Panelists John Cruciani and Scott Davis, both Partners with Husch Blackwell gave an insightful presentation on the Texas Two-Step Bankruptcy, explaining how it works and providing an overview of the Texas corporate statutes from which the maneuver flows. They also discussed the high profile case of Johnson & Johnson (“J&J”), as well as an update on other ongoing cases, and finally the implications for insurers. A video replay of this presentation is available to members on the AIRROC “On Demand” platform.
A Texas Two-Step Bankruptcy is a controversial legal maneuver that can be used to manage a company’s exposure to potential legal claims. In carrying out a Texas Two-Step Bankruptcy, a company splits into two or more companies via a divisive merger whereby forming a new legal entity into which it transfers any tort liabilities, while transferring a relatively small portion of the original company’s assets. The second step of the Texas Two-Step occurs when the newly created corporation then files for bankruptcy, effectively shielding some or all of the assets of the original company from the cost of the tort liabilities. This action also provides the new company, the liability bearing entity, with the protection of the Bankruptcy Code’s automatic stay, thus halting all litigation.
J&J recently attempted this with their talc liabilities. On October 12, 2021, J&J reorganized under the Texas divisional merger statute and created LTL Management, LLC (“LTL”). All of the talc-related litigation liabilities were transferred to LTL. Unsurprisingly, LTL is an acronym for Legacy Talc Litigation. Two days later, LTL filed for bankruptcy in North Carolina. On a venue challenge, the case was subsequently transferred to the Bankruptcy Court for the District of New Jersey, where J&J has its headquarters and principal operations.
The talc claimants filed a motion to dismiss, arguing that the bankruptcy was filed for an improper purpose. They argued that J&J utilized the bankruptcy system in bad faith to shield itself from liability and cap claimant recoveries. They further argued that it was a sham transaction as there was no business purpose to LTL as it had virtually no employees, no operations, lenders, bondholders, customers, suppliers or vendors, and was created solely for the purpose of delay and so that LTL could pay the mass tort claimants pennies on the dollar.
The New Jersey Bankruptcy Court refused to dismiss LTL’s Chapter 11 case, finding that it was not filed in bad faith. The Court found that LTL was in compliance with the Texas statute’s requirements for implementation of a divisive merger. The Court further determined that the Chapter 11 filing to address mass tort exposure is a valid purpose and is wholly consistent with the aims of the Bankruptcy Code. That decision is on direct appeal to the U.S. Court of Appeals for the Third Circuit. The panel is of the view that the Third Circuit will likely affirm that the case was not filed in bad faith and as the bankruptcy moves forward, the case will ultimately come down to whether under the language of the Texas statute, there is “adequate provisions for discharge of liabilities.” The J&J plan does propose a $2 billion trust to compensate talc claimants implemented by a funding agreement that is tied to the valuation of J&J.
Currently, there is proposed legislation, H.R. 4777, The Nondebtor Release Prohibition Act, which would prohibit non-consensual third party releases and provide for the dismissal of bankruptcy cases filed after the implementation of a divisional merger transaction where the entity has taken on liabilities within 10 years before filing. This proposed legislation emanates from the Purdue Pharma
case where the Sackler family, as part of the plan of bankruptcy, entered into third party releases to provide immunity from civil lawsuits. This proposed legislation would essentially block the Texas Two-Step strategy. Word on the street is that the likelihood of this legislation passing is low.
Scott Davis spoke about the insurance considerations of the Texas Two-Step Bankruptcy strategy, noting that it is a response to the social inflation impact of runaway jury awards that cannot be reasonably paid by an operating company. It is a strategy to mitigate lingering liabilities. If J&J is successful, it will provide a blue print that others will follow to evade accountability from inflated jury awards and force mass tort litigation to be resolved under the framework of the bankruptcy system.
From an insurance perspective, the strategy does not present unique questions of law but rather unique considerations of equity and effectiveness that may drive the Bankruptcy Court’s approach to these cases. The availability of insurance will always be a key component to the success of the reorganization because it is one of the assets of the new debtor entity.
Some of the relevant insurance issues that arise in a bankruptcy context include: Who is the insured? Can the policies be assigned? Which court has jurisdiction over coverage disputes? The application of an SIR is also a complicated issue that frequently arises, as well as the duty to defend, exhaustion of underlying limits, drop down of excess coverage and possible voiding of prior settlements or buybacks. In navigating these issues, insurers much be cognizant of the intricacies of bankruptcy law, particularly those that reflect the courts’ origins as courts of equity.