[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Is the Texas Two-Step a Proper Chapter 11 Dance?
by | posted in: Bankruptcy, Bankruptcy Reform, Chapter 11, Corporate Governance, fraudulent transfer, Mass Torts, Texas Two-Step and the Future of Mass Tort Bankruptcy Series, Third-Party Releases | 0

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 [BRT: see 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] Upending the Traditional Chapter 11 Bargain
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Corporate Governance, Fiduciary Duties, Mass Torts, Texas Two-Step and the Future of Mass Tort Bankruptcy Series | 0

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.

Bankruptcy Court Ruling Imposes Lender Liability
by | posted in: Bankruptcy, Corporate Governance, Fiduciary Duties, Priority | 0

By Daniel S. Shamah, Jeff Norton, Jennifer Taylor, Sung Pak, and Joshua Chow (O’Melveny & Myers LLP)

“Lender liability” is an umbrella term often used to describe claims against lenders who overstep their boundaries when seeking to enforce a loan.  It embraces both contractual and tort-based theories of liability, including claims for breach of contract, breach of the covenant of good faith and fair dealing, and fiduciary duty claims, as well as bankruptcy-based theories like equitable subordination.  While courts have historically held that lender liability claims are difficult to sustain, there are cases that give guidance on how lenders cross the line and the consequences of doing so.  In this recent article, the authors highlight one recent Texas bankruptcy court decision in which a court determined that a lender engaged in the kind of egregious conduct that could lead to disallowance of a loan and an award of damages and interest.  Lenders in particular should study this case closely for tips on how to avoid these landmines.

The full article is available here.

 

Holdout Panic
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates, Insider Status | 0

By Stephen J. Lubben (Seton Hall Law School)

Stephen J. Lubben

It has been recognized that corporations themselves are designed to promote collective action, and thus “a primary function of corporate law is to coordinate and constrain individual behavior – even profit-motivated behavior.”  Given that corporate debt instruments largely serve a governance function amongst creditors, it is not surprising that they, like corporations themselves, tend to quash individual action in favor of the group.  But the divergence between individual and group interests comes to the fore in times of stress.

An individual creditor can be either an oppressed minority investor or a holdout.  Majority holders can be either the group seeking an efficient and beneficial restructuring, or effectively an insider group that collaborates with more formal insiders to extract value from minority creditors.  Which reality is genuine is highly dependent on the particular facts of the case at hand, and may be quite difficult for an outsider to discern.

Restructuring law attempts to balance this uncertainty by providing a series of checks and balances.  In general, restructuring law begins with a preference for the collective, but encircles the collective with a series of rules that protect individual creditors from abuse.  

Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act.  In general, the basic challenge here is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors.  It is very easy to avoid holdouts if the majority always wins.

My paper explores the ways in which modern restructuring practice has moved toward that “majority always wins” extreme.  This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts.  But in indulging our fears of holdouts, we have lost the essential balance of the system.

Take the example of the RSA – or restructuring support agreement – that, in a variety of ways, can represent a generalized assault on the requirement in section 1123(a)(4) that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class.”  RSAs achieve this end by providing for backstop fees paid to a select group that will never have to backstop anything or DIP loans that the debtor does not really need.

In one recent case, pre-bankruptcy the debtor contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes.   That is, some of the secured noteholders paid the interest payment due to all the secured noteholders.

In exchange, these distinctive noteholders received new “super-priority secured notes” secured by a lien that surpassed the old secured notes’ liens, while also carrying a hefty 10% coupon.  When the debtor filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and “make whole call” fees.  In short, the select lenders made a small, six-month loan for a very high return at low risk.  This opportunity was not available to everyone in the original class of noteholders.

In short, I conclude that the modern American restructuring system has evolved to favor the interests of the majority to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors.  At some point, this reality is bound to have consequences for both the debt markets and the utility of chapter 11.

The full article is available here.

Texas Two-Stepping Out of Bankruptcy
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates, Chapter 11, fraudulent transfer, Jurisprudence, Legislation | 0

By Michael A. Francus (Harvard Law School)

Michael Francus

Johnson & Johnson’s use of the Texas Two-Step to manage its talc liabilities has put the company, and the Two-Step, front and center in the roiling debates over aggressive uses of the bankruptcy system. Those debates have led to scholarly criticism, congressional hearings, and proposed legislation that would curtail debtors’ ability to so use the bankruptcy courts.

My Essay details the mechanics of the Two-Step. Beginning with the Texas divisive merger, the funding agreement, and forum shopping for the Fourth Circuit, the Essay fleshes out precisely how the Two-Step boxes in tort claimants. Like other scholarship, this Essay identifies the risk that such maneuvering effects a fraudulent transfer. It also goes a step further, arguing that the point of the Two-Step is not to succeed, but to delay. Fraudulent-transfer litigation in a bankruptcy consumes time because it requires an adversary proceeding, and that delay pressures tort claimants to settle. So the Two-Step can succeed as long as claimants cannot wait out the course of the bankruptcy, even if a court never declares the particular Two-Step to be a proper use of divisive merger law rather than an improper fraudulent transfer.

Instead of playing into this delay game, this Essay argues, courts should evaluate the Texas Two-Step for good faith. Tort claimants can raise such challenges as a motion to dismiss (as some have) and thus avoid the need for a fraudulent-transfer adversary proceeding. And under current doctrine, the Two-Step likely qualifies as a bad-faith filing: In most cases, the Two-Step is a litigation tactic. And the Two-Step, invariably, is filed by an entity created solely to file for bankruptcy. Both of those are doctrinal hallmarks of bad-faith bankruptcies.

More broadly, the Essay explains, the Two-Step and good-faith challenges to it underscore the continuing role of common law in bankruptcy. The Code does not define good-faith filing, so courts have developed the doctrine case by case. They may yet find an acceptable form of Two-Step, one which yields tort claimants the rights they would receive in, say, a Johnson & Johnson bankruptcy, without hurting Johnson & Johnson’s ability to do business by forcing the whole company into bankruptcy. Along the way, though, a vigilant common-law gatekeeping is warranted, and judges should not hesitate to dismiss Two-Steps thinking that a later ruling on a fraudulent-transfer adversary proceeding can adequately safeguard tort claimants from an improper use of the bankruptcy system.

The full essay will be available at 121 Mich. L. Rev. Online __ (forthcoming 2022) and can be accessed here.

The Ninth Circuit Affirms Creditors’ Ability to Block ‘Cramdown’ by Purchasing Claims
by | posted in: Claims Trading, Cramdown and Priority | 0

By George P. Angelich and Annie Y. Stoops (Arent Fox).

The Ninth Circuit affirmed the creditor’s ability to block “cramdown” by purchasing junior debt for the purpose of protecting its own existing claim.  In re Fagerdala USA-Lompoc, Inc., 891 F.3d 848 (9th Cir. 2018).  In reversing the bankruptcy court’s decision to designate claims for bad faith under 11 U.S.C. § 1126(e), the Ninth Circuit held that the creditor acting in its self-interest by purchasing unsecured claims to block “cramdown” did not constitute bad faith unless evidence showed the creditor acted with a motive ulterior to the purpose of protecting its economic interest in a bankruptcy proceeding.  Examples of “ulterior motive” included a creditor purchasing claims for the purpose of blocking litigation against it or a debtor arranging to have an insider purchase claims.

Fagerdala clarifies that creditors may purchase claims in defense of their economic interests in bankruptcy proceedings.  In holding that the bad faith inquiry under 11 U.S.C.  § 1126(e) requires evidence of an “ulterior motive,” the Ninth Circuit sets the stage for designation where a non-creditor or strategic investor purchases claims as an offensive move to gain an advantage over the Chapter 11 debtor.

The full article is available here.

A New Risk to Bankruptcy Sales – Unwinding of the Sale Due to a Bad Faith Filing
by | posted in: Valuation | 0

Authors: Lenard M. Parkins and Karl D. Burrer of Haynes and Boone, LLP

Parkins_Lenny HeadshotBurrer_Karl headshotRecently, the Eleventh Circuit rendered its decision in the Wortley v. Chrispus Venture Capital, LLC case unwinding a four-year old sale order based on a finding that the underlying bankruptcy case was filed in bad faith. The decision injects a new risk for buyers of distressed assets – the potential reversal of a sale order years after the closing of the transaction.

While the Wortley opinion clearly provides that a finding of “bad faith” with respect to the filing of a bankruptcy case can result in its dismissal (even) years later, it is unclear whether the holding requires the unwinding of all sales that transpired prior to dismissal of a bankruptcy case subsequently deemed to have been filed in bad faith. As a general matter, a dismissal for a bad-faith filing is a matter of court discretion under section 1112(b) – not a matter of jurisdiction.  Further, section 349 seems to provide that dismissals are not per se intended to unwind sales to good faith purchasers in a bankruptcy case. Accordingly, it can be argued that the Wortley holding should be limited to circumstances in which the purchaser is also the party found to have unclean hands with respect to the debtor’s bankruptcy filing.  Notwithstanding this analysis, the decision will require a new (and potentially amorphous) aspect of diligence for bankruptcy purchasers: the original motivation for the bankruptcy filing.

See here for a more detailed discussion of the Wortley decision.