Texas Two-Step: New Classic or Passing Fad?

Texas Two-Step
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The Third Circuit recently rejected Johnson & Johnson’s attempt to shed its talc mass tort liability into bankruptcy through the “Texas two-step.” In re LTL Management LLC, 58 F.4th 738 (3d Cir. 2023). Based on this ruling, 3M is facing a similar challenge to its two-step attempt to shed combat-earplug liability. In re Aero Technologies, No. 22-02890 (Bankr. S.D. Ind. Feb. 25, 2023), ECF No. 1198. But what is this new mass tort dance craze, and why is it not catching on here in Minnesota? Hint, it is not just because we prefer the polka.

As the name implies, the Texas two-step involves two general steps, with the first usually taking place in Texas. In this step, companies facing mass tort liability use Texas’s divisional merger statute to split the original company into two new companies. The “bad-co” primarily holds the mass tort liabilities. The “good-co” primarily holds the going-concern assets.

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In LTL’s case, a subsidiary of J&J faced lawsuits alleging the company’s talcum powder caused ovarian cancer or mesothelioma. This subsidiary was split, and LTL is the bad-co holding the talc liabilities. As you probably imagine, this first step is highly controversial and likely tripped up LTL’s dance, but we will get into that more later.

The dance’s second step places the liability-holding bad-co into chapter 11 bankruptcy. The reorganization plan includes a funded claims process for resolving and paying the tort liabilities. That plan also usually includes exculpation or gatekeeping clauses to direct claims to bad-co and shield good-co and other affiliates from direct liability. This second step is similar to what The Archdiocese of Saint Paul and Minneapolis did here through its chapter 11 bankruptcy (Minnesota bankruptcy case number 15-30125). As you have probably heard, the scope of these third-party releases is also controversial and subject to evolving case law and congressional review.

In LTL’s case, however, the Third Circuit held that LTL’s chapter 11 was filed in bad faith and had to be dismissed. This is because a financing arrangement between bad-co and good-co, which was further backed by J&J itself, made it so that LTL could not be in “financial distress.” The Third Circuit follows a majority rule that a bankruptcy debtor must be in financial distress to file a bankruptcy in good faith. Accord In re Cedar Shore Resort, 235 F.3d 375, 381 (8th Cir. 2000). With the full weight of J&J behind LTL, it could not be in financial distress.

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LTL also argued that, despite its financial condition, the Texas-two step provides a better process for resolving mass torts through the bankruptcy court than through district court litigation. The Third Circuit also rejected this argument, explaining that claimants have important rights outside of bankruptcy that should only be disrupted by bankruptcy when necessitated by a debtor’s financial distress.

This means that LTL’s bid fell on its face because it tripped out of the Fourth Circuit by accident. After reorganizing under Texas law, LTL converted to a North Carolina company and opened a bank account there. LTL did this to take advantage of the district’s favorable bankruptcy case law. Critically, the Fourth Circuit applies a different test for good faith bankruptcy filings that does not require that the debtor be in financial distress. Carolin Corp. v. Miller, 886 F.2d 693, 700–01 (4th Cir. 1989). Instead, subjective intent or an ability to reorganize is sufficient—two factors LTL arguably met.

However, the North Carolina bankruptcy court concluded that LTL’s venue manufacturing went too far. Because most of LTL’s relevant operations, witnesses, and litigation is in New Jersey, the North Carolina court agreed that New Jersey is a clearly more favorable venue. While venue was technically valid in North Carolina, the bankruptcy court agreed to transfer the case to New Jersey.

This change to a venue requiring “financial distress” brings us back to the controversial divisionary merger, splitting the original target of mass tort litigation into bad-co and good-co. While this special type of “merger” available in Texas and Delaware may sound unique, it still requires something that arguably flew under the radar prior to LTL: “reasonably equivalent exchange in value.” If you wondered how liabilities and assets could be split into two separate companies without running afoul of Uniform Voidable Transactions laws (i.e., fraudulent transfers), this is the key. As a footnote in the Third Circuit’s LTL decision observes, the very financing arrangement that rendered LTL financially sound likely resulted from the need for bad-co to receive a reasonably equivalent exchange in value for the assets taken by good-co. LTL Management, 58 F.4th at 762 n.18. If this is the case, then the divisionary merger might not be much different than what could be accomplished under typical corporate laws, including in Minnesota.

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This suggests that companies facing financial distress from mass tort litigation might be able to dance a two-step in Minnesota. However, some districts have reputations for being more favorable venues for conducting chapter 11 reorganizations. See Lynn M. LoPucki, Chapter 11’s Descent into Lawlessness, 96 Am. Bankr. L.J. 247 (2022). Indeed, large, financially stable companies looking to shed mass tort liability will still likely need to try to take that second step in the Fourth Circuit, where “financial distress” is not a requirement. Further, as LTL experienced, the ability to stay in their preferred district will likely depend on whether the venue actually makes sense and whether there is a single clearly more favorable venue elsewhere.

This heavily shifting dance floor makes the longevity of this dance craze uncertain—especially with the possibility of the Supreme Court or Congress cutting in.

Ken C. Edstrom & Alex J. Beeby

Kenneth “Ken” C. Edstrom is in his 40th year in the practice of law. He concentrates his practice on all aspects of insolvency. He is a 20-time winner of the Super Lawyer designation, is rated by Martindale-Hubbell as Preeminent AV, and has been board certified in business bankruptcy for 22 years. Alexander “Alex” J. Beeby is on his second career. Prior to law school, he founded and ran a food co-op for nine years. After six years of practice, he joined Sapientia as a member of its growing insolvency team. He has clerked for several federal and state judges including Hon. Kesha L. Tanabe, Minnesota’s newest bankruptcy judge.

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