Third Circuit Court of Appeals Steps Away from the Texas Two Step

By NallyAnn Scaturro*

In this article, the author examines a decision by a panel of the U.S. Court of Appeals for the Third Circuit and its implications for the future of mass tort litigation.

Chapter 11 of the Bankruptcy Code is meant to allow debtors the opportunity to “deal with the reorganization of a financially distressed enterprise.”1 Chapter 11 is employed by enterprises that wish to continue operating their businesses while paying creditors back (usually allowing a debtor to reduce its debts by paying only a portion of its obligations) through a court-approved reorganization plan. In fact, “Congress designed Chapter 11 to give those businesses teetering on the verge of a fatal financial plummet an opportunity to reorganize on solid ground and try again, not to give profitable enterprises an opportunity to evade contractual or other liability.”2 Additionally, although financial distress is not explicitly addressed in the United States Bankruptcy Code (the Bankruptcy Code), the code is clearly not intended to insulate “financially secure debtors.3 For these reasons, the U.S. Court of Appeals for the Third Circuit panel ruled that Johnson & Johnson (a corporation with a higher credit rating than the United States) unit LTL Management LLC was not in financial distress when it filed for bankruptcy, thus it could not use the bankruptcy system to shield itself from liabilities and deny mass tort litigants the chance to prove to a jury of their peers injuries claimed to be caused by a consumer product when it had the financial capacity to meet these claims. This article first explains what constitutes good faith and financial distress in order to validly file a bankruptcy petition. It then discusses the reasoning behind the Third Circuit finding that LTL was not in financial distress. It concludes by exploring what the decision means for the future of mass tort litigation.

GOOD FAITH STANDARD

The good faith requirement is vitally important to maintaining the equitable nature of bankruptcy and the underlying purposes of Chapter 11 of the Bankruptcy Code.4 Good faith is necessary because bankruptcy significantly disrupts creditors’ existing claims against a debtor by vesting Chapter 11 petitioners with considerable powers, including the automatic stay, the exclusive right to propose a reorganization plan, and the discharge of debts, that can impose significant hardship on particular creditors. In fact, the good faith requirement is so central to the inquiry that Chapter 11 bankruptcy petitions are subject to dismissal under 11 U.S.C. § 1112(B)5 unless filed in “good faith.”6 Once at issue, it is the debtor’s burden to establish good faith.7 In order to make this determination courts, “examine the totality of the facts and circumstances and determine where a petition falls along the spectrum ranging from the clearly acceptable to the patently abusive.”8 While a debtor’s subject intent may be relevant, the analysis of good faith hinges on “whether the debtor has sought to step outside the equitable limitations” of Chapter 11.9 In deciding whether a petition was filed in good faith courts consider two questions to be especially relevant: (1) whether the petition serves a valid bankruptcy purpose, and (2) whether it is filed merely to obtain a tactical litigation advantage.10

Additionally, a valid bankruptcy purpose assumes the debtor is in financial distress.11 As the Third Circuit has made clear in its ruling, “Whether financial distress exists depends on the underlying basic facts, such as the debtor’s ability to pay its current debts, and inferred facts, such as projections of how much pending future liabilities (like litigation) could cost in the future.”12 Additionally, financial distress must be both apparent and imminent enough to justify a filing because the mere attenuated possibility that a debtor may have to file for bankruptcy in the future does not establish good faith.13 It should be noted that debtors can be in financial distress without being insolvent,14 but insufficient cash flow to pay liabilities (or the future likelihood of these issues occurring) are likely always relevant to this inquiry 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.15

IN RE LTL MANAGEMENT, LLC

Johnson & Johnson (J&J) produced Johnson’s Baby Powder for well over a century. Its base was talc, which recent studies showed contained traces of asbestos, causing ovarian cancer and mesothelioma. Suits were brought, some succeeded, some failed, and others settled. Soon 38,000 ovarian cancer actions were filed (mostly consolidated in federal multidistrict litigation in New Jersey), and over 400 mesothelioma actions were pending. Then a Missouri jury awarded $4.69 billion to 22 ovarian cancer plaintiffs, which was later reduced on appeal to $2.24 billion to 20 plaintiffs.16 It should be noted, however, that since 2018 damages in all other monetary awards to claimants averaged about $39.7 million per claim and J&J often succeeded at trial.17 Additionally, J&J settled roughly 6,800 talc-related claims for just under $1 billion in total and was able to get about 1,300 ovarian cancer and 250 mesothelioma actions dismissed without payment.18 However, claiming to be fearful of the mounting claims filed against it, J&J decided to use a move popularly known as the Texas Two Step to split into two new entities: LTL Management LLC (LTL) and Johnson and Johnson Consumer Inc. J&J then transferred its liabilities relating to talc litigation to LTL along with a funding support agreement. LTL then filed for Chapter 11 bankruptcy two days after its creation. The Texas Two Step is a controversial bankruptcy maneuver that involves a parent company spinning off a unit and transferring its tort liability to that unit, usually through Texas corporate law allowing divisional mergers. The spinoff unit then declares bankruptcy and the assets of the original company parent company are safeguarded. The Third Circuit noted LTL is “essentially a shell company formed almost exclusively to manage and defend thousands of talc-related claims while insulating at least the assets now in New Consumer.”19 The Third Circuit found that LTL was not in financial distress when it filed for bankruptcy because of the funding agreement it had with Johnson & Johnson that allowed it payment rights to $61.5 billion, which the court explained was “not unlike an ATM disguised as a contract.” In fact, the court noted LTL was “highly solvent with access to cash to comfortably meet its liabilities as they came through.” Additionally, “the funding agreement itself stated that LTL held assets having a value at least equal to its liabilities and had financial capacity sufficient to satisfy its obligations as they became due in the ordinary course of business, including any talc related liabilities.” Therefore, even though LTL inherited great liability from J&J its access to funds to meet that liability exceeded all reasonable projections of claimants’ damages and the mere possibility that talc litigation might have required it to file for bankruptcy in the future did not establish good faith as to the petition date.

EFFECT ON MASS TORTS LITIGATION

As the Third Circuit emphasized, when financial distress is present, bankruptcy may be an appropriate forum for a debtor to address mass torts liability. For example, a debtor in financial distress may require bankruptcy to “enable a continuation of its business and maintain access to capital markets” or to allow a debtor to efficiently obtain financing when there are “outstanding uncertain and unliquidated future liabilities.” Additionally, mass tort cases may present these issues as well as others, such as the “exodus of customers and suppliers wary of the firm’s credit-risk.”20 As the Third Circuit explained, “Mass tort liability can push a debtor to the brink. But to measure the debtor’s distance to it, courts must always weigh not just the scope of liabilities the debtor faces, but also the capacity it has to meet them.”21 Importantly, courts must weigh the risk of premature filing because “inevitably those cases will involve a bankruptcy court estimating claims on a great scale – introducing the possibility of undervaluing future claims (and underfunding assets left to satisfy them) and the difficulty of fairly compensating claimants with wide-ranging degrees of exposure and injury.22 For these reasons, claimants pre-bankruptcy remedies – the chance to prove to a jury of their peers injuries claimed to be caused by a consumer product – are only to be disrupted when necessary.23 Finally, J&J’s triple A-rated payment obligations for LTL’s liabilities greatly weakened its bankruptcy case. “Put another way, the bigger the backstop a parent company provides a subsidiary the less fit that subsidiary is to file.”24 When a funding agreement provides more than enough financial support to protect a debtor, allowing it to meet its obligations as they arise, that debtor cannot seek shelter in the system designed to provide such protection to those without.

CONCLUSION

Bankruptcy is reserved for those who need its protection. Therefore, absent financial distress there is no need to reorganize under the protection of Chapter 11 and no valid reason to disrupt mass tort claimants’ pre-bankruptcy rights. Although it is impossible to predict the precise forms financial distress may take in the years to come courts will continue to do a case-by-case analysis, considering all relevant factors in light of the purposes underlying the bankruptcy code: offering debtors a release from burdensome debt and the opportunity to have a financial fresh start.25

*NallyAnn Scaturro is an associate attorney in the Mass Torts and Product Liability group based in the New York office at Sullivan Papain Block McManus Coffinas & Cannavo P.C. She may be contacted at nscaturro@triallaw1.com.
1 SGL Carbon, 200 F.3d at 166 (quoting S. Rep. No. 95-989, at 9, reprinted in 1978 U.S.C.C.A.N. 5787, 5795).

2 Cedar Shore Resort, Inc v. Mueller (In re Cedar Shore Resort, Inc.), 235 F.3d 375, 381 (8th Cir. 2000).

3 Barclays-Am./Bus. Credit, Inc. v. Radio WBHP, Inc. (In re Dixie Broad., Inc., 871 F.2d 1023, 1027-28 (11th Cir. 1989).

4 Id. at 161-62 (“A debtor who attempts to garner shelter under the Bankruptcy Code . . . must act in conformity with the Code’s underlying principles.”).

5 Section 1112(b) provides dismissal for “cause.” Although not specifically listed in the statute, lack of good faith constitutes “cause.” See In re SGL Carbon Corp., 200 F.3d 154, 159-62 (3d Cir. 1999).

6 BEPCO, 589 F.3d at 618 (citing NMSBOCSKDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), 384 F.3d 108, 118 (3d Cir 2004).

7 BEPCO, 589 F.3d at 618 (citing Integrated Telecom, 384 F.3d at 118); SGL Carbon, 200 F.3d at 162 n.10.

8 BEPCO, 589 F.3d at 618 (citing Integrated Telecom, 384 F.3d at 118). See also Cedar Shore Resort Inc., 235 F.3d at 379-80 (in evaluating good faith, courts “consider the totality of the circumstances, including the debtor’s financial condition, motives, and the local financial realities”; dismissing petition, in part, because the debtor was “not in dire financial straits.”).

9 Id. at 618 n.8 (citing SGL Carbon, 200 F.3d at 165).

10 Id. at 618 (citing Integrated Telecom, 384 F.3d at 119-20) (the court notes that valid bankruptcy purposes include “preserving a going concern” or “maximizing the value of the debtor’s estate”).

11 Integrated Telecom, 384 F.3d at 128.

12 In re LTL Mgmt., LLC, No. 22-2003 (3d Cir. Jan. 30, 2023).

13 SGL Carbon, 200 F.3d at 164; Baker v. Latham Sparrowbush Assocs. (In re Cohoes Indus. Terminal, Inc), 931 F.2d, 228 (2d Cir. 1991) (“Although a debtor need not be in extremis in order to file, . . . it must, at least, face such financial difficulty that, if it did not file at that time, it could anticipate the need to file in the future.”).

14 The Bankruptcy Code does not contain any particular insolvency requirement. See SGL Carbon, 200 F.3d at 162; Integrated Telecom, 384 at 121.

15 Integrated Telecom, 384 F.3d at 121 (quoting Thomas H. Jackson, The Logic and Limits of Bankruptcy Law 10 (1986)).

16 Ingham v. Johnson & Johnson, 608 S.W. 3d 663 (Mo. Ct. App. 2020), cert. denied, 141 S. Ct. 2716 (2021).

17 In re LTL Mgmt., supra.

18 Id.

19 Id.

20 See e.g. Mark J. Roe, Bankruptcy and Mass Tort, 84 Colum. L. Rev. 846, 855 (1984) (describing “adverse” and “severe” effects large-scale, future tort claims may have on a firm).

21 In re LTL Mgmt., supra.

22 See Report of the National Bankruptcy Review Commission 343-44 (Oct. 20, 1997) (recognizing claims-estimation accuracy is an important component of the integrity of the mass tort bankruptcy process and noting underestimation of claims occurred in the Johns-Manville case, one of the earliest asbestos bankruptcy cases, while also pointing to the adequate funding of trusts in subsequent cases to show those risks are surmountable).

23 In re LTL Mgmt., supra.

24 Id.

25 Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934) (“[Bankruptcy] gives to the honest but unfortunate debtor . . . a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.”).

NallyAnn Scaturro, Third Circuit Court of Appeals Steps Away
from the Texas Two Step, 19 PRATT’S JOURNAL OF BANKRUPTCY LAW 118 (2023)

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