See a related update, published Feb. 16, 2023.
In re LTL Mgmt. LLC, No. 21-30589 (MBK) [Docket No. 1572] (Bankr. D.N.J. 2021)
Other than being a dance, what is the Texas Two-Step, in terms of corporate mergers?
The “Texas Two-Step” has proved to be a lifeline allowing companies to form in such a way that protects assets from bankruptcy claims. Take for example Johnson & Johnson (“J&J”), which is facing “Talc Litigation” throughout the country. In Texas, the “Two-Step” allows J&J and other companies facing mass tort litigation to protect vital assets and transfer the liabilities to a newly-created entity, all of which is permitted in the divisive merger statute in the Texas Business Organizations Code.
The “Divisive Merger”
So, how does it work? First, a Texas entity is created and then it undertakes a “divisive merger” that splits that company into two companies. One company is created whereby it will receive the liabilities, along with limited assets available for tort victims, while protecting the significant assets of the other company. Though this would typically be a fraudulent transfer, Texas law makes it legal. The company with the liabilities then files for bankruptcy, and the other company is hopeful to be released from all claims against it.
So, this is exactly what happened when J&J undertook a divisive merger and filed for bankruptcy solely for the company with the liabilities. Two entities were created: Johnson & Johnson’s Consumer Health (“JJCH”), which retained the assets, and LTL Management, LLC (“LTL”), which held the mass tort/talc liabilities.
The victims’ attorneys filed a motion to dismiss. They argued that the bankruptcy was filed for an improper purpose. They argued that J&J utilized the bankruptcy system as a litigation strategy to address its talc-related litigation liabilities by first creating the entity holding the liabilities, LTL, hours before filing bankruptcy to halt all litigation — for the benefit of its solvent operating parent and affiliated entities, as well as certain third parties, without such entities filing for Chapter 11. They further argued that there was no business purpose to LTL. It had virtually no employees, it had no trade creditors, lenders, bondholders, customers, suppliers, vendors, landlords, tax creditors, etc. and was created solely for the purpose of delay and so that LTI could pay the mass tort claimants pennies on the dollar in the event LTL was able to obtain bankruptcy court approval to settle the claims either through a plan or via a stand-alone order.
LTL admitted that the “Texas Two-Step” was undertaken to deal with the mass tort litigation under one forum as opposed to dealing with numerous lawsuits throughout the country. In fact, the claimants’ expert admitted that the use of the Texas Two-Step and subsequent bankruptcy filing by LTL, was designed to allow the entity with the assets to continue to operate JJCH’s business without the threat of the lawsuits, and to provide LTL with a process to settle all current and future claims in an equitable and efficient manner.
Bankruptcy Court’s Finding
The bankruptcy court denied the motion to dismiss finding that filing bankruptcy with the purpose of addressing liabilities related to personal injury claims to preserve corporate value is permissible. In fact, the bankruptcy court noted that the board had a fiduciary duty to protect the company’s assets. Further, the bankruptcy court found the Texas Two-Step did not necessarily release JJCH from liabilities or that their assets were placed out of reach of creditors without a negotiated settlement under a plan of reorganization in which the negotiated settlement could be funded by JJCH and its related entities in consideration of a release.
The bankruptcy court went on to state that the bankruptcy system is far superior to continued litigation in state and federal courts and at the end may be in the best interests of the claimants. In this regard, the bankruptcy court noted it was a court of equity and as such was far better suited to resolve all the claims as opposed to litigating tens of thousands of mass torts claims. It further stated, “Debtor’s efforts to address the financially draining mass tort exposure through a bankruptcy is wholly consistent with the aims of the Bankruptcy Code.”
Finally, the bankruptcy court found the use of the Texas Two-Step was not an abusive or unfair litigation strategy justifying dismissal of the case for bad faith as there was nothing inherently unlawful or improper employing Texas Two Step scheme for one of the entities to file bankruptcy.
So, the “Texas Two-Step” is alive and well. The takeaway from this well thought-out opinion is that, yes, in the exercise of a board’s fiduciary duty, it can split an entity into an entity that holds mass tort liabilities with limited assets and another entity that holds the operating assets; all for the purpose of resolving mass tort litigation. Yet, the company holding the assets will not necessarily be absolved of the liability as it will still be required to contribute sufficient assets to settle mass tort lawsuits while continuing operations without the threat of demise. More to follow as this was a victory to avoid dismissal. Now the hard part: settling the mass tort litigation.