Attorney Greg Gordon, a partner at Jones Day, proposed an innovative solution to Johnson & Johnson and other major corporations facing mountains of lawsuits alleging their products sickened or killed people: they could use the bankruptcy system to force all plaintiffs into a single settlement.
It took some fancy legal maneuvering — forming a subsidiary to take on all of the liability, then putting that new company into Chapter 11.
The “Texas two-step” gambit was attacked by plaintiffs’ lawyers, who claimed it amounted to a bad-faith bankruptcy filing and a fraudulent ploy to shield the parent companies’ assets. Not so, Gordon told judges overseeing bankruptcies where the novel strategy was being tested. He claimed that the parent companies would provide billions of dollars in compensation to the subsidiaries.
Gordon’s attempt to reassure bankruptcy judges created a new legal problem. The 3rd Circuit Court of Appeals halted J&J’s two-step on Monday, ruling that its cash-flush subsidiary lacked a legitimate claim to bankruptcy protection because it was not in “financial distress.”
The decision forces J&J back into trial courts to fight nearly 40,000 lawsuits and casts doubt on the legality of the Texas two-step strategy. The plaintiffs claim that J&J’s talc products, including Baby Powder, caused cancer, which J&J denies.
The reasoning of the appeal court judges highlighted what some legal experts call an inherent contradiction: bankruptcies being carried out by multinational corporations worth billions of dollars that were in no danger of running out of money to pay plaintiff-creditors. The panel rejected the main argument that Gordon and the companies used to defend the strategy. The companies argued that the bankruptcies served the greater good of all parties, including the plaintiffs, by providing fair payouts more efficiently and equitably than the “lottery” offered by trial courts.
The decision rejected “the idea that a profitable company can force personal-injury claimants out of jury trials and into bankruptcy court simply by arguing that doing so is more efficient than the civil justice system,” according to Melissa Jacoby, a bankruptcy law professor at the University of North Carolina School of Law.
Gordon and Jones Day did not return calls seeking comment. In a statement, a lawyer for Johnson & Johnson’s subsidiary said the company would request a rehearing of the panel’s decision by the full 3rd Circuit court. The potential cost of fighting the lawsuits, according to the attorney, Neal Katyal, justified the bankruptcy filing.
In a series of reports last year exploring corporate attempts to avoid lawsuits through bankruptcies, Reuters detailed the secret planning of Texas two-steps by Johnson & Johnson and other major firms.
As a precedent, the judges’ reasoning in J&J raises the legal hurdles for companies pursuing the novel strategy. The ruling could trap two-stepping companies between the competing demands of bankruptcy courts and appeals courts, which are likely to hear more challenges to the tactic.
Bankruptcy judges, for their part, are hesitant to approve any action that prevents creditors from accessing debtor assets. Their courts punish companies that, for example, try to shield money by moving it out of company accounts before filing for Chapter 11, a practice known as a fraudulent transfer of assets. Plaintiffs opposing two-step bankruptcies claim the strategy is a creative fraudulent transfer because it shields the firm being sued by shifting its liabilities to a new shell company.
At a bankruptcy attorneys’ conference last April, Gordon stated that J&J and three other companies attempting a two-step countered such concerns by agreeing to “unlimited” funding of their subsidiaries. The new units had enough cash to pay claims, so fraud couldn’t have been the intention, the reasoning went.
“We don’t even want to argue about it,” Gordon said of fraudulent transfers.
Gordon’s strategy worked in bankruptcy court, but it set J&J up for failure when it went before the 3rd Circuit appeals panel. The judges ruled that J&J’s claims that it generously financed its subsidiary, LTL Management, undermined any claim of financial peril.
“We take J&J and LTL at their word and agree,” wrote Circuit Judge Thomas Ambro, explaining why LTL did not qualify for bankruptcy. According to the judge, J&J’s promise of unlimited funding was essentially a “ATM” for the subsidiary, shielding it from “any threat to its financial viability.”
LITIGATION FOR 50 YEARS?
Johnson & Johnson is now facing the same mountain of litigation that drove the company into bankruptcy.
Gordon described the lawsuits as “completely unmanageable” and a dire threat to J&J that could last for decades at the bankruptcy conference. In five years, the company’s costs for verdicts, settlements, and legal fees soared to about $4.5 billion, he said.
“How do you handle 40,000 cases? How do you deal with the fact that you’re getting 10,000 more people every year, and that this trend is expected to continue for the next 50 years?” Gordon inquired. “What do you do as a company, no matter how big it is, about that?”
Johnson & Johnson, which has a market capitalization of more than $400 billion, claims that the flood of lawsuits posed a significant financial risk. “The current situation, with a significant volume of current and future claims and a plaintiff bar business model primed to generate more, is exactly the type of ongoing and future financial distress that courts have recognized as serving a valid bankruptcy purpose,” Katyal, the lawyer for J&J’s subsidiary, told Reuters.
According to two legal experts, J&J’s attempt to overturn the bankruptcy dismissal will be difficult. According to Jacoby, a law professor at the University of North Carolina, the full 3rd Circuit is unlikely to overturn Judge Ambro’s decision because he is an expert in bankruptcy law. And, according to Lindsey Simon, a University of Georgia School of Law professor, the United States Supreme Court typically intervenes only when there are conflicting decisions among courts of appeal.
So far, only the Third Circuit has weighed in, but other circuits may soon take up challenges to similar bankruptcy filings.
‘INNOVATIVE LAWYERS’
Aside from J&J, four other companies have pursued subsidiary bankruptcies in order to halt dangerous-product lawsuits. With the assistance of Gordon and Jones Day, three companies completed Texas two-steps: global construction giant Saint-Gobain and manufacturers Georgia-Pacific and Trane Technologies (The strategy gets its name from the Texas law used to divide the company being sued into two, creating the subsidiary that absorbs liability.) 3M Co used a similar bankruptcy strategy to avoid about 290,000 claims for allegedly defective military earplugs.
Saint-Gobain, Trane, and 3M all declined to comment. Georgia-Pacific did not respond to requests for comment.
The 3rd Circuit decision has no direct bearing on these cases, but other courts may soon weigh in. The 7th Circuit Court of Appeals is expected to hear arguments in the coming months on a challenge to the bankruptcy of the 3M subsidiary. Instead of forming a new company, as required by Texas law, 3M assigned its lawsuits to an existing subsidiary. The goals were the same: stop the lawsuits and force the plaintiffs to settle in bankruptcy.
An Indiana bankruptcy judge, however, deviated from standard practice last year by allowing the lawsuits against 3M to proceed even as its subsidiary’s Chapter 11 case continued, effectively defeating the point of 3M’s maneuver.
If the 7th Circuit sides with 3M and issues an opinion that contradicts the 3rd Circuit decision, the chances of a Supreme Court intervention increase. If 3M loses, it may strengthen case law against such bankruptcy gambits and discourage companies from pursuing them in the future.
Meanwhile, the Georgia-Pacific Texas two-step is being challenged in the 4th Circuit. Following the rejection of a plaintiffs’ challenge alleging that the bankruptcy was filed in bad faith by a North Carolina judge, plaintiffs’ attorneys advanced a different argument, one that echoed the 3M case. They claimed that the litigation against Georgia-
Pacific should be allowed to proceed because the parent company did not file for bankruptcy. The case is now before the 4th Circuit Court of Appeals.
The 3rd Circuit panel stated that it did not intend to outright ban the Texas two-step. Judge Ambro went out of his way to commend lawyers like Gordon for “being inventive” and “trying out novel solutions.”
Nonetheless, the legal safeguards in Ambro’s decision will make it much more difficult for companies to follow Gordon’s playbook, according to David Molton, a Brown Rudnick LLP lawyer representing talc plaintiffs who challenged J&J’s strategy.
According to Molton, Ambro put “pretty firm gates” on bankruptcy tactics aimed at halting defective-product litigation. “What Judge Ambro did say was, ‘I’m not here to eliminate creative lawyers, but I’m here to tell you when that creative lawyering goes outside the bounds, I’m going to put a stop to it,'” Molton said.