Everything is bigger in Texas, including—according to some—a company’s opportunity to shed liabilities. Over the past few years, a legal maneuver—sometimes referred to as the “Texas Two-Step”—has emerged as a strategy for companies facing mass tort liabilities. The maneuver relies on a Texas corporate statute that permits the division of a company’s balance sheet (the first step) by sequestering certain liabilities in a new entity (“BadCo”) and keeping the majority of the company’s assets in another entity (“GoodCo”).1 BadCo then files for bankruptcy (the second step) and seeks to resolve its newly-acquired liabilities, while GoodCo continues as a going concern. This maneuver is perceived as adversely impacting creditors of BadCo, and thus has faced increased scrutiny in bankruptcy courts and Congress. Below, we briefly describe the strategy, provide some case studies, and discuss its prospective use and possible curtailment.
Divisive mergers are accomplished under Section 10.008 of the Texas Business Organizations Code,2 and allow a domestic entity to divide into multiple entities and allocate its assets and liabilities into the newly-formed entity, or entities, as it deems fit. That statute expressly provides that the merger is deemed to have been accomplished “without . . . any transfer or assignment having occurred.”3 Purportedly, this lack of a “transfer” enables the transaction to sidestep fraudulent transfer law. In short, if there is no transfer in a divisive merger, then it is more difficult to claw back BadCo’s transfer of assets to GoodCo or unwind GoodCo’s transfer of liabilities to BadCo. As such, although GoodCo may ultimately fund a portion of a prospective BadCo bankruptcy, the statute provides GoodCo with the ability to unburden itself from massive liabilities at a discount. The process has been used by both Georgia-Pacific and CertainTeed Corp., and both cases are discussed below.
In 2017, Georgia-Pacific effectuated a divisive merger that created a new Texas entity, Bestwall LLC, to which it assigned $175 million in assets as well as its massive liabilities related to past and future asbestos claims against the company.4 Bestwall LLC then changed its domicile to North Carolina5 and filed for chapter 11 relief in the U.S. Bankruptcy Court for the Western District of North Carolina,6 where it sought authority to establish a trust which would deal with claims of current and future asbestos claimants under section 524(g) of the Bankruptcy Code.7 The bankruptcy filing was challenged as a sham by asbestos creditors, who asserted that Georgia-Pacific was seeking “a ‘bankruptcy discount’ despite its professed ability to pay the asbestos liabilities in full.”8 However, motions to dismiss the bankruptcy case were denied for lack of cause.9 In September 2020, the bankruptcy court ultimately approved a settlement whereby Georgia-Pacific agreed to fund the section 524(g) trust with $1 billion to resolve asbestos claims.10
In 2019, CertainTeed Corp., a manufacturer of construction materials that contained asbestos, converted into a Texas LLC and effected a divisive merger that created two entities: CertainTeed LLC, which retained 97% of the company’s assets and non-asbestos liabilities, and DBMP LLC, which inherited the company’s asbestos liabilities and agreed to indemnify CertainTeed LLC for any future asbestos liability in exchange for funding an asbestos trust. DBMP LLC subsequently converted to a North Carolina LLC and promptly filed for chapter 11 relief in the U.S. District Court for the Western District of North Carolina.
Asbestos claimants took immediate action in the bankruptcy, filing a motion for relief from the automatic stay so that they could challenge the Texas Two-Step maneuver. U.S. Bankruptcy Court Judge Craig Whitley denied the motion, but suggested that Texas’s divisive merger statute does not permit a company to prejudice creditors or circumvent fraudulent transfer law.11 Judge Whitley suggested that the asbestos claimants seek derivative standing to bring claims stemming from the divisive merger, rather than seeking stay relief or dismissal of the chapter 11 cases.12
On August 23, 2021, the official committee of asbestos personal injury claimants and the future asbestos claimants representative filed a motion to substantively consolidate the debtor’s estate with the assets of CertainTeed13 and a motion seeking derivative standing to prosecute causes of actions on behalf of the debtors.14 If such relief is granted, it could effectively unwind the merger and create liability for parties that received pre-petition payments from CertainTeed.15
Johnson & Johnson
Reports recently surfaced that Johnson & Johnson (“J&J”) was considering a Texas Two-Step to resolve claims related to its talc liability. After hearing these reports, tort claimants sought to preempt the maneuver by filing an emergency motion for a preliminary injunction and temporary restraining order in the related bankruptcy proceedings of Imerys Talc America Inc.16 The tort claimants sought “to ensure J&J does not conduct a divisive merger or undertake any other corporate manipulations which may affect the value of the uncapped indemnities that it owes[.]”17 In an August 27, 2021 bench ruling, U.S. Bankruptcy Court Judge Laurie Selber Silverstein denied the tort claimants’ motion, finding that the movants lacked derivative standing and, more significantly, J&J’s actions to effectuate a divisive merger—even if they impede collections—would not violate the automatic stay in the Imerys proceedings.18
The utilization of the Texas Two-Step in these cases (or in the case of J&J, the mere suggestion that it might be used in the future) has led to a Congressional reaction that, if implemented, may be the death knell of the Texas Two-Step. In July 2021, a new bill emerged to address the perceived abuse of the maneuver. The Nondebtor Release Prohibition Act of 2021 (“NRPA”), introduced by Sen. Elizabeth Warren (D-Mass.), Sen. Richard Durbin (D-Ill.) and Sen. Richard Blumenthal (D-Conn.) in the Senate, and Rep. Jerrold Nadler (D-N.Y.) and Rep. Carolyn Maloney (D-N.Y.) in the House of Representatives, would provide creditors with a tool to challenge the Texas Two-Step. Specifically, if enacted, the NRPA would amend the Bankruptcy Code to provide that:
[o]n a request of a party in interest, and after notice and a hearing, the court shall dismiss a [chapter 11] case . . . if the debtor or a predecessor of the debtor was the subject of, or was formed or organized in connection with a divisional merger or equivalent transaction or restructuring that—(1) had the intent or foreseeable effect of—(A) separating material assets from material liabilities of an entity eligible to be a debtor under this title; and (B) assigning or allocating all or a substantial portion of those liabilities to the debtor, or the debtor assuming or retaining all or a substantial portion of those liabilities; and (2) occurred during the 10-year period preceding the date of the filing of the petition.19
Although the NRPA is sponsored by both chairs of the respective Judiciary Committees, it remains to be seen if this legislation will be enacted into law. Regardless of the NRPA’s fate, creditors will continue to challenge the Texas Two-Step using the currently available tools, including challenging such mergers as fraudulent transfers in BadCo’s bankruptcy or seeking substantive consolidation in BadCo’s bankruptcy to reunite its liabilities with the assets of GoodCo. A decision in the DBMP case could lay the foundation for successful challenges, so this litigation bears close scrutiny.
1 This “first step” is nothing new. During the Great Recession, a number of financial institutions used a similar strategy whereby a core bank (“Good Bank”) cleaned up its balance sheet by placing non-performing or otherwise troubled assets into a newly-formed bank (“Bad Bank”). Ridded of such burdens, Good Bank could more easily continue or return to its normal banking and lending operations.
2 Delaware enacted a similar statute in 2018; however, it only applies to LLCs and does not contain the same language regarding transfers. See DLLCA § 18-217. Unlike Texas, Delaware law specifically provides that “[i]n the event that any allocation of assets, debts, liabilities and duties to division companies in accordance with a plan of division is determined by a court of competent jurisdiction to constitute a fraudulent transfer, each division company shall be jointly and severally liable on account of such fraudulent transfer notwithstanding the allocations made in the plan of division[.]” Id. § 18-217(l)(5).
3 See § 10.008(a)(2)(C).
4 In re Bestwall LLC, Case No. 17-31795, Dkt. No. 2 at 31 (Bankr. W.D.N.C.). For reference, Georgia-Pacific paid nearly $3 billion to settle related claims prior to Bestwall LLC’s filing.
5 Bestwall LLC’s decision to convert to a North Carolina entity seems to be an effort, which would later prove successful, to secure jurisdiction in the North Carolina bankruptcy court and avoid attempts to transfer venue or dismiss its bankruptcy petition as a bad faith filing. See Id., Dkt. No. 891 (memorandum opinion and order denying the official committee of asbestos claimants’ motion for dismissal or change of venue based, in part, on Bestwall LLC’s domicile in North Carolina).
6 The tendency for asbestos companies to file for bankruptcy in this district is perhaps attributable to a prior “debtor-friendly” order by Judge George R. Hodges of the U.S. Bankruptcy Court for the Western District of North Carolina that estimated Garlock Sealing Technologies LLC and its affiliates’ asbestos liability in an amount significantly lower (by about $1 billion) than what asbestos plaintiff representatives sought. See In re Garlock Sealing Technologies, LLC, Case No. 10-31607, Dkt. No. 3296 (Bankr. W.D.N.C. Jan. 10, 2014).
7 Section 524(g) of the Bankruptcy Code permits debtors faced with liabilities stemming from their use or distribution of asbestos-containing products to resolve current and future asbestos-related liabilities. Specifically, it allows bankruptcy plans to enjoin holders of future asbestos claims from pursuing them against the reorganized company, instead channeling such claims to a trust, which administers claim recovery post-confirmation.
8 Id., Dkt. Nos. 938.
9 Id., Dkt. Nos. 495, 1546.
10 Id., Dkt. No. 1398.
11 In re DBMP LLC, Case No. 20-30080, Dkt. No. 972 (Bankr. W.D.N.C.).
12 Id. at 52.
13 Id., Dkt. No. 1005.
14 Id., Dkt. No. 1008.
15 In an effort to assuage concerns that it was trying to use the Texas Two-Step to harm creditors, on September 15, 2021, the debtor filed a motion for an order authorizing it to enter into an amended funding arrangement with CertainTeed LLC. See id., Dkt. No. 1051.
16 In re Imerys Talc America Inc, Case No. 1:19-bk-10289, Adv. Case No. 21-51006, Adv. Dkt. No. 4 (Bankr. D. Del.). Imerys Talc was named as a defendant in over 10,000 tort claims and, although allegedly indemnified by J&J, filed for chapter 11 relief to resolve these liabilities. The company sold its assets in bankruptcy, but the J&J indemnity obligations remained in the bankruptcy estate as trust assets, along with approximately $300 million in cash, for the benefit of personal injury creditors.
17 Id., Case No. 1:19-bk-10289, Dkt. No. 3874 at 5.
18 Id., Dkt. No. 3975. A motion for a temporary restraining order or preliminary injunction filed in a similar action brought by talc claimants in New Jersey Superior Court was also recently rejected. See Carl v. Johnson & Johnson, Civil Action No. 300 (MCL), Dkt. No. ATL-L-6546-14 (N.J. Super. Ct. Sept. 20, 2021). There, the plaintiffs argued that the maneuver would violate a state voidable transfer statute. The court, however, reasoned that “plaintiffs cannot usurp the corporate decision-making of large companies merely by filing tort claims and then hypothesizing about the potential harm they could suffer from one or more theoretical future corporate transactions.” Id. at 11.
19 Nondebtor Release Prohibition Act of 2021, S. 2497 (IS), 117th Cong. (2021) (available at https://www.warren.senate.gov/imo/media/doc/DUN21578.pdf).