court, the bankruptcy court cited to increased efficiency, balanced recoveries, and preservation of funds for future claimants in reaching its conclusion. The claimants appealed.
On appeal, on January 30, 2023, the U.S. Court of Appeals for the Third Circuit dismissed the case due to LTL’s funding agreement. Under Section 1112(b)[CA6] of the Bankruptcy Code, bankruptcy petitions are subject to dismissal unless filed with good faith. In analyzing whether a petition is filed in good faith, the Third Circuit raises two inquires: "(1) whether the petition serves a valid bankruptcy purpose[;] and (2) whether [it] is filed merely to obtain a tactical litigation advantage." A valid bankruptcy purpose assumes a debtor is in financial distress.
Third Circuit precedent provides that a debtor not in financial distress cannot show that its Chapter 11 petition serves a valid bankruptcy purpose supporting good faith. Therefore, without financial distress, the bankruptcy cannot survive. Financial distress, however, can look different for each organization that files for Chapter 11 bankruptcy. In this case, the court chose to study the debtor’s balance-sheet insolvency, insufficient cash flows to pay liabilities, and immediacy of financial distress.
The Third Circuit ultimately found that LTL was not in financial distress at its filing. Because of its funding agreement, including roughly $61.5 billion payment rights against J&J and New Consumer’s value to satisfy its talc-related costs, LTL was not in financial distress at the time of filing, and therefore, LTL’s petition did not serve a valid bankruptcy purpose. With this dismissal, the automatic stay was lifted, and 11,000 more lawsuits were filed, bringing J&J’s [CA7] estimated liability to $10 billion.
While In re LTL is the first bad faith dismissal of a Texas Two-Step, the Third Circuit dismissed the case based on the specific facts and circumstances of the LTL case, not the general legality or viability of the Texas Two-Step. Moreover, the court hinted at how LTL could fix their funding agreement to allow it to file for bankruptcy. Therefore, with this decision, companies could still conduct the Texas Two-Step, as long as they refrain from including a comparable funding agreement to LTL’s.
Why the Texas Two-Step Should Go
Two key critiques of the Texas Two-Step are that this maneuver is done in bad faith or is a fraudulent transfer. The Texas Two-Step essentially allows companies to evade mass torts and get a “discount” on their settlements.
Bad Faith
Most attempts to defeat the Texas Two-Step include an argument in bad faith. The Bankruptcy Code lacks a clear definition of good or bad faith. Two ways to bring a bad faith claim are through “new debtor syndrome” or “no bankruptcy-purpose filing.” New Debtor Syndrome occurs when an entity has distressed assets, no ongoing business operations, and was created just before filing. No bankruptcy-purpose filing occurs when a filing has a valid bankruptcy purpose or is used as a litigation tactic. Both claims are very similar to the structure and purpose of the Texas Two-Step. Companies are newly formed just with liabilities, days before bankruptcy filings, generally with the purpose of reaching a lesser settlement.
Fraudulent Transfer
Opponents could also argue that the Texas Two-Step is similar to a fraudulent transfer. Section 548 of the Bankruptcy Code[CA8] states that a trustee can avoid a transfer of an interest or obligations, if the debtor made such a transfer with an intent to hinder, delay, or defraud an entity to which the debtor was indebted and was insolvent on the date of the transfer. Here, by using the Texas Two-Step, the divisional merger creates a new organization by transfer of assets with the intent to file for bankruptcy to seek the protection of the automatic stay.
The main difficulty with this critique is that the Texas Business Organizations Code defines the divisional merger as a non-transfer. This contrasting definition, combined with the time and costs required to litigate a fraudulent transfer claim, deters creditors from using this argument. However, just because the divisional merger is technically not a transfer, does not mean that it is not a transfer, and this method could be used to fight the use of the Texas Two-Step.
Viability of the Texas Two-Step
Will the Texas Two-Step remain a viable option for companies facing mass torts? Creditors prefer pleading bad faith because in most cases, the company’s use of the Texas Two-Step is for bad faith purposes. The claim can be brought through a motion in the bankruptcy proceeding, as opposed to filing a separate suit. On the other hand, a fraudulent transfer claim requires a separate suit, and therefore more time and money. Even with many attempts at a bad faith claim, courts have consistently skirted the actual issue of the Texas Two-Step.
Outside of changing the Bankruptcy Code, the Texas Two-Step will likely remain a viable option, as courts may continue to single out debtor’s specific attempts at using it, instead of making a decision on the legality of the entire maneuver. If bad faith claims continue to only alter the pathway for the Texas Two-Step, plaintiffs should attempt to attack it through a fraudulent transfer claim, which would truly get at the center of the maneuver.