Outsize Role Bankruptcy Courts Play in Mass Tort Litigation

This article addresses the “Texas Two-Step” litigation strategy when it comes to bankruptcy and discusses whether this strategy of utilizing the Chapter 11 process to handle mass tort litigation claims is fair, effective and will survive the scrutiny of the courts.

Mass-tort bankruptcy cases have been capturing headlines recently. Everyday household names have sought bankruptcy protection to deal with mass-tort litigation claims including LTL Management LLC/Johnson & Johnson (J&J), Aearo Technologies LLC/3M and others.

Large conglomerates are using the bankruptcy system as a litigation strategy to settle or otherwise deal with mass tort claims. This strategy, coined the Texas Two-Step, evolved years ago, but has become an increasingly popular albeit controversial litigation tool, causing bankruptcy courts to grapple with whether these cases should be allowed under the Bankruptcy Code. This practice is expected to reach the United States Supreme Court soon.

The Texas Two-Step occurs when a corporation divides itself into two (or more) organizations and then allocates its assets and liabilities. The company with the liabilities files for bankruptcy, which stays the mass-tort litigation and in turn forces plaintiffs/claimants to pursue their claims through the bankruptcy courts.

The non-debtor entity (typically the parent company) will then enter into a funding agreement through a Chapter 11 reorganization plan to obtain the benefit of the automatic stay even though it is typically only provided to the bankruptcy filing entity. The purpose of the funding agreement is to provide funds to the bankrupt entity for the benefit of the tort claimants.

The big question is whether this strategy of utilizing the Chapter 11 process to handle mass tort litigation claims is fair, effective and will survive the scrutiny of the courts.

Notably, most of these Texas Two-Step cases are all being challenged in the same manner. The corporate debtors assert that the automatic stay

should apply to the non-debtor entity, which has not filed for bankruptcy. And tort claimants seek dismissal, arguing that these bankruptcy cases have been filed in bad faith and these tort claims belong in state court.

As circuits try to navigate the issues of this increasingly popular and controversial strategy, we anticipate U.S. Supreme Court intervention is on the horizon, since courts have reached different outcomes as to whether this strategy is permissible.

LTL Management

In 2021, J&J engaged in a divisive merger and created LTL Management . At that time, J&J faced tens of thousands of lawsuits by consumers alleging that they were diagnosed with cancer and other illnesses caused by talc, which is an ingredient in the baby powder J&J produced. J&J continued to hold substantially all the assets and transferred all of its talc injury liabilities to LTL.

Shortly after LTL was created, it filed for bankruptcy protection under Chapter 11 and the pending talc cases were stayed. The automatic stay allowed J&J to attempt to use the bankruptcy court’s quick timeline to settle claims, and potentially avoid defending the mass-tort claims on a case-by-case basis.

In 2022, the Talc Claimants Committee sought dismissal of LTL’s bankruptcy on grounds that the bankruptcy petition was filed in bad faith.

The bankruptcy court denied the motion and the Talc Claimants Committee appealed.

On appeal, the U.S. Court of Appeals for the Third Circuit agreed that the petition was filed in bad faith and reversed the ruling, finding that LTL was not in financial distress (a requirement for Chapter 11 bankruptcy protection) and that the J&J funding agreement in place was sufficient to resolve LTL’s talc liability claims.

In January 2023, the Third Circuit ordered the dismissal of the LTL Chapter 11 case because of its “bad faith filing”, since the debtor (LTL) was not in “financial distress”.

Within hours of dismissal, LTL filed a second bankruptcy case (LTL II). The Talc Claimants Committee immediately sought dismissal of the new case on similar grounds as the first LTL bankruptcy case.

In July 2023, the LTL II case was dismissed by the bankruptcy court as a “bad faith filing”, based on the ruling by the Third Circuit in LTL that a debtor must be in financial distress. In August 2023, a Notice of Appeal was filed.

Prior to the LTL II ruling, another bankruptcy court in a different jurisdiction relied on the decision in the LTL matter.

Aearo Technologies

In 2022, a subsidiary of 3M, Aearo Technologies, filed for Chapter 11 protection after being named a defendant in thousands of lawsuits alleging personal injury from faulty earplugs sold to the U.S. military.

This Chapter 11 bankruptcy filing, although not a Texas Two-Step case, automatically stayed the personal injury lawsuits filed against Aearo.

Aearo requested the automatic stay be extended to 3M, which was denied.

Prior to the Aearo filing, 3M contributed more than $1 billion to a funding agreement with Aearo to pay for the personal injury claims. Shortly after the LTL decision, the Tort Claimants Committee in the Aearo bankruptcy case sought dismissal of the case. The arguments of the Tort Claimants Committee was similar to those set forth by the Talc Claimants Committee in LTL namely that the Aearo debtors were not in financial distress.

In June 2023, the bankruptcy court dismissed Aearo’s bankruptcy case. The decision cited to LTL, and the bankruptcy court found the Aearo was “financially healthy.” The bankruptcy court noted that, unlike LTL, Aearo had debt but apparently not enough to afford Chapter 11 protection. A petition for authorization to take a direct appeal of the decision to the U.S. Court of Appeals for the Seventh Circuit is pending.

These decisions indicate that a corporate debtor has filed in “bad faith” if the corporation is not in “financial distress.”

There is already one Texas-Two Step case that has survived a motion to dismiss for bad faith filing. In re Bestwall LLC, case no. 17-31795. Whether this standard will apply uniformly in each circuit appears to be unlikely.

Bestwall

Georgia-Pacific LLC formed Bestwall to absorb its asbestos-related liability claims and then filed Bestwall for bankruptcy. Similar to the LTL and Aearo matters, a funding agreement is in place in the Bestwall case.

In 2019, claimants sought dismissal of Bestwall’s bankruptcy case. The bankruptcy court, applying a stringent standard adopted by the U.S. Court of Appeals for the Fourth Circuit, did not grant claimants motion.

Like Aearo, Bestwall requested that the automatic stay apply to its parent Georgia-Pacific. The district court granted Bestwall’s request and the Fourth Circuit affirmed the district court’s ruling. In August 2023, the Fourth Circuit declined to reconsider its decision, and upheld its bar against claims relating to asbestos injuries being pursued against Georgia-Pacific. Currently, those asserting claims against Georgia-Pacific must pursue their claims against Georgia-Pacific and Bestwall in the bankruptcy court.

Recently, claimants filed another motion in the bankruptcy court, arguing that Bestwall’s bankruptcy case should be dismissed for reasons similar to LTL. In June 2023, the claimants filed supplemental authority in support of their dismissal motion, citing the LTL and Aearo decisions. In July 2023, the bankruptcy court denied the motions to dismiss. A motion to file a direct appeal to the Fourth Circuit is likely to be filed by the claimants.

Another bankruptcy case which challenges this litigation strategy is In re Aldrich Pump, case no. 20-30608 (Bankr.W.D.N.C., filed June 18, 2020).

In Aldrich Pump, motions to dismiss were filed. The motions to dismiss were heard in July 2023, and the decision is pending.

Utilizing the bankruptcy courts to address mass tort litigation has been employed in different circuits. Whether this litigation strategy is authorized under the Bankruptcy Code will likely be resolved only with

Supreme Court intervention. LTL was the first “Texas-Two Step” bankruptcy case dismissed as a bad faith filing. If other circuits follow suit remains unclear. In the interim, claimants will continue to oppose this litigation strategy because they believe it deprives them of their right to a jury trial under the Seventh Amendment.

Reprinted with permission from the September 17, 2023, issue of the New York Law Journal^©, ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.