Texas Two-Step Bankruptcy: Meaning, Criticism, Example

What Is a Texas Two-Step Bankruptcy?

The term Texas Two-Step bankruptcy refers to a controversial legal maneuver that a company can use to manage its exposure to potential legal claims. To carry out a Texas Two-Step bankruptcy, a company must first create a new legal entity into which it transfers its tort liabilities while transferring a relatively small portion of the original company’s assets. The newly created corporation then files for bankruptcy, effectively shielding the original company from the tort liability costs. It is a controversial step, as critics argue that it allows companies to hide from their legal responsibilities.

How a Texas Two-Step Bankruptcy Works

Lawsuits and other legal issues can often be problematic for businesses of all shapes and sizes. Being embroiled in litigation, such as class action lawsuits, can cost time, money, and a loss of trust among consumers and the general public. But there are certain legal manoeuvers that companies have at their disposal to alleviate themselves of the burden of legal claims that may be filed against them.

The Texas Two-Step bankruptcy is one of those tactics. It is a form of corporate bankruptcy. Put simply, it is a legal step that a company can use to pass off its legal and financial liabilities to another company. As the name implies, there are two essential steps to carrying out a Texas Two-Step bankruptcy:

1. Create a new corporation. Companies will typically register this new corporation in a jurisdiction, such as Texas, whose system of corporate law is understood to be business-friendly.
2. Transfer the tort liabilities in question over to that newly created corporation. This process of creating a new company and transferring over a corporation's liabilities is known as a divisive merger and sometimes as a reverse merger.

When this process is complete, the next step in the process is for the newly created company to file for Chapter 11 bankruptcy. This shields the original or parent company from the costs associated with its tort liabilities.

In practice, this means that the dispute over tort liability must be resolved through the bankruptcy process. It also means the resolution comes without necessarily having recourse to the full assets owned by the original company, which is now a separate legal entity. By contrast, a typical legal procedure might instead involve taking the matter to a jury trial or settling out of court with the claimants.

Criticism of the Texas Two-Step Bankruptcy

The Texas Two-Step bankruptcy is controversial. Critics, including those from the legal community, argue that it gives corporations a pass on accepting responsibility for their legal obligations. They also say it provides corporations with another way to shield themselves, which is a privilege that regular consumers can't access.

Here's why. Creating another corporation, transferring the tort liabilities, and then declaring bankruptcy (sometimes fairly quickly) allows the company to avoid litigation in the event of a lawsuit. It also allows the company to absolve itself of any financial responsibility to its consumer base and its shareholders.

Although there are no laws that prevent companies from taking this step, it is possible that future laws or legal decisions may undermine the viability of the Texas Two-Step bankruptcy strategy.

Example of a Texas Two-Step Bankruptcy

Perhaps the most famous example of a Texas Two-Step bankruptcy is Johnson & Johnson (JNJ). The company was sued by consumers who alleged that some of its talcum-based baby powder products had contained asbestos, which contributed to cancer.

A Missouri appeals court ordered the company to pay $2.1 billion to the claimants in a June 2021 ruling. Later that year, the company used a divisive merger to create a new subsidiary called LTL Management LLC and transferred its talcum-related liabilities to that subsidiary along with a $2 billion trust intended to provide funding for any potential future claims against LTL.

This means that people can't pursue Johson & Johnson because the assets belong to LTL. And the $2 billion trust, which is significantly smaller than the total assets available to JNJ, could effectively limit the maximum damages future plaintiffs could claim, ultimately shielding JNJ from potentially unlimited liabilities.

JNJ's strategy received widespread media attention. Critics argued that it wrongly limited claimants' ability to receive damages and that forcing the resolution through bankruptcy proceedings could potentially delay and frustrate victims’ pursuit of compensation. Defenders argue that the bankruptcy process will determine whether the company's actions were fair. They also state that the process protects companies from the risk of unreasonably punitive jury verdicts.

In February 2022, Judge Michael Kaplan of the Bankruptcy Court for the District of New Jersey supported the strategy and ruled against a motion to dismiss LTL's bankruptcy, In the ruling, Kaplan determined that the maneuver was a legitimate use of the bankruptcy code.

“The Court remains steadfast in its belief that justice will best be served by expeditiously providing critical compensation through a court-supervised, fair, and less costly settlement trust arrangement.”

Similar decisions that seem to uphold the Texas Two-Step bankruptcy have also been reached in North Carolina. Yet there is also opposition to the practice. Sen. Dick Durbin (D-Ill.), who serves as the chair of the Senate Judiciary Committee, is publicly critical of the practice and called for legislation to outlaw it. In speaking to the Financial Times in February 2022, Durbin derided the legal strategy as a “get out of jail free card.”