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Texas Two-Step Bankruptcy Definition

What Is a Texas Two-Step Bankruptcy?

The term Texas Two-Step bankruptcy refers to a controversial legal maneuver that a company can use to manage its exposure to potential legal claims. To carry out a Texas Two-Step bankruptcy, a company must first create 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. It is a controversial step, as critics argue that it allows companies to hide from their legal responsibilities.

Key Takeaways

  • A Texas Two-Step bankruptcy is a legal defense that companies can use to deal with their tort liabilities.
  • The process involves creating a subsidiary through a divisive or reverse merger and transferring the tort liabilities, after which the new company declares bankruptcy.
  • Undertaking a Texas Two-Step shields the original company from any claims or payouts.
  • Critics say the tactic allows companies to hide from their legal and financial obligations.
  • The practice is commonly associated with the legal defenses made by Johnson & Johnson in relation to alleged asbestos in some of their baby powder products.

How a Texas Two-Step Bankruptcy Works

Lawsuits and other legal issues can often be problematic for businesses of all shapes and sizes. Being embroiled in litigation, such as class action lawsuits, can cost time, money, and a loss of trust among consumers and the general public. But there are certain legal manoeuvers that companies have at their disposal to alleviate themselves of the burden of legal claims that may be filed against them.

The Texas Two-Step bankruptcy is one of those tactics. It is a form of corporate bankruptcy. Put simply, it is a legal step that a company can use to pass off its legal and financial liabilities to another company. As the name implies, there are two essential steps to carrying out a Texas Two-Step bankruptcy:

  1. 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.
  2. Transfer 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 sometimes 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. This shields the original or parent company from the costs associated with its tort liabilities.

In practice, this means that the dispute over tort liability must be resolved through the bankruptcy process. It also means the resolution comes without necessarily having recourse to the full assets owned by the original company, which 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.

391

The total number of corporate bankruptcies in 2022, which is the lowest in 13 years.

Criticism of the Texas Two-Step Bankruptcy

The Texas Two-Step bankruptcy is controversial. Critics, including those from the legal community, argue that it gives corporations a pass on accepting responsibility for their legal obligations. They also say it provides corporations with another way to shield themselves, which is a privilege that regular consumers can't access.

Here's why. Creating another corporation, transferring the tort liabilities, and then declaring bankruptcy (sometimes fairly quickly) allows the company to avoid litigation in the event of a lawsuit. It also allows the company to absolve itself of any financial responsibility to its consumer base and its shareholders.

Although there are no laws that prevent companies from taking this step, it is possible that future laws or legal decisions may undermine the viability of the Texas Two-Step bankruptcy strategy.

So why is it called a Texas Two-Step bankruptcy? There are a couple of reasons why the tactic was given this name. The first is because it's a reference to the dance, the Texas Two-Step, which is generally associated with traditional country music. But perhaps, more important, is the fact that the divisive or reverse merger is a technique that is widely accepted in the state of Texas.

Example of a Texas Two-Step Bankruptcy

Perhaps the most famous example of a Texas Two-Step bankruptcy is Johnson & Johnson (JNJ). The company was sued by consumers who alleged that some of its talcum-based baby powder products had contained asbestos, which contributed to cancer.

A Missouri appeals court ordered the company to pay $2.1 billion to the claimants in a June 2021 ruling. Later that year, the company used a divisive merger to create a new subsidiary called LTL Management LLC and transferred its talcum-related liabilities to that subsidiary along with a $2 billion trust intended to provide funding for any potential future claims against LTL.

This means that people can't pursue Johson & Johnson because the assets belong to LTL. And the $2 billion trust, which is significantly smaller than the total assets available to JNJ, could effectively limit the maximum damages future plaintiffs could claim, ultimately shielding JNJ from potentially unlimited liabilities.

JNJ's strategy received widespread media attention. Critics argued that it wrongly limited claimants' ability to receive damages and that forcing the resolution through bankruptcy proceedings could potentially delay and frustrate victims’ pursuit of compensation. Defenders argue that the bankruptcy process will determine whether the company's actions were fair. They also state that the process protects companies from the risk of unreasonably punitive jury verdicts.

The Texas Two-Step bankruptcy isn't commonly used. In fact, only a small number of companies have even attempted it.

In February 2022, Judge Michael Kaplan of the Bankruptcy Court for the District of New Jersey supported the strategy and ruled against a motion to dismiss LTL's bankruptcy, In the ruling, Kaplan determined that the maneuver was a legitimate use of the bankruptcy code.

“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 (D-Ill.), who serves as the chair of the Senate Judiciary Committee, is publicly critical of the practice and 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 legal cases like Johnson & Johnson's, this technique could 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. Others argue that it 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.

Article Sources
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  1. Thompson Coburn LLP. “Johnson & Johnson: The Texas two-step and talc-related liabilities.”

  2. Sheldon Whitehouse United States Senator for Rhode Island. "Whitehouse Chairs Courts Subcommittee Hearing on Corporate Abuse of Bankruptcy to Avoid Accountability."

  3. U.S. Courts. "Chapter 11 - Bankruptcy Basics."

  4. S&P Global. "US corporate bankruptcy filings sink to new low in 2022."

  5. Sheldon Whitehouse United States Senator for Rhode Island. "Whitehouse Responds to Ruling Upholding the Harmful Texas Two-Step Bankruptcy Maneuver."

  6.  Bloomberg Law. “J&J’s ‘Texas Two-Step’ Talc Bankruptcy Strategy Remains in Doubt.”

  7. New York Times. “Women With Cancer Awarded Billions in Baby Powder Suit.”

  8. Financial Times. “US lawmakers plan bill to outlaw ‘Texas two-step’ bankruptcy ploy.”

  9. Michigan Law Review. "Texas Two-Stepping Out of Bankruptcy."

  10. United States Bankruptcy Court District of New Jersey. “Memorandum Opinion re: LTL Management LLC.” Page 55.

  11. United States Bankruptcy Court District of New Jersey. "LTL Management, LLC, Plaintiff, v. Those Parties Listed on Appendix A To Complaint and John and Jane Does 1-1000," Pages 45-54.

  12. Financial Times. “US lawmakers plan bill to outlaw ‘Texas two-step’ bankruptcy ploy.”

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