Americans wondering if any issue today can unite warring members of the nation’s two major political parties may finally have an answer. On January 23, 2024, Democratic U.S. Senators Dick Durbin and Sheldon Whitehouse joined with their Republican counterpart and frequent political foe, Josh Hawley, to oppose a maneuver called the Texas Two-Step. There is no evidence that the three legislators wish to end Lone Star staters’ penchant for donning cowboy boots to waltz to the strains of Western swing music legend Bob Wills.
Instead, in an amicus brief in Bestwall LLC v. Official Committee of Asbestos Claimants, the three Senate Judiciary Committee members took aim at an increasingly prominent legal tactic with the same name as the iconic dance. The trio urged the U.S. Supreme Court to overturn a ruling made by the U.S. Appeals Court for the Fourth Circuit allowing paper giant Georgia-Pacific to pirouette its way out of millions in asbestos liability claims by diverting litigation to a newly created subsidiary, Bestwell LLC.
Employing a relatively unique Texas state law, Georgia-Pacific and other large corporations facing lawsuits by many plaintiffs — mass tort claims — are splitting themselves in two, placing the assets in one healthy company and the liabilities, including legal threats, in another, which they then place in bankruptcy. Critics claim this so-called Texas Two-Step is a legal sleight of hand by which companies shield their assets from victims to whom they may owe millions or even billions of dollars. In another example, when plaintiffs in all 50 states sued health product giant Johnson & Johnson, claiming that asbestos in its talcum powder caused ovarian cancer, the corporation created a subsidiary, LTL Management, into which it poured its legal liabilities before declaring the new entity bankrupt.
But the legal, as well as the political, tide may be turning. In the Johnson & Johnson case, the U.S. Court of Appeals for the Third Circuit last January rejected the company’s use of the Texas Two-Step, claiming that its purpose-built subsidiary, LTL, was not eligible for bankruptcy protection because it isn’t in financial distress. Ultimately, the U.S. Supreme Court may need to resolve the competing interpretations of bankruptcy law issued by the two different federal appeals courts overseeing the Georgia-Pacific and Johnson & Johnson cases.
To learn more about the Texas Two-Step, Harvard Law Today recently spoke with bankruptcy law expert Jared Ellias, who says that the tactic risks undermining public confidence in the bankruptcy system. He argues that lawmakers and lawyers must wrestle with the larger question of whether this approach is permissible or whether bankruptcy should remain available as a tool to help address high profile societal problems exemplified by the opioid epidemic or child sex abuse, in which plaintiffs have attempted to use bankruptcy courts to hold large U.S. corporations accountable.
Harvard Law Today: What is the Texas Two-Step and why is it called that?
Jared Ellias: The Texas Two-Step is a method that some companies have used to try to deal with liability related to mass torts. They use Texas law, which is why it’s called the Texas Two-Step, to split themselves into a bad company and a good company and spin off all the liability associated with the mass tort claims into the bad company, which they then have file for bankruptcy. That’s the basic move: a big company, which is a collection of assets and liabilities, segregates its liabilities. And then they say that nothing bad has happened, because they also create a funding agreement between the good company with the assets and the bad company with all the liabilities, which is the one that’s filed for bankruptcy. Johnson & Johnson did something similar [when the corporation faced tens of thousands of mass tort claims related to its talcum-based baby power], where the bad company was called LTL Management.
HLT: What are the primary criticisms of this strategy?
Ellias: The primary criticism is that it’s an abuse of the bankruptcy system. Bankruptcy law has a lot of provisions that are designed to help companies that run into financial trouble. And for companies with mass torts, what does bankruptcy do? First, it pauses all the lawsuits against them and channels everything into a single forum. Second, it creates an orderly procedure for resolving, estimating, and then paying out those claims. And third, it gives those companies a global resolution of those claims. So, bankruptcy law has always offered companies with mass torts issues a place to go for relief from those issues.
The Texas Two-Step is something different. With the Texas Two-Step, companies that are otherwise healthy seek to use the bankruptcy system to solve their problems without also submitting their operating business to the jurisdiction of the bankruptcy court. Let me contrast Johnson & Johnson and its spin-off, LTL, with another company that had mass torts issues. Pacific Gas & Electric, a gigantic company with mass torts issues related to wildfires in California, filed the entire business for bankruptcy in 2019, including all the wires, the employees, everything. And while in bankruptcy they sought to negotiate with, and they eventually reached, a resolution with the fire survivors. Johnson & Johnson, by contrast, sought to put the talc-related liabilities into a bankruptcy without putting Johnson & Johnson, a massively wealthy public company, into the bankruptcy system. That’s a distinct use of bankruptcy, which is different than what we had seen up until a few years ago.
HLT: You mentioned that corporations using the Texas Two-Step create funding agreements between the company with the assets and the one with the liabilities. Do those agreements enable plaintiffs and courts to get to all the assets they otherwise could?
Ellias: There are three problems, at least from the perspective of the tort victims. First, the companies claim that these Texas Two-Steps don’t disadvantage plaintiffs because the funding agreement entitles the bad company to demand payments from the good company to fund settlement of the tort claims. The tort victims always worry that these funding agreements are illusory, and won’t end up being enforceable, or that this extra step will then create a roadblock to recovery, or perhaps cause the tort victims to suffer from a more limited recovery than would have been the case otherwise. Problem number two is that, when you have these mass torts related bankruptcies, a great deal of the bargaining power that the tort victims have is because the whole company is in bankruptcy. Under the supervision of a bankruptcy judge, they’re able to study the company to make sure they’re getting paid as much as possible. The Texas Two-Step structure liberates the operating business from the bankruptcy process. And this is thought to significantly undercut the bargaining power of the tort victims, because without the pressure on the business created by operating under Chapter 11, which no management team wants, you worry that a settlement will get pushed out for months or years. I should note that many scholars think this is a feature and not a bug and perhaps think we should move towards a bankruptcy system where you don’t put companies into the fishbowl of bankruptcy, but I think that would require congressional re-design, not a lawyerly innovation. A third problem with this structure from the perspective of the tort victims is that, by losing their day in court, they also lose the ability to gamble on an especially large jury verdict.
HLT: Are there any advantages to the plaintiffs?
Ellias: Yes, there are several advantages. First, there’s uniformity of treatment for all plaintiffs no matter when they sued. You don’t have to worry that because you sued later, and get a later court date, that there will be less money in the bank vault by the time you have your day in court. In theory, the bankruptcy could lead to a faster resolution of the claim, getting money in your pocket sooner than would have been the case had you gone through the state law process with all the appeals. There can be certain advantages with having one lawyer representing the class of tort victims instead of having many lawyers squabbling with each other about things that only lawyers care about it. Finally, to the extent that the aggregate amount of legal fees is lower if you use this structure, then there’s more money in the bank vault for the tort victims.
So, there are reasons to look at a structure like this and say, “Well, perhaps this could be better.” Companies like Johnson & Johnson would tell you that the tort system creates a lottery. Some people get juries that are nicer to them than other juries. That it’s unbearable for companies to have to defend themselves from mountains of tort lawsuits, because it’s enormously expensive and it drains the time and attention of management, who ought to focus on innovating and not on defending lawsuits based on conduct from 40 years ago. I think the big takeaway is that situations like this are really hard. Our legal system doesn’t do a great job of dealing with them, no matter how you do it. And the big question here is, should we allow companies to segregate their liabilities into shell companies and then file those things for bankruptcy when the rest of the business is thriving?
HLT: And do you have an opinion on that question?
Ellias: My opinion is that this is an inappropriate use of the bankruptcy system. One of the things that bankruptcy cares a lot about is maintaining public confidence in the system. And that public confidence is undermined when rich, famous companies appear to engage in gamesmanship where they take from people who often have suffered a great deal their state law rights to see the person who harmed them in court and replace those rights with a bankruptcy in the distant courtroom, where it seems like the system is just rigged against those victims. It’s a careful balance, because we also wouldn’t want to live in a world where bankruptcy isn’t available as a solution to aggregate litigation. But my argument has always been that if Johnson & Johnson wants to use the bankruptcy system to deal with the talcum claims, they should just file the whole business into bankruptcy and not use this elite lawyer-driven gamification of the bankruptcy system, which just doesn’t lend itself to a process that will be perceived by tort victims as credible and fair.
HLT: I didn’t realize otherwise strongly profitable companies could claim bankruptcy protection. Don’t they have to be in financial distress?
Ellias: Historically, bankruptcy law has not required that you be in financial distress to file for bankruptcy. Part of the reason is that financial distress is sometimes in the eye of the beholder. You can be a company that’s doing quite well but perceive yourself as being terribly challenged by things you see on the horizon. Is that company distressed? Well, that’s hard to say. What about a company that’s just suffering from short-term issues? Imagine the major airlines in 2020, when COVID restrictions shut down travel. They were deeply distressed. But if you take the long view, there’s going to be a need for air travel again and it’s hard to build an airline that’s able to sustain itself. In the Johnson & Johnson/LTL case, however, the U.S. Court of Appeals for the Third Circuit seemed to create a new standard, which requires that you have financial distress. But that raises a host of questions because, historically, that hasn’t been a threshold requirement for bankruptcy in the U.S.
HLT: Is there a risk — putting aside the Texas Two-Step, for a moment — that allowing an otherwise highly profitable company to declare bankruptcy to limit civil liability might itself dent public confidence in the system?
Ellias: Part of the question that’s raised by all this litigation is, what is the role of the bankruptcy system in solving the problems in American society? The gambit by the lawyers who came up with the Texas Two-Step tactic is that the bankruptcy system is well positioned to step into a more prominent role of dealing with this problem of aggregate litigation, and to move beyond its existing role of serving companies that have been brought to their knees by mass torts, and instead, also service companies that are hobbled but still walking. That’s really the big policy question. Over the past 10 years, we’ve increasingly asked the bankruptcy system to deal with problems that American society doesn’t otherwise want to find good solutions for, whether because of polarization or log jams to litigation, George Triantis and I have written about this. Maybe bankruptcy could be something that governments could utilize effectively to accomplish goals that might be blocked by our system of government.
But what, exactly, do we envision the role of the bankruptcy system to be? Over the past decade, we’ve seen the bankruptcy system used to deal with childhood victims of sex abuse that was covered up by powerful institutions, such as the Boy Scouts of America, as well as various church-related groups. We’ve seen the bankruptcy system deal with climate change in California, and the risk associated with running power from one place to another in an increasingly dry landscape, a problem that is possibly bigger than even the wealthiest state governments in the world can handle. And then here, we’re seeing bankruptcy used by wealthy companies that think the tort system is becoming this major problem for their ability to conduct business. All these questions are buried beneath layers of legal doctrine. But the policy question is really, what should bankruptcy judges and lawyers be spending their time on? I taught my first class of the semester this week. I always start by noting that bankruptcy is an exception to the general rules. The general rule is that if you make a promise, you have to keep it or you get sued. Bankruptcy law changes the process by which those rights are vindicated. Well, when do we allow companies to step into bankruptcy? That’s really the Texas Two-Step question.
HLT: Senators Dick Durbin and Sheldon Whitehouse recently teamed up with Senator Josh Hawley, who is not exactly their ideological soulmate, to file an amicus brief in another case arguing that the Texas Two-Step is subverting the bankruptcy system and violates congressional intent. Do you sense a growing bipartisan interest in this question and, if so, why?
Ellias: The nature of a bankruptcy proceeding is that somebody’s going to be disappointed. And when it’s a mass torts case, a lot of people are disappointed. And when you have something like the Texas Two-Step, you start to raise questions about whether or not the system is rigged. So, that’s an easy issue for members of both parties to get behind, especially if they’re not starting from the perspective that the tort system is broken. It’s very easy for members of the Republican Party to say this is just unfair to the little person. And it’s very easy for Democrats to say the same thing. There’s often bipartisan interest in making changes to the bankruptcy system when there are high profile cases, which then creates the perception that something is being abused. And what we always worry about as bankruptcy scholars is that those changes can be reactive and reactionary, and not necessarily in the best interest of the health of the system. I’m worried a lot right now about what the Supreme Court is going to do in the Purdue Pharma case, another high-profile mass torts case. You may have questions about the specific legal moves that the debtor and the judge made and whether or not that falls within the constitutional power of the bankruptcy courts, some of which are seen by lots of people as an abuse, although there are those who dispute it. But my worry is that the Supreme Court will do something that hobbles the usefulness of the bankruptcy system in helping to solve societal problems to provide relief to people who need it.
You worry that, when we talk about policy changes in the aftermath of these very high-profile cases, we start to lose sight of the usefulness of doctrine and law that’s on the chopping block that has been used on average more often for good than for bad. I’m always in favor of having a flexible and empowered bankruptcy system. And I generally trust that bankruptcy judges have very good intentions and are trying very hard to navigate very difficult situations. I don’t think that there’s a world in which a situation like we have with the Johnson & Johnson talcum litigation, or the Purdue Pharma opioid litigation leads us to a happy ending. For us as bankruptcy lawyers and scholars, we have to sometimes ask, are we taking away the best possible resolution in a scenario where everything is going to feel awful?
This interview has been edited for length and clarity.
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