The “Texas Two-Step” is a heavily criticized bankruptcy strategy employed by companies in recent years to shield assets while shedding liabilities, including mass tort claims.
First, the company creates a new entity to which it will assign its liabilities while the parent company retains the majority of the assets. This is often referred to as a “divisive merger”. Such mergers often take place in business friendly states like Texas.
Second, the newly created entity saddled with the liabilities files for protection under Chapter 11, which filing results in the automatic stay of all litigation. Upon filing for bankruptcy protection, the filing company often seeks to extent the automatic stay to the non-filing parent company.
Johnson & Johnson employed the strategy as defense to thousands of lawsuit relating to its talc-based products.
When employed successfully, the liabilities are addressed in the Chapter 11 plan of reorganization or liquidation, the parent company is shielded from liability, and the parent company continues its business with little impact on its operations.
The tactic has been criticized as an abuse of the bankruptcy process that encourages bad faith bankruptcy filings and enables parent companies to avoid responsibility for the harm caused by its products or services.
On July 23, 2024, bi-partisan U.S. Senators introduced S. 4746, “Ending Corporate Bankruptcy Abuse Act of 2024” (ECBA), to curb this practice. The language of the ECBA can be found here.
According to one of the sponsoring senators, Senators Sheldon Whitehouse, a Rhode Island Democrat, “Large corporations on solid financial footing – like Johnson & Johnson and Georgia-Pacific – shouldn’t be able use the Texas two-step trick to shirk responsibility for injuries their products have caused.”
According to a summary in support of the ECBA, the ECBA
- Instructs courts to presume Texas Two-Step filings as bad-faith bankruptcies: Courts would presume a bankruptcy has been filed in bad faith if it shows clear indicia of a Texas Two-Step bankruptcy, such as if: the debtor manufactured venue for the case; a purpose or effect or cap the amount of liability even if the debtor or affiliate has sufficient funds to pay; the debtor was formed as result of a recent divisional merger; the debtor engaged in what would be considered a fraudulent transfer; or the debtor does not have a valid reorganizational purpose. The bill would also resolve a circuit outlier by standardizing to the prevailing standard of dismissing a bankruptcy for either subjective bad faith or objective futility.
- Prohibits stays of litigation in Texas Two-Step cases: Stays of litigation against a debtor’s non-bankrupt affiliates would be prohibited where the debtor engaged in a Texas Two-Step maneuver within the previous four years. The bill would add a Texas Two-Step exception to the Bankruptcy Code’s statutory litigation stay, which is normally triggered automatically when a debtor files for bankruptcy. This exception would ensure that, when the BadCo debtor formed in the Two-Step files for bankruptcy, the statutory stay will not block litigation against the GoodCo affiliate. This provision is narrowly scoped and would apply to Two-Step bankruptcies involving mass-tort/injury cases affecting more than 100 individuals. By carving out an exception to the statutory stay and prohibiting injunctions in Two-Step cases, this provision ensures that injury victims can get their day in court and deters corporations from abusing bankruptcy protections.
The ECBA has been referred to the Senate Judiciary Committee for action.
House Representatives Emilia Sykes, an Ohio Democrat, Lance Gooden, a Texas Republican, and Jerrold Nadler, a New York Democrat, introduced the House version of the ECBA on the same date, which has been referred to the House Judiciary Committee for action. The text of the House version can be found here.