J & J Does the Texas Two Step
Maybe you thought the Texas two step was just a country dance. Not any more. It’s also the name given to a type of merger aimed at reducing, or eliminating, corporate liabilities.
Here’s how it works. Texas corporate law defines the term “merger” to include a company’s transforming itself into a Texas entity—the type of entity doesn’t matter. The company then undergoes a maneuver given the oxymoronic name “divisive merger” by splitting in two.[1] Texas law requires that the agreement and plan of merger allocate company assets and liabilities between the two.[2] What’s more, no party to the merger “is liable for the debt or other obligation” of the other parties.[3]
In recent years, companies facing large asbestos claims have used the scheme to place assets in one surviving entity and liabilities in another, a newly formed entity, which is then put in Chapter 11 bankruptcy.
The latest company to avail itself of this stratagem is Johnson & Johnson. J & J faces over 38,000 lawsuits, including 35,000 in a multi-district litigation in New Jersey, alleging that two of its talc products, Baby Powder and Shower to Shower, caused the plaintiffs inflammation leading to ovarian cancer or, in rare cases, mesothelioma. The company claims it has spent nearly $1 billion in defense costs and incurred verdicts and settlements totaling $3.5 billion, including a verdict of over $2.2 billion in a Missouri state court case involving 22 plaintiffs.
Confronted with the prospect of decades of litigation and claiming the cost of the suits is unsustainable, J & J formed a corporate entity in Texas, LTL Management LLC, and used a divisive merger to split off the talc-related claims from the rest of its business. LTL converted to a North Carolina LLC on October 12, 2021 and then filed for Chapter 11 protection in the U.S. Bankruptcy Court in Charlotte, North Carolina on October 14.[4] LTL claimed between $1 billion and $10 billion in assets and liabilities in the same $1 to $10 billion range.
LTL also asserted that it has responsibility to oversee a wholly owned subsidiary, Royalty A & M LLC, which, it estimates, will make available a portfolio of royalty revenue streams, totaling $50 million annually, for five years. The Bankruptcy Court is now left to unravel J & J’s complicated corporate structure[5] and deal with all of the talc-related claims plaintiffs filed against J & J, their irate lawyers and rest of the fallout from the company’s Texas two step.
Along with the Chapter 11 filing, LTL is seeking the Bankruptcy Court’s approval for a $2 billion “qualified settlement fund” under Section 468B[6] of the Internal Revenue Code to resolve all current and future talc claims, maintaining that this sum is “substantially in excess of any liability [LTL] should have,” in order to eliminate any doubt regarding [LTL’s] ability to pay legitimate claims.”
The plaintiffs and their lawyers would certainly beg to differ. Not only are they going to take issue with court approval of a sum LTL has determined unilaterally, they can credibly respond that a single verdict, in the Missouri case, was in excess of $2 billion.
Along with the Chapter 11 petition and application for approval of the settlement fund, LTL also filed a 132-page “Informational Brief,” in which it recounted the history of its talc products, and complained about the litigation tactics and anti-talc media blitz of plaintiffs’ lawyers, and its treatment in the media generally, all of which resulted in a sales downturn, leading to the decision by J & J to discontinue its line of talc-based products in the U.S. and Canada.
The Informational Brief also contains an extended discussion of the litigated talc claims and what it describes as “shockingly high” verdicts, and an attack on plaintiffs’ scientific expert witnesses and their opinions as to causation. But the Bankruptcy Court won’t be relitigating those cases.
None of this is to suggest that the claims made in the talc cases are valid or that J & J’s grievances are without basis. According to the company’s bankruptcy filings, about 1300 of the ovarian cancer and 250 mesothelioma cases have been dismissed without payment. And there have been 16 jury verdicts in J & J’s favor, including in six of eight trials in 2021.
What is also telling is that while J & J’s Baby Powder has been on the market since 1894, concerns that the company’s products may be contaminated with asbestos did not arise until the 1970s. As J & J notes, the issue has been controversial since then, and the science is anything but settled.
All of this is pretty complicated, but begs a simple question: Is this ploy going to work? After all, Texas law also includes a broad definition of “fraudulent transfers,” which include a transfer made “with the intent to hinder, delay or defraud any creditor of the debtor.”[7] A separate provision makes fraudulent a transfer made or obligation incurred by a debtor which arose prior to the transfer “if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent economic value.”[8]
A transfer of liabilities to one surviving entity in a divisive merger evidently seems to fit within that definition. But that’s not the end of the analysis. Texas law also provides that when a merger takes effect and assets and liabilities are allocated among surviving entities, that allocation takes place “without any transfer or assignment having occurred.”[9] Hence, the argument J & J will rely on when the issue of a fraudulent transfer inevitably arises: since there is no transfer at all when the vehicle for the allocation is a merger, divisive or otherwise, there can be no fraudulent transfer.
Semantics aside, and assuming Texas law applies, the question is whether the Texas statutory definition of a fraudulent transfer is limited by the state’s law governing mergers. That’s an assumption that may well be tested by the plaintiffs.
While no Texas court has squarely addressed the issue, in a case where there was no allegation of fraudulent transfer liability—the matter involved assignment of a non-disclosure agreement—a court ruled no transfer had taken place when the surviving corporation succeeded to the rights and obligations of the entity which ceased to exist.[10] Courts in other jurisdictions have reached a contrary result.[11]