Peter Cal

On January 30, the United States Court of Appeals for the Third Circuit dismissed a Chapter 11 bankruptcy filing for a subsidiary of Johnson & Johnson (J&J) created exclusively to isolate in the new subsidiary mass tort claims arising from allegations that the company’s talc products caused cancer.

The Chapter 11 bankruptcy case filed by LTL Management, LLC, a subsidiary of J&J, is noteworthy because it involves the creative use of a corporate restructuring tool recognized under Texas law to isolate mass tort liabilities in a single entity that then files for bankruptcy protection to resolve the mass tort liabilities in a perceived friendly forum. On a practical level, the appellate court’s decision relies upon existing law and provides support to creditors opposing a bankruptcy case filed by an entity that is not in financial distress and one in which the debtor claims the Chapter 11 process provides a better means of dealing with mass tort litigation than is otherwise available in the state and/or federal courts. The decision, however, leaves several important issues unanswered.

As background, J&J relied on the availability of a “divisive” merger – commonly referred to as the “Texas Two-Step” – under the Texas Business Organization Code and spun off the liabilities associated with its talc business into one subsidiary (LTL) while another subsidiary took over the valuable operating business. LTL would also have the benefit of a funding agreement based on the value of the old J&J entity that was restructured into two entities in the divisive merger under Texas law.  Based on the funding agreement, LTL had access to $61.5 billion to satisfy the tort claims and the administrative costs of LTL’s bankruptcy case. Ironically, the funding agreement in large part provided the basis for the Third Circuit to dismiss the LTL bankruptcy case as a bad-faith filing.

LTL filed its bankruptcy case in the United States Bankruptcy Court for the Western District of North Carolina (North Carolina bankruptcy court) based on favorable case law in the U.S. Court of Appeals for the Fourth Circuit concerning bad-faith bankruptcy filings. On the same day it filed its bankruptcy petition, LTL also sought an extension of the automatic stay to protect approximately 600 non-debtor entities, including J&J and certain affiliates, retailers of J&J products, and insurers, or, alternatively, an injunction precluding the tort claimants from pursuing claims against the non-debtor entities. The creditors moved to transfer the bankruptcy case to the United States Bankruptcy Court for the District of New Jersey (New Jersey bankruptcy court), the venue of federal multidistrict litigation involving the mass tort claims.  The North Carolina bankruptcy court granted the injunction for 60 days and transferred venue to the New Jersey bankruptcy court. Once in New Jersey, the mass tort claimants moved to dismiss the LTL bankruptcy case as a bad-faith filing. The New Jersey bankruptcy court, after a five-day trial, denied the motions to dismiss the bankruptcy case and extended the injunctions.  These decisions were accepted by the Third Circuit for a direct appeal.

Relying upon settled case law in the Third Circuit, the court identified the test for evaluating whether the case was filed in bad faith as (1) whether the bankruptcy filing serves a valid bankruptcy purpose and (2) whether it is filed merely to obtain a tactical litigation advantage.  The appellate court held that there can never be a valid bankruptcy purpose unless the debtor is in financial distress – “The theme is clear:  absent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose.”  In re LTL Mgmt., LLC, 2023 WL 1098189, *9 (3^rd Cir. Jan. 30, 2023).  Although the court said there is not a “rigid” test to apply to determine when an entity is in financial distress, it said insolvency was not required. According to the appellate court, the funding agreement, which based on the evidence would be sufficient to pay all the mass tort claims, precluded a finding of financial distress. The appellate court left open the possibility that the conclusion could change in the future as the mass tort litigation progressed.

Based on its decision concerning the lack of financial distress, the appellate court did not answer whether the use of the Texas Two-Step was an improper attempt to gain a tactical litigation advantage or whether the injunctions against pursuing litigation against the non-debtor entities were appropriate. The court also did not need to address whether the transfer of the mass tort liabilities into a separate entity was a fraudulent transfer notwithstanding the funding agreement.

For now, the efficacy of a divisive merger to isolate mass tort liabilities from an entity’s operating business has been called into question. Creditors pursuing litigation against an entity that files bankruptcy to obtain the benefit of the automatic stay should focus on the bad faith standard and the threshold issue of whether the debtor is in financial distress.