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]

J & J has not fared well in the early going. According to press reports,[12] on October 23, 2021, Bankruptcy Judge J. Craig Whitley for the time being refused to stay ongoing talc lawsuits against J & J, some reportedly nearing verdict, pending a November hearing. A bankruptcy stay ordinarily halts lawsuits against a debtor when it files Chapter 11. So far, the stay only benefits LTL, which doesn't appear to be a defendant in any of the cases. The judge said he did not have sufficient evidence about J & J's corporate structure to decide whether it merited the protection of a bankruptcy stay.

Judge Whitley’s reaction to J & J's plan probably didn't give the company much comfort. He said that, depending on your perspective, it’s either a “brilliant strategy” or "manifestly unfair." He wasn’t prepared to commit to one interpretation or the other.

For good measure, the judge questioned whether the case was appropriately filed in North Carolina, since LTL has a limited connection with the state. No doubt, he would jump at the opportunity to send the case to someone else's courtroom.[13]

How this turns out for J & J is anybody’s guess. What looks like a sleight of hand might just work, even if the end result is a settlement of all claims through the vehicle of the bankruptcy action, which may be exactly what the company is looking for anyway.

__________________ [1] Texas Bus. Org. Code Ann. §1.002(55)(A). [2] Texas Bus. Org. Code Ann. §10.003. [3] Texas Bus. Org. Code Ann. §10.008(a)(4). [4] In re: LTL Management LLC, Case No. 21-30589 (Bankr. W.D.N.C. filed Oct. 14, 2021). [5] For example, in 1972, J & J created an operating division for its baby products. From 1979 through 2015, an entity known as J & J Consumer, Inc. acquired that business and became responsible for all claims alleging that the talc-related products caused cancer or other diseases. Under a funding agreement dated October 12, 2021, a different entity, also known as Johnson & Johnson Consumer, Inc., is obligated to pay all costs and expenses of LTL, including those associated with the bankruptcy. If that were not complicated enough, J & J has reportedly been unable to locate the documents that establish that the original J & J Consumer, Inc. is liable for talc-related claims. [6] 26 C.F.R. §1.46B-1. Qualified settlement funds are tax qualified trust for litigation proceeds. Defendants get an immediate tax deduction for the amount of the fund and a full release. Plaintiffs can determine how and when they will be paid. Their lawyers can structure their fees or be paid immediately. [7] Texas Bus. Org. Code Ann. §24.005(a)(1). [8] Texas Bus. Org. Code Ann. §24.006(a). [9] Texas Bus. Corp. Act Ann. Art. 5.06(a)(2); Texas Bus. Org. Code Ann §10.008(a)(2). [10] TXO Prod. Co. v. M.D. Mark, Inc., 999 S.W.2d 137,141 (Tex. App. 1999). [11] E.g., PPG Ind., Inc. v. Guardian Ind. Corp., 597 F.2d 1090, 1096 (6th Cir. 1979). [12] Jonathan Randles, Bankruptcy Judge Declines to Pause Talc Litigation Against Johnson & Johnson, Wall Street Journal (Oct. 25, 2021). [13] Jonathan Randles, J & J Bankruptcy Claims May Not Belong in Charlotte Bankruptcy Court, Judge Says, Wall Street Journal (October 21, 2021).