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.
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.