[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Is the Texas Two-Step a Proper Chapter 11 Dance?

By David Skeel (University of Pennsylvania Carey Law School)

Note: This is the fifth in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), and here (by Anthony Casey and Joshua Macey).

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David Skeel

Are Texas Two-Steps ever a proper use of Chapter 11?  The argument that they aren’t—a view held by some scholars and reflected in proposed legislation in Washington—isn’t silly. Most current bankruptcy scholars grew up with Thomas Jackson’s creditors’ bargain theory of bankruptcy, which explains bankruptcy as a solution to creditor coordination problems that threaten to jeopardize the going concern value of an otherwise viable firm. The BadCo that files for bankruptcy in a Texas two-step does not have any going concern value. It’s just trying to manage massive liabilities. Why should this be allowed?

In rejecting a challenge to Johnson & Johnson’s recent two-step, the bankruptcy court supplied a forceful rejoinder to the view that preserving going concern value (or otherwise efficiently deploying a distressed company’s assets) is the only proper purpose for Chapter 11. Judge Kaplan points out that bankruptcy is often a superior mechanism for resolving tort liability as compared to the Multidistrict Litigation process or piecemeal litigation outside of bankruptcy. It is more orderly and can give more equitable and consistent treatment to victims. Judge Kaplan’s conclusion that LTL (the BadCo created by the J&J two-step) belongs in bankruptcy, and that a bankruptcy that involves mass tort liabilities but not the ongoing business that caused them is proper, is fully defensible in my view.

Where Judge Kaplan’s opinion goes off the rails is in too cavalierly dismissing the possibility that two-steps will be abused, as when he muses that “open[ing] the floodgates” to two-steps might not be such a bad thing. Those crafting future two-steps will be tempted to leave BadCo with inadequate ability to pay its victims, since nothing in the Texas divisional merger statute prevents this. Bankruptcy supplies two tools for policing these abuses, the good faith requirement [BRTsee this earlier Roundtable post on good faith and Texas Two-Steps] and fraudulent conveyance law. If courts are vigilant, these tools should be sufficient to discourage abusive two-steps. But if courts are cavalier about the potential abuses, the legislation pending in Washington will begin to seem a lot less ill-advised.

Perhaps the best thing that could happen for Texas two-steps would be for courts to bar the use of non-debtor releases outside of the asbestos context, where they are explicitly authorized by section 524(g) of the Bankruptcy Code. The Second Circuit may be poised to take this step in the Purdue Pharma opioid case, if it upholds the District Court’s conclusion that the releases of nondebtors in that case—most notably, the Sackler family—are not authorized by the Bankruptcy Code. If non-debtor releases were disallowed except where explicitly authorized, Texas two-steps would remain viable in asbestos cases such as J&J, but the floodgates would not open in other contexts, since the maneuver only works if the eventual reorganization includes a non-debtor release for GoodCo.

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] A Qualified Defense of Divisional Mergers

By Anthony Casey and Joshua Macey (University of Chicago Law School)

Note: This is the fourth in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), and here (by Jared A. Ellias).

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Anthony Casey
Joshua Macey

One of the most important contexts in which Chapter 11 proceedings can facilitate the preservation of value is the resolution of financial distress related to mass tort claims. Over the last forty years, Chapter 11 has been invoked to facilitate settlement in dozens of large mass tort cases. Without Chapter 11, these value-preserving settlements would have never been possible.

Mass tort cases involve complex claims of multiple—often tens of thousands of—claimants looking to recover value from a business enterprise. The core provisions of Chapter 11, which are designed to coordinate behavior among claimants, address precisely these types of multilateral-claims situations. These provisions allow the quick, efficient, and fair resolution of claims and preserve value for the claimants and the other stakeholders of the business.

Providing a mechanism for the resolution of these mass tort cases is a quintessential function of bankruptcy law. Without bankruptcy resolution, the uncertainty of future liability in mass tort cases can prevent a debtor from productively carrying on its business and undertaking projects or asset sales that could create value and facilitate a cooperative resolution.

How do divisional mergers fit with this purpose? A divisional merger is a state-law transaction where a business entity divides itself into two new entities. It is attractive in some cases because it is simple and requires fewer steps than other methods for creating entity partitions. But the substantive outcome is no different. Any laws penalizing and prohibiting divisional mergers would therefore have little substantive effect. Rather they would simply channel transactions from one form of entity partitioning to another.

The important question, therefore, is whether a divisional merger—or any other form of entity creation—is being used to facilitate a socially valuable outcome consistent with the purpose of Chapter 11. When used appropriately, a divisional merger preceding a bankruptcy filing can facilitate a socially valuable resolution of mass tort claims, isolating (but not limiting) the mass tort liability for resolution independent of the other operations of the business.

To see why this is true, consider a large otherwise solvent business enterprise facing tens of thousands of potential tort lawsuits. One option would be for the entire enterprise to enter bankruptcy. But there are major costs to an enterprise-wide proceeding. The tools of Chapter 11 are blunt. The automatic stay applies across all creditors even those unrelated to the mass torts. Similarly, the filing triggers all sorts of enterprise-wide rules and restrictions. All creditors—including those with no connection to the mass tort litigation—must file their claims and can demand to be involved in the proceedings and in plan confirmation. The enterprise-wide filing brings extra parties and extra claims into the process and creates opportunities for those parties to take strategic litigation positions that can delay or prevent resolution.

The divisional merger structure reduces these enterprise-related complications. In the right situation, this structure can simplify the process and focus the proceedings on the specific mass tort resolution that is necessary for the preservation of value.

The proper way to address divisional mergers, in our view, is not to prohibit them altogether, but rather to make sure that they do not leave tort victims worse off. The transaction should therefore provide a source of adequate funding to resolve the tort liabilities. Consistent with this principle, recent cases that have utilized the divisional merger structure prior to a Chapter 11 petition have provided funding agreements that ensure that claimants have access to the same or more value in pursuing their claims against the business.

The bankruptcy proceedings that follow the merger should also provide meaningful disclosure and discovery about the merger, the funding agreement, and the underlying tort claims to allow a fair valuation of liability and a reasonable estimate of the number of claimants. Fortunately, bankruptcy judges are willing and able to provide these procedural safeguards.

The alternative of prohibiting divisional mergers will likely leave claimants worse off. Drawn out proceedings transfer value from tort claimants to bankruptcy professionals. It might also lead to unfair outcomes where some tort claimants receive large recoveries and others receive nothing at all. In turn, potential claimants will race to the courthouse chasing early judgments that leave the firm without funds to pay later claimants.

The purpose of Chapter 11 is not to reduce liability, but rather to reduce complexity and cost. And a well-designed divisional merger promotes that purpose while providing a fair and efficient system for resolving group claims.

 

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Upending the Traditional Chapter 11 Bargain

By Jared A. Ellias (University of California, Hastings College of the Law; Harvard Law School)

Note: This is the third in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts) and here (by Jonathan C. Lipson).

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In October 2021, Johnson & Johnson (“J&J”) executed a strategy to use the bankruptcy system to resolve a massive flood of personal injury lawsuits.  In doing so, J&J found a way to obtain the benefits of Chapter 11 without accepting the burden of operating a business under court oversight.  J&J achieved this outcome by executing a corporate law move dubbed the “Texas Two-Step.”  The Two-Step split J&J’s consumer division into two entities: (1) LTL Management LLC, which was allocated all of J&J’s baby powder-related tort liability; and (2) a second entity that contained the assets of its consumer businesses.  LTL Management subsequently filed for bankruptcy without the assets of the consumer business.  In a landmark recent opinion, Judge Michael B. Kaplan of the Bankruptcy Court for the District of New Jersey held that these maneuvers were not a bad faith bankruptcy filing.  As I argue below, Judge Kaplan’s ruling, which attempts to use bankruptcy law to ameliorate weaknesses in tort law, may inspire other wealthy firms to emulate J&J’s tactics.  It may also feed a potential backlash from higher courts and Congress that may make the bankruptcy system less useful to large firms.

In short, J&J’s bankruptcy strategy upends the traditional bargain that Chapter 11 offers to distressed corporations and their creditors.  Congress designed a bankruptcy system that provides companies with powerful protections, such as an automatic stay of non-bankruptcy litigation.  In exchange, companies must submit their assets to court oversight.  To be sure, a bankruptcy filing always undermines some of the bargaining power that mass tort claimants have outside of bankruptcy, such as the ability to bring many individual lawsuits.  However, the burden of court oversight also gives creditors bargaining power, as companies seek to exit bankruptcy quickly to escape the expense and distraction of a bankruptcy proceeding.  J&J argues it has found a better way of using the bankruptcy system: J&J would use a contract to make the assets of the consumer division available to pay any amounts owed to tort victims and its procedural machinations meant that those assets would not be depleted by wasteful court oversight.

As Michael Francus recently argued, J&J’s strategy is best understood as the latest move in the long-standing chess game of hardball bankruptcy tactics between the lawyers who represent tort victims and the lawyers who advise large companies with tort liability.  For example, in 2003, Pfizer resurrected a dead subsidiary and caused it to file for bankruptcy to obtain a judicial order halting all litigation against Pfizer, which potentially had its own liability associated with the subsidiary’s products.  Pfizer’s strategy involved taking a corporation that had been defunct for over a decade, giving it an “independent board of directors,” employees and office space.  By doing so, Pfizer was able to benefit from a bankruptcy court injunction for several years before reaching a settlement after a decade of scorched earth litigation.  Other high-profile companies, most prominently Purdue Pharma, have also tried to stretch bankruptcy law to resolve claims against third parties without those entities filing for bankruptcy themselves.

The “Texas Two-Step” strategy deployed by J&J takes these existing strategies a step further by surgically separating assets from liabilities to create a favorable bargaining environment.  In holding that this maneuver was not a bad faith use of the bankruptcy system, Judge Kaplan opens the door to other wealthy firms to engage in similar maneuvering to resolve mass torts problems. For example, will the next company with headline-grabbing tort liability, such as an unexpected oil spill, respond by “spinning off” its liabilities into a bankruptcy filing?  In the past, this only would have happened if the resulting liability rendered the polluter insolvent, but now even wealthy and solvent firms may decide that their fiduciary duty requires them to use the bankruptcy system to deal with their liability.

In his ruling, Judge Kaplan overruled the arguments of, among others, a group of bankruptcy scholars (including myself) that worry that the complexity of J&J’s maneuvers will undermine public confidence in the integrity of the bankruptcy system. To be sure, Judge Kaplan’s opinion makes persuasive arguments about the limits of the tort system.  The question, though, is whether the ultimate outcome of Judge Kaplan’s attempt to use bankruptcy law to rectify problems in the tort system will be to create new problems for the bankruptcy system as Congress explores new legislation and appellate courts issue rulings that respond to perceived overreach by reducing the power of bankruptcy judges and, as a result, the usefulness of bankruptcy law.

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Vertical Forum Shopping in Bankruptcy

By Jonathan C. Lipson (Temple University-Beasley School of Law)

Note: This is the second in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

The first post in this series can be found here.

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Jonathan C. Lipson

Forum shopping has long been an issue in chapter 11 reorganization, chiefly because liberal venue rules permit gamesmanship.  Section 1408 of the Judicial Code allows a corporate debtor to “bootstrap” into the bankruptcy court of any district where at least one entity in the group was formed.  If a forum is chosen “strategically,” Professors Lynn LoPucki and Bill Whitford first warned (in 1991), “the choice can have an important effect on the distribution of the losses emanating from a bankruptcy reorganization.”

They were describing what may be called “horizontal” forum shopping:  picking among the nation’s roughly 200 bankruptcy panels to find the one the debtor considers best for its situation.  Cases such as LTL Management and Purdue Pharma suggest there is another kind to think about, a variation on what proceduralists call “vertical” forum shopping.

Vertical forum shopping typically concerns competition between state and federal courts, and the rule of decision they apply (i.e., Erie v. Tompkins).  Bankruptcy has a similar state-federal dynamic, but also presents the potential for broader, and more problematic, competitions.

LTL involves the chapter 11 reorganization of Johnson & Johnson’s tort-feasing talc subsidiary.  The debtor had been formed shortly before bankruptcy in a controversial “divisive merger,” which many viewed as little more than a fancied-up fraudulent transfer.  Talc plaintiffs moved to dismiss the case on grounds that it was not commenced in good faith.

In a thorough and thoughtful opinion, U.S. Bankruptcy Judge Michael Kaplan denied the motion because he believed the economic benefits of reorganization appeared to outweigh alternatives.  But, the motion to dismiss also raised “a far more significant issue: which judicial system—the state/federal court trial system,” or chapter 11 “serves best the interests of th[e] bankruptcy estate, comprised primarily of present and future tort claimants with serious financial and physical injuries.”

This question—which system?—is bankruptcy’s version of vertical forum shopping.

On one hand, Judge Kaplan is probably right about the economics:  chapter 11 is likely to pay more to more talc claimants than litigation in other courts.  Nonbankruptcy litigation might produce a few outsize winners—billion-dollar verdicts or multi-million-dollar settlements—but there may be little left for most judgment creditors to collect.

On the other hand, chapter 11’s distributive benefits can trade off against what we might call “dignitary” interests, including individual rights to a “day in court” and a jury trial.  Congress intended to preserve some dignitary protections in chapter 11 cases, including the right to a jury trial of contingent and unliquidated personal injury and wrongful death claims.  But the rise of channeling injunctions and nondebtor releases has undermined those protections.

In Purdue Pharma, for example, the debtor’s controversial plan would give personal injury creditors a bare right to a jury trial against the company, and cap recoveries at about $48,000—surely not enough to cover the cost of the trial.  Worse, it would eliminate the right entirely as to the Sackler family, which owned and controlled the company when it committed two sets of confessed drug crimes.  The viability of those releases is pending before the Second Circuit Court of Appeals.

Vertical forum shopping in chapter 11 can threaten not only the role of other courts, but also other branches of government.  Again, while LTL spotted the issue, Purdue crystallized it.

A supplemental injunction at the beginning of Purdue halted administrative and regulatory actions against Purdue and the Sacklers.  While this left the possibility of criminal prosecution, the U.S. Department of Justice negotiated deals with the Sacklers and Purdue that made it practically impossible for states to prosecute (and, of course, many preferred to settle with the Sacklers rather than fight, anyway).

Purdue Pharma and LTL are likely to be very different cases.  The bankruptcy judge and the debtors in Purdue resisted important efforts to vindicate dignitary concerns, such as a bellwether trial of allegations against the Sacklers or a fulsome examination of them.  Tragically, the lack of those efforts may have undercut the Sacklers’ proposed payout, leading the judge to declare himself “bitter.”

In LTL, by contrast, Judge Kaplan and the debtors have signaled a willingness to deploy these types of mechanisms, should the case remain in bankruptcy.

At this point, it is too early to know.  Angered by the brazen nature of the divisive merger, the talc plaintiffs have appealed to the Third Circuit.

I discuss dignitary issues implicated by vertical forum shopping in chapter 11 in a draft paper, The Problem of Social Debt, which I can share if you email me (jlipson [at] temple [dot] edu).

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Introduction to LTL Management’s Bankruptcy

By Jin Lee and Amelia Ricketts (Harvard Law School)

Note: This is the first in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Jin Lee
Amelia Ricketts

Judge Kaplan’s recent decision not to dismiss the LTL Management (LTL)/Johnson & Johnson (J&J) bankruptcy has further stirred controversy about the hotly debated Texas Two-Step Maneuver, and put an end to speculation on how the bankruptcy court would rule on J&J’s Texas Two-Step bankruptcy filing.  (The decision has been appealed directly to the Third Circuit).

The court rejected tort claimants’ arguments that LTL’s filing violated the good faith requirement for Chapter 11 filings or warranted “for cause” dismissal under Section 1112.  Judge Kaplan held that the filing was an appropriate use of the Bankruptcy Code to maximize value available to creditors, commenting that the bankruptcy court would be the “optimal” venue to resolve tort claimants’ treatment.  The judge emphasized compliance with the terms of the Texas divisional merger statute as evidence of J&J’s good faith.  He also viewed the funding agreement among LTL, J&J, and J&J’s consumer division subsidiary as providing LTL with appropriate capitalization to meet the talc claimants’ needs.  As a result, Judge Kaplan concluded that the talc claimants’ interests would be best served by the bankruptcy process and denied their motion to dismiss.

The full post discussing the case is available here: Introduction to LTL Management’s Bankruptcy.