What Is a Texas Two Step Bankruptcy?
A Texas Two Step Bankruptcy is a controversial legal maneuver that a company can use to manage its exposure to potential legal claims. In carrying out a Texas Two Step Bankruptcy, a company first creates a new legal entity into which it transfers its tort liabilities while transferring a relatively small portion of the original company’s assets. The newly created corporation then files for bankruptcy, effectively shielding the original company from the tort liability costs.
The Texas Two Step Bankruptcy is controversial, with critics arguing that it allows companies to hide from their legal responsibilities. The method has drawn criticism from parts of the legal community and the public at large, as well as from Congress. Therefore, it is possible that future laws or legal decisions may undermine the viability of the Texas Two Step Bankruptcy strategy.
- A Texas Two Step Bankruptcy is a legal defense companies pursue for tort liabilities use.
- The practice is commonly associated with the legal defenses recently made by Johnson & Johnson (JNJ) in relation to alleged asbestos in some of their baby powder products.
- Some politicians have taken steps to potentially outlaw the practice, while it has so far been largely upheld in the courts.
How a Texas Two Step Bankruptcy Works
As its name implies, there are two essential steps to carrying out a Texas Two Step Bankruptcy, the first of which is to create a new corporation. Companies will typically register this new corporation in a jurisdiction, such as Texas, whose system of corporate law is understood to be business-friendly. After this corporation is created, the company then transfers the tort liabilities in question over to that newly created corporation. This process of creating a new company and transferring over a corporation's liabilities is known as a “divisive merger,” and is sometimes also referred to as a “reverse merger.”
When this process is complete, the next step in the process is for the newly created company to file for Chapter 11 bankruptcy. In practice, this means that the dispute over the tort liability will need to be resolved through the bankruptcy process, and without necessarily having recourse to the full assets owned by the original company that is now a separate legal entity. By contrast, a typical legal procedure might instead involve taking the matter to a jury trial or settling out of court with the claimants.
Example of a Texas Two Step Bankruptcy
Perhaps the most famous example of a Texas Two Step Bankruptcy is the strategy employed by the pharmaceutical-and-consumer-products giant Johnson & Johnson. For the past several years, the company has been subjected to lawsuits in which claimants have alleged that some of its talcum-based baby powder products had contained asbestos, thereby contributing to incidents of cancer.
In June 2021, one such lawsuit resulted in an appeals court in Missouri ordering the company to pay $2.1 billion to the claimants. Later that year, the company used a divisive merger to create a new subsidiary called LTL Management LLC, transferring its talcum-related liabilities to that subsidiary along with a $2 billion trust intended to provide funding for any potential future claims against LTL.
Because the talcum-related liabilities are now held in the new subsidiary, claimants can theoretically no longer pursue the JNJ for damages but must instead pursue LTL. Given that LTL’s $2 billion trust is significantly smaller than the total assets available to JNJ, this could effectively limit the maximum damages that future claimants could claim, thereby shielding JNJ from potentially unlimited liabilities.
This strategy by JNJ received fairly widespread media attention, in which it was cited as a clear example of a Texas Two Step Bankruptcy. Critics of the approach have argued that it wrongly limits claimants' ability to receive damages, and that by forcing resolution of the legal dispute through bankruptcy proceedings, it could potentially delay and frustrate victims’ pursuit of compensation. Defenders of the Texas Two Step Bankruptcy process argue that the bankruptcy process will ultimately determine whether the actions of the company are fair, and that this process protects companies from the risk of unreasonably punitive jury verdicts.
Moving forward, to what extent the courts will uphold Texas Two Step Bankruptcy remains to be seen. In February 2022, Judge Michael Kaplan of the Bankruptcy Court for the District of New Jersey gave support to the strategy by ruling against a motion to dismiss the bankruptcy filing of JNJ’s subsidiary, LTL Management LLC. In this ruling, Judge Kaplan determined that JNJ and its subsidiary's maneuver was a legitimate use of the Bankruptcy Code and added that the bankruptcy system would be a superior method for resolving JNJ’s outstanding claims regarding its baby powder products.
In his concluding remarks, Judge Kaplan noted, “The Court remains steadfast in its belief that justice will best be served by expeditiously providing critical compensation through a court-supervised, fair, and less costly settlement trust arrangement.”
Similar decisions that seem to uphold the Texas Two Step Bankruptcy have also been reached in North Carolina. Yet there is also opposition to the practice. Sen. Dick Durbin, who currently serves as the chair of the Senate Judiciary Committee, has been publicly critical of the practice and has recently called for legislation to outlaw it. In speaking to the Financial Times in February 2022, Durbin derided the legal strategy as a “get out of jail free card.”
Why Is Texas Two Step Bankruptcy Named after Texas?
The Texas in Texas Two Step Bankruptcy is included for both technical and informal reasons. The technical reason is that the strategy relies on a divisive merger (also known as a reverse merger), which is a technique that is widely accepted in Texas. But the name is also partly a reference to the Texas two-step, a popular dance associated with traditional country music.
Is the Texas Two Step Bankruptcy Only Used in Asbestos-Related Cases?
Although the Texas Two Step Bankruptcy is most commonly associated with asbestos-related legal cases such as those of JNJ, this technique could in principle be used to resolve any type of tort liability. For this reason, the individual decisions reached in the courts relating to this technique have significance beyond the specific legal cases involved, since these decisions could lead to similar strategies being used by companies in a wide variety of industries. Similarly, any potential legislation outlawing the practice would presumably restrict its use in a wide range of applications, not just those relating to asbestos claims.
Why Is the Texas Two Step Bankruptcy Controversial?
Some critics of the Texas Two Step Bankruptcy argue that it provides wealthy defendants with a way to escape their legitimate legal obligations, essentially viewing the practice as a clever legal trick. However, others argue that the Texas Two Step Bankruptcy is a legitimate way to settle outstanding legal disputes, one that could potentially accelerate the often lengthy process of trials by jury. Although individual judges can have some influence over the acceptance of this practice through the precedents set by their rulings, politicians may ultimately exert even greater influence by passing new laws that either uphold or restrict the practice.