The Texas Two-step: How Corporate Debtors Manipulate Chapter 11 Reorganizations to Dance Around Mass Tort Liability

• Jurisdiction: Texas,United States,Federal
• Citation: Vol. 39 No. 3
• Publication year: 2023

The Texas Two-Step: How Corporate Debtors Manipulate Chapter 11 Reorganizations to Dance Around Mass Tort Liability

Laura S. Rossi

THE TEXAS TWO-STEP: HOW CORPORATE DEBTORS MANIPULATE CHAPTER 11 REORGANIZATIONS TO DANCE AROUND MASS TORT LIABILITY

Abstract

The purpose of the bankruptcy system is to grant a "fresh start" to the honest but unfortunate debtor, while the purpose of the tort system is to make injured parties "whole" again. As a result, these systems inevitably clash when a business debtor files for bankruptcy while there are pending tort claims against it. The tension between these systems has reached a whole new level following the emergence of a new strategy deemed the "Texas Two-Step. "

A Texas statute leaves open a loophole for otherwise solvent companies to dodge mass tort liabilities and protect their assets, leaving injured plaintiffs with little hope of adequate recovery. The acceptance of such a maneuver into widespread bankruptcy practice will allow culpable companies to escape accountability and, more devastatingly, call into question the integrity of the bankruptcy and tort systems. Johnson & Johnson, a multinational conglomerate known for producing some of the most famous household products, is one of many companies using the Two-Step strategy to resolve injury claims related to its talc-based baby powder. Though many questions remain about the Two-Step's durability, the Third Circuit issued an opinion in the J&J case which could prove detrimental for the Two-Step's survival.

Because the Two-Step is a product of state law that engages with federal bankruptcy law, the solution requires striking a delicate balance between honoring state sovereignty while still effectively preventing putative debtors from seeking chapter 11 protection for reasons beyond the Code's intent. This Comment proposes a combination of judicial and legislative reforms that would prevent the Texas Two-Step from becoming the "norm" for companies facing mass tort liability. More specifically, this Comment advocates for reform of state and federal laws that currently allow the Texas Two-Step to proceed, in addition to encouraging courts to follow the Third Circuit's approach from In re LTL Management regarding bad faith.

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Table of Contents

Introduction..........................................................................................587

I. Chapter 11 Reorganizations.....................................................590

A. Chapter 11 Reorganization & Creditors' Committees ............. 590

B. Treatment of Tort Claims after Chapter 11 Reorganization ..... 592

C. The "Good-Faith" Filing Requirement................................... 595

II. What's the Deal with Texas?...................................................596

A. "Divisive Mergers" under Texas Law..................................... 596

B. Creditors' Rights .................................................................... 598

III. The Texas Two-Step in Practice...............................................601

A. The Rise of Asbestos Lawsuits................................................. 601

B. Georgia-Pacific and CertainTeed Bankruptcies ...................... 604

C. The Johnson & Johnson Dilemma ........................................... 606

D. Dangers of the Dance ............................................................. 611

IV. Cut the Music : Avenues for Judicial & Legislative Reform.........................................................................................613

A. Judicial Attack: Closing the Statutory Loophole...................... 613

B. Judicial Attack: Adopting the Third Circuit's "Bad Faith" Analysis.................................................................................. 615

C. Legislative Reform: Strengthening Tort Creditors' Clawback Powers ................................................................... 616

D. Legislative Reform: Banning Forum Shopping in Texas Two-Step Cases ...................................................................... 621

Conclusion.............................................................................................625

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INTRODUCTION

The principal purpose of the bankruptcy system is to grant a "fresh start" to the "honest but unfortunate debtor."¹ A business debtor may achieve a fresh start by filing for a chapter 11 reorganization under the Bankruptcy code (the "Code"). Under chapter 11, an insolvent business may reorganize its debts according to a plan of reorganization while still carrying out normal business functions. Because the business continues to operate after filing under chapter 11, the debtor is able to maximize its recoverable assets to pay off creditors.² chapter 11 reorganizations ultimately assist "the financially distressed business enterprise by providing it with breathing space in which to return to a viable state."³ In other words, chapter 11 is specifically reserved for businesses facing genuine financial turmoil.⁴

Once a debtor files for bankruptcy, creditors—including tort creditors—are automatically barred from collecting on a prepetition debt or claim.⁵ The primary purpose of tort law is "to give compensation, indemnity, or restitution for harms" inflicted upon the plaintiff.⁶ Courts grant compensatory damages as an attempt to put the injured party in the same position as she would have been had the tort not been committed, thus making her "whole" again.⁷ The costs of litigation, in turn, deter manufacturers from producing, selling, and marketing defective or hazardous products.⁸ When a plaintiff files a tort claim against a business for harms caused by a defective or hazardous product, and that business later files for bankruptcy protection, the purposes of these two systems begin to clash.

The relationship between bankruptcy and tort law has faced greater tension in recent years, largely due to the discovery of a loophole in one of Texas's business statutes. The Texas Legislature substantially amended the Texas

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Business Corporation Act ("TBCA") in 1989 to modernize its merger provisions and attract businesses to incorporate in the state.⁹ One amendment created the "divisive merger," which effectively allows corporations to split the company in two through a plan of merger.¹⁰ An essential element of the merger plan, and its most compelling implication for bankruptcy relief, is how the corporation chooses to allocate its assets and liabilities among the two entities.¹¹ In anticipation of creditors' concerns over this practice, the Texas Legislature noted that "[c]reditors' rights would not be adversely affected by the proposed amendment, and creditors would continue to have protection afforded by the Uniform Fraudulent Transfer Act and other existing statutes that protect the rights of creditors."¹² Unfortunately, the legislature failed to anticipate the emergence of the Texas Two-Step.¹³

The Texas Two-Step is a mechanism by which a company¹⁴ first splits into two entities, transferring all of its assets to Subsidiary A and all of its liabilities to Subsidiary B, and then plunges Subsidiary B into bankruptcy.¹⁵ This strategy, if employed successfully by a company facing mass liabilities, would substantially limit compensation for injured plaintiffs and bring an "indefinite halt" to all related trials being heard in state and federal courts. ¹⁶ Major companies, including Georgia-Pacific and CertainTeed, previously adopted this strategy to deal with liabilities arising from mass asbestos exposure claims.¹⁷ However, "[t]he largest Two-Step" to date is currently being attempted by Johnson & Johnson Consumer Inc. ("J&J"), a wholly owned subsidiary of Johnson & Johnson.¹⁸ After plaintiffs in New Jersey and Missouri unsuccessfully tried to bar the company from undergoing a divisional merger,¹⁹

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J&J underwent the Texas Two-Step in 2021 as an attempt to shield itself "from almost 40,000 claims that its baby talcum powder caused cancers."²⁰

The Texas Two-Step greatly threatens the integrity of both the bankruptcy and tort systems. Though the fresh start policy is supposed to be reserved for the honest but unfortunate debtor, companies that have undergone the Two-Step have attempted to manipulate the bankruptcy system to delay or deny justice for people harmed by their dangerous products.²¹ The Two-Step creates room for otherwise solvent business debtors to shield themselves from the consequences of their wrongful conduct in direct violation of the policy underlying the Code.²²

The Texas Two-Step also prevents an injured plaintiff from having their chance to be made "whole" again.²³ When a company moves its liabilities to a new entity with insufficient assets and keeps its remaining assets out of reach, injured plaintiffs cannot be adequately compensated.²⁴ Instead of having their day in court, an injured plaintiff merely becomes just another creditor tied up in bankruptcy proceedings.²⁵ And the parent company—the one actually liable for these injuries—is left untouched and unstigmatized by the bankruptcy proceedings.²⁶ Because of these potentially devastating consequences, the Texas Two-Step dilemma requires prompt resolution before it becomes the norm for companies facing mass tort and related liabilities.

Section I of this Comment describes the role of creditors' committees in a chapter 11 reorganization before detailing how tort creditors in bankruptcy already face strong headwinds, even without the Two-Step. It concludes with a brief discussion of the implicit good faith filing requirement in chapter 11 cases. Section II explores the Texas statute more in depth and examines how it affects

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the rights of creditors. Section III evaluates the Texas Two-Step in practice by chronicling how Georgia-Pacific and CertainTeed's chapter 11 bankruptcy proceedings paved the way for J&J to replicate this strategy in 2022. This section also discusses the Third Circuit's January 2023 decision to dismiss LTL...