Over the past few years, corporations facing thousands of lawsuits have increasingly turned to a legal tactic that was literally a joke in The Office: declaring bankruptcy under a different name. As the legal theory goes, it doesn’t matter if the company is actually insolvent or in need of debt restructuring, because a quirk in Texas law allows companies to perform a “divisional merger” in which two new companies are created: one to keep all the productive business assets and one to absorb the litigation liabilities. The latter company then declares bankruptcy and uses the bankruptcy process to delay, reduce, or wholly eliminate the claims against it. This so-called “Texas two-step” looked to be the future for most mass torts (particularly those involving carcinogens) until Monday, when the 3rd U.S. Circuit Court of Appeals pumped the brakes in the LTL Management case.
LTL Management marked Johnson & Johnson’s effort to avoid liability for its talc-based baby powder products. (Disclosure: I’ve litigated against J&J subsidiaries but have no financial interest in the talc litigation.) Tens of thousands of people have sued the company, claiming it knew these products contained asbestos that caused women to develop ovarian cancer and mesothelioma. In response to a slew of lawsuits from patients and their survivors across the country, J&J created two new companies. It offloaded all its liabilities into one, called LTL Management, and shifted all its assets into another, called J&J Consumer Inc. The first company, LTL Management, then swiftly declared bankruptcy and obtained an injunction against lawsuits involving J&J’s talc products, preventing alleged talc victims from moving forward at all in their cases, much less recovering damages. Meanwhile, the second company, J&J Consumer Inc., just kept on making money.
If this looks like an obvious shell game, that’s because it is. And it gets worse. J&J is headquartered and incorporated in New Jersey. Yet it created these new companies under the laws of Texas, then filed bankruptcy in North Carolina. Why? Forum shopping. North Carolina is in the 4th U.S. Circuit Court of Appeals, which has a low standard for determining if a bankruptcy was filed “in good faith.” That gives the Texas two-step a better chance of passing muster. As the 3rd Circuit noted yesterday, it is “perhaps not by coincidence then, debtors formed by divisional mergers and bearing substantial asbestos liability seem to prefer filing in the Fourth Circuit, with four such cases being filed in the Western District of North Carolina in the years before LTL’s filing.”
But that’s where everything started going off the rails for J&J. The bankruptcy court for the Western District of North Carolina noticed some rather obvious problems with the filing. For example, “the employees of the Debtor are all employees of Johnson & Johnson Services, Inc., a New Jersey corporation,” and “the Debtor’s assets involve no operation of a business in North Carolina.” The court concluded that “in this case, the Debtor is not just forum shopping; the Debtor is manufacturing forum and creating a venue to file bankruptcy.” In our era of rising judicial sophistry and arrogance, Judge J. Craig Whitley’s candor and humility is refreshing: Pointing out that J&J’s claims mirrored four previous bankruptcy cases filed in his district, he wrote: “There is no reason this court should be the only bankruptcy court to have the opportunity to weigh in on these novel legal issues, especially considering that the ‘Texas Two Step’ tactic is being employed by national corporations and impacts tens of thousands of present and future claimants across the country.”
Judge Whitley thus transferred the case to New Jersey, where it should have been filed in the first place.
New Jersey was a more receptive venue for J&J, which is one of the state’s largest businesses. The plaintiffs filed a motion to dismiss the bankruptcy, but the New Jersey bankruptcy court let J&J have its cake and eat it too, allowing LTL Management to rely on a $61 billion “funding agreement” with J&J to show that it wasn’t just pulling off an enormous fraudulent transfer while also allowing LTL Management to pretend it only had $373.1 million in assets for purposes of deciding if the company was in “financial distress.” The bankruptcy was allowed to proceed—including, crucially, the “automatic stay” that prevented lawsuits against J&J from going forward in other venues.
Plaintiffs appealed to the 3rd Circuit, and J&J did what a lot of shady companies do when they want an appellate court to adopt a cockamamie legal theory that lets them avoid ever facing a jury trial: hire Neal Katyal. (Plaintiffs hired David Frederick. If you’re so inclined, the two-and-a-half-hour oral argument is available here.) And on Monday, the court sided firmly with the plaintiffs.
The 3rd Circuit’s precedential opinion doesn’t wholly neutralize the “Texas two-step,” but it does make it harder for corporations to knock over more structural components in our already shaky civil justice system. Bankruptcy is, by design, one of the more potent tools in the law, a legal black hole with a gravitational pull that automatically halts every lawsuit in the country against a debtor, grants courts the discretionary power to halt other lawsuits that might affect the debtor, and pulls in every debt, contract, and claim ever made against the company, enabling debtors to set their claimants against one another as they fight for timing and priority. In LTL Management, the 3rd Circuit made clear that bankruptcy is not merely an alternative proceeding that corporations can elect if they dislike the results produced by the civil justice system: “absent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose. … Financial distress must not only be apparent, but it must be immediate enough to justify a filing.”
J&J is, of course, not in financial distress. The 3rd Circuit noted: “At the time of LTL’s filing, J&J had well over $400 billion in equity value with a AAA credit rating and $31 billion just in cash and marketable securities. It distributed over $13 billion to shareholders in each of 2020 and 2021.” Moreover, the 3rd Circuit recognized that J&J’s estimate of the potential defense costs and liability from its talc products—well over $300 billion—was wildly inflated: J&J had already settled about 6,800 talc-related claims for under $1 billion and obtained dismissals of about 1,300 ovarian cancer and over 250 mesothelioma claims without paying a dime to the plaintiffs. The essence of the 3rd Circuit’s opinion is that courts need to look seriously at the company’s actual situation, rather than eagerly accepting every bit of contradictory hype pushed by the company’s lawyers.
Presumably, J&J’s next step is to file for certiorari with the U.S. Supreme Court. (It could file for en banc review with the full 3rd Circuit, but that is likely a lost cause. Because it was a precedential decision, the draft was already circulated among the entire 3rd Circuit and the three-judge panel was nonetheless comfortable with their unanimous opinion.) Certiorari seems a longshot: The Supreme Court already declined an opportunity to review a $2.24 billion talc judgment against J&J in favor of 20 ovarian cancer plaintiffs, there’s no split among the circuits yet on the “Texas two-step,” and the 3rd Circuit’s opinion is well reasoned and limited to the issue at hand.
One final point: this case also provides us with a concrete answer to the question “how much does it cost to get the supposed liberal hero Neal Katyal to help a Sedition Caucus–funding corporation like Johnson & Johnson try to slam the courthouse doors on thousands of cancer victims?” The answer is $2,465 an hour.
