The fate of Texas Two Step in the US dealt setback in appellate ruling

The "Texas Two Step" has become common (albeit controversial) parlance in US chapter 11 arenas as US courts grapple with the device made possible by Texas state law—specifically "divisive mergers" that offer a unique tool for Texas entities to manage exposure to potential mass tort claims. Under Texas law, a merger includes not only companies merging into one, but also includes the opposite-- when a company divides into two or more entities. These are known as "divisive mergers," and Texas is the only state aside from Delaware to allow a divisive merger (but Delaware only does so for limited liability companies).

The process known as a "Texas Two Step" involves (1) a company undergoing a Texas divisive merger and separating its assets and liabilities among two new entities, then (2) placing the liability burdened new entity into chapter 11, which halts litigation, and then seeking a channeling injunction and third party releases in favor of its related (and asset holding) entities under a chapter 11 plan.

Critics of the scheme have alleged the Texas Two Step's re-allocation of assets and liabilities should not be condoned by the US Bankruptcy Code. Critics argue, inter alia, that such a chapter 11 petition is filed in bad faith, which constitutes cause for dismissal of the case. What constitutes good or bad faith, however, is not explicitly defined in the US Bankruptcy Code. Although US courts have attempted to define their contours by observing the equitable nature of bankruptcy law and the overall purpose of chapter 11, the courts have developed different standards in determining whether a chapter 11 petition is filed in good faith.

Specifically, the Third Circuit Court of Appeals recently held that a Texas Two Step case, In re LTL Management, was not filed in good faith, and, hence should be dismissed. This decision stands in opposition to a decision in another (albeit lower) court, which denied a previous attempt to strike down a Texas Two Step case in this manner. That case, In re Bestwall, applied a "much more stringent standard for dismissal" articulated by the Fourth Circuit Court of Appeals. Therefore, while the Third Circuit dismissed In re LTL Management as filed in bad faith, it remains to be seen whether other Texas Two Step cases will be successfully challenged in this manner.

The Third Circuit dismisses In re LTL Management for bad faith filing

On January 30, 2023, the Third Circuit ordered that the Texas Two Step chapter 11 case In re LTL Management be dismissed as a bad faith filing. Johnson & Johnson Consumer Inc. ("Old Consumer"), a wholly owned subsidiary of Johnson & Johnson ("J&J"), manufactured, among other things, Johnson's Baby Powder, which contained talc. Concerns that talc contained traces of asbestos—and therefore caused mesothelioma and ovarian cancer—spurred numerous lawsuits against Old Consumer and J&J. Old Consumer, therefore, undertook the "divisive merger" strategy afforded by Texas law, splitting into two new entities. One entity, Johnson & Johnson Consumer, Inc. ("New Consumer"), held all assets of Old Consumer. The other entity, LTL Management LLC ("LTL"), held all liabilities of Old Consumer. LTL's corporate parents entered into an agreement with LTL that provided LTL with funding from New Consumer and J&J ("LTL Funding Agreement") to cover LTL's liabilities, including costs associated with funding a trust to address talc liability.

After the divisive merger, LTL filed a petition for relief under chapter 11 of the Bankruptcy Code in the US Bankruptcy Court for the Western District of North Carolina, where other Texas Two Step cases had been commenced. That court, however, ultimately transferred the case to the US Bankruptcy Court for the District of New Jersey. Thereafter, the Talc Claimants Committee ("TCC") moved to dismiss LTL's bankruptcy case as a bad faith filing. The bankruptcy court denied the TCC's motion to dismiss. While the bankruptcy court appeared to doubt whether LTL would exhaust its right to payment under the LTL Funding Agreement, the bankruptcy court nonetheless held that LTL's filing served a valid bankruptcy purpose, and that LTL was in "financial distress" by viewing the scope and costs of the talc litigation faced by Old Consumer and the effect of those costs on its business.

On appeal, the Third Circuit Court of Appeals observed that bankruptcy petitions are subject to dismissal under Section 1112(b) of the US Bankruptcy Code unless filed in good faith. The appellate court found that good faith requires a chapter 11 petition be filed (1) for a valid bankruptcy purpose, and (2) not to obtain a tactical litigation advantage. A valid bankruptcy purpose presumes a debtor is in "financial distress" and filed its petition to preserve a going concern or to maximize the value of its estate. The Third Circuit emphasized that, while financial distress does not necessarily require a debtor to be insolvent, a debtor who does not suffer from immediate financial distress cannot demonstrate that its petition serves a valid bankruptcy purpose supporting a good faith filing. A general desire to benefit from the provisions of the US Bankruptcy Code may not justify a presence in bankruptcy without financial distress.

The Third Circuit held that based on the facts LTL was not in financial distress. In reaching this conclusion, the Third Circuit first ruled that only LTL's financial condition is determinative, and that its financial state should be viewed independent of any other entity— namely, Old Consumer and New Consumer. The Third Circuit found the value of LTL's assets, including the LTL Funding Agreement (which was valued at US $61.5 million), meant that LTL was highly solvent with sufficient access to cash to meet its liabilities as they came due. Particularly, the LTL Funding Agreement gave LTL direct access to J&J's "exceptionally strong" balance sheet. This, coupled with the bankruptcy court's over-estimation of LTL's future talc liabilities, meant that LTL would not exhaust its rights under the LTL Funding Agreement and the bankruptcy filing was "at best premature." Perhaps, the Third Circuit surmised, with the progression of talc litigation outside of bankruptcy, LTL may one day demonstrate that cash available under the LTL Funding Agreement is insufficient to meet talc liabilities. LTL, however, had not made such a showing and its chapter 11 filing thus served no proper purpose.

In re LTL Management marks the first bad faith dismissal of a Texas Two Step case. While seemingly a win for critics of the Texas Two Step, the facts may limit any broad application in Texas Two Step cases. Specifically, the Third Circuit's finding of bad faith largely hinged on the LTL Funding Agreement, which allowed LTL to continue to fund its liabilities. Other Texas Two Step transactions, however, may not feature such agreements that afford means to fund all projected liabilities. In fact, the Third Circuit imagined such a scenario, acknowledging that its logic might "suggest LTL need only part with [the LTL Funding Agreement] to render itself fit for a renewed filing." It can be reasoned that an entity with no comparable funding agreement, for example, would face immediate financial distress in meeting its liabilities and would, therefore, enter chapter 11 with a valid purpose, even in the Third Circuit.

On March 22, 2023, the Third Circuit denied a request from LTL seeking a rehearing of its ruling en banc. LTL requested the Third Circuit stay the dismissal mandate pending LTL's expected petition for review by the United States Supreme Court. but that motion for a stay was denied by the Third Circuit on March 31, 2023. The next chess move involved LTL and J&J replacing the LTL Funding Agreement with a new arrangement that provides for New Consumer and/or J&J to backstop (if needed) funding for a US$8.9 billion bankruptcy plan trust that resolves all talc claims in one forum – namely a second LTL chapter 11 case that was filed on April 4, 2023. LTL asserts that the new funding arrangement and second chapter 11 case satisfies the Third Circuit's concerns and is filed with plan support agreements from more than 60,000 talc claimants. The litigation may continue as the official tort claimants' committee from the first chapter 11 case, however, has signaled opposition.

A Texas Two Step previously survived in face of motion to dismiss for bad faith

In re LTL Management was not the first Texas Two Step case to face a motion to dismiss for bad faith. Applying what the Bankruptcy Court for the District of New Jersey described as a "much more stringent standard for dismissal of a case for lacking good faith," the Bankruptcy Court for the Western District of North Carolina (which is in the Fourth Circuit) previously denied a motion to dismiss a Texas Two Step filing for bad faith in In re Bestwall LLC, 605 B.R. 43 (Bankr. W.D.N.C. 2019).

Even though all four Texas Two-Step cases used Texas law to accomplish their divisive mergers, all but one filed their bankruptcy cases in the Bankruptcy Court for the Western District of North Carolina, despite minimal contacts with that state. The popularity of this forum is likely due to the Fourth Circuit's standard for bad faith dismissal of a chapter 11 filing. In fact, the Fourth Circuit's dismissal standard has been described as "one of the most stringent articulated by the federal courts." In re Dunes Hotel Assoc., 188 B.R. 162, 168 (Bankr. D.S.C. 1995). In order to dismiss a chapter 11 case for bad faith in the Fourth Circuit, a court must find that the chapter 11 case is both (a) objectively futile and (b) filed in subjective bad faith. Carolin Corp. v. Miller, 886 F.2d 693, 700-01 (4th Cir. 1989).

Indeed, the official committee of product liability claimants in In re Bestwall failed in its efforts to achieve dismissal of the chapter 11 filing because of the Fourth Circuit's stringent standard. In In re Bestwall, BestWall Gypsum Co. ("Old Bestwall") had been previously purchased by Georgia-Pacific, LLC ("Old GP"). Old Bestwall, which manufactured and sold certain asbestos containing products, continued operations after its purchase by Old GP and amassed approximately 64,000 asbestos related tort claims. Then, during a 2017 corporate restructuring, Old GP was dissolved, and Old Bestwall was merged into two new entities through a Texas divisive merger: (1) Bestwall, LLC ("Bestwall") whose sole responsibility is the assumption, management, and defense of Old Bestwall's asbestos-related litigation claims, and (2) Georgia-Pacific LLC ("New GP"), which continues Old GP's manufacture and sale of tissue, pulp, paper, packaging and building products. In addition to asbestos related litigation, Bestwall also received a funding agreement from New GP, wherein New GP agreed to provide funding for all costs of the chapter 11 case and funding for a section 524(g) asbestos trust ("GP Funding Agreement"). Bestwall then completed the Texas Two Step by filing for relief under chapter 11 of the Bankruptcy Code in the Bankruptcy Court for the Western District of North Carolina.

When presented with a motion to dismiss for bad faith filing, the bankruptcy court looked first to whether Bestwall's bankruptcy case was "objectively futile." Under Fourth Circuit law, the objective futility inquiry should "concentrate on assessing whether there is no going concern to preserve . . . and . . . no hope of rehabilitation, except according to the debtor's 'terminal euphoria.'" Contrary to the Third Circuit's view of the need for distress, the bankruptcy court, applying the Fourth Circuit standard, instead lauded Bestwall's financial wherewithal finding that the objective futility test focuses on the debtor's financial stability and the means to a realistic rehabilitation.

With this background, the bankruptcy court found that attempting to resolve asbestos claims through Section 524(g) alone is a valid reorganizational purpose, and filing for chapter 11, especially in the context of an asbestos or mass tort case, need not be due to insolvency. Because Bestwall had substantial assets, including the GP Funding Agreement, the bankruptcy court determined that Bestwall would be able to acquire the funds necessary to fund an asbestos trust under Section 524(g) of the US Bankruptcy Code. Therefore, the court found that Bestwall had the objective ability to meet its obligations and reorganize as a going concern. Because the Court concluded Bestwall had the resources with which to reorganize, it determined the chapter 11 filing was not objectively futile and, under the conjunctive two part test, did not need to address whether the case was filed in subjective bad faith.

Competing standards

As demonstrated, the Fourth Circuit's standard applied in In re Bestwall stands nearly in direct contrast with the Third Circuit's ruling in In re LTL Management. Under Fourth Circuit law, the presence of the GP Funding Agreement ensured Bestwall's ability to reorganize and create an asbestos trust. The bankruptcy court determined this alone was a valid bankruptcy purpose. In In re LTL Management, on the other hand, the Third Circuit also determined that the LTL Funding Agreement rendered LTL financially stable. However, according to the Third Circuit, the LTL Funding Agreement doomed LTL's bankruptcy filing because the absence of financial distress meant the chapter 11 case was filed without a proper bankruptcy purpose.

The opposing standards in these cases stem from fundamentally different views of the accessibility of protections afforded by the US Bankruptcy Code. According to the Fourth Circuit Court of Appeals,

"it is better to risk proceeding with a wrongly motivated invocation of Chapter 11 protections whose futility is not immediately manifest than to risk cutting off even a remote chance that that a reorganization effort so motivated might nevertheless yield a successful rehabilitation."

Carolin, 886 F.2d at 701. Under this view, even a "wrongly motivated" rehabilitation effort is to be encouraged if it is at all feasible. On the other hand, the Third Circuit finds its standard rooted in equitable limitations, sanctioning the use of bankruptcy to disrupt the system of individual creditor remedies only where justified to protect recoveries for those creditors. In re Integrated Telecom Express, Inc., 384 F.3d 108, 129–129 (3d Cir. 2004).

This contrast will likely lead continued litigation and venue skirmishes throughout Texas Two Step cases, and interested parties, therefore, should keep apprised of further developments in this evolving area. Notably, in light of the Third Circuit's decision in In re LTL Management, Texas Two Step case law may effect a larger swath of entities than those considering the chapter 11 process to mitigate mass tort litigation risk. All parties to a chapter 11, particularly in the Third Circuit, must consider whether a commercial debtor is in "financial distress" and filed its petition for a proper purpose. Otherwise, any debtor may face a motion to dismiss for bad faith filing. Stay tuned for further developments in this fast moving area, including possibly in the United States Supreme Court and in LTL's second chapter 11 case.