The Third Circuit recently reversed a decision from the bankruptcy court and dismissed the chapter 11 bankruptcy filing of LTL Management, LLC (“LTL”), a Johnson & Johnson subsidiary created through the use of the “Texas two-step” maneuver, intended to isolate Johnson & Johnson’s talc related tort liabilities. See In re LTL Mgmt., LLC, No. 22-2003, 2023 WL 1098189 (3d Cir. Jan. 30, 2023). In issuing its decision, the Third Circuit held that LTL did not file its chapter 11 in good faith because the company was not in financial distress (a requirement which is not expressly included in the Bankruptcy Code). The Court explained: “Good intentions—such as to protect the J&J brand or comprehensively resolve litigation—do not suffice alone. What counts to access the Bankruptcy Code’s safe harbor is to meet its intended purposes. Only a putative debtor in financial distress can do so. LTL was not.” Id. at *1.

While the decision serves as an impediment to any future debtors’ ability to continue to utilize the “Texas two-step” strategy in bankruptcy, it does not completely foreclose the use of Texas two-step chapter 11 bankruptcies. Among other things, (i) a subsidiary created using the Texas two-step may still file bankruptcy in good faith if it suffered financial distress, and (ii) certain courts outside of the Third Circuit do not “financial distress” to find that the debtor’s bankruptcy petition was filed in good faith.

Key Takeaways

This ruling could impact bankruptcies in the Third Circuit – and potentially beyond – significantly.

  • While the Bankruptcy Code does not require a showing of insolvency to file for bankruptcy, the Third Circuit has now added a requirement that a debtor be in “financial distress.” Congress does not require such distress – though Court rulings on “good faith” have often considered the Debtor’s financial condition.
  • The Court noted that consideration of “financial distress” and good faith should focus on the Debtor’s financial well-being – not the well-being of other non-filing entities.
  • While the Third Circuit does not rule as to the propriety of the “Texas two-step” divisional merger per se, Chapter 11 Debtors will need to think carefully before utilizing such strategies prior to filing for bankruptcy in the Third Circuit. Companies looking to isolate mass tort claims via a separate entity in bankruptcy must carefully structure the bifurcation of assets and liabilities between the parent and bankruptcy-bound subsidiaries. As the Third Circuit noted, “the bigger a backstop a parent company provides a subsidiary, the less fit that subsidiary is to file.”
  • This is part of a recent series of cases in which creditors have questioned the fairness of bankruptcies designed to limit parental liabilities for potential tort or other mass liabilities. The victim claimants in the Purdue Pharma L.P. bankruptcy challenged potential non-debtor releases for the owners of officers of the debtors, before ultimately settling on appeal. Tort claimants in the Aearo Technologies LLC bankruptcy are seeking dismissal of the case as also filed in bad faith. In Aearo the victims recently argued that the Bankruptcy Court for the Southern District of Indiana should consider the Third Circuit’s ruling in LTL and dismiss the case. However the debtors in Aearo will likely assert that the facts there vary from the facts in LTL – Aearo was a long-existing subsidiary of 3M that recently filed for bankruptcy.