Why J&J's 'Texas-two step' setback could make it harder for companies to shed lawsuits

A new legal setback for Johnson & Johnson (JNJ) could make it more difficult for 3M (MMM) and other big companies to use a controversial bankruptcy tactic to shed costly product-liability lawsuits.

A US bankruptcy judge on Friday rejected a second attempt by J&J to resolve approximately 100,000 claims alleging the company’s talcum-based baby powder contained asbestos and caused cancer. J&J, which denies the claims, had offered a settlement of $8.9 billion.

The judge ruled that J&J affiliate LTL Management LLC, which was formed strictly to absorb the talc claims in a maneuver known as the “Texas two-step,” wasn’t in immediate "financial distress" and therefore could not qualify for Chapter 11 bankruptcy protection.

J&J is not the only company hoping to use the bankruptcy of an affiliate or subsidiary to settle mass liabilities. 3M and Georgia-Pacific are similarly trying to offload hundreds of thousands of injury claims using versions of the technique.

Those efforts have drawn challenges in multiple jurisdictions, with varying outcomes, leading some legal experts to expect the US Supreme Court to take up the issue.

“The trend is against using the Texas two-step,” said former bankruptcy judge and Northwestern University Pritzker School of Law professor Bruce Markell.

How it works

The strategy takes advantage of state laws that allow for the transfer of liabilities through a so-called divisive merger, which is a way to separate a company's operations into discreet business entities.

Texas was the first state to allow this, in 2006, which helps explain why the strategy came to be known as the "Texas two-step."

The first step is the division. The second is that the liability-retaining entity gets limited funding from its solvent parent, files for bankruptcy, and then manages mass tort litigation with the limited funds.

The benefits are that further litigation is paused, capping costs, and the assets of the solvent company are walled off from the reach of plaintiffs. The hope is that the solvent parent can also absolve itself of secondary liability for the claims.

Critics of the strategy see it as a subversion of the US Bankruptcy Code. Whether a solvent company can successfully use this strategy to protect its assets, Markell said, often centers on a key unresolved question still being debated by the courts.

That question, according to Markell: "Who is the debtor?"

'Fatally premature'

J&J has thus far not been able to prove to judges that the subsidiary it tailor-made for bankruptcy was in fact the true debtor. The company said it would appeal the most recent ruling.

3M has run into similar resistance in a maneuver that somewhat resembles what J&J did.

It is trying to use the bankruptcy of a group of already established subsidiaries that share the name "Aearo" to settle more than 255,000 cases filed by military service members and civilians who say Aearo-made earplugs were faulty and caused their hearing loss.

The 3M cases represent one of the biggest examples of multidistrict litigation in history.

In June, a US bankruptcy judge in Indiana ruled that the 3M subsidiaries were not in immediate jeopardy, calling the bankruptcy filings "fatally premature." The court found they lacked the hallmarks of a bankrupt debtor, echoing the determination made in the J&J case.

3M is appealing that ruling to the Seventh Circuit Court of Appeals, which has yet to say if it will limit bankruptcy as the Third Circuit Court of Appeals did in J&J’s case.

In a statement to Yahoo Finance, a spokesperson for 3M said "the Aearo proceeding is in a different court than LTL and did not involve the same type of transaction."

Paper-making giant Georgia-Pacific has had more success thus far with this strategy after creating a new affiliate called Bestwall LLC to resolve asbestos-related lawsuits against the main company.

A three-judge panel for the Fourth Circuit Court of Appeals blessed the maneuver in June.

One judge dissented, calling the company's restructuring "little more than a corporate shell game" that allowed it to "[obtain] shelter from its substantial asbestos liabilities without ever having to file for bankruptcy."

Plaintiffs are asking the appellate court to reconsider the ruling.

"Bankruptcy offers an equitable and practical approach to resolve the complex legal challenges faced by Bestwall LLC," the American Tort Reform Association said in a statement concerning the plaintiffs' dispute.

"Unlike traditional mass tort litigation, bankruptcy ensures that claimants receive fair resolution without enduring the uncertainty, delays and expenses often associated with lengthy trials."

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