By enabling defendants to shield themselves from mass tort liability, the “Texas Two-Step” is a new obstacle for plaintiffs pursuing mass tort cases against manufacturers of dangerous products. For the uninitiated, the Texas Two-Step is a bankruptcy process in which a solvent corporation spins off certain liabilities into a new and undercapitalized subsidiary and then has the subsidiary declare bankruptcy.
In the first step of a Texas Two-Step, the parent corporation creates a new subsidiary in Texas under that state’s divisive merger statute in which the corporation splits off future liabilities from the solvent parent’s assets. The parent corporation keeps control of the spun-off subsidiary through its board of directors. In the second step, the spun-off subsidiary declares Chapter 11 bankruptcy as a debtor-in-possession, securing an automatic stay on any litigation against the subsidiary or its parent corporation. The purpose of the Chapter 11 bankruptcy is to address the mass tort liabilities for present and future claims and obtain a third-party release for the parent company to prevent litigants from pursuing recoveries from the parent in perpetuity.
Several companies have tried to use the Texas Two-Step to shield themselves from mass tort liability in the past few years.
Three companies facing asbestos liability, Aldrich Pump LLC, Bestwall, and DBMP LLC, recently filed chapter 11 bankruptcies in the Western District of North Carolina after being created from a divisive merger statute (Aldrich and Bestwall) or after confirmation of their predecessor’s chapter 11 plan, which included a divisional merger support agreement (DBMP).
In 2021, Johnson & Johnson attempted a Texas Two-Step to shield itself from talc powder litigation by creating LTL Management LLC to hold the company’s talc powder liabilities. Various talc powder tort plaintiffs petitioned the bankruptcy court to dismiss LTL’s bankruptcy.
Although the bankruptcy court denied the plaintiffs’ motion, the Third Circuit in January 2023 reversed that denial and ordered the dismissal of LTL’s bankruptcy petition. The Third Circuit concluded LTL lacked a valid purpose for filing for bankruptcy as it failed to show that it suffered from financial distress. In particular, the Third Circuit noted that Johnson & Johnson had pledged to provide up to $61.5 billion towards LTL’s talc litigation costs and to pay any settlements or judgments in talc claims. The Third Circuit ruled that companies in good financial health could not use bankruptcy merely to manage their litigation exposure and rejected the LTL bankruptcy.
In April 2023, Johnson & Johnson refiled for voluntary Chapter 11 bankruptcy, having negotiated an $8.9 billion settlement with an ad hoc committee of plaintiffs’ firms. Members of the plaintiffs’ bar are hotly disputing this settlement refiling, and the ultimate fate of this second bankruptcy attempt by Johnson & Johnson remains uncertain.
Companies facing mass tort liabilities are watching this case closely. While the Third Circuit’s vacating of the first LTL bankruptcy was heralded as a win by certain segments of the plaintiffs’ bar, the second attempt is evidence that mass tort defendants will continue to refine their strategies and are unlikely to abandon their efforts to find creative uses of the U.S. Bankruptcy Code to resolve legacy liabilities.
Regardless of how the LTL bankruptcy fares in court, continued use of the Texas Two-Step will change how plaintiffs pursue mass tort litigation. These changes will include who will serve on litigation leadership teams, how mass tort cases are financed and budgeted, and what recoveries plaintiffs might expect to receive.
Litigation leadership teams will need to bring on bankruptcy and Texas Two-Step specialists
With the Texas Two-Step and other creative bankruptcy solutions at play in any mass tort litigation, plaintiffs’ litigation leadership teams will need to structure themselves differently than before. In particular, they will need to add specialists who can provide guidance should a defendant pursue a Texas Two-Step.
First, teams may want to bring on bankruptcy counsel who have worked on previous mass tort cases involving the Texas Two-Step. Having lived through a Texas Two-Step, these lawyers will be knowledgeable about how to pursue effective strategies for dealing with the maneuver. Plaintiffs’ counsel in LTL Management LLC has provided future leadership teams with a roadmap for challenging the use of a Texas Two-Step, and could be willing to consult with future leadership teams on how to do so in their particular litigation.
Second, leadership teams should bring on as consultants bankruptcy attorneys who have broad experience in Chapter 11 cases involving mass tort liabilities. By knowing the bankruptcy system inside and out, these attorneys could advise teams on strategies plaintiffs’ attorneys familiar with the Texas Two-Step may not be aware of.
Finally, leadership teams should work with liability experts early on. These experts can estimate the total liabilities in a mass tort by making predictions about the potential number of cases, the injuries in those cases, and the values of those injuries. Importantly, they’ll be able to model these liabilities both in a typical mass tort litigation and if a defendant were to declare bankruptcy. Having this context early on will help leadership teams decide whether the scope of potential liability could give a defendant a reason to entertain a Texas Two-Step, or if any talk about it is merely a bluff.
Texas Two-Step cases will change litigation budgeting and funding for mass torts
The Texas Two-Step will change how plaintiffs’ leadership teams budget for litigation. Firms must account for the cost of retaining the specialists I mentioned in the preceding section. As we are often reminded of during high-profile bankruptcies, corporate bankruptcy counsel are among the most expensive attorneys in practice today. Their fees could easily top seven or eight figures, which is an expense for leadership teams that didn’t exist just a short few years ago.
Additionally, many plaintiffs’ firms rely on litigation funding to help defray the substantial costs of mass tort litigation. However, if defendants limit their potential liability through a Texas Two-Step, litigation funding companies may reduce their appetite to fund mass tort cases because plaintiffs’ recoveries—and, in turn, funding companies’ returns on their investments—will be limited to whatever cash a defendant has put in their spun-off liability subsidiary.
If litigation funding for mass tort cases dries up, it may prevent smaller plaintiffs’ firms or new entrants from developing mass tort practices, as only the largest law firms will have the financial resources to absorb the cost of mass tort litigation. It could also spur the birth of a new kind of funding that takes the place of traditional litigation funding.
These concerns are a reminder of how important the early liability analysis I described in the preceding section is. Knowing what the total liabilities in a mass tort litigation could be will provide plaintiffs’ leadership teams with an idea of how much money they should reasonably invest in litigating a mass tort and whether they can make do without outside litigation funding. With lower potential liabilities and potential recoveries, leadership teams may need to change how they would normally spend on experts, consultants, and other litigation costs.
How the Texas Two-Step may affect plaintiffs’ recoveries
If the Texas Two-Step allows mass tort defendants to limit their potential economic exposure to whatever money they choose to capitalize their legacy liability subsidiaries with or pledge to their subsidiaries, mass tort plaintiffs will need to lower their expectations of their financial recoveries. And, if courts ultimately uphold the validity of the Texas Two-Step, case law may eventually tease out an appropriate level of funding that defendants need to provide to a legacy liability subsidiary so that the court will find third-party releases for the parent acceptable as a matter of public policy.
Interestingly, the Texas Two-Step may lead to predictable recoveries for plaintiffs in mass tort cases, with plaintiffs getting treated more equitably than in litigation and avoiding situations where some walk away with massive recoveries while others walk away with little or no compensation. This “fewer home runs but fewer strikeouts” scenario could drive a wedge between plaintiffs’ firms based on their clients’ claims, and could complicate the settlement process.
Even more problematic is that bankruptcy takes away mass tort claimants’ Seventh Amendment rights to a jury trial, as they would have to negotiate the resolution of their claims under the narrow parameters of a plan approved by bankruptcy court. This is a trade-off of an important right that claimants must be made aware of when asked to vote on any Chapter 11 reorganization plan. Whether their counsel should recommend they do so is a different question for a different day. That question will likely generate different answers depending on the particulars of a case.
Thanks to the Texas Two-Step, changes to plaintiffs’ settlement negotiation strategies will be in order
If they haven’t already, plaintiffs’ litigation leadership teams must consider the effects the Texas Two-Step will have on how they negotiate settlements in their mass tort cases.
First, the threat of the Texas Two-Step may push teams to pursue litigation and settlement negotiations more quickly before defendants can limit their liability with a spin-off subsidiary. With this quicker timeline might come a compressed evaluation process that trades depth for speed and greater certainty.
Second, teams may need to consider whether to factor in the potential for the Texas Two-Step when determining settlement values. Could they warm up to a discount—and get buy-in for it from other counsel—knowing that a Texas Two-Step would be off the table?
Third, the potential for a Texas Two-Step could lead to conflicts between plaintiffs’ firms. Larger firms with significant financial resources and a diversified portfolio of cases may be willing to fight a Texas Two-Step rather than take a discounted settlement. Smaller boutique firms, including those whose futures might be riding on the results of several mass torts, may feel financial pressure to settle instead of “betting the house” on taking a mass tort to trial—especially if their cases are funded in part by loans with 20%–25% interest rates. There is an opportunity here for lawyers with the diplomatic skills to bridge divides between competing interest groups to keep the band together for the greater interest of their collective clients.
Today, it’s the Texas Two-Step. Tomorrow it will be a different maneuver
While some defendants may turn to the Texas Two-Step today to limit their mass tort liability, these same defendants will continue to ask their high-priced corporate and bankruptcy counsel to devise innovative successors to the maneuver, regardless of whether plaintiffs can persuade courts to close the dance floor on this particular strategy.
Bankruptcy provides a solution for a vexing problem corporations face more and more today on account of their dangerous products: how to dispose of massive legal liabilities on their balance sheets. The sizes of those legal liabilities, and the albatrosses they become in the eyes of lenders, investors, and potential suitors likely justifies to executives and corporate boards their corporations’ investing in devising new techniques for offloading those liabilities.
The Texas Two-Step forever changed mass tort litigation. Plaintiffs’ litigation leadership teams need to adjust how they litigate mass tort lawsuits today and into the future to prevent their clients’ claims from being stomped by an innovative—and perhaps ultimately successful—attempt by corporate defendants to skirt their full legal liabilities.
Mark Eveland is the chief executive officer of Verus, a leading mass tort litigation support services firm. He can be reached at meveland@verusllc.com.
Reprinted with permission from the July 18, 2023 edition of The Legal Intelligencer © 2023 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.
