Will The Texas Two-Step Create New Restructuring Opportunities For Companies Facing Mass Tort Liabilities?

Johnson & Johnson is using the bankruptcy code and a relatively obscure Texas statute in an attempt to limit its overall exposure to mass tort litigation over asbestos in the talc used in its baby powder products. This strategy, dubbed the “Texas Two-Step” by its critics, involved Johnson & Johnson first converting to a Texas organization, then using a “divisive merger” under the Texas Business Organizations Code to create a new, separate entity. [1] This new entity kept Johnson & Johnson’s mass tort liabilities and a limited number of assets to satisfy these asbestos claims. [2]In addition, Johnson & Johnson agreed to pay all of the bankruptcy related expenses of the new entity and fund a $2 billion trust to pay its mass tort liability claims. The new entity then filed for chapter 11 bankruptcy in order to resolve the mass tort liabilities without Johnson & Johnson having to endure a bankruptcy proceeding or make its assets available to satisfy its mass tort liability claims.

Creating a new entity to absorb a company’s liability would typically be considered a fraudulent transfer under bankruptcy law or The Texas Uniform Fraudulent Transfer Act (TUFTA).  However, Texas Business Organizations Code also provides that such a divisive merger is effectuated without “any transfer or assignment having occurred,” arguably making the divisive merger transaction exempt from the Uniform Fraudulent Transfer Act. [3] While Johnson & Johnson is not the first company to use the Texas Two-Step in an attempt to avoid facing mass tort liabilities, it is undoubtedly the highest profile. Notably, Bestwall LLC and Aldrich Pump LLC used the divisive merger statute to relieve themselves from mass tort claims and protect their assets before having the new entity file for bankruptcy protection.

Mass tort liability claimants argue that the Texas Two-Step is nothing more than an attempt for large corporations to obtain the benefits of a bankruptcy proceeding without filing for bankruptcy (much like the criticism directed at Nonconsensual Third-Party releases discussed in our previous Client Alert found here). However, debtors utilizing the Text Two- Step argue that the process is the most efficient way to fairly administer mass torts claims without all the difficulty and costs that would be incurred if the original entity filed a large, complex bankruptcy. The original entity also provides assets to the new entity to fund payments to mass tort claimants.

In the Johnson & Johnson bankruptcy, New Jersey Bankruptcy Court Judge Michael Kaplan refused to dismiss Johnson & Johnson’s spinoff entity’s bankruptcy, holding that Johnson & Johnson’s use of the Texas Business Organizations Code does not rise to the level of a bad faith bankruptcy filing. However, recognizing the impact of his decision, Judge Kaplan also allowed the appeal of his decision to go straight to the U.S. Court of Appeals for the Third Circuit.

That said, Judge Kaplan’s decision does not mean Johnson & Johnson’s Texas Two-Step cannot be attacked on other grounds; only that the Texas Two-Step did not mean the bankruptcy was filed in bad faith. For example, mass tort claimants in other bankruptcies are seeking to undo the Texas Two-Step through a “substantive consolidation,” merging the liabilities of the separate mass tort entity with the original entity that isn’t in bankruptcy or arguing that fraudulent transfer liability can be found if all of the elements of a fraudulent transfer are established, notwithstanding the language of the Texas Business Organizations Code.

In sum, the Texas Two-Step presents a potential strategy for companies to avoid bankruptcy filing by dividing their mass tort claims from the company and avoiding the stigma of bankruptcy while also protecting most of their assets from the bankruptcy process. However, creditors are still challenging this process on multiple grounds. DarrowEverett LLP will continue to follow this emerging topic and will report any future changes to the process.

[1] Tex. Bus. Orgs. Code Ann. § 1.002(55)(A).
[2]Tex. Bus. Orgs. Code Ann. § 1.003.
[3] Tex. Bus. Orgs. Code Ann. § 1.008(a)(2)(C).

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