Courts don’t often dismiss bankruptcy cases, so it’s newsworthy that the Third Circuit Court of Appeals, which has jurisdiction over Pennsylvania and Delaware bankruptcy cases, dismissed a bankruptcy case that a Johnson & Johnson subsidiary filed after J&J used a controversial Texas corporate law to corral large liabilities into the entity. The Court’s decision helps creditors prevent slippery debtors from abusing the bankruptcy process, but doesn’t put any new limits on this controversial restructuring practice.

The Texas Two-Step

The Texas Two-Step – a liability dodge endorsed by Texas law – is as slick as it sounds. A subsidiary of Johnson & Johnson has been sued repeatedly over allegations its famous baby powder contains cancer-causing asbestos. Facing big litigation risk, J&J merged it into a placeholder Texas company that survived the merger, then split the survivor into two Texas companies, one that owns all of the former subsidiary’s productive business assets that we’ll call “New Consumer”, and another that owns all of the former subsidiary’s liabilities that J&J called “LTL Management, LLC”. ¹ Texas law shielded New Consumer from the liabilities ², enabling it to keep doing business without a trip through bankruptcy. Meanwhile J&J and New Consumer agreed in writing to provide LTL Management with funding to pay talc claims against it in an amount equal to the enterprise value of New Consumer, and LTL filed for bankruptcy two days after the split.

An End Run Around Accountability?

When a business files a bankruptcy petition, the Bankruptcy Code puts an automatic stay on litigation against it until claims are resolved in bankruptcy court. Once the bankruptcy process is complete, no one can sue the company for anything that happened before it filed for bankruptcy. ³ J&J envisioned the bankruptcy court approving a mass-tort settlement fund fashioned after the settlement funds pioneered in bankruptcy courts during prior asbestos and silicon breast implant controversies. These settlement funds channel plaintiffs’ claims through a settlement process that avoids protracted litigation, and they’ve achieved good results for plaintiffs in extraordinarily difficult circumstances. But they are controversial, because they force large classes of plaintiffs to release their claims against the debtor and its non-bankrupt affiliates, without the plaintiffs’ unanimous consent.

The talc plaintiffs saw J&J’s maneuver as an end-run around accountability, and fought it.

After the split, New Consumer and LTL Management both converted to North Carolina companies in order to be able to file for bankruptcy in the Bankruptcy Court for the Western District of North Carolina. They did this because North Carolina bankruptcy courts are in the Federal Fourth Circuit, and the Fourth Circuit makes it hard to dismiss a bankruptcy case as not being filed in good faith. A creditor who wants to dismiss the case and keep suing the debtor must prove not just the debtor’s “subjective bad faith” (which means proving what a company’s executives were thinking), but also the “objective futility of any possible reorganization” (which means proving a negative condition, through speculation). ⁴ Unfortunately for J&J, the Western District of North Carolina Bankruptcy Court decided they were just forum-shopping, and sent LTL’s bankruptcy case to New Jersey where parent J&J is headquartered.

Dismissing a Chapter 11 Bankruptcy Filing in the Third Circuit as Not in Good Faith

In the Third Circuit, which handles appeals from Federal Courts in Pennsylvania, Delaware, and New Jersey, when a creditor challenges a Chapter 11 bankruptcy debtor’s good faith, the debtor must prove it filed the bankruptcy petition for a “valid bankruptcy purpose”, such as being in financial distress and wanting to preserve a going concern or asset value to pay claims, and not “to obtain a tactical litigation advantage”. ⁵ The Bankruptcy Court for the District of New Jersey ruled against the talc plaintiffs and held that LTL Management filed for a valid bankruptcy purpose, because it was in financial distress from present and future talc liabilities, and was trying to use the Bankruptcy Code to resolve its talc liabilities by creating a settlement trust. ⁶ The Bankruptcy Court also held LTL was not seeking unfair tactical advantage, because “the bankruptcy court is the optimal venue for redressing the harms of both present and future talc claimants in this case”. ⁷

Third Circuit Bankruptcy Courts Should Try to Preserve Creditors’ Due Process Rights

On direct appeal, the Third Circuit Court of Appeals overruled the Bankruptcy Court and held that LTL Management failed to prove its good faith, providing sound guidance for creditors who want to dismiss a debtor’s bankruptcy case. The Appeals Court found that LTL was not in financial distress because, by LTL’s own admissions, J&J equipped LTL to pay talc liabilities through LTL’s “$61.5 billion payment right against J&J and New Consumer…. that was very valuable, likely to grow, [] minimally conditional [and] reliable, as J&J and New Consumer were highly creditworthy counterparties … with the capacity to satisfy it.” ⁸ The Appeals Court acknowledged the irony that J&J undermined LTL’s fitness for bankruptcy by providing enough money to pay its bankruptcy claims. ⁹ Creditors can compare whether their own distressed debtor has access to the assets or guarantees of parent companies or affiliates, insurance proceeds, or other pending payment rights that controvert its avowed financial distress.

The Appeals Court also overruled the Bankruptcy Court’s holding that, from a utilitarian perspective, bankruptcy is the best way to resolve complex liabilities. The Appeals Court preferred the wisdom of Solomon, holding that “given Chapter 11’s ability to redefine fundamental rights of third parties, only those facing financial distress can call on bankruptcy’s tools to do so.” 10

Pre-Petition Restructuring to Shed Liabilities is a Legal Problem for Another Day

The Appeals Court avoided deciding if J&J’s Texas Two-Step contradicted the principles and purposes of the Bankruptcy Code. The practice is controversial and has some legal vulnerabilities – J&J likely gave LTL a funding backstop greater than expected talc liabilities in order to avoid fraudulent conveyance litigation over dividing talc liabilities from available assets. But brasher debtors are using this and similar means to dump their liabilities, and this practice will get further scrutiny. That being said, there are valid, legally defensible means to restructure a business under Pennsylvania, Delaware, or other states’ laws, in addition to going to Texas, and the Bankruptcy Code does not require a Chapter 11 debtor to be insolvent before filing a bankruptcy petition.

Whether you operate a business that needs to restructure or are a creditor enforcing a payment obligation from a distressed company, qualified counsel can help you test the law’s limits. You may contact our firm’s Bankruptcy and Creditor’s Rights practice to discuss your options in either circumstance.

The Court’s opinion is available here.

1. The process had additional steps not discussed here that are outside of the scope of this article. It differs from restructuring options provided by most other states including Pennsylvania or Delaware, and companies organized in
   Pennsylvania or Delaware have some other considerations to address under either state’s laws, but it may be
   available to companies organized in Pennsylvania, Delaware, and other states that want to form and merge into a
   Texas entity.

2. Texas Bus. Orgs. Code Ann. §10.008(a)(4).

3. With rare exceptions.

4. In re LTL Management, LLC, No. 22-2003, at *28, FN 8 (3 rd Cir. Jan. 20, 2023), citing Carolin Corp. v. Miller, 886
   F.2d 693, 694 (4 th Cir. 1989)

5. In re LTL Management at *34, quoting In re 15375 Mem’l Corp. v. BEPCO, L.P., 589 F.3d 605, 618 (3d Cir. 2009)

6.  In re LTL Management at **30-31.

7. In re LTL Management at *31.

8. In re LTL Management at *46.

9. Id.

10. In re LTL Management at *55; see also Id. at *56 (“J&J’s belief that this bankruptcy creates the best of all possible
    worlds for it and the talk claimants is not enough, no matter how sincerely held. Nor is the Bankruptcy Court’s
    commendable effort to resolve a more-than-thorny problem. These cannot displace the rule that resort to Chapter 11
    is appropriate only for entities facing financial distress. This safeguard ensures that claimants’ pre-bankruptcy
    remedies—here, the chance to prove to a jury of their peers injuries claimed to be cause by a consumer product—are
    disrupted only when necessary.”).