JOHNSON & JOHNSON’S “TEXAS TWO-STEP” BANKRUPTCY PLAN REJECTED BY THIRD CIRCUIT; BASIC TORT LAW QUESTIONS RAISED

On January 30, 2023, Judge Thomas Ambro of the Third Circuit rejected Johnson & Johnson’s efforts to “offload” its baby powder talc claims through a so-called “Texas two-step” divisional merger, coupled with a bankruptcy filing.  The case raises important issues at the intersection of tort and bankruptcy law, dating all the way back to the Johns-Manville asbestos cases resulting in the first mass tort bankruptcy filing right after the 1978 enactment of the current Bankruptcy Code.

J&J of course is one of the world’s largest companies, selling pharmaceutical, medical device and consumer products.  Its consumer products were housed in a company Judge Ambro termed “Old Consumer,” and it included iconic names such as Band-Aids, Tylenol and Listerine, as well as J&J Baby Powder, which generated the talcum powder claims at issue.

Starting in 2010, baby powder users began to bring claims for inhaling talc dust, including mesothelioma claims, based on the allegation that baby powder included small amounts of asbestos.  Those claims accelerated during the middle of the past decade when allegations were made that baby powder also caused ovarian cancer.  The FDA found traces of asbestos in baby powder samples, and Health Canada found a small but statistically significant correlation between baby powder use and ovarian cancer.

The door having been opened, almost 40,000 ovarian cancer and 500 mesothelioma cases were filed against J&J and its Old Consumer subsidiary.  Thousands more are predictable over time.  While J&J generally fared well in those litigations, winning far more cases then they lost, and settling 6,800 cases at an average of $150,000 per claim, there was a massive verdict of $4.7 billion in Missouri for 22 plaintiffs in the so-called Ingham case (and subsequently reduced to $2.2 billion for 20 plaintiffs, or an average of $100 million per plaintiff) (Ingham v. J&J, 608 S.W.2d 663 (Mo. App. 2020), cert. denied, 141 S. Ct. 2716 (2021).  Further, while J&J was winning most of the cases, the average verdict when it lost and the verdict was upheld on appeal was $40 million.

Overall, by 2021, J&J had paid $1 billion to settle; $2.5 billion in verdicts; and $1 billion in defense costs, with more to follow for the foreseeable future.

To deal with these liabilities, J&J sought to “hive off” the baby powder division from the rest of its consumer products.  The device it utilized was a “Texas two-step,” which has become a popular bankruptcy strategy.  The name makes it sound worse than it is.  Essentially, the strategy allows a company to divide its assets and liabilities between two “Newcos” (Step 1), with the original company then terminating (Step 2).  It is called a “Texas two-step” not based on a prairie poker game or a cattle rustling scheme, but because it is authorized by the Texas Business Organizations Code.  Judge Ambro said a less derogatory term is a “divisional merger,” which is less like an actual merger and more like an asset divestiture.  Here the baby powder business, and its associated claims, went into a new entity, LTL, and the remaining consumer products businesses went into another new subsidiary.

To avoid the entire transaction from simply being described as a fraudulent conveyance, there had to be consideration.  Here the consideration was a small amount of cash ($6 million), a small royalty stream from the non-baby powder consumer businesses (valued at $367 million), and a funding agreement pursuant to which J&J agreed to pay up to $61.5 billion to LTL over time.  That number wasn’t just picked out of thin air.  It was based on a valuation of J&J’s consumer businesses as a whole, designed to give J&J the argument that talc claimants still had access to a reasonably equivalent value to all of the assets of Old Consumer to satisfy their claims.  Following the divisional merger, and the execution of these related agreements, LTL filed for bankruptcy with the intention of creating a claims trust.

The talc creditors moved to dismiss the bankruptcy as having been filed in bad faith.  The bankruptcy court denied that motion, but the Third Circuit reversed.  Judge Ambro found, based upon the funding agreement, that LTL was under no imminent threat of financial distress.  Hence, he ruled there was no valid bankruptcy purpose to the filing.  He acknowledged there could be difficult questions down the road as to when financial distress could be sufficiently severe and imminent as to justify a filing, but he deferred these questions for another day.  This is the most challenging part of the opinion, as it leaves practitioners with almost no guidance.

While that ambiguity is certainly problematic, arguably it is a good thing to the extent it forces other companies contemplating a “Texas two-step” to think twice.  Very few companies in the world could offer $60 billion in funding for such a transaction.  Even with that funding, why did J&J engineer the “two-step” unless it perceived it was better off isolating the talc liabilities?  Doesn’t that fact alone suggest the possibility of a fraudulent conveyance, where even $60 billion might not be reasonably equivalent consideration?

Even more fundamentally, this case raises basic questions about the interaction of tort and bankruptcy law which are still outstanding 45 years since the Bankruptcy Code was passed, and the Johns-Manville bankruptcy case was filed.  Ever since Manville, it has been an accepted strategy to deal with mass tort litigations by filing a bankruptcy petition and creating a claims trust, funded with corporate cash flow and/or common stock.  The “Texas two-step” is an evolution of that strategy, which in effect hives off claims into a Newco and says to the claimants “this is your trust; deal with it.”  To the extent that the strategy side-steps the usual lengthy negotiations associated with the resolution of most mass tort cases, perhaps the “Texas two-step” approach to mass torts really is a bridge too far.

The facts recited by Judge Ambro in his decision also raise basic questions about the tort system generally.  If J&J has paid $3.5 billion in settlements and verdicts, then applying a simple one-third contingency metric, plaintiffs have received approximately $2.4 billion and plaintiffs’ counsel have received $1.2 billion.  Adding $1 billion in defense costs to that, total legal fees are $2.2 billion to make $2.4 billion in compensation payments.  No one would logically and rationally design a system where it takes $1 in transaction costs to generate barely $1 in compensation.  No other country in the world does this, and despite that little changes.  It is no wonder that companies facing thousands of similar tort claims believe that their best option is to resort to bankruptcy.

In addition, when J&J wins the overwhelming majority of its cases, but loses large when it does lose, one can’t help but acknowledge that the American tort system has too much in common with the lottery.  And not just any lottery.  The Powerball.  While the plaintiffs’ bar says with some justification that they are key to vindicating plaintiffs’ rights to achieve justice against the mighty and powerful, that may be true within the existing system, but one can legitimately ask whether that system should be changed.  Unfortunately, those changes come up against the immovable object of deeply held interests.  While there have been some changes around the margins – limits on punitive damages, pain and suffering and wrongful death, among some, and advertising campaigns by the insurance industry and the United States Chamber of Commerce and the almost synonymous American Tort Reform Association, among others – there has been very little overall evolution since the era of the mass tort first arose two generations ago.

When the tort system has such large transaction costs, and a lottery­-like characteristic as well, one can ask how well it is performing its key twin functions of providing efficient compensation based on attribution of fault.  And when the bankruptcy system has to be called upon to help deal with those flaws, which it was not designed to do, further questions are raised.  One might say that is the evolution of the common law at work, but it is hard to see this version as anything like the same as that described by Oliver Wendell Holmes, Jr. in his book.

The views expressed here are those of the author, and do not necessarily represent or reflect the views of NYCLA, its affiliates, its officers or its Board.