It isn’t often that technical bankruptcy mechanics find their way into national news headlines. One notable – and repeat – exception to this is the resurgent “Texas Two-Step”. Although it was far from the first, the most highly publicized example in recent years is the Johnson & Johnson-LTL proceeding, which has reignited interest in the approach. As we discuss in this article, the LTL case, and others that have come before it, tell a complicated story in which it remains to be seen if the “Texas Two-Step” can perform.
The “Texas Two-Step”
A divisive merger by another name, the “Texas Two-Step” involves a company relocating to Texas (or Delaware) and splitting into two new entities. One of those resulting entities primarily houses the prior company’s assets; the other holds its tort or other major liabilities. The entity housing the liabilities then files for Chapter 11. Typically, the liability entity enters into a funding agreement with certain non-filing affiliates to ensure it can fund the bankruptcy (and an eventual resolution of the target claims), all while the original company’s assets are kept with the non-filing asset entity.
Two-Step evangelists tout it as a way to centralize mass tort liability while ringfencing the potential collateral consequences of potential payouts, but the reality is far more complicated. As of September 2023, no Texas Two-Step case has resulted in a confirmed plan of reorganization. As we discuss below, the legal issues generated by reliance on the maneuver have also proven complicated and, in large part, unresolved.
The “Texas Two-Step”
A divisive merger by another name, the “Texas Two-Step” involves a company relocating to Texas (or Delaware) and splitting into two new entities. One of those resulting entities primarily houses the prior company’s assets; the other holds its tort or other major liabilities. The entity housing the liabilities then files for Chapter 11. Typically, the liability entity enters into a funding agreement with certain non-filing affiliates to ensure it can fund the bankruptcy (and an eventual resolution of the target claims), all while the original company’s assets are kept with the non-filing asset entity.
Two-Step evangelists tout it as a way to centralize mass tort liability while ringfencing the potential collateral consequences of potential payouts, but the reality is far more complicated. As of September 2023, no Texas Two-Step case has resulted in a confirmed plan of reorganization. As we discuss below, the legal issues generated by reliance on the maneuver have also proven complicated and, in large part, unresolved.
Johnson & Johnson: Too Much of a Good Thing (Twice)
Johnson & Johnson’s (J&J) LTL bankruptcy is arguably the most well‑known Two-Step in recent years. The case stems from sprawling litigation against a J&J subsidiary (among others), which asserts that the company’s talc powder causes ovarian cancer. After completing a divisive merger in Texas and setting up a funding agreement with J&J worth more than $60bn (and a short stop in the North Carolina Bankruptcy Court before a transfer over LTL’s objection), LTL overcame several motions to dismiss before the New Jersey Bankruptcy Court, which allowed the case to proceed1.
The Third Circuit had other ideas. On appeal, it found that LTL did not qualify for bankruptcy because, as a result of its generous funding agreement, which the court observed was “not unlike an ATM disguised as a contract”2, LTL had more than enough cash to address its reasonably foreseeable liabilities. The Third Circuit found these liabilities speculative based on the state of the pending talc litigation.
For a variety of procedural reasons, it took about three months for the Third Circuit’s decision to result in an order dismissing the LTL bankruptcy. As we learned when LTL filed its second bankruptcy petition just two hours after that order, LTL had used the time to secure a revised funding agreement and negotiate with counsel to over 50,000 potential talc plaintiffs a roughly $8.9bn trust for claims payouts, all aimed at curing the Third Circuit’s concerns.
Unfortunately for LTL, its changes fell short. In July 2023, the bankruptcy court, relying on the Third Circuit’s decision, dismissed LTL’s second bankruptcy, finding again that LTL was not in financial distress3. The case is now back on appeal, and time will tell whether the dismissal is reversed, or whether LTL puts an old adage to the test and takes a third swing at filing. In the meantime, it is worth noting that courts’ scrutiny of funding arrangements and their effects on solvency have extended beyond the world of the Two-Step, with the dismissal of 3M subsidiary Aearo Technologies’ bankruptcy on substantially similar grounds to that of LTL4.
Johnson & Johnson: Too Much of a Good Thing (Twice)
Johnson & Johnson’s (J&J) LTL bankruptcy is arguably the most well‑known Two-Step in recent years. The case stems from sprawling litigation against a J&J subsidiary (among others), which asserts that the company’s talc powder causes ovarian cancer. After completing a divisive merger in Texas and setting up a funding agreement with J&J worth more than $60bn (and a short stop in the North Carolina Bankruptcy Court before a transfer over LTL’s objection), LTL overcame several motions to dismiss before the New Jersey Bankruptcy Court, which allowed the case to proceed1.
The Third Circuit had other ideas. On appeal, it found that LTL did not qualify for bankruptcy because, as a result of its generous funding agreement, which the court observed was “not unlike an ATM disguised as a contract”2, LTL had more than enough cash to address its reasonably foreseeable liabilities. The Third Circuit found these liabilities speculative based on the state of the pending talc litigation.
For a variety of procedural reasons, it took about three months for the Third Circuit’s decision to result in an order dismissing the LTL bankruptcy. As we learned when LTL filed its second bankruptcy petition just two hours after that order, LTL had used the time to secure a revised funding agreement and negotiate with counsel to over 50,000 potential talc plaintiffs a roughly $8.9bn trust for claims payouts, all aimed at curing the Third Circuit’s concerns.
Unfortunately for LTL, its changes fell short. In July 2023, the bankruptcy court, relying on the Third Circuit’s decision, dismissed LTL’s second bankruptcy, finding again that LTL was not in financial distress3. The case is now back on appeal, and time will tell whether the dismissal is reversed, or whether LTL puts an old adage to the test and takes a third swing at filing. In the meantime, it is worth noting that courts’ scrutiny of funding arrangements and their effects on solvency have extended beyond the world of the Two-Step, with the dismissal of 3M subsidiary Aearo Technologies’ bankruptcy on substantially similar grounds to that of LTL4.
Litigation Risk
The potential consequences of a successful fraudulent transfer suit are significant: the Two-Step could be unwound, or the non-filing asset company could face a significant (potentially existential) judgment.
Fraudulent Transfers
Companies that make it past the starting gate, unlike LTL, face another, as-yet untested hurdle in fraudulent transfer litigation. It’s not hard to imagine the complaint: the debtor agreed to take on $X in liability (a) in order to hinder, defraud or delay tort claimants from collecting on their claims and/or (b) in exchange for a funding agreement worth less than $X. The potential consequences of a successful fraudulent transfer suit are significant: the Two-Step could be unwound, or the non-filing asset company could face a significant (potentially existential) judgment. Early Two-Step dancer DBMP attempted to rebut a fraudulent transfer suit by arguing, in part, that a provision of Texas law says a divisive merger isn’t a transfer at all. However, the bankruptcy court rejected that notion, and the case now sits in discovery as the restructuring world watches closely to see what happens.
Fraudulent Transfers
Companies that make it past the starting gate, unlike LTL, face another, as-yet untested hurdle in fraudulent transfer litigation. It’s not hard to imagine the complaint: the debtor agreed to take on $X in liability (a) in order to hinder, defraud or delay tort claimants from collecting on their claims and/or (b) in exchange for a funding agreement worth less than $X. The potential consequences of a successful fraudulent transfer suit are significant: the Two-Step could be unwound, or the non-filing asset company could face a significant (potentially existential) judgment. Early Two-Step dancer DBMP attempted to rebut a fraudulent transfer suit by arguing, in part, that a provision of Texas law says a divisive merger isn’t a transfer at all. However, the bankruptcy court rejected that notion, and the case now sits in discovery as the restructuring world watches closely to see what happens.
Uncertain Future
The final hurdle of a Chapter 11 is confirmation of a plan of reorganization. Until this milestone is achieved, it’s not clear whether this route into bankruptcy is accompanied by a way out. In the meantime, divisive mergers have caught more than the attention of the restructuring community and the popular press; Congress is watching too, and some of its members are actively seeking to relegate the Two‑Step to the legislative dustbin. Until then, it will be anyone’s guess if (or when) the music of the Texas Two-Step will stop.
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