The Third Circuit recently reversed a decision from the bankruptcy court and dismissed the chapter 11 bankruptcy filing of LTL Management, LLC (“LTL”), a Johnson & Johnson subsidiary created through the use of the “Texas two-step” maneuver, intended to isolate Johnson & Johnson’s talc related tort liabilities. See In re LTL Mgmt., LLC, No. 22-2003, 2023 WL 1098189 (3d Cir. Jan. 30, 2023).  In issuing its decision, the Third Circuit held that LTL did not file its chapter 11 in good faith because the company was not in financial distress (a requirement which is not expressly included in the Bankruptcy Code).  The Court explained: “Good intentions—such as to protect the J&J brand or comprehensively resolve litigation—do not suffice alone. What counts to access the Bankruptcy Code’s safe harbor is to meet its intended purposes. Only a putative debtor in financial distress can do so. LTL was not.”  Id. at *1.  While the decision serves as an impediment to any future debtors’ ability to continue to utilize the “Texas two-step” strategy in bankruptcy, it does not completely foreclose the use of Texas two-step chapter 11 bankruptcies.  Among other things, (i) a subsidiary created using the Texas two-step could still file bankruptcy in good faith if it suffered financial distress, and (ii) certain courts outside of the Third Circuit do not “financial distress” to find that the debtor’s bankruptcy petition was filed in good faith.

Background and Bankruptcy Court Decision

Johnson & Johnson Consumer Inc. (“Old Consumer”) was a unit of Johnson & Johnson which sold, among other products, Johnson’s Baby Powder.  In recent years, tens of thousands of lawsuits were filed against Old Consumer and Johnson & Johnson alleging that Johnson’s Baby Powder caused ovarian cancer and mesothelioma based on concerns that talc contained traces of asbestos.  In October 2021, facing increasing litigation costs related to these talc claims, LTL was created in a “Texas two-step” maneuver through which Johnson & Johnson assigned the assets of Old Consumer to a new entity called Johnson & Johnson Consumer Inc. (“New Consumer”) and simultaneously assigned all of its talc liabilities to LTL along with certain assets including a funding support agreement from LTL’s corporate parents (the “Funding Agreement”).  Under the Funding Agreement, LTL could cause New Consumer and Johnson & Johnson to pay it cash up to the value of New Consumer (measured at $61.5 billion) to satisfy any bankruptcy related expenses and talc costs.  Two days later, LTL filed bankruptcy under Chapter 11 in the United States Bankruptcy Court for the Western District of North Carolina.  The North Carolina Bankruptcy Court issued an order preliminarily enjoining talc claims against third parties, including New Consumer and Johnson & Johnson, for sixty days and also transferred the case to the District of New Jersey, where Johnson & Johnson is headquartered.

In early 2022, the Official Committee of Talc Claimants and certain individual talc claimants moved to dismiss the bankruptcy filing, arguing that the bankruptcy was not filed in good faith.  Bankruptcy Judge Kaplan denied the motions to dismiss finding that the case was filed in good faith and served a valid bankruptcy purpose because LTL sought to resolve its talc liability through the use of a trust under § 524(g) of the Bankruptcy Code. The Bankruptcy Court also found that LTL was in financial distress because the viability of the Johnson & Johnson companies were imperiled based on the litigation faced and costs incurred by Old Consumer.  Judge Kaplan also granted LTL’s motion to extend the preliminary injunction to non-debtor third parties, including New consumer and Johnson & Johnson.  The talc claimants directly appealed those decisions to the Third Circuit.

Third Circuit Decision

The Third Circuit reversed the Bankruptcy Court’s decisions on appeal, finding that the LTL filing was not in good faith because LTL was not in financial distress.  The Bankruptcy Code does not expressly require debtors to be in financial distress in order to file bankruptcy in good faith.  Nevertheless, the Court relied on Third Circuit precedent to hold that “a debtor who does not suffer from financial distress cannot demonstrate its Chapter 11 petition serves a valid bankruptcy purpose supporting good faith.”  In re LTL, 2023 WL 1098189 at *8.  The Court also explained that a company does not necessarily need to be insolvent for it to be considered to be in financial distress.  “Instead, the good-faith gateway asks whether the debtor faces the kinds of problems that justify Chapter 11 relief. . . . . [A] a debtor’s balance-sheet insolvency or insufficient cash flows to pay liabilities (or the future likelihood of these issues occurring) are likely always relevant. This is because they pose a problem Chapter 11 is designed to address: that the system of individual creditor remedies may be bad for the creditors as a group when there are not enough assets to go around.” Id. at *9.

In finding that LTL was not in financial distress, the Court focused on the fact that LTL had a valuable Funding Agreement with a $61.5 billion payment right to fund talc liabilities and bankruptcy costs.  The Court also found that the Bankruptcy Court incorrectly focused on the financial condition of Old Consumer, rather than on the financial condition of the filing entity, LTL, in making its good faith determination.  The Court also disagreed with the Bankruptcy Court’s conclusions regarding pending litigation costs, finding that the Bankruptcy Court’s projections “ignore [] the possibility of meaningful settlement, as well as successful defense and dismissal, of claims by assuming most, if not all, would go to and succeed at trial.  In doing so, these projections contradict the record.” In re LTL, 2023 WL 1098189 at *14.  Thus, the Court reasoned that “[i]n this context, it becomes clear that, on its filing, LTL did not have any likely need in the present or the near-term, or even in the long-term, to exhaust its funding rights to pay talc liabilities. In the over five years of litigation to date, the aggregate costs had reached $4.5 billion (less than 7.5% of the $61.5 billion value on the petition date), with about half of these costs attributable to one ovarian cancer verdict, Ingham, to date an outlier victory for plaintiffs.” Id.

Impact of the Decision

The dismissal of LTL’s bankruptcy filing will terminate the preliminary injunction and enable tens of thousands of claimants injured by Johnson & Johnson’s products to seek recovery from the healthy parent entity in the tort system.  However, that outcome may need to await the result of an appeal to the Supreme Court, should LTL decide to seek review of the decision by the Supreme Court.

Further, the Third Circuit made clear in its decision that it was not deciding that any use of the controversial Texas two-step strategy would result in a bad faith bankruptcy filing:  “Some may argue any divisional merger to excise the liability and stigma of a product gone bad contradicts the principles and purposes of the Bankruptcy Code. But even that is a call that awaits another day and another case. For here the debtor was in no financial distress when it sought Chapter 11 protection. To ignore a parent (and grandparent) safety net shielding all liability then foreseen would allow tunnel vision to create a legal blind spot. We will not do so.” In re LTL, 2023 WL 1098189 at *18.  In fact, the Court noted that the Fourth Circuit, where certain other Texas two-step bankruptcies are pending, applies a different standard to dismiss a bankruptcy petition for lack of good faith, which does not turn on a debtor’s financial distress.  “In the Fourth Circuit, a court can only dismiss a bankruptcy petition for lack of good faith on a showing of the debtor’s “subjective bad faith” and the “objective futility of any possible reorganization.” Id. at *5 n. 8 (citing Carolin Corp. v. Miller, 886 F.2d 693, 694 (4th Cir. 1989)).  Thus, while the LTL decision raises significant questions about the ability of otherwise healthy companies to address their tort liabilities through the use of the Texas two-step structure within the Third Circuit, the Texas two-step remains a potentially viable strategy, particularly outside of the Third Circuit.