The Third Circuit’s recent opinion in LTL-the so-called “Texas Two-Step” case- might surprise some bankruptcy watchers. Previously, one might have thought that a chapter 11 debtor could defeat a motion to dismiss as having been filed in “bad faith” by showing either that the debtor: (1) was in financial trouble; or (2) had many creditors.
LTL, by contrast, suggests that the Third Circuit may be choreographing a new dance—a “one-step”?—that focuses solely on the underlying policy goals of chapter 11 despite numerosity, where future threats to enterprise solvency are uncertain. In LTL, consumer-products giant Johnson & Johnson was defending about 38,000 lawsuits arising from allegations that its talc products contained asbestos. Although talc liability “put financial pressure” on J&J, it had won or settled many cases. Still, J&J tried to contain its projected liability in a new subsidiary (LTL) formed pursuant to a “divisional merger” under Texas law, which then became the debtor in the LTL chapter 11.
To avoid the plausible claim that this was little more than a fancied-up fraudulent transfer, parent J&J entered into a “funding agreement” with LTL, under which J&J committed the full value of its now-liability-free consumer products subsidiary—$61.5 billion— to pay talc claims. Tort plaintiffs moved to dismiss the bankruptcy on grounds that it was filed in bad faith. LTL responded that the case was filed in good faith, because it would surely pay more tort creditors more through a chapter 11 plan than the much-maligned “tort system”. The Bankruptcy Court accepted this argument, and denied the motion to dismiss.
Third Circuit Judge Ambro disagreed. “Good intentions,” he wrote for a unanimous panel that reversed the Bankruptcy Court, “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.”
Most analysis will focus on the solvency leg of the analysis. But LTL may have broader implications for how we think about the purpose of chapter 11. One can imagine that LTL sought to use bankruptcy not merely to provide a more efficient resolution to its talc liability. Instead, my hunch is that an unstated purpose in LTL was to enable J&J to control the process by which liability would be determined, all while keeping J&J free from the scrutiny, risk, and hassle of chapter 11.
Like most chapter 11 tortfeasors, LTL would probably have used a plan of reorganization to force creditors into expedited claim allowance processes and to impair or eliminate the right to a jury trial, at the expense of individual protections from Congress and the Supreme Court. Meanwhile, J&J’s other operations would largely be immune from creditor scrutiny, “borrowing” LTL’s bankruptcy benefits without its burdens.
On this view, several controversial cases (notably Purdue Pharma) might warrant closer scrutiny. Like J&J, Purdue Pharma faced no immediate financial crisis—it had no funded debt. Like J&J, Purdue Pharma’s owners, the Sacklers, undertook “defensive maneuvers” before bankruptcy to protect their fortune and brand. Like LTL, Purdue Pharma’s plan (the subject of a pending appeal in the Second Circuit), would shield the owners of the company on grounds that this resolution maximized value.
Of course, the response would be that the Purdue Pharma case is three-and-a-half years old and in a different Circuit. No one sought to dismiss that case. But, as I explain here, efforts to fight the deal Purdue Pharma and the Sacklers sought to implement in bankruptcy met strong resistance from the bankruptcy judge, the debtors and, ultimately, most creditor groups. A motion to dismiss would surely have been treated with similar skepticism.
“Good faith” is a composite impression, akin to a policy judgment, so it is difficult to say that either the Bankruptcy Court or the Third Circuit in LTL was “wrong.” Instead, LTL may signal growing concern by Article III courts that chapter 11’s reach exceeds its grasp. The Third Circuit’s opinion in LTL echoes the skepticism of District Courts in Ascena and 3M about the use of bespoke concoctions such as nondebtor releases and sweeping preliminary injunctions to displace other courts and other legal processes.
Whether the Second Circuit will continue this trend in Purdue Pharma, where its nondebtor releases are sub judice, remains to be seen.
Jonathan C. Lipson is the Harold E. Kohn Chair and Professor of Law of Temple University—Beasley School of Law. He represented a wrongful death claimant on a pro bono basis in the Purdue Pharma case and later filed an amicus brief before the Second Circuit opposing certain aspects of Purdue Pharma’s reorganization plan.