Introduction

Corporations looking to manage potential mass-tort liability via the Chapter 11 bankruptcy reorganization maneuver known as the “Texas Two-Step” have been dealt a major blow by a recent Third Circuit opinion, In re LTL Management, LLC.[1] The so-called Texas-Two Step is a corporate reorganization strategy that takes advantage of a quirk in Texas corporate law to assign potential liabilities to a new entity—notably separate from the profitable segments of the original company—with this new entity immediately seeking Chapter 11 bankruptcy reorganization to set up a non-litigation claims administration process, with the goal of separating the original company from continued litigation.[2]

LTL Management arose from the Johnson & Johnson talc mass-tort litigation, in which tens of thousands of claimants allege Johnson’s Baby Powder contained traces of asbestos, allegedly causing the claimants to develop ovarian cancer or mesothelioma.[3] After executing a maneuver similar to that described above (and specifically described in detail below), the U.S. Bankruptcy Court for the District of New Jersey entered an order staying the talc litigation, and denied motions by the claimants to dismiss the bankruptcy petition.[4] Reviewing this denial of the motions to dismiss, on January 30, 2023, a Third Circuit panel consisting of Circuit Judges Thomas L. Ambro, L. Felipe Restrepo, and Julio M. Fuentes unanimously reversed the bankruptcy court, thus rejecting Johnson & Johnson’s strategy.[5]

Factual & Procedural Background

Johnson & Johnson (“J&J”) began selling Johnson’s Baby Powder in 1894, and after various intercompany transactions over the decades, by the time period relevant to this litigation the product was ultimately being sold by a wholly owned subsidiary called Johnson & Johnson Consumer Inc., referred to in the LTL Management opinion as “Old Consumer.”[6]

In 2010 litigation began to arise alleging the talc in Johnson’s Baby Powder was contaminated with asbestos and causing mesothelioma, and this litigation accelerated in 2013 and 2016 with new allegations that the product was causing ovarian cancer.[7] The pace of lawsuit filings increased further after publication of reports from the U.S. Food & Drug Administration and Health Canada respectively confirming trace amounts of asbestos in the baby powder and confirming the link with ovarian cancer, and by the time the corporate restructuring and bankruptcy proceedings at issue in LTL Management were initiated in 2021, over 38,000 claims were proceeding against J&J and Old Consumer.[8] At this point Old Consumer had already paid out approximately $3.5 billion in verdicts and settlements, and incurred nearly $1 billion in defense costs.[9] Nonetheless, Old Consumer still had an estimated corporate worth of $61.5 billion, and continued to control a large number of profitable products and brands.[10]

The corporate reorganization and bankruptcy plan at issue in LTL Management commenced on October 12, 2021, taking advantage of a provision of Texas corporate law providing for a type of corporate merger that counterintuitively results in the formation of two new corporate entities and the termination of the existence of the original entity, with the assets and liabilities of the original entity able to be freely allocated among the two new entities.[11] This is the first stage of so-called “Texas Two-Step.”[12]

In this case, the merger process resulted in two entirely new corporate entities, LTL Management LLC (“LTL”) and Johnson & Johnson Consumer Inc. (“New Consumer”).[13] Critically, essentially all potential liabilities relating to the talc litigation were allocated to LTL, and the continuing and profitable product lines were allocated to New Consumer.[14] Additionally, LTL was allocated rights under a funding agreement that obligated J&J and New Consumer to fund a trust for the settlement of talc claims with a minimum value based on the estimated value of New Consumer, $61.5 billion.[15]

Two days later, on October 14, 2021, LTL executed the second stage of the Texas Two-Step by filing a petition for Chapter 11 bankruptcy reorganization in the Bankruptcy Court for the Western District of North Carolina (LTL had in the intervening two days been converted into a North Carolina LLC), and sought to extend the automatic bankruptcy stay as to the pending talc litigation in addition to seeking a preliminary injunction enjoining all such claims.[16] A month later, however, this bankruptcy proceeding was transferred to the Bankruptcy Court for the District of New Jersey.[17] (The North Carolina court indicated LTL had attempted to “manufacture venue” to take advantage of a more demanding standard for the dismissal of a bankruptcy petition under Fourth Circuit precedent.[18])

At this point, a number of groups of talc plaintiffs moved in the New Jersey court to dismiss LTL’s bankruptcy petition, arguing it was not filed in good faith.[19] After a five-day trial these motions were denied by the bankruptcy court and the injunction sought by LTL was granted.[20] The orders were then certified for direct appeal and authorized for same by the Third Circuit.[21]

Ultimately, the Third Circuit reversed the bankruptcy court, and held LTL’s bankruptcy petition should be dismissed.

The Court’s Reasoning

LTL Management commenced its reasoning by examining whether the Chapter 11 petition at issue was filed in good faith, and whether financial distress is required to establish good faith.[22] The bankruptcy code provides for the dismissal of a Chapter 11 petition for “cause,” and although lack of good faith is not explicitly mentioned in the code, courts have found it to constitute such cause based on the fundamentally equitable nature of bankruptcy.[23] In assessing a lack a of good cause, a court inquires into “whether the petition serves a valid bankruptcy purposes, and “whether it is filed merely to obtain a tactical litigation advantage”; valid bankruptcy purposes include “preserving a going concern” or “maximizing the value of the debtor’s estate.”[24] Critically, a valid bankruptcy purpose “assumes a debtor is in financial distress.”[25]

The court then discussed financial distress as a requirement of good faith.[26] LTL Management explained how that at least some degree of financial distress is necessary for a good-faith Chapter 11 petition.[27] That said, the court explained how the degree of actual financial distress is a necessarily a fact-sensitive inquiry—actual insolvency is not strictly required.[28] Rather, the court recognized how “uncertain and unliquidated future liabilities” can create sufficient financial distress to permit a good-faith Chapter 11 petition while the bankruptcy debtor is still formally solvent—the key consideration is whether the debtor’s financial distress is both apparent and immediate enough to justify filing.[29] Illustrating its reasoning with past Chapter 11 petitions in the face of mass tort liability resulting in the establishment of settlement trusts, LTL Management concluded “courts must always weigh not just the scope of liabilities the debtor faces, but also the capacity it has to meet them.”[30]

LTL Management next turned to apply this standard to the case at bar.[31] The court first made clear that only the financial condition of LTL itself as an entity was relevant, separate and apart from the now-defunct Old Consumer.[32] Rather, the good-faith assessment should consider only the realities of the assets and liability of LTL, the new entity formed solely to take on the mass-tort liabilities of Old Consumer, the only entity actually in bankruptcy and subject to the good-faith requirement.[33] Here LTL Management made its key finding—in evaluating the financial condition of LTL, its most critical asset was the $61.5 billion minimum payment right against J&J and New Consumer to establish a settlement trust for talc claims.[34] As the ultimate parent, J&J, had an equity value of over $400 billion, a credit rating of AAA, and $31 billion in cash and marketable securities, LTL Management concluded LTL would be able to rely on J&J as a backstop for potential talc liability even beyond current worse-case scenarios for future judgments and settlements.[35] The court did note should future events prove the talc liabilities arising from Johnson’s Baby Powder exceed even these worse-case scenario projections, Chapter 11 bankruptcy reorganization may be available at that time, but it was not justified at the time LTL actually filed its petition.[36] The core section of LTL Management’s reasoning concluded:

In sum, while it is unwise today to attempt a tidy definition of financial distress justifying in all cases resort to Chapter 11, we can confidently say the circumstances here fall outside those bounds. Because LTL was not in financial distress, it cannot show its petition served a valid bankruptcy purpose and was filed in good faith under [the Bankruptcy] Code…..[37]

Lastly, LTL Management considered whether there were “unusual circumstances” present such that dismissal of the petition was not in the interest of creditors or the bankruptcy estate.[38] Given its immediately preceding conclusion LTL was never in financial distress in light of its funding guarantee from J&J, there could be no reasonable justification to establish unusual circumstances to otherwise deny dismissal of the petition.[39]

Conclusion

Management of potential mass-tort liability via the Texas Two-Step in bankruptcy courts covered the by Third Circuit (those of New Jersey, Pennsylvania, Delaware, and the Virgin Islands) appears to now be non-viable, at least without arranging significant structural differences from Johnson & Johnson’s approach, or potential U.S. Supreme Court review of LTL Management itself.

It is worth noting, however, LTL Management is the first Court of Appeal case to review this strategy; other circuits may ultimately take a differing approach. For the time being, therefore, any company looking to manage potential mass-tort liability in this fashion should strongly endeavor for the underlying Chapter 11 bankruptcy to proceed in courts outside the territorial jurisdiction of the Third Circuit.

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Sources

[1] In re LTL Management, LLC, __ F.4th __, Nos. 22-2003, 22-2004, 22-2005, 22-2006, 22-2007, 22-2008, 22-2009, 22-2010, 22-2011, 2023 WL 1098189 (3rd Cir. Jan. 30, 2023) (all pinpoint citations to Westlaw star pagination).

[2] See Jason Fernando, Texas Two-Step Bankruptcy Definition, Investopedia (January 4, 2023), https://www.investopedia.com/texas-two-step-bankruptcy-definition-5225888.

[3] LTL Management, 2023 WL 1098189 at *1.

[4] Id.

[5] Id.

[6] Id. at *1-2.

[7] Id. at *2.

[8] Id.

[9] Id. at *3.

[10] Id.

[11] Id.

[12] Id.

[13] Id. at *4. LTL Management described the corporate reorganization sequence of events in “slightly abbreviated form” as:

Old Consumer merged into Chenango Zero, LLC, a Texas limited liability company and indirect, wholly owned subsidiary of J&J (“Chenango Zero”), with Chenango Zero surviving the merger. Chenango Zero (formerly Old Consumer) effected a divisional merger under the Texas Business Organizations Code by which two new Texas limited liability companies were created, Chenango One LLC (“Chenango One”) and Chenango Two LLC (“Chenango Two”), and Chenango Zero ceased to exist. Chenango One then converted into a North Carolina limited liability company and changed its name to “LTL Management LLC.” Chenango Two merged into Curahee Holding Company Inc., the direct parent company of LTL (“Curahee”). Curahee survived the merger and changed its name to “Johnson & Johnson Consumer Inc.” (now New Consumer).

Id. at *4 n.3.

[14] Id. at *4-5.

[15] Id. at *4.

[16] Id. at *5.

[17] Id.

[18] Id.

[19] Id. at *6.

[20] Id.

[21] Id. at *7.

[22] Id. at *7-12.

[23] Id. at *7.

[24] Id. at *8.

[25] Id.

[26] Id.

[27] Id. at *8-9.

[28] Id.

[29] Id. at *9.

[30] Id. at *12.

[31] Id.

[32] Id.

[33] Id. at *12-13.

[34] Id. at *12.

[35] Id. at *13-16.

[36] Id. at *16.

[37] Id.

[38] Id. at *17.

[39] Id.