United States: The Third Circuit Rejects Texas Two-Step Bankruptcy Strategy: A Funding Agreement With Affiliates Made The Debtor Too Financially Sound To Seek Bankruptcy Relief

Recently, the United States Court of Appeals for the Third Circuit dismissed the chapter 11 case of LTL Management, LLC ("LTL"), a company created in a divisional merger under Texas law to capture and seek to resolve comprehensively in chapter 11 talc-related mass tort liabilities, for lack of good faith. When a divisional merger is followed by a surviving entity filing chapter 11 to resolve liabilities allocated to it in the plan of merger, the transaction is commonly called a "Texas Two-Step," with the first step being the divisional merger and the second step being the bankruptcy filing.  This decision casts doubt on the effectiveness of using the Texas Two-Step and a funding agreement with a financially sound parent or affiliate to address mass tort liability in bankruptcy, as discussed below.

The Texas Business and Organizations Code allows an entity to divide into two or more new entities, vesting the predecessor's assets and valuable business segments in one entity and the predecessor's liabilities in the other.  No entity created in the merger is liable for the obligations of the other. Companies with mass tort liability have utilized the Texas Two-Step as a mechanism to isolate and seek to resolve globally mass tort claims under a chapter 11 plan without exposing valuable business segments or the entire corporate enterprise to a bankruptcy proceeding. A funding agreement is often coupled with the Texas-Two Step to mitigate intentional and constructive (i.e., consideration-based) avoidable transfer claims arising from the separation of assets from liabilities.

In LTL's case, the Third Circuit found that the funding agreement pursuant to which LTL was entitled to payments from a highly solvent and credit-worthy parent in excess of the foreseeable mass tort liability negated a finding of financial distress necessitating dismissal of the bankruptcy case since "absent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose."  The Court underscored that "[g]ood intentions—such as to protect the J&J brand or comprehensively resolve litigation—do not suffice alone. What counts to access the Bankruptcy Code's safe harbor is to meet its intended purposes. Only a putative debtor in financial distress can do so. LTL was not."

While the LTL decision may hinder future debtors' ability to use the Texas Two-Step strategy in bankruptcy, it does not necessarily preclude use of the Texas Two-Step as an entity created thereunder could still file bankruptcy in good faith if it suffered financial distress at the time of a chapter 11 filing. And financial distress does not mean insolvency, as the Third Circuit made clear "that a debtor must be in financial distress is not to say it must necessarily be insolvent." Moreover, courts outside of the Third Circuit, some of which do not require financial distress as a basis for finding a bankruptcy was filed in good faith, are not bound by the Third Circuit's decision in LTL.

Background

Johnson and Johnson Consumer Inc. ("Old Customer"), a subsidiary of Johnson & Johnson ("J&J"), implemented the first step of a Texas Two-Step corporate restructuring when it divided into LTL and Johnson & Johnson Consumer Inc. ("New Customer").  At the time, Old Customer was plagued with governmental actions and over 38,400 claims asserting that Old Customer's talc-based products caused ovarian cancer and mesothelioma. In the divisional merger, LTL received, among other things, all liability for the claims related to Old Customer's talc-based products and the rights to funding from New Customer and J&J under a funding agreement. 

Outside of bankruptcy, the funding agreement provided LTL with the ability to cause J&J and New Customer, jointly and severally, to pay up to the value of New Customer to satisfy the talc-related costs and ordinary expenses.  In bankruptcy, the funding agreement gave LTL the right to receive cash in the same amount to fund administrative costs and to fund a trust created in a plan of reorganization to satisfy talc liability for existing and future claimants. The Third Circuit noted that the funding agreement contained few conditions and no repayment obligation.  The agreement also set a floor for the value of New Customer at $61.5 billion, the value of New Customer at the time of the divisional merger.  The agreement, however, did not impose a cap on the value of New Customer and the right to payment was subject to increase as the value of New Customer increased post-merger.

Within days of the divisional merger, LTL filed chapter 11 in the Bankruptcy Court for the Western District of North Carolina. The case, however, was transferred to the Bankruptcy Court for the District of New Jersey, where J&J is headquartered.  Following the transfer, the Official Committee of Talc Claimants filed a motion to dismiss LTL's bankruptcy filing. The bankruptcy court denied the motion, holding that LTL had filed bankruptcy in good faith.  The Committee of Talc Claimants requested direct appeal to the Third Circuit, which was granted. 

The Third Circuit Finds a Lack of Good Faith

In its analysis, the Third Circuit reasoned that the bankruptcy petition must serve a valid bankruptcy purpose to be a good faith filing, which the Third Circuit held requires a degree of financial distress that must not only be apparent but also sufficiently immediate to justify a filing. 

In reviewing LTL's financial condition, the Court balanced the projected cost of the talc-related liability, based on past settlement negotiations and litigation outcomes, with the value of the funding agreement.  The Court found that "while LTL faces substantial future talc liability, its funding backstop plainly mitigates any financial distress foreseen on its petition date."  Given the lack of financial distress, the Court concluded that the bankruptcy petition was not filed in good faith.  The Court, however, made clear that the requirement of financial distress is not a requirement of insolvency, and that use of the Texas Two-Step would not necessarily result in a bad faith filing—noting:

Finally, the Court held that the state-law property interest must be given the same effect inside and outside of bankruptcy.  The Texas Two-Step created new entities with their own set of assets and liabilities, and only the financial condition of the debtor, LTL, is determinative of good faith. As such, the Court determined that the bankruptcy court had committed legal error in grounding its analysis in the financial condition of Old Customer, rather than LTL.

Conclusion

While the Third Circuit noted that it does not mean to discourage lawyers and management teams from being inventive, and that a company's financial health can be threatened in all sorts of  ways that could justify relief under the bankruptcy laws, applying this decision will require innovation, as crafting a Texas Two-Step transaction in the Third Circuit will now require that the debtor be in financial distress. Further, this new financial distress requirement, which is not found in the Bankruptcy Code, could prove to be persuasive in other circuits.  Only time will tell as to the overall effect of the LTL decision.

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