Catching up with the Texas Two-Step: A neutral summary of what it is, what people are saying about it, and what we can learn

“MASS EXPLOITATION,”^[1] “the new fad in fraudulent transfers,”^[2] “[a] literal corporate shell game,”^[3] “a sickening attempt to avoid responsibility.”^[4] Strong emotions surround a new corporate reorganizational strategy employed by businesses facing mass torts. And yet, not a single court to have encountered this strategy has rejected it.^[5] What is going on?

The “Texas Two-Step” reorganization is named for one of the states whose corporate codes allow for its unique features. Texas, Delaware, Pennsylvania, and Arizona enable corporations to undergo “divisional” or “divisive” mergers, in which the corporation can split into two and assign assets and liabilities between the resulting enterprises.^[6]

Although the transactions can be “labyrinthine,”^[7] the gist of a Two-Step is that an entity facing mass tort liability (“OldCo”) will move to Texas, split into two, and assign its liability to only one successor (the “Vehicle”). In addition to liability, the Vehicle will have cash, a revenue stream, and a funding agreement. The funding agreement will typically have OldCo’s other successor (“NewCo”), and OldCo’s parent company pledge their funds to back up the Vehicle’s ability to pay mass tort claims up to OldCo’s value. The Vehicle will then take its assets and liabilities and file for Chapter 11 bankruptcy. Its goal will be to set up a trust to compensate mass tort claimants using its assets and the funding agreement. It will also seek court orders forcing mass tort claimants to seek relief from the trust rather than NewCo or the Vehicle’s parent.

The end result of this complex transaction is a global resolution to the mass tort claims without an enterprise-wide Chapter 11 filing. This creates controversy. Proponents believe Two-Steps provide equitable, efficient, and global relief to mass tort claimants without a race to the courthouse. Conversely, opponents believe Two-Steps are unfair, inefficient, and provide reduced recovery. Moreover, because Two-Steps have so far sought to resolve asbestos liability, a great deal of understandable emotion is involved.^[8]

This emotion boiled over into the outrage manifested in headlines and on Capitol Hill.^[9] On the other hand, courts routinely rule against Two-Step opponents.^[10] There are therefore two entrenched camps with a great deal of disconnect between them. And with a transaction as complex as the Two-Step, it may be difficult for an outside observer to understand enough to decide with whom they agree.

This Article, therefore, seeks to provide a dispassionate overview of what a Two-Step is and what people are saying about it so mass tort lawyers unfamiliar with bankruptcy law can orient themselves; bankruptcy lawyers who have not been following events as they unfurl may catch up, and interested policymakers can best decide how to meet their goals.

Part I will provide a foundation for understanding the Two-Step. It will provide a primer on the relevant state and federal law and tie them all together through a walkthrough of a real Two-Step. Part II will objectively summarize the main arguments made by both Two-Step proponents and opponents. It will also provide a summary of each issue’s caselaw. Finally, Part III will provide takeaways for policymakers and businesses facing enterprise-threatening mass torts.

I. How Does a Two-Step Work?

The Two-Step can seem opaque. The transactions are complex because the law behind them is complex. A Two-Step has to consider differences in business laws among the states and how those state business laws interact with federal bankruptcy law. Understanding a Two-Step therefore requires a foundation in a wide body of relevant law. It also helps to see a Two-Step in action, and the recent high-profile Johnson & Johnson Two-Step provides such an opportunity.

A. The Law

Like bankruptcy in general, the Two-Step operates through state substantive law and federal procedural law. State law provides the basis for the divisive mergers and special funding agreements that make a Two-Step bankruptcy unique. Bankruptcy law has procedural features which make the Two-Step attractive, such as an automatic stay of claims against the debtor while the bankruptcy is pending, the opportunity to establish global settlement trusts, and the chance for court orders that channel all related claims into those trusts. All these laws interact through the Butner Principle that “property interests are created and defined by state law,” and are not altered by the bankruptcy filing unless “a federal interest requires a different result.”^[11]

1. State Law

State law provides for the mechanisms which make Two-Steps unique. Two-Steps rely on divisive merger statutes, which are a feature of some state business codes; indemnity, which can be contractual or common law; and funding agreements, which are contracts. Because of the Butner Principle, these laws inform the substantive rights of creditors and debtors alike in bankruptcy proceedings.

Divisive mergers are what make a Two-Step attractive to businesses. Texas, Delaware, Pennsylvania, and Arizona each have divisive merger statutes.^[12] Because Two-Steps prefer Texas, this Part will focus on Texas law. The statute “applies to all business entities, regardless of when such entities were formed.”^[13] It allows a Texas corporation to divide into multiple new companies while ending the existence of the original entity.^[14] All of its assets and liabilities are then split between its successor entities.^[15] When a particular liability is assigned to a successor entity, that entity bears sole responsibility, and its affiliate entity bears none.^[16] Thus, a Two-Step entails reincorporating in Texas, divisively merging, and placing all mass tort liability in one successor entity. The business that divisively merged was OldCo, the successor without liability was NewCo, and the successor with liability was the Vehicle.

The reason Vehicles are important is indemnity. Indemnity creates a right to reimbursement for “loss, damage, or liability in tort.”^[17] The absolute liability created by divisive mergers may create an indemnity obligation between the Vehicle and NewCo.^[18] Vehicles can also hold indemnification agreements that require them to reimburse other members of their corporate family for damage awards they incur due to mass torts.^[19] Vehicles, therefore, truly house the entirety of an enterprise’s mass tort liability.

However, vehicles hold more than liability; their most important asset is also a creature of state law. As part of the Two-Step, a Vehicle will carry a contract—the funding agreement—from NewCo and its parent company to pay mass tort claims that the Vehicle itself cannot.^[20] The agreement has a floor of OldCo’s value and a ceiling of NewCo’s value.^[21] Fundamental contract law need not be expounded upon here beyond noting that the Vehicle has a legally enforceable right to funding from the parties to the agreement and that once the Vehicle enters bankruptcy, that state-law contract right becomes property of the bankruptcy estate and therefore is enforceable by the bankruptcy court.^[22]

These state laws are important because of a core bankruptcy doctrine known as the Butner Principle. Butner held that, except in some specific circumstances, “Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law.”^[23] These interests are, therefore, “created and defined by state law” and are not altered by the bankruptcy filing absent a specific federal interest.^[24] Therefore, to the degree they impact the property of the bankruptcy estate, the state laws discussed here apply to the bankruptcy proceedings.

2. Bankruptcy Law

The Bankruptcy Code is synonymous with Title 11 of the United States Code.^[25] While Chapter 11 of Title 11 specifically governs reorganization,^[26] Two-Steps primarily implicate general case management provisions of the Code, such as the automatic stay, preliminary injunctions, and mass tort trusts. Applying some of these laws in the context of a Two-Step also implicates bankruptcy jurisdiction.

The automatic stay plays a pivotal role in any bankruptcy. Authorized by § 362(a) of the Bankruptcy Code, it essentially bars creditors from attempting to liquidate their claims against the debtor for the duration of the bankruptcy proceeding.^[27] It stops creditors from engaging in self-help remedies such as repossession and halts matters pending before any tribunal with nationwide effect.^[28] This prevents a race to the courthouse to obtain a judgment before assets are depleted, and it gives the debtor, the court, and creditors breathing room to ensure the debtor’s assets are most effectively and equitably used to satisfy claims.^[29] While the automatic stay typically only applies to a debtor, bankruptcy courts have relied on § 362 to stay proceedings against non-debtors when an action against the non-debtor would, in essence, be an action against the debtor.^[30] The automatic stay is an attractive feature for all debtors, especially enterprises facing mass torts.

The automatic stay is not the only authority for bankruptcy courts to bar claims. Section 105(a) of the bankruptcy code allows bankruptcy courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”^[31] This can include preliminary injunctions to halt actions that would deplete the bankruptcy estate.^[32] In conjunction with the automatic stay, § 105(a) injunctions can operate to bring “all litigation against the debtor under one roof.”^[33]

While these sections are important during the pendency of bankruptcy proceedings, the goal of a Two-Step is to utilize 11 U.S.C. § 524(g). “The key to a fair resolution of mass tort liability is the preservation of assets for future claimants.”^[34] Thus, in 1994 Congress added § 524(g) to the Bankruptcy Code.^[35] Section 524(g) establishes a global settlement trust to benefit present and future mass tort claimants.^[36] The section imposes many requirements upon the trust, including that shares of the debtor partially fund the trust, that the trust is entitled to a majority of shares of the debtor, its parent, or its subsidiary, and that the trust use its assets to pay claims.^[37] A 75% supermajority of claimants must also approve the trust.^[38] If all requirements are met, the bankruptcy court may issue orders preventing the mass tort claimants from seeking redress from any party except the trust.^[39] Thus, the goal of a Two-Step is to establish a § 524(g) trust and secure channeling injunctions to globally resolve present and future mass tort claims that were held by OldCo and are now held by the Vehicle without dragging in NewCo or the corporate parent beyond their funding agreement obligations.^[40]

Attempts to limit recourse to non-debtors also raise questions regarding bankruptcy jurisdiction. Bankruptcy courts may employ “core” or “related to” jurisdiction.^[41] Core bankruptcy jurisdiction describes cases and proceedings “arising under” Title 11 or proceedings “arising in” a Title 11 case.^[42] A case or proceeding “arises under” Title 11 when the Bankruptcy Code “creates the cause of action or provides the substantive right being invoked.”^[43] A proceeding “arises in” Title 11 when it, “by its nature, could arise only in the context of a bankruptcy case.”^[44] Bankruptcy courts have the power to hear, decide, and enter final orders in cases when they have core jurisdiction.^[45] Related to jurisdiction arises when the outcome of a proceeding could “conceivably have any effect” on the bankruptcy estate.^[46] In this context, bankruptcy courts may only issue proposed findings of fact and conclusions of law that are subject to de novo district court review unless the parties consent for the bankruptcy court to issue a final decision.^[47] These statutory rules governing core and related to jurisdiction affect the bankruptcy court’s authority to bar mass tort claimants from seeking damages from non-debtor entities that are indemnified by a Vehicle.

B. A Walkthrough

The stated goal of the Two-Step at issue in In re LTL Management LLC was to globally and equitably resolve asbestos mass tort claims against a Johnson & Johnson (“J&J”) subsidiary without subjecting the entire enterprise to a bankruptcy proceeding.^[48] J&J began selling JOHNSON’S® Baby Powder (“Johnson’s”) in 1894, and created a formal baby products division in 1972.^[49] In 1974, that division—along with all its assets and liabilities—was transferred to another corporation in the J&J family as part of normal business activity.^[50] After a series of additional inter-company transactions, a New Jersey based J&J subsidiary named Johnson & Johnson Consumer Inc. (“Old JJCI”) owned the talc business and assumed all liability for claims that Johnson’s, which was talc-based and may have contained asbestos, caused ovarian cancer or mesothelioma.^[51] From 1894 to 2010, those claims had been “limited” and “isolated.”^[52] This changed in 2013, when a jury found for a plaintiff who alleged that Johnson’s caused her ovarian cancer.^[53] Old JJCI faced over 1,300 talc-related lawsuits by the end of 2015.^[54] By January 2020, Old JJCI’s successor-in-interest was named in a talc lawsuit on average over once every hour, with the total number of claims since 2014 reaching 38,000 in 2021.^[55] Talc litigation payments would rise to account for 122% of Old JJCI’s pre-tax cash flows, and drive Old JJCI’s income before tax from a $2.1 billion profit in 2019 to a $1.1 billion loss in 2020.^[56] Thus, Old JJCI began a “labyrinthine” and “somewhat overwhelming” series of mergers—a Two-Step—to reach a global resolution of these claims.^[57]

Old JJCI’s Two-Step began in October 2021, when its then-parent company transferred it to the newly-formed Currahee Holding Company Inc.^[58] Currahee then created a wholly-owned subsidiary in Texas, sister to Old JJCI, named Chenango Zero LLC.^[59] Old JJCI then merged into Chenango Zero, leaving Chenango Zero as the only surviving entity.^[60] At this point, Chenango Zero was a Texas LLC, wholly-owned by Currahee and indirectly owned by J&J.^[61] Old JJCI no longer existed, and Texas-based Chenango Zero owned all its assets and liabilities.^[62]

Chenango Zero then used Texas corporate law to divisively merge.^[63] Chenango Zero ceased to exist, and in its place were two Texas LLCs—Chenango One and Chenango Two.^[64] These businesses divided all of Chenango Zero’s assets and liabilities.^[65] Chenango One then took its portion of Chenango Zero and converted itself into a North Carolina LLC named LTL Management LLC.^[66] Chenango Two took its portion of Chenango Zero and merged back into Currahee.^[67] Currahee then changed its name to Johnson & Johnson Consumer Inc. (“New JJCI”).^[68] The result of this “labyrinth[]” of mergers was that New-Jersey based Old JJCI had ceased to exist and split its assets and liabilities into New JJCI and LTL Management.^[69]

After the merger, LTL held all of Old JJCI’s talc liability.^[70] Because of the 1974 agreement between Old JJCI and J&J, LTL also held all of J&J’s talc liability.^[71] LTL was, therefore, on the hook for damages not only in suits where it was a named defendant but also in suits which named Old JJCI or J&J.

LTL inherited more than liability from Old JJCI. It also received a funding agreement and approximately $373 million in other assets, such as cash and ownership of a business with ongoing intellectual property licensing cash flow.^[72] The funding agreement was arguably LTL’s largest asset, and central to the Two-Step.^[73] It obligated J&J and New JJCI, jointly and severally, to (1) pay LTL’s talc-related liabilities at any time when there is no bankruptcy case, and (2) in the event of a Chapter 11 filing, fund a trust to pay talc-related liabilities.^[74] The funding agreement would kick in if LTL’s other assets were insufficient, and would cap at the value of New JJCI.^[75] The value of New JJCI was not explicitly calculated; instead, the minimum funding amount was the value of Old JJCI at the time of the merger minus the value of talc liability at that time, but the amount would increase as New JJCI gained value over time.^[76] J&J and New JJCI prepaid $2 billion into this fund.^[77] If J&J or New JJCI refused to pay, LTL could ask the bankruptcy court to adjudicate New JJCI’s value and enforce the agreement.^[78] LTL had no obligation to repay J&J or New JJCI.^[79] Without the funding agreement, J&J and New JJCI would be under no obligation to satisfy talc claims against LTL.^[80] This would be true of J&J even without a Two-Step.^[81]

Two days after the mergers began, and with its assets and liabilities in hand, LTL filed for Chapter 11 bankruptcy with the explicit purpose of creating a trust for global resolution of talc claims under § 524(g).^[82] While the proceeding was pending, LTL sought an order confirming that the automatic stay would apply to talc claims against J&J, New JJCI, and certain other entities LTL or Old JJCI had indemnified, because it would be required to reimburse those entities for whatever they pay in talc damages.^[83] It also sought a preliminary injunction barring claims against these non-debtors under § 105(a) for the same reason.^[84] The Chapter 11 proceedings are ongoing, but should the Two-Step go as planned, LTL will likely ask for the court to issue injunctions channeling all talc claims into a § 524(g) trust.^[85] The Two-Step bankruptcy would then be complete, with a global resolution of talc claims against LTL—and by extension, New JJCI and J&J—without subjecting the entire Old JJCI or J&J enterprise to bankruptcy proceedings.

II. What Are People Saying About the Two-Step?

The overarching question regarding the Two-Step is whether it harms mass tort claimants. Overall, proponents argue that Two-Steps provide efficient, equitable, and global resolutions to present and future mass tort claims. Opponents argue that the Two-Step is a “literal corporate shell game,” causing delay and leaving potential tort plaintiffs with pennies on the dollar. While often given emotional or moral overtones, this clash can be boiled down to three primary legal sticking points. The first is whether bankruptcy courts are an appropriate venue for mass tort resolution. The second is whether Chapter 11 vehicle corporations, created by divisional merger and provided with funding agreements, are proper bankruptcy debtors. The last is whether channeling injunctions are necessary to preserve value for creditors, or whether they cause delay and block access to potential deep pockets for tort claimants. Courts have agreed with Two-Step proponents on all three issues.

A. Bankruptcy Courts as a Venue for Mass Tort Resolution

Bankruptcy courts are not strangers to mass tort resolution, but the Two-Step has generated pushback against this established role. Two-Step proponents and others argue that bankruptcy provides a unique opportunity for an efficient, equitable, and global resolution of claims, both present, and future. Opponents argue that bankruptcy is inefficient, deprives plaintiffs of the chance for large tort awards, and might violating due process. Courts considering Two-Steps and other mass tort bankruptcies have defended the role of bankruptcy in the resolution of mass torts, finding it to be efficient and fair.

1. Proponents

Two-Step proponents argue that the bankruptcy system is a valid forum in which to resolve mass tort disputes.^[86] They assert that bankruptcy resolution of mass torts has a statutory basis and provides for efficient, equitable, and global resolution of present and future claims in a way that stops a winner-take-all race to the courthouse.^[87]

Two-Step proponents assert that bankruptcy is a valid forum for mass tort resolution because it is Congressionally sanctioned.^[88] In particular, proponents note that § 524(g) expects and facilitates the resolution of mass torts—especially relating to asbestos—in the bankruptcy context.^[89] They argue that Congress specifically enacted § 524(g) for this purpose.^[90] They therefore assert that while bankruptcy may not be the only option for mass tort resolution, it is a statutorily valid forum.^[91]

Many proponents take the next step and argue that, at least in some circumstances, claimants should prefer the bankruptcy system to the tort system.^[92] They argue that the bankruptcy system provides efficient, equitable, and global resolution to mass torts, whereas the tort system is slow and uneven.^[93] In the interest of brevity, this will be expanded upon in the discussion of the In re LTL Management LLC decision below. At bottom, Two-Step proponents argue that debtors have a right to be in bankruptcy, and that exercising this right may create the most good for the largest number of claimants.

2. Opponents

Two-Step opponents argue that the bankruptcy system is improperly infringing upon the tort system. They argue that the tort system is more efficient, that it better compensates plaintiffs, and that removing tort claims from the tort system may violate due process.^[94]

Two-Step opponents argue that the tort system is preferable because it—especially in the context of multidistrict litigation—is more efficient and would give plaintiffs larger awards.^[95] They begin by arguing that MDL is the traditional avenue of mass tort resolution, that it resolves thousands of claims annually, and that a specialized bench and bar have grown around it.^[96] They also assert that drafters of the MDL statute intended it to be the primary mechanism of mass tort resolution.^[97] Finally, they assert that bankruptcies provide pennies on the dollar when compared to larger tort verdicts.^[98]

Two-Step opponents also argue that mass tort plaintiffs deserve their day in court, and that forcing that court to be a bankruptcy court violates due process.^[99] Proponents assert that two Supreme Court cases, Amchem Products, Inc. v. Windsor and Ortiz v. Fireboard Corp., “make clear” that mandatory and global resolutions to mass torts must be closely examined as potential due process violations, and that Two-Steps resemble the mandatory mass tort settlement fund struck down in Fireboard.^[100] As such, opponents assert that Two-Steps improperly divert tort claims from the tort system into a less specialized and constitutionally problematic alternative.^[101]

3. Courts

Courts not only hold that bankruptcy provides an appropriate venue for mass tort resolution, but signal that it may be preferable to the tort system. Chief Judge Kaplan championed this position in his recent opinion in In re LTL Management LLC:

Argument has been put forward by Movants, other parties in interest, and the drafters of the amici curie brief that allowing this case to proceed will inevitably “open the floodgates” to similar machinations and chapter 11 filings by other companies defending against mass tort claims. Given the Court’s view that establishment of a settlement trust within the bankruptcy system offers a preferred approach to best serve the interests of injured tort claimants and their families, maybe the gates indeed should be opened.^[102]

Chief Judge Kaplan is not alone. Bankruptcy and circuit courts alike defend Chapter 11 as a vehicle for mass tort resolution.^[103] They do so in Two-Step cases and beyond, especially when the mass tort claims are related to asbestos, because they determine that the bankruptcy system provides global, timely, and equitable relief for present and future claimants, while “a just and efficient resolution of asbestos claims has often eluded the traditional tort system.”^[104]

In re LTL Management LLC is the most recent and perhaps highest-profile decision to defend bankruptcy resolution of mass torts.^[105] It weighed the prospect of bankruptcy and tort resolution for the talc claims at issue, arriving at the “strong conviction that the bankruptcy court is the optimal venue for redressing the harms of both present and future talc claimants in this case—ensuring a meaningful, timely, and equitable recovery.”^[106] In reaching this conclusion, the court placed a heavy emphasis on the tort system’s lack of efficiency and reliability in processing talc cases thus far. Thirty-eight thousand tort cases have been filed against Old JJCI since 2014,^[107] and projections estimated 10,000 more cases would be filed per year going forward.^[108] The court noted with disapproval that, of those 38,000 cases, only 49 had reached a trial, and only 6,800 had settled.^[109] Of those 49 trials, the defendants prevailed in 18 cases, plaintiffs prevailed in 17, and the parties settled the remaining six.^[110] However, while only a minority of jury verdicts were for plaintiffs, their individual awards reached as much as $4.69 billion.^[111] Talc litigation, therefore, caused Old JJCI’s cash flow to drop from a $2.1 billion profit in 2019 to a $1.1 billion loss in 2020.^[112] As such, there was a danger that Old JJCI would become unable to pay future verdicts and legal bills as claims piled up.^[113] Taking all this into account, the court asserted that the current tort system status quo was “an uneven, slow-paced race to the courthouse, with winners and losers,” which threatened the solvency of LTL, and, therefore, the ability of both present and future claimants to receive equitable and efficient compensation for their injuries.^[114]

The court determined that class actions were not an option available to speed up tort resolution and ensure equitable compensation.^[115] This was primarily because of the due process concerns addressed by the Supreme Court in AmChem Products, Inc v. Windsor^[116] and Fireboard Corp.^[117] Those decisions and the LTL court noted that the dissimilarity of individual claims and the high probability of unidentified future plaintiffs could render class action untenable in products liability mass torts.^[118] Fireboard also barred the creation of a mandatory settlement fund in the context of a products liability class action.^[119] However, the Fireboard court also specifically noted that bankruptcy and probate were exceptions to its ruling.^[120] Therefore, the In re LTL Management court concluded that the Supreme Court has sanctioned bankruptcy resolution of mass torts.^[121] More pragmatically, it noted that the unavailability of global resolution would leave potential talc plaintiffs to pursue their cases one-by-one as their symptoms emerged in an individual race to the courthouse, only to sit through years of litigation in the hopes of being among the lucky few to win a blockbuster award while JJCI could still afford to pay.^[122]

The court also determined that multi-district litigation would not provide efficient and fair results.^[123] Pointing to the current talc MDL pending in the District of New Jersey—which does not include mesothelioma cases, Canadian cases, state court proceedings, or future talc claimants—the court noted that plaintiffs have waited six years for “at best … a handful of bellwether trials later in 2022,” after which nearly 40,000 individual cases would return to federal courts across the country to await their own pre-trial proceedings, trials, and appeals.^[124] With this pace, the court found that “the vast majority suffering from illness in the existing backlog of cases will not see a penny of recovery for years.”^[125] Given the issues presented by the tort system, and the lack of remedy from class actions and MDLs, the court concluded that the tort system has been unable to fairly and efficiently meet the needs of present claimants and is ill-suited to meet the needs of future claimants.^[126] As such, the court rejected as “folly” the assertion that “the tort system offers the only fair and just pathway of redress and that other alternatives should simply fall by the wayside.”^[127]

Instead, the court asserted that bankruptcy was efficient and equitable, and, therefore, at least as valid an option for talc claim resolution as the tort system.^[128] First, the court argued that bankruptcy is efficient because it can compel the participation of all parties in interest in a single forum and provide for global resolution of claims.^[129] Second, the court argued that bankruptcy provides claimants with equitable compensation because it can create trusts with fixed criteria for evaluating claims and fund these trusts through present assets and future earnings, thus trading an unpredictable race to the courthouse for even compensation for all claimants.^[130] The court pointed to recent examples of mass tort bankruptcy trusts as evidence of these claims,^[131] and asserted that this is what Congress intended when it enacted § 524(g).^[132] Therefore, the In re LTL Management LLC court concluded that bankruptcy was not only an acceptable venue, but the best venue for the resolution of talc claims.^[133]

B. Chapter 11 Vehicle Corporations and Good Faith

If mass torts belong in bankruptcy, the next question is who should be filing. As discussed above, Two-Step bankruptcies are filed by Vehicles.^[134] These Vehicles are created through divisive mergers, equipped with funding agreements, and quickly enter Chapter 11 to establish a § 524(g) trust or similar global settlement.^[135] Proponents argue that Vehicles are proper Chapter 11 debtors because claimants have access to equal or greater assets than would be available in an OldCo filing, while the divisional merger prevents the destruction of value and harm to trade creditors, employees, customers, business partners, and other tort claimants that would ensue in an “exponentially more expensive” OldCo filing.^[136] Opponents argue that Vehicles are shell corporations with no going concern to preserve, created to shield the assets of solvent OldCos. Courts decline to dismiss Vehicle filings under their circuits’ differing good faith and bad faith standards.

1. Proponents

Proponents argue that the Two-Step preserves value and serves a valid bankruptcy purpose. They believe it preserves value for two reasons. First, they argue that funding agreements leave claimants with access to equal or greater assets than they would have in an OldCo filing.^[137] Second, they argue that OldCo filings are needlessly destructive.^[138] Taking these two factors together, proponents argue that Two-Steps serve the valid bankruptcy purpose of establishing § 524(g) trusts to globally resolve asbestos mass torts without the waste of enterprise-wide OldCo filings.^[139]

Two-Step proponents argue that funding agreements preserve, and potentially enhance, the assets available to creditors.^[140] This is because the Vehicle has assets of its own and the remainder of OldCo’s assets available from NewCo., and^[141] Moreover, proponents note funding agreements tend to have additional backing from highly solvent third parties.^[142] This means that, even if the Vehicle and NewCo were to see a downturn in business, the Vehicle’s ability to pay claimants would be unimpaired.^[143] For example, the debtor in In re LTL Management LLC had a funding agreement that held New JJCI and J&J—a third party with a better credit rating than the United States of America—jointly and severally liable.^[144] Proponents, therefore, assert that the funding agreement would leave LTL in a better position to pay than Old JJCI, because the funding agreement’s value has upside potential if the value of New JJCI goes up, while it also protects against any diminution in value in New JJCI through the backstop provided by J&J.^[145] Funding agreements such as these lead proponents to believe that Two-Steps are valid restructurings.^[146] Finally, they argue that any assertion that debtors could improperly shield assets through a Two-Step “is neither feasible nor credible” because § 524(g) itself requires “the active participation and support of claimant representatives, the consent of a majority of the claimants themselves, and the approval of [the bankruptcy court] and the [d]istrict [c]ourt.”^[147]

Proponents also argue that, where Two-Steps preserve value, OldCo filings would destroy it.^[148] They note that OldCos have more stakeholders than Vehicles, such as trade creditors, employees, customers, business partners, and other tort claimants.^[149] Proponents assert that these stakeholders—as well as claimants—would be needlessly harmed by an OldCo filing, because there would be additional delay and cost without any corresponding benefit.^[150]

Using these two factors, proponents argue that Two-Steps aid creditors by facilitating the creation of § 524(g) trusts for the global resolution of asbestos mass torts.^[151] They assert that this is a valid bankruptcy purpose, because the trust will pay “all valid current and future claimants in full and on a fair and equitable basis.”^[152] They further argue that Congress intended employment of § 524(g) to be a valid bankruptcy purpose when it adopted the statute.^[153] Therefore, they believe that Two-Step bankruptcies can meet this purpose through funding agreements without the waste an OldCo filing creates. As such, they believe Two-Steps are equally valid, if not preferable, bankruptcy filings in the mass tort context.

2. Opponents

Some opponents have acknowledged that Two-Steps do not “technically run[] afoul of fraudulent transfer laws.”^[154] Presumably, this is because the Texas statute specifically states that no transfer of property occurs in a divisional merger.^[155] Instead, Opponents assert that “fraud will not prevail, the substance will not give way to form, and technical considerations will not prevent substantial justice from being done.”^[156] As such, they argue that Vehicles are shell corporations, organized in bad faith to shield solvent entities from liability and gain a litigation advantage.^[157]

Two-Step opponents argue that the Vehicles have no going concern to preserve.^[158] Opponents assert that Vehicles have “no business operations,” and are merely holding companies for non-debtor subsidiaries, cash, and funding agreements.^[159] Therefore, they argue that Vehicles are not proper Chapter 11 debtors because Chapter 11 requires debtors to have a going concern to preserve.^[160]

Opponents also argue that Vehicles are bad-faith attempts by solvent corporations to shield their assets and gain a litigation advantage.^[161] They point to credit ratings of parent companies, past payments of tort verdicts, and funding agreements as evidence that OldCos are financially healthy enough to continue to pay tort verdicts.^[162] From there, opponents assert that Vehicle filings force claimants out of the tort system and into a bankruptcy setting in which they would receive reduced compensation, which they argue cannot be said to maximize value to creditors.^[163] They also argue that Vehicles only seek to take advantage of a single bankruptcy provision—the automatic stay—to achieve this result and therefore file in bad faith.^[164]

3. Courts

Courts agree with proponents. Even under different legal standards, they have uniformly rejected arguments that a bankruptcy filing is in bad faith simply because it was a Two-Step.^[165] In the Third Circuit, where a bankruptcy petition can be dismissed unless filed in good faith, the only bankruptcy court to have considered a Two-Step found good faith because the Two-Step served a valid bankruptcy purpose and was not filed merely to obtain a tactical litigation advantage. In the Fourth Circuit, where bad faith dismissal requires the court to find both that a reorganization would be objectively futile and that the debtor filed in subjective bad faith, all opinions have held or opined in dicta that Two-Steps are not bad faith filings because, at minimum, reorganization would not be objectively futile.^[166]

a. Applying Third Circuit Precedent

In re LTL Management LLC is the only decision thus far to apply Third Circuit precedent to a Two-Step. While the meaning of the circuit’s good faith requirement is murky, the parties and court agreed that the “general focus” of the inquiry should be on “(1) whether the petition serves a valid bankruptcy purpose and (2) whether the petition is filed merely to obtain a tactical litigation advantage.”^[167] The court held that, under these factors, LTL filed its petition in good faith.

The court first held that establishing a § 524(g) trust is a valid bankruptcy purpose.^[168] It noted that Supreme Court precedent requires a purpose of either preserving a going concern or maximizing property available to satisfy creditors.^[169] It also noted that the Third Circuit only requires businesses be in some degree of financial distress to file for bankruptcy, and that while no particular degree of distress is required, the threshold is certainly before insolvency.^[170] With these two guideposts in mind, the court found that LTL was not in a position where it could continue to pay talc verdicts,^[171] that this constituted financial distress, and that a § 524(g) trust would preserve the business and “provide all claimants—including future claimants who have yet to institute litigation—with an efficient means through which to equitably resolve their claims,” thus maximizing assets available to creditors.^[172] The court rejected arguments relating to J&J’s solvency because “apart from voluntarily undertaking such an obligation or judicial finding as to alter ego status, J&J (like all parent corporations) have no legal duty to satisfy the claims against its wholly-owned or affiliated subsidiaries.”^[173] It also noted that Congress intended § 524(g) trusts to be used to aid both asbestos claimants and the corporations facing asbestos liability.^[174] And while the court agreed that seeking to take advantage of a single provision of the bankruptcy code does not establish a valid bankruptcy purpose on its own, it held LTL sought to use § 524(g), “the centrality of the bankruptcy forum,” “the efficiencies found in the claims allowance and estimation process,” and “the breathing spell” provided by the automatic stay.^[175] The court, therefore, determined that LTL’s goal of establishing a trust to globally resolve talc claims was a valid bankruptcy purpose.^[176]

The court next held that LTL did not file the petition to secure an unfair tactical advantage.^[177] It first assessed whether the Two-Step harmed creditors. The court began by determining that, while creditors may have been harmed outside of bankruptcy because they would have to rely on LTL to enforce its rights under the funding agreement, this was not the case here because the court had oversight over the bankruptcy estate and could ensure that LTL’s rights were enforced.^[178] It next held that the funding agreement adequately capitalized LTL because creditors can enforce claims against LTL’s assets “with the added benefit of having both J&J and New JJCI backstop such obligations, up to the fair market value of Old JJCI as a floor amount, along with any additional value in New JJCI.”^[179] As for whether Old JJCI should have filed, Chief Judge Kaplan wrote:

Let me be clear; this is not a case of too big to fail… rather, this is a case of too much value to be wasted, which value could be better used to achieve some semblance of justice for existing and future talc victims. The Court is not addressing the needs of a failing company engaged in a forced liquidation. Instead, the J&J corporate enterprise is a profitable global supplier of health, consumer products, and pharmaceuticals that employs over 130,000 individuals globally, whose families are dependent upon continued successful operations. Why is it necessary to place at risk the livelihoods of employees, suppliers, distributors, vendors, landlords, retailers—just to name a few innocent third parties—due to the dramatically increased costs and risks associated with all chapter 11 filings, when there is no palpable benefits to those suffering and their families? Clearly, the added hundreds of millions of dollars that would be spent on professional fees alone would be better directed to a settlement trust for the benefit of the cancer victims. As acknowledged by other courts, bankruptcy filings by J&J, Old JJCI, or New JJCI would pose potential negative consequences, without offering a positive change in direction or pathway to success in this case.^[180]

The court, therefore, determined that creditors were no worse off than before the Two-Step.^[181] It then held that because LTL was doing nothing more than employing “the tools provided by Congress under the Bankruptcy Code” to pay its creditors and did not seek an advantage beyond those which the Code bestows upon a typical debtor, LTL did not file the petition to secure an unfair litigation advantage.^[182]

b. Applying Fourth Circuit Precedent

The Two-Step has fared just as well under Fourth Circuit precedent. Courts in the Fourth Circuit will not dismiss a bankruptcy petition unless it was filed in bad faith, and they will not make such a finding unless the reorganization would be objectively futile and the debtor filed in subjective bad faith.^[183] The bar for dismissal is therefore high, and a Two-Step has yet to reach it.^[184]

For a filing to be objectively futile, there must be “no going concern to preserve” and “no hope of rehabilitation.”^[185] No such finding has been made by a court in the Fourth Circuit. Like LTL in New Jersey, the Vehicles before courts in the Fourth Circuit have had “substantial assets,” owned “ongoing active businesses,” and received “substantial cash flow.”^[186] The volume of asbestos claims they faced were “sufficient financial distress” to seek global resolution under § 524(g), but not so much that there was no hope of rehabilitation.^[187] Judge Whitely of the Western District of North Carolina has twice questioned in dicta whether the Two-Step was valid under Texas law because, while the capacity to pay claims may be unaltered, “it is too early to say” whether NewCos will properly employ their funding agreements, and creditors rights, therefore, may have been altered.^[188] However, a motion to dismiss was not before the court in either instance, and the court noted that neither Two-Step was likely to qualify as a bad faith filing under Fourth Circuit law.^[189]

At tbottom, courts seem to agree that a bankruptcy is not in bad faith simply because a Two-Step Vehicle filed the petition. Regardless of the standard applied, there appears to be an early consensus that there is nothing inherently fraudulent about the use of a pre-filing divisive merger, so long as the Vehicle holds a funding agreement that grants it the same ability to pay as its predecessor in interest.

C. Blocking Claims Against Non-Debtors

If Vehicles are proper Chapter 11 debtors, the final question is whether mass tort claims should continue against non-debtors the Vehicle is required to indemnify. This question appears in two stages. At the first stage, channeling prevents claimants from pursuing recovery from Vehicle affiliates while bankruptcy proceedings are underway. This is accomplished through various combinations of the automatic stay, § 105(a), and the court’s inherent powers.^[190] In the second stage, channeling forces claimants to seek recovery only from the § 524(g) trust and not indemnified non-debtors. This is accomplished through the unique provisions in § 524(g). Proponents argue that claims channeling is vital to a successful reorganization because otherwise, indemnity claims would deplete the estate. Opponents argue that the automatic stay only extends to debtors and that bankruptcy courts do not have jurisdiction to bar claims against non-debtors. While courts have only rendered decisions regarding the first stage, they have uniformly enjoined the pursuit of claims against indemnified non-debtors while bankruptcy proceedings are pending. Section 524(g) claims channeling will not be addressed here because Two-Step proceedings have not yet reached their respective confirmation stages.

1. Proponents

Proponents argue that barring indemnified non-debtor claims is necessary to protect the value of the bankruptcy estate and effectuate a § 524(g) trust.^[191] They assert that the automatic stay and § 105(a) should be employed for this purpose during the pendency of the bankruptcy.^[192] Because the court decisions on preliminary channeling hew closely to proponents’ arguments, this section will not address them for the sake of brevity.

2. Opponents

Opponents believe claims against non-debtors should not be restricted. They argue that neither the automatic stay nor § 105(a) provide a basis for such relief.

Two-Step opponents argue that the automatic stay only applies to debtors.^[193] They assert that if NewCo and the corporate parent want the protection of the automatic stay, they should have filed for bankruptcy themselves instead of the Vehicle.^[194] This argument is addressed above in Part II.b.ii. Relatedly, they argue that cases authorizing an extension of the automatic stay are inapposite.^[195] Those cases, opponents assert, involved actions that sought to name another party to sue the debtor indirectly.^[196] Opponents assert that this is not the case here, because they maintain that mass tort claimants would much rather sue the indemnified non-debtor than the Vehicle.^[197]

Two-Step opponents believe § 105(a) injunctions should not be granted because bankruptcy courts do not have jurisdiction in this context.^[198] They first assert that injunctions are not core jurisdiction^[199] because “injunctions of litigation frequently occur outside bankruptcy in actions having nothing to do with bankruptcy.”^[200] They argue that the statutory authorization § 105(a) provides for injunctions does not change their “fundamental nature.” Therefore § 105(a) does not create a unique bankruptcy right upon which to ground core bankruptcy jurisdiction.^[201] They next assert that bankruptcy courts do not have related to jurisdiction for the same reason they argue the automatic stay should not apply.^[202] They therefore conclude that there is no jurisdictional basis for § 105(a) injunctions barring claims against non-debtor entities.

3. Courts

Bankruptcy courts hold that they have the power to bar non-debtor claims while proceedings are ongoing, and district courts have declined to find an abuse of discretion.^[203] While courts in the Third and Fourth circuits have separate precedents, they have looked at the same three questions: (1) is bankruptcy jurisdiction proper, (2) can claims be barred by the automatic stay, and (3) can injunctions be issued under § 105(a).^[204]

First, courts have found both core and related-to bankruptcy jurisdiction for barring actions against non-debtors.^[205] Bankruptcy courts have core jurisdiction over any request to extend the automatic stay to third parties because the relief sought arises from § 362(a) of the bankruptcy code.^[206] Courts also have related-to jurisdiction because Vehicles are required to indemnify third parties either under indemnity agreements or as a function of the divisional merger, and as such third-party claims would deplete the bankruptcy estate.^[207] For example, LTL would have been obligated to reimburse J&J for any talc judgment against it.^[208] Courts have therefore found multiple grounds for bankruptcy jurisdiction over non-debtor claims in Two-Steps.

Next, courts in each circuit have extended the automatic stay to indemnified non-debtor entities on behalf of the Vehicle.^[209] They do so because, while the automatic stay does not generally apply to non-debtors, a mass tort claim against an indemnified non-debtor is essentially a claim against the debtor.^[210] Failing to extend the stay would therefore allow claimants to make an end-run around bankruptcy proceedings by liquidating their claims against non-debtors, who would then seek compensation from the bankruptcy estate.^[211] Decisions have also held that funding agreement claims against corporate family members are property of the estate. They, therefore, should not be independently pursued by mass tort claimants outside the bankruptcy system.^[212] The LTL Management decision also applied Third Circuit precedent to note that, while it appeared that a judgment against protected parties would be unlikely to preclude or estop the debtor from defending itself in talc cases, this was not a certainty, and “this theory should not be tested at the debtor’s peril.”^[213] As such, courts have been willing to extend the automatic stay to non-debtors.

Finally, courts in both circuits have granted injunctions under § 105(a).^[214] To assess the propriety of a § 105(a) injunction, courts apply a bankruptcy-tailored version of the traditional four-part preliminary injunction test.^[215] Courts, therefore, consider whether the debtor has shown a reasonable chance of successful reorganization, whether the bankruptcy estate would be irreparably harmed by a denial of relief, whether granting relief would result in even greater harm to the claimants, and whether granting relief would be in the public interest.^[216] Courts agree that Vehicles have a reasonable chance of successful reorganization because they have “significant assets” of their own and have the ability to draw on their funding agreements.^[217] Courts also agree that debtors would face irreparable harm without non-debtor injunctions, because prosecution of claims against non-debtors would deplete the estate through indemnity reimbursement.^[218] The DBMP and Aldrich Pump decisions add the nuance that, if a Two-Step is indeed a fraudulent transfer, such a claim is property of the bankruptcy estate and should be protected by the court.^[219] Courts next agree that the balance of the harms weigh in favor of debtors.^[220] The LTL Management decision asserts that claimants would not be harmed by, but instead benefit from, the restructuring, and as such it was important to all parties to preserve the bankruptcy estate.^[221] Additionally, all decisions agree that potential delay is less harmful than reorganizational failure.^[222] Finally, courts agree that a successful reorganization is in the public interest.^[223] In particular, they note that the establishment of a trust would “ensure claimants, present and future, are treated fairly and equitably, result in consistency among claimants, . . . promote judicial economy,”^[224] and accomplish the Congressional objective of § 524(g).^[225]

III. What Are the Practical Takeaways?

There are practical takeaways for both supporters and opponents of Two-Steps, regardless of the type of stakeholder one is. From a policy perspective, the takeaway is that Two-Steps are statutory creatures, and as such legislation can facilitate or hinder them. From a business perspective, the takeaway is that the Two-Step is a viable but risky reorganizational strategy for enterprises facing mass torts.

A. Legislating

State and federal law have permeated this discussion of the Two-Step. Legislating, therefore, presents an opportunity to help or hinder future Two-Steps.

Because courts have thus far supported Two-Steps, the best legislative option to encourage them would be for more states to enact divisive merger statutes. Texas was the first to do so roughly 30 years ago, and has since been followed by Delaware, Pennsylvania, and Arizona.^[226] The Delaware statute was introduced approximately five months after the highly-publicized Bestwall filing.^[227] Legislatures of other states could use these statutes as models for their own, thereby reducing the need for the “labyrinthine” transactions required to move corporations from their home states to others with the required statutory mechanisms.^[228] This would make it easier for businesses facing enterprise-threatening mass torts to engage in a divisional merger bankruptcy. For proponents, this means saving jobs, saving trade creditors and business partners, expediting recovery for tort claimants, and ensuring all claimants are granted relief—not just those who win the race to the courthouse.

Meanwhile, the Two-Steps’ complexity allows opponents to pursue legislation at both federal and state levels. On the federal side, Congress has the constitutional authority to enact “uniform Laws on the subject of Bankruptcies.”^[229] Legislation has already been proposed that would prohibit Two-Step Vehicles from filing for bankruptcy.^[230] This may be more in terrorem than pro-claimant reform, however, because divisive mergers are still available under state law, and Vehicles could still hold all liability for mass tort claims. Closing off bankruptcy in such circumstances could harm claimants more than the Two-Step itself.^[231] Two-Step opponents must therefore be wary of missing the forest of helping claimants for the trees of stopping Two-Steps when it comes to legislative reform. Another potential avenue would be to take a page from the headlines and revise fraudulent transfer statutes to include divisional mergers explicitly.^[232] These claims would be the bankruptcy estate’s property, which would allow bankruptcy court oversight.^[233] The safest way to legislatively hinder Two-Steps, however, would be for state legislatures to repeal divisive merger statutes. Vehicles could not form without the existence of divisive merger statutes, and an OldCo filing would be the only remaining option. With any legislative efforts, however, it is important for both sides not to lose sight of their espoused goal of aiding mass tort claimants.

B. Restructuring

At present, Two-Steps are a potentially viable—albeit risky—reorganizational strategy for businesses facing mass tort liability. Courts have signaled their willingness to entertain Two-Steps.^[234] But there are some potential downsides to consider. Two-Steps require enterprises to “bear the brunt of public and judicial scrutiny, as well as the time and costs” of both implementing the transaction and going through a Chapter 11 reorganization.^[235] Moreover, the funding of a § 524(g) trust is no small thing,^[236] and as discussed above, funding agreements may subject the corporate family to more liability than an OldCo filing.^[237] That being said, if bankruptcy is inevitable, it is possible that these costs are worth bearing.

It is also worth noting that, while decisions have favored Two-Steps, not all judges have been happy to issue such rulings. Judge Whitely has twice indicated in dicta that he has concerns about the “propriety” of the Two-Step.^[238] Moreover, there has yet to be a circuit court decision on the Two-Step, and lower courts have only ruled in two circuits thus far.^[239] As Chief Judge Kaplan noted, “there is no expectation that [In re LTL Management LLC] will be the final word on the matter.”^[240] Thus, Two-Steps are a potential mechanism for resolving mass torts, but they carry their own set of risks and costs that should be considered.

Conclusion

The Two-Step is a complex reorganization. It navigates a maze of mergers, indemnity, funding agreements, and claims-channeling laws to create global resolutions to mass torts without pulling an entire enterprise into bankruptcy.

The result of this complexity is controversy. Some believe Two-Steps provide efficient and equitable results to present and future claimants without needless waste. Some believe the opposite. The fault line grew from competing views on the fitness of the bankruptcy system as a vehicle for mass-tort resolution, the propriety of Vehicles created through divisional mergers, and whether actions between mass tort claimants and indemnified non-debtors should be barred.

Despite the controversy, the Two-Step is a risky but potentially viable reorganization strategy for businesses facing high levels of mass-tort liability. Legislatures can promote or restrict Two-Steps, but they should first consider what goal they are striving toward and what mechanism best promotes that result.