The Texas Two-Step: How a Fortune 50 Company Used a Quirk in the Lone Star State's Laws to Shield itself from Product Liability

Over the past six years, Johnson and Johnson, the $420 Billion American pharmaceutical company, well-known for its talc-based baby powder, has faced nearly 40,000 lawsuits on grounds that its talc products cause cancer.[1] After several high-figure judgements against the company, including a $2.5 billion verdict in 2018, J&J took a controversial step in October 2021, undergoing major corporate restructuring and bankruptcy.[2]

Under its original corporate structure, one J&J subsidiary, Johnson & Johnson Consumer Inc. (which we’ll call “Old JJCI”), was responsible for all talc-based baby powder claims against J&J. On October 12, 2021, in a series of complex maneuvers, Old JJCI dissolved itself, leaving two surviving corporate entities, a Texas LLC called Johnson and Johnson Consumer Inc. (which we’ll call "New JJCI"), and a North Carolina LLC called “LTL Management, LLC.”  LTL assumed responsibility for Old JJCI’s liabilities related to the baby powder lawsuits. As part of a funding agreement, New JJCI and the parent company would fund a trust to pay costs and expenses incurred by LTL if LTL’s assets were insufficient to pay. LTL filed for Chapter 11 bankruptcy in the North Carolina Bankruptcy Court two days later, on October 14, 2021.[3]  

An individual or a corporation facing financial distress can file under Chapter 11 of the Bankruptcy Code. Unlike Chapter 7 bankruptcies, a Chapter 11 merely reorganizes its assets and debts rather than liquidating the company. The debtor files a reorganization plan identifying debts and classes of creditors, provides a determination for which debts will and will not be paid in full, and proposes methods for how the debts will be paid.[4]

The plan can be negotiated by the parties, and creditors adversely affected by the plan can vote against it. Ultimately, if the reorganization plan is confirmed by the bankruptcy court, either on the basis of creditor approval or a court finding that the plan is fair, the plan becomes binding.[5]  

The purpose of Chapter 11 is to further a good faith and realistic reorganizational attempt. A court may dismiss a Chapter 11 filing if it determines the filing was not in good faith. A good faith inquiry includes determining whether the petitioner sought to achieve objectives outside the legitimate scope of the bankruptcy laws when filing for protection under Chapter 11, including whether the petition was filed to obtain a tactical litigation advantage.[6] 

As a consequence of LTL’s Chapter 11 filing, the tens of thousands of talc-based baby powder claims against J&J are on hold.  As the bankruptcy process proceeds in the North Carolina Bankruptcy Court, New JJCI continues to operate J&J’s health business free from the management responsibilities and the costs of the baby powder litigations.

J&J’s corporate restructuring maneuver was made possible by a Texas law, which allows Texas corporations to split into multiple corporate entities, and divide the corporate asset and liabilities between the pieces.[7] This law enables what has become known as the Texas Two-Step, a means by which corporations can avoid liability by strategic use of bankruptcy laws.

The Texas two-step works by converting an existing company into a Texas corporation, and then engaging in a “divisive” merger. This allows the corporation to split into multiple corporate entities and to allocate the assets and liabilities of the original corporation between the newly created entities.  A corporation looking to limit its liability can allocate corporate liabilities to one of the newly created corporations, the so-called ‘BadCo’, while dedicating the greater part of corporate assets to the other new entity, the ‘GoodCo.’ The Texas Two-Step is completed by the “BadCo” filing for Chapter 11 bankruptcy. This puts on hold the pending lawsuits filed against the original corporation, inherited by the now bankrupt BadCo, while the other surviving corporation, GoodCo, operates the business with its assets shielded from recovery.[8]

Funding agreements, in which GoodCo agrees to fund BadCo, are the means by which creditor claims are supposed to be satisfied. Indeed, the Texas law requires that a divisive merger not abridge the rights of creditors.[9]  In the J&J case, the funding agreement would theoretically bind J&J and New JJCI to fund LTL up to $61 Billion to satisfy baby-powder related liabilities. However, critics contend that replacing litigation with a funding agreement allows the corporation to place an artificial cap on the total amount it will have to pay out, rather than having judgement amounts determined through the usual system of civil lawsuits. Furthermore, as this agreement is between a parent corporation and its subsidiary, the only party that can enforce the funding agreement is the subsidiary, which was specifically set up to limit liability.[10]

In December 2021, the Official Committee of Talc Claimants, which was appointed by an arm of the Department of Justice to represent claimants against J&J, filed a motion in the Bankruptcy Court of New Jersey to dismiss LTL’s Chapter 11 case.

TCC argued that LTL “is a mere instrumentality of J&J” and that the purpose of LTL and of the bankruptcy “is not to compensate creditors, but to protect J&J and its other valuable non-debtor affiliates [and] to shield J&J from liability…and to remove its valuable operating assets from the reach of a single group of creditors. It goes on to claims that LTL “is a dummy entity with facially inadequate capitalization created only to purge J&J’s and Old JJCI’s massive talc-related tort liability, all to hinder and delay injured talc creditors.”[11]

As such, it asked the court to dismiss the Chapter 11 case on the grounds that it had no valid bankruptcy purpose, and was not filed in good faith.

J&J argued that the costs associated with continuing litigation for decades would be unsustainable, and that attorneys’ fees would diminish the funds available to pay out judgements and settlements to the claimants. Chapter 11 filing was therefore necessary to administer the claims and payouts in an efficient and equitable manner.[12] J&J also pointed to the funding agreement as evidence that the bankruptcy filing was in good faith and for a valid purpose.[13]

The federal Bankruptcy Court in New Jersey sided with J&J, holding that the “filing of a chapter 11 case with the expressed aim of addressing the present and future liabilities associated with ongoing global personal injury claims to preserve corporate value is unquestionably a proper purpose under the Bankruptcy Code.” The court also found no evidence that J&J “manufactured a limited fund by undervaluing or limiting assets.”[14] 

The Bankruptcy Court’s ruling was appealed to the Court of Appeals for the Third Circuit, which heard oral arguments from the parties in September, 2022. The Committee once again argued that the bankruptcy has no valid purpose, and violated bankruptcy principles by ensuring that shareholders continued to receive dividends and equity paid from J&J, while claimants from the baby powder lawsuits await LTL bankruptcy proceedings. LTL relied on the findings of the lower court that bankruptcy is a more efficient way to manage the claims in question than civil litigation, in which money that could go to claimants goes to attorneys instead.[15]

The Third Circuit appeal is being followed closely, as its ruling will likely have a major impact on the legal strategies pursued by large corporations facing mass tort liability. The Department of Justice has expressed concern that, if J&J is successful in court, other companies facing no financial distress would have a new avenue to avoid liability through strategic use of bankruptcy laws.[16] Some note that the Texas Two-Step can be effective in shielding corporations from liability simply by dragging out the bankruptcy process, pressuring claimants who cannot afford to wait to settle their claims, even if a court eventually holds the corporate restructuring to be improper.[17]

J&J acknowledged that using the Texas Two-Step can lead to the perception that a large and profitable corporation is trying to evade liability, but defended the action on grounds that it avoids the legal chaos in which claimants seek “wild, lottery-style judgements” which reduce the total payout available to all claimants.[18]

Whichever way the Court of Appeals rules, the case is likely to go to the U.S. Supreme Court, and some expect that a ruling for J&J may spur Congress to enact legislation limiting the use of the Texas Two-Step.[19]