February 8, 2023
The recent decision by the US Third Circuit Court of Appeals in In re LTL Management, LLC did not address or negate the viability of divisive mergers of entities under the Texas Business Organizations Code (the “TBOC”). Various news articles concerning the decision have reported that the court disapproved of the so-called “Texas Two-Step” transactions undertaken by Johnson & Johnson (“J&J”) in the face of its mounting talc tort litigation. Contrary to those published reports, the court assumed without analysis that the first step of the Texas Two-Step, namely the divisive merger undertaken pursuant to the TBOC, passed all of the talc liabilities of its predecessor J&J subsidiary corporation to the bankruptcy debtor, LTL Management, LLC (“LTL”). The court instead focused exclusively on the second step of the Texas Two-Step, namely the filing of the Chapter 11 bankruptcy petition. Applying bankruptcy law precedent, the court concluded that the bankruptcy petition was not filed in good faith because the debtor in the case was not in “financial distress” when it filed its Chapter 11 petition.
As described by the court, J&J engaged in a series of reorganizational steps with the stated goal of isolating its talc-based tort claims in a newly formed entity for the purpose of adjudicating and resolving all talc tort claims through a single organized and fair bankruptcy proceeding, rather than through thousands of individual lawsuits. Since 1979, J&J’s subsidiary, Johnson & Johnson Consumer Inc. (“Old Consumer”), had sold various talc products that were the subject of numerous lawsuits claiming causation of ovarian cancer and mesothelioma. The reorganization transactions undertaken by J&J first involved Old Consumer merging into a new Texas limited liability company, which survived the merger and became an indirect, wholly owned subsidiary of J&J. That limited liability company then effected a divisive merger under the TBOC by which two new Texas limited liability companies were created, and the original Texas limited liability company ceased to exist. Under the divisive merger, the responsibility for essentially all liabilities of Old Consumer tied to talc-related claims were allocated to that new Texas LLC, as permitted under the TBOC. That LLC was then converted into a North Carolina limited liability company which changed its name to “LTL Management LLC.” According to the court, LTL also received in the divisive merger $6 million in cash and a portfolio of royalty streams derived from consumer brands, valued by LTL at approximately $367 million. The second new Texas limited liability company was allocated in the divisive merger all of the remaining assets and liabilities of Old Consumer and then was merged into the direct parent corporation of LTL, which survived and changed its name to “Johnson & Johnson Consumer Inc.” (“New Consumer”).
At the time of the effectiveness of the Texas divisive merger, a Funding Agreement was executed by J&J, New Consumer and the transitory LLC that engaged in the divisive merger. The rights under this Funding Agreement were allocated to the predecessor of LTL in the divisive merger. After completion of all of the reorganization transactions, the Funding Agreement required New Consumer and J&J, jointly and severally, to pay to LTL up to the value of New Consumer for purposes of satisfying any talc-related costs of LTL as well as its normal course expenses. The Funding Agreement had few conditions to funding and no obligation on the part of LTL to repay any amounts that it received. The payment right under the Funding Agreement could not drop below a floor defined as the value of New Consumer measured on the date of the divisive merger, which was estimated by LTL to be $61.5 billion, and was subject to increase as the value of New Consumer increased after the reorganization.
The Chapter 11 bankruptcy petition was filed by LTL shortly after completion of these reorganization transactions. The bankruptcy court decided that the bankruptcy filing was justified and made in good faith based on various reasons that were discussed and analyzed by the appellate court.
The Third Circuit Court disagreed with the opinions of the bankruptcy court and concluded that the Funding Agreement essentially undercut the argument that LTL was insolvent or in “financial distress”. After an extensive analysis, the court concluded that the bankruptcy filing should be dismissed primarily because the funding backstop under the Funding Agreement mitigates any financial distress foreseen on the date that the Chapter 11 petition was filed.
Potential claims of fraudulent transfer under state law were not directly addressed by the court. However, in one footnote, the court noted that if LTL were to terminate its Funding Agreement with its parent entities so as to render itself insolvent, interested parties may seek to avoid any transfer made within two years of the bankruptcy filing if the transfer was made in exchange for less than a reasonably equivalent value or a party has become insolvent as a result of the transfer.
The analysis by the Third Circuit Court in the LTL case did not contradict or challenge the availability and potential benefits of effecting a divisive merger pursuant to the provisions of the TBOC. The court refused to address the argument that the Texas divisive merger, which was effected to isolate potential liabilities arising from the talc-related litigation in a new entity formed by the merger, contradicted the principles and purposes of the Bankruptcy Code. Accordingly, Texas law practitioners and Texas entities should take some comfort from the court case and should not be deterred from continuing to pursue divisive mergers of entities under the TBOC in appropriate circumstances and after consideration of potential fraudulent transfer concerns.