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Remember the Texas Two-Step?  Well, it is alive and well, but lessons can be learned from the dismissal of the LTL Management, LLC bankruptcy.

 

Background

(Bill Siegel first discussed this J&J litigation, the “Texas Two-Step,” and how a divisive merger is created – in his April 2022 article.)

Johnson & Johnson Consumer Inc. (“Old Consumer”), a wholly-owned subsidiary of Johnson & Johnson (“J&J”) sold health products including Baby Powder with a talc base. By 2021, J&J was facing more than 38,000 talc lawsuits. Due to mounting legal costs and in some cases judgments being entered, Old Consumer (through a series of intercompany transactions primarily under Texas state law) split into two new entities. There was a) LTL, which primarily held Old Consumer’s liabilities relating to the talc litigation, did not conduct any business, and was the recipient of a funding support agreement from its corporate parents, and b) J&J, consisting of $6 million in cash and a portfolio of royalty streams derived from consumer brands — valued by LTL at approximately $367 million. In addition, the right to receive payments under the Funding Agreement could not drop below a floor defined as the value of New Consumer (referred to below) measured on the date of the divisive merger. This value was estimated by LTL to be $61.5 billion and was subject to increase as the value of New Consumer increased after the reorganization.

 

Divisive Merger and the Texas Two-Step

Having created LTL to hold the talc debt, J&J next created Johnson & Johnson Consumer Inc. (“New Consumer”), which held almost all of the profitable business assets previously held by Old Consumer. The goal was obvious. J&J intended to create a new subsidiary that would hold all talc liabilities for the purpose of filing a Chapter 11 — without adversely affecting Old Consumer’s profitable business. This intercompany reorganization is what is known as a divisive merger and if done in Texas, is known as the “Texas Two-Step” under the Texas Business Organizations Code.

Almost immediately after filing bankruptcy, certain talc claimants filed a motion to dismiss. The Bankruptcy Court denied the motion and permitted the talc claimants to appeal directly to the Third Circuit Court of Appeals as opposed to appealing it to the district court.

 

The Third Circuit Considers “Financial Distress”

On direct appeal, the Third Circuit reversed the bankruptcy court and directed that the LTL case be dismissed.

In summary, the Third Circuit held that “resorting to Chapter 11 is appropriate only for entities facing financial distress.” From there, the Third Circuit found that LTL did not qualify as a debtor in possession in light of the funding agreement. It had a $61.5 billion backstop from New Consumer and from the J&J parent. Further, parent J&J has $400 billion in equity value, a AAA credit rating, plus $31 billion in cash and marketable securities. Plus, shareholders had received $13 billion in 2020 and 2021.

As to the lawsuits filed, 20 plaintiffs had been awarded $2.24 billion and of the 38 completed trials, fewer than half the plaintiffs received monetary awards. In those cases where J&J didn’t win and that were not reversed on appeal, the average award was $39.7 million. Before bankruptcy, the companies had spent about $4.5 billion on verdicts, settlements, and litigation expenses. In a statement to its auditors, J&J estimated that the companies’ probable liabilities for tort claims were $2.4 billion for the succeeding two years.

In its analysis, the Third Circuit noted that the relevant inquiries were (a) whether there was a valid bankruptcy purpose, and (b) whether the filing was merely for tactical litigation advantage. Yet, it appears that the Third Circuit avoided the issue of whether the filing was a litigation tactic and instead focused on whether there was “valid bankruptcy purpose.” In this regard, the Third Circuit focused on whether LTL was under “financial distress.” If LTL was not under financial distress, then the Chapter 11 filing was not filed in “good faith.” A lack of good faith constitutes cause for dismissal under Section 1112(b) of the Bankruptcy Code and from there the court can conclude there was no valid purpose for filing Chapter 11.

 

Insolvency Does Not Equal Financial Distress

The mere fact that LTL was insolvent did not necessarily constitute financial distress. Here, the Third Circuit focused on the funding agreement that “gave LTL direct access to J&J’s exceptionally strong balance sheet,” i.e., $400 billion in equity value and $31 billion in cash and marketable securities. Further, LTL had the ability to enter into “meaningful settlements” and had experienced some success in defense at the trial stage. “Because LTL was not in financial distress,” the Third Circuit held that “it cannot show its petition served a valid bankruptcy purpose and was filed in good faith under Code § 1112(b).” The Third Circuit further found that there were no “unusual circumstances” under section 1112(b)(2) to avert dismissal.

 

The Texas Two-Step is Alive and Well

Notwithstanding the dismissal of the LTL bankruptcy, the Texas Two-Step appears to be alive and well.

Of note, the Third Circuit did not disapprove the “Texas Two-Step” transaction. In fact, the Third Circuit assumed its very existence and the adequacy of the first step of the divisive merger in terms isolating the debts in a newly created entity. Moreover, it did not address potential fraudulent transfer claims other than mentioning that potential claims may exist if the funding agreement was terminated. Also, it did not attack the concept of a divisive merger under the Texas Business Organizations Code in terms of isolating liabilities to the detriment of creditors and creating another entity to hold the assets and operate as a going and profitable concern..

At the end of the day, if a company enters into a divisive merger and then files the debt-ridden entity into Chapter 11, it appears the focus will be on the facts and circumstances of the divisive merger and the viability of the entity holding all the debt. The mere fact that a divisive merger took place should not be an issue. In addition, the existence of whether fraudulent transfers exist may not be a concern as well.

ABOUT THE AUTHOR:

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William L. (Bill) Siegel is a Shareholder and Section Head of the Cowles and Thompson Bankruptcy and Creditors’ Rights Practice Group as well as a member of the Corporate and Business Practice Group.