The Texas Two-Step Restructuring Strategy: Handling Mass Tort ClaimsUpdated:
If we take a step back and ask ourselves what restructuring really is – at its most fundamental level, devoid of any verbiage – a reasonable answer would be that it involves a balancing act of trying to fairly distribute economic value when not everyone, by definition, can get back what they’re currently or potentially owed.
To put a bit more meat on the bones, the entire edifice of restructuring can really be thought of as trying to create a predictable system by which the economic value of a debtor can be fairly distributed to creditors to satisfy their claims, while also balancing the fact that there won’t be enough to go around and we want the debtor to be viable moving forward.
While most restructurings – whether in-court or out-of-court – will usually result in a bit of litigation around technicalities, it’s rare that you’ll see serious arguments being made at a more fundamental level about the very structure of the restructuring transaction itself being unfair (and thus requesting that it be unwound or precluded from moving forward).
However, over the past five years we’ve seen this occur more frequently as the structure of restructuring transactions have become more novel and more aggressive in terms of what they're trying to do.
For example, over the past few years we’ve seen non-pro-rata uptiers from Serta, Boardriders, and TriMark – along with Incora just a few months ago – in which a simple majority of existing creditors have primed those not in the in-group. Thereby pushing the minority holders back in terms of priority and devastating the value of their holdings.
This all comes after the shock-and-awe of J. Crew doing their IP transfer in 2017 – followed by the likes of PetSmart – that shifted existing assets out from underneath existing creditors by utilizing unrestricted subsidiaries (we’ve seen a slightly more complex iteration of this just last month with Envision Healthcare).
When all the cases referenced above were announced, breathless commentary erupted in the financial press about the seeming unfairness of these transactions. The undertone of the commentary being that these kinds of transactions are just obviously unfair and that if they are upheld by the courts it would speaks to some level of brokenness in the bankruptcy system.
However, part of the reason why I wrote the Serta case study in the members area – that covers both non-pro-rata uptiers and the usage of unrestricted subsidiaries – was to try to show why these kinds of transactions make sense, how credit docs can be amended to prevent them if so desired, and why courts have (mostly!) permitted them.
Note: Mostly is the operative word. Some have unwound their more novel restructurings (e.g., Travelport unwound their attempted IP transfer in 2020), while most that have successfully done these more aggressive restructurings have settled instead of pursuing litigation too far (e.g., TriMark in early 2022). In the future I may write about this a bit more, as there's some interesting strategy behind how a debtor should navigate the wreckage after doing these kinds of transactions.
Anyway, what we’ll be talking about today doesn’t really involve a novel form of restructuring transaction – at least in the way that non-pro-rata uptiers and IP transfers are – but rather involves something that’s a layer above: reshaping the organizational structure of a debtor solely to be able to deal with a large and unknowable amount of future liabilities in a somewhat more efficient way by leveraging the bankruptcy system (without putting the entire company into bankruptcy in the process).
The Texas Two-Step Restructuring Strategy
Since the Texas Two-Step is a somewhat novel approach that's been done by just a few debtors, I wanted to use this post to get beyond just the mechanics of how its implemented. Instead, I wanted to also touch on the rationale for pursuing this strategy and touch on how to think about the issue of "fairness" (e.g., why aren't these cases immediately dismissed as bad faith filing?).
Anyway, since this is an absurdly long post I've broken it down into a few different sections that you can navigate using the links below.
The Rationale Behind the Texas Two-Step
The Mechanics of the Texas Two-Step
The Fairness of the Texas Two-Step
The Rationale Behind the Texas Two-Step
Over the past five years a small number of debtors – all of whom have had mass tort liabilities – have perused a so-called Texas Two-Step strategy (e.g., Georgia Pacific / Bestwall, Trane Technologies / Aldrich Pump, and CertainTeed / DMBP). Now, most controversially, we have the ongoing case of Johnson & Johnson (technically Johnson & Johnson Consumer Inc. / LTL Management).
The basic rationale for pursuing this strategy is quite straight forward. Imagine you’re a large company (e.g., Johnson & Johnson) that has thousands of products and over a hundred thousand employees. In other words, you’re a big and diversified conglomerate -- you don’t do just one thing, you do a myriad of different things and have done so for over a century.
But imagine that one of your products, allegedly, has caused cancer among some users due to how it has been formulated (e.g., your baby powder has included talc). As a consequence, you now have tens of thousands of pending lawsuits against you. However, after years of fighting these suits it’s not clear what your liability is really going to end up being. You’re winning almost all of the personal injury cases brought against you – after spending hundreds of millions on legal expenses – but you’ve also lost one case (involving just 22 plaintiffs!) that has suddenly strapped you with over two billion in liabilities.
Clearly this is a chaotic and uncertain situation for everyone involved…
From the perspective of the company, even if they win all the remaining cases they’ll still need to spend billions fighting them and it will take years and years to work through them all. However, given that the company is dealing with a large volume of cases (in the case of J&J, tens of thousands!) there’s always the possibility that they lose some cases and are suddenly on the hook for billions more than anticipated.
From the perspective of those bringing suit, they’ll be waiting years for any kind of resolution and, based on precedence, most are going to lose. But those few that win will be in for an astonishing payday (along with their lawyers, of course).
So, even if the company doesn't believe they’ve done anything wrong and believe they can win every future case it still, on balance, is going to be a massive overhang on the company to continue litigating these claims (investors don’t like having thousands of lawsuits pending!) and they’d rather it all just be resolved. This is especially true when the company is a large, diversified conglomerate -- they have many other things, related to the good functioning of their business now and in the future, to worry about.
Now, if we take a step back, one way to think about the bankruptcy process is that it’s a forcing function. When a company is trying to do an out-of-court restructuring, sometimes it’s impossible to get everyone to the table to agree on something. Sometimes the company just needs to file to get everyone to seriously get down to business, find an equitable resolution that can be agreed upon by a sufficient number of creditors, and move on.
So, what if there were a way to take all these potential future liabilities (the lawsuits) that the company has, concentrate them in one entity, put a pool of money alongside it, and then have that entity file Chapter 11. The ParentCo could still be on the hook for what the final amount of compensation is, if it’s above the money that's already been placed at this severed off entity, but the bankruptcy process would force a resolution of these claims against the company once and for all. In other words, the forcing function on the bankruptcy system would force everyone to come to the table, figure out a dollar amount for existing claims and any future claims, and be done with it.
So, this is where the Texas Two-Step comes in. It’s a way to sever off these legal liabilities into a singular entity, have that entity file, and then utilize the bankruptcy process to come to a final resolution as to what is really owed and distribute that to all the creditors (e.g., the thousands of those that have brought personal injury suits against the debtor).
Now perhaps I’ve framed the rationale for using the Texas Two-Step in such a way that you see no issue with it (because, full disclosure, I largely have no issue with it!).
Certainly one could reasonably argue the Texas Two-Step represents an ideal outcome -- one that illustrates the benefits of having such a robust bankruptcy system. Because what this type of restructuring allows is for the ParentCo to be able to focus on their primary business and gain certainty around their liabilities. Meanwhile the creditors will be able to have a quicker resolution of their claims and all creditors (tort claimants) with a valid claim will get some level of compensation (instead of most getting nothing while a small minority get tens of millions, which is what has happened in the case of J&J over the past few years).
However, there’s no getting around the fact that to a layman – or an enterprising politician who has forgotten their bankruptcy and tort law from their time at HLS or YLS – seeing a company sever off liabilities into an entity and then have that entity file bankruptcy doesn’t look great. Rather, it looks like the company is trying to skirt their financial responsibility by abusing the bankruptcy system.
While Jones Day has made hundreds of millions from architecting the Texas Two-Step and then working with debtors on implementing it, they’ve also created something almost perfectly suited to creating outrage.
In fact, the Texas Two-Step has caused sufficient and wide-spread enough outrage that there have been Senate hearings on it and a piece of legislation introduced – The Nondebtor Release Prohibition Act – to try to prevent this strategy from being utilized moving forward (and retroactively void those that have occurred, which would be a ridiculous mess if it were to occur).
The Mechanics of the Texas Two-Step
So now that we’ve painted the rationale for why someone would pursue a Texas Two-Step, along with providing a very brief overview of what it is, we should probably cover the mechanics a bit more granularly (e.g., what does Texas have to do with any of this?).
Traditionally when we think about mergers, we think about two distinct entities merging to create a larger entity. However, Texas law has a quirk in that mergers can also refer to a divisional merger whereby an entity incorporated in Texas can split into two discrete entities.
All that’s required is that the merger plan specifies how the company will be broken in two and that, importantly, the liabilities associated with each company must have assets sufficient to cover them.
So, what will happen in a Texas Two-Step is that a company will briefly reincorporate in Texas and undergo a divisional merger, resulting in the creation of what we’ll call GoodCo and LiabilityCo. The pre-merger company, that we’ll call OldCo, will cease to exist.
As the names would imply, LiabilityCo will get all the mass tort liabilities that were previously associated with OldCo along with some assets. The GoodCo will get everything else – essentially looking like the OldCo except without all the tort liabilities and without a few assets.
After this is done, GoodCo will reincorporate in the state that OldCo was previously incorporated in. LiabilityCo will reincorporate in the state that it will file in. This has historically been in North Carolina as the Western District of North Carolina was where the first attempts at the Texas Two-Step occurred so there’s case precedence.
However, after much argument, J&J's case last year was moved from North Carolina to New Jersey – where they’ve been traditionally incorporated and where GoodCo reincorporated – and the case hasn’t been dismissed. So, depending on how the case further evolves, there will likely be less narrow “venue selection” relating to where the filing takes place in future cases involving a Texas Two-Step.
Note: In the case of Johnson & Johnson, their subsidiary (Johnson & Johnson Consumer Inc., or JJCI) reincorporated in Texas. The LiabilityCo – called LTL Management – assumed all talc-related liabilities that JJCI previously had, along with a series of assets. This included a bank account with $6m in cash and equity interests in Royalty A&M, which are valued at north of $360m and will generate roughly $50m per year. However, this isn’t the full extent of how much Johnson & Johnson will contribute as we’ll soon get into. Rather, these are just the assets that LiabilityCo (LTL Management) had from the outset.
Prior to LiabilityCo filing chapter 11, a series of intercompany agreements will be entered into between GoodCo and LiabilityCo. This will include the fact that GoodCo will fund the chapter 11 process of LiabilityCo and, most importantly, that GoodCo will fund a Qualified Settlement Fund (QSF) to cover the mass tort claims against LiabilityCo. However, the QSF will only be assessable as part of an approved Plan of Reorganization with certain strings attached (e.g., releases for GoodCo to ensure that litigation can’t restart against them). In other words, GoodCo is still on the hook for paying settlement dollars, but any deal reached must require that GoodCo is insulated from any future litigation. After all, the whole point of this strategy is to create a definitive resolution instead of stretching it out for years and perpetually draining cash due to never-ending litigation.
Note: In the case of J&J, the QSF was pre-funded with $2b to handle all claims as part of a reorganization. Importantly, the QSF and existing assets of LiabilityCo aren't necessarily the maximum that would be divided among creditors, but rather should be thought of as being the initial starting point or the initial bargaining position. You’d certainly expect J&J to pay in more to LTL if it meant reaching a quick PoR with acceptable releases.
Anyway, after LiabilityCo files an immediate request for an injunction against all pending litigation (against either LiabilityCo or GoodCo) will be requested and it will almost certainly be granted (this is rather formulaic and will almost always be granted unless the court deems a case to obviously be a bad-faith filing). With an injunction granted, this allows GoodCo to go about their business as usual while LiabilityCo works through the lengthy restructuring process and tries to reach a satisfactory PoR.
The Fairness of the Texas Two-Step
So, mechanically the Texas Two-Step isn’t really that complicated. You’re just reincorporating a company with lots of mass tort liabilities in Texas – due to their favorable laws on divisional mergers – and then spitting out a GoodCo and LiabilityCo.
The GoodCo then reincorporates back wherever it was previously and can focus on its core business again while being free from the overhang of ongoing litigation. Meanwhile LiabilityCo reincorporates somewhere (in the past it’s been North Carolina but moving forward it may be back to the same state as GoodCo) and files.
After filing an injunction will be granted that freezes ongoing litigation. LiabilityCo then has some breathing room and will seek to work through the bankruptcy process and come to a comprehensive solution that addresses all mass tort claims against it by using the assets it got immediately after the divisional merger, the QSF funded by GoodCo, and likely some additional funding from GoodCo. Eventually a PoR will be reached which will be include releases to ensure that GoodCo can't face future litigation.
While the Texas Two-Step might not sound that complicated mechanically, there’s no getting around the reality that the optics of a Texas Two-Step just aren’t ideal.
Jones Day isn’t really making hundreds of millions due to their brilliant structuring of the Texas Two-Step, rather they're making this money for being able to execute something that has caused such an outrage among the general population, politicians, and even some legal scholars (in other words, Jones Day is primarily earning their keep by convincing courts these aren’t bad-faith filings, that the cases should proceed despite the uproar, and that this approach is not only equitable but fair to all involved).
The reality is that almost immediately after a LiabilityCo files, you can bet on certain creditors asking the court for the case to be dismissed as a bad faith filing. So, since the very structure of these kinds of transactions are being argued from the outset largely based on the fundamental question of fairness, how should we think about the issue of fairness here?
While no one would claim that I’m an ethicist – or that I approach these kinds of questions without bias – if this kind of question interests you, then you should go read through the trial of the talc claimants’ motion to dismiss LTL’s case from earlier this year.
Arguing for dismissal were the two official committees of talc claimants along with several personal injury law firms. These parties were making the case that this is obviously a bad faith filing that was using the bankruptcy system purely to gain some form of litigation advantage (in other words, that the filing was fundamentally unfair to talc claimants). Against them were LTL’s counsel, led by Gregory Gordon of Jones Day and Allie Brown of Skadden Arps.
Brushing aside many more technical arguments, there were three broad arguments that Gordon and Brown were making that get to the heart of why this kind of case is justified and why the case should not be dismissed.
First, Gordon made the argument that the primary “winners” from dismissing the filing would be the plaintiff’s law firms who would be able to continually litigate against GoodCo (JJCI) moving forward. While they may lose most of their cases, as has occurred thus far, they would keep trying while hoping to hit a home run and then reap a nice "40% fee" off the top of it (like with the aforementioned case, with just 22 plaintiffs, that resulted in an award of over two billion).
Gordon’s argument is that surely it's more equitable if everyone gets something. If those in favor of dismissal want the most equitable outcome, how is it more equitable when a few strike massive paydays, while the majority receive nothing? Especially considering it's not the case that there's a hard cap right now on the amount available for claimants. Everyone knows it'll probably be more than the assets of LTL and the $2b sitting in the QSF.
Second, Brown made the argument that there are 38,000 claims outstanding, and the average trial would cost JJCI around $2m to $5m. Extrapolating these numbers out, Brown said it’d cost JJCI up to $190b just to try these cases (leaving aside the potential liability if they were to lose some of these). Further, Brown argued that by any reasonable standard JJCI can only be involved in ten trials a year -- so getting through all the trials individually would take, uh, 3,800 years? So, Gordon's first argument in favor of proceeding centered around equity, while Brown's argument centered around feasibility.
Third, Gordon returned to make the broadest and most fundamental argument. JJCI is a large company with a diverse product line, thousands of employees, and countless suppliers. It simply can’t reasonably compete against competitors with this litigation overhang, and as litigation expenses ramp up as described above – even if all were decided in favor of JJCI – eventually JJCI would need to file chapter 11 itself. However, unlike LTL filing, JJCI itself filing would have a seismic impact -- resulting in mass disruption to thousands of employees, suppliers, etc. and causing significant losses to other pre-existing creditors in JJCI's capital structure and, of course, shareholders.
The unspoken argument from Gordon and Brown is really, “Look, we don’t recognize that talc causes these adverse effects, but we’re willing to try to deal with this issue. However, is it truly in the best interests of anyone (outside of perhaps some personal injury lawyers) to have JJCI inevitably file due to the unceasing litigation that would occur if we didn’t do this Texas Two-Step? What is the alternative end result here? Is it to return to the status quo where a few claimants win tens of millions while everyone else losses? Beyond any equity-related arguments, litigation continued in this way would take, literally, centuries and require up to two hundred billion dollars along the way. So, that’s per se unfeasible, which only leaves the other alternative being that JJCI itself is forced to file chapter 11 after litigation expenses overwhelm it. However, would JJCI inevitably having to file due to the weight of this litigation truly be preferable? Beyond the collateral damage that would occur – to employees, suppliers, other creditors, etc. – it wouldn’t make a difference. The intercompany agreements in place already mean that JJCI is on the hook for funding LTL's chapter 11 process and potentially putting in more money to secure a Plan of Reorganization along with the releases! In fact, one could argue if JJCI were to file the amount of value destruction that would occur – due to additional litigation expense pre-filing, reputational harm, and the prolonged nature of what would be an extremely complicated filing – would result in claimants getting less than they could now by following this process and allowing a healthy GoodCo / JJCI to exist while being unburdened by these mass tort claims. So, while many don’t like the optics of the Texas Two-Step, this is the most efficient way to equitably deal with all of these claims in a comprehensive and timely manner. In short, it ensures that everyone gets something while not destroying the value of JJCI in the process.”
As mentioned earlier, one of the stages of a traditional Texas Two-Step has been to reincorporate LiabilityCo in the Western District of North Carolina. When LTL initially filed there a battle immediately erupted over whether the venue should be moved to where GoodCo reincorporated and where OldCo was previously incorporated (New Jersey). The thinking on both sides was that moving the case to New Jersey would raise the odds of the case being dismissed as a bad faith filing or otherwise cause serious issues with how the case would proceed.
However, Judge Kaplan of New Jersey – who’s overseeing the case – has surprised even those that are most bullish on the utilization of the Texas Two-Step. He’s made it clear that far from the bankruptcy system being a merely adequate place to deal with mass tort liabilities, it’s a superior venue to the alternatives.
As Judge Kaplan said in his opinion denying dismissal: “There is nothing to fear in the migration of tort litigation out of the tort system and into the bankruptcy system. Rather, this Court regards the chapter 11 process as a meaningful opportunity for justice, which can produce comprehensive, equitable, and timely recoveries for injured parties. The bankruptcy courts offer a unique opportunity to compel the participation of all parties in interest (insurers, retailers, distributors, claimants, as well as Debtor and its affiliates) in a single forum with an aim of reaching a viable and fair settlement.”
He then proceeded to write: “Bankruptcy has proven an attractive alternative to the tort system for corporations [facing mass tort claims] because it permits a global resolution and discharge of present and future liability, while claimant's interests are protected by the bankruptcy court's power to use future earnings to compensate similarly situated tort claimants equitably.”
We are still a long way away from any form of resolution in LTL’s case. However, what has transpired over the past few months has further cemented the seeming viability of utilizing the Texas Two-Step to handle mass tort liabilities.
Judge Kaplan’s decision undoubtably rings hollow for many and the usage of the Texas Two-Step still strikes many as being fundamentally unfair and a perversion or abuse of the bankruptcy system.
But, in the end, fairness must be bound by practical realities as they are found. Leveraging the bankruptcy system to handle mass tort liabilities may produce bad optics, but there is no better and more feasible mechanism to ensure that a fulsome resolution is reached, all valid claims are treated similarly and equitably, and that the ParentCo/GoodCo can continue to operate when it would otherwise be swallowed up in litigation and then desperately lurch towards filing chapter 11 itself.
Hopefully this post has been somewhat interesting. I’ve tried to take a broader lens as opposed to just getting into the weeds of the arguments back and forth on the ongoing J&J saga or getting into the other older asbestos cases like Georgia-Pacific / Bestwall.In case you’re wondering, all of this would never come up in a restructuring interview (unless you decided to bring it up!). So, if you’re gearing up for interviews focus on the basics of restructuring investment banking, classic restructuring interview questions, etc.