The Texas Two-Step: The New Fad in Fraudulent Transfers

There's a new fad in fraudulent transfers. It's called the Texas Two-Step. Here's how it goes. A company has a lot of tort liabilities (e.g., asbestos, talc, benzene, Roundup). The company transforms into a Texas corporate entity (the particular type doesn't matter). The new Texas entity then undertakes a "divisive merger" that splits the company into two companies, and it allocates the assets and liabilities as it pleases among the successor entities.

The result is that one successor entity ends up saddled with the tort liabilities (BadCo) and the other with the assets (GoodCo).  The companies then convert to whatever type of entity the want to be going forward for corporate governance (or venue) purposes, and the BadCo files for bankruptcy, while GoodCo keeps chugging away. The tort victims find themselves creditors in the bankruptcy of BadCo and get bupkes, while the bankruptcy plan inevitably includes a release of all claims against GoodCo. Pretty nifty way to hinder, delay, or defraud creditors if it works, right?

Well, that's the question:  does this work?  We've only seen two Texas Two-Steps to date. There have been a few Texas Two-Steps to date (and one might be a Wilmington Waltz). First was BestWall's asbestos bankruptcy. BestWall (formerly part of Georgia Pacific) is a subsidiary of Koch Industries, and its bankruptcy is pending in the Western District of North Carolina. No plan has been confirmed, but the case has been dragging on since 2017, and the asbestos victims have been enjoined from suing any of the non-bankrupt Koch entities. Plan exclusivity has long-lapsed, but the court won't dismiss the case and doesn't seem willing to consider any alternatives. Even if the Two-Step isn't completely successful in the end, it will surely reduce whatever settlement the Koch entities have to pay.

Then there's DBMP (CertainTeed), another asbestos case, again in the Western District of North Carolina. Same story going on there; there's an adversary proceeding pending about the preliminary injunction. Also in WDNC, before the same judge is Aldrich Pump. Same judge as DBMP, and again a preliminary injunction. And then pending in Delaware is Paddock Enterprises, LLC, the rump of Owens-Illinois. The UST filed an examiner motion over the divisive merger transaction. Denied.

In any case, the Two-Step looks promising enough that Johnson & Johnson is supposedly considering using it for its talc liabilities.

For those of you who want to go under the hood, the key to the Texas Two-Step is a quirk of Texas law.It's possible in every state to split a company's assets and liabilities just through a spin-off (dividend up a sub's shares to shareholders, resulting in them directly holding two companies), and we've seen spin-offs used as fraudulent transfers:  Andarko/Tronox and Sears/Lands End. But Texas offers another method for doing so, basically lower cost asset partitioning that also might evade fraudulent transfer liability.

Texas law defines "merger" as including not just two companies merging into one, but also the exact opposite, when a company divides into two or more entities.  This sort of corporate division is sometimes called a "divisive merger".  Texas is one of two states that allow for divisive mergers. Delaware is the other, but it only provides for divisive merger for LLCs. (Texas seems to be competing with Delaware in a corporate law race to the bottom--look at waiver of fiduciary duties--but that's for another blog.)

Why would it matter that a division is defined as a "merger" under Texas law?  Because the Texas Business Organizations Code provides that a merger operates "without ...  any transfer or assignment having occurred."  The thinking is that if there's no transfer in a divisive merger, then there cannot be a fraudulent transfer. The deemed lack of a transfer is what makes the Texas Two-Step special.

Now, it is far from clear that Texas's fraudulent transfer law--or any other jurisdiction's--would defer to the Texas Business Organizations Code regarding whether there is a transfer, but there's no law on that point (but it has gotten some consideration in this thoughtful law review comment). The conversion into a Texas entity might itself be considered a transfer and step transaction doctrine might bundle everything together. Still, that lack of clarity is important settlement leverage. Maybe GoodCo ends up chipping in a bit to the bankruptcy in exchange for a release. But GoodCo's ability to make a credible argument that it has no liability on account of the Texas Two-Step is surely going to reduce what GoodCo has to pay and by an amount that vastly exceeds the transaction costs for these shenanigans.

So where does this all point? On one level, it points to a problem of states undermining fraudulent transfer law somewhat deliberately (I think). But more broadly, it points to a need to substantially strengthen fraudulent transfer law:  longer statutes of limitations, a statutory step doctrine, treble damages for actual (deliberate) fraudulent transfers, aiding and abetting liability, and criminal penalties for actual fraudulent transfers (which will mean that lawyers cannot ethically counsel such transactions).  Unfortunately, that's a political fight between the wolves and the lambs. The wolves know that this stuff matters and will fight tooth and nail, and even though the lambs outnumber the wolves, they are clueless and won't do anything to protect themselves. And that's why we're all likely to be seeing more of the Texas Two-Step.

Comments

[Bob Lawless]

It is "far from clear" that Texas's Uniform Fraudulent Transfer Act (UFTA) would defer to the Texas Corporate Code on the definition of a "transfer?" I'll only buy that if "far from clear" means UFTA clearly would not defer to the Texas Corporate Code. UFTA says "As used in this Act" certain words have certain definitions. It would be lawyerly sophistry to argue that another statute then somehow mysteriously controls the definition, almost as if there is some natural law meaning of "transfer." The same is true for the Bankruptcy Code.

Both UFTA and the Bankruptcy Code have a deliberately broad definition of "transfer" and that includes the "indirect parting" of an interest in asset. That broad language is there to eliminate exactly the sort of form-over-substance lawyering happening with the "Texas Two-Step." As you allude, Adam, the game here is a nonfrivolous argument that will allow these companies to create costs and litigation leverage to escape full responsibility.

P.S.--I still have concerns about the potential for abuse of criminal fraudulent liability claims in consumer cases. It gives creditors and trustees too big of a hammer to wield against consumers.

[Adam Levitin]

Even if UFTA controls over TBOC, there's still a problem: who is the transferor and who is the transferee. Entity A splits into entities B and C. There is no more A. B didn't transfer anything to C, and C didn't receive anything from A. So how does the remedy operate? Indeed, who is the defendant (I think you need to sue the transferor as well as the transferee, at least at state law)? Delaware's LLC Act provides that:

"In the event that any allocation of assets, debts, liabilities and duties to division companies in accordance with a plan of division is determined by a court of competent jurisdiction to constitute a fraudulent transfer, each division company shall be jointly and severally liable on account of such fraudulent transfer notwithstanding the allocations made in the plan of division; provided, however, the validity and effectiveness of the division are not otherwise affected thereby."

There's no equivalent Texas provision. I guess a judge could fashion a remedy, but it's just more legal leverage for the Two-Stepper.

P.S. I agree with you about most consumer cases. I would treat consumer 7s and 13s differently, but consumer 11s should be under the same rule.

[Bk]

If there was a statutory step doctrine, I would worry about whether companies might find an ambiguity or weakness in the statutory test. If it is statutory, it would be hard to update or modify for changing practices.

So I may prefer judge-made law regarding the step doctrine.

The other suggestions sound good.

[c b]

Really great post. Surely most bankruptcy judges would find this is a fraudulent transfer (although maybe the debtor judge-shops one who won’t?)…. Unbelievable on some level that it’s even conceivable otherwise. Really great though in any case.

[Bob Lawless]

Remedy, Adam? You sue the guys and gals with the money.

My more serious answer is that you sue whoever has the assets the company "indirectly parted" with. Completely off the top of my head, I don't think anyone other than the assets you want back is a necessary party to the proceeding.

My quibble with your response is that you're partly arguing the definition. I take your point, but aren't you using a nonstatutory, everyday meaning of the word "transfer." Under the statute, it includes "every mode, direct or indirect, absolute or conditional,
voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset." That is a pretty broad signal to ignore this sophistry of "I didn't 'part' with the asset. I just never had it."

[Bob Lawless]

P.S.--I should be clear that I am not accusing you of sophistry. Those are the arguments the lawyers for J&J will make.

[Thomas Moers Mayer]

Good post, Adam.

I have long been a proponent of aiding-and-abetting liability for intentional fraudulent transfers, imposed on the lawyers sell such schemes to clients. See my paper, "Will the Lawyers Pay? The Ethical, Civil and Criminal Exposure of Counsel for Setting Up Offshore Asset Protection Trusts" -- presented at various ACTEC and PLI conferences. (I think the asset protection bar is a far greater danger to the system than clever corporate lawyers). I believe there are a handful of states that have imposed such liability. Also, you would not need to criminalize fraudulent transfer law to make it unethical for a lawyer to advise a client to commit an intentional fraudulent transfer. A bunch of states already hold that such advice is unethical because it is in furtherance of a "fraud". Alas, the American Law Institute has weakened this argument by renaming the statute the "Uniform Voidable Transfer Act", which I refer to as the "de-moralization" of fraudulent transfer law.

Alas, further -- bankruptcy law has veered away from imposing aiding and abetting liability ever since Learned Hand found none in connection with a preference action and other courts misinterpreted his opinion as applying to all avoidance actions. I find it bizarre that a doctrine with roots in Twyne's Case (which was all about aiding-and-abetting) has evolved into a pure recover-the-asset statute.

With respect to the definition of "transfer" -- the federal definition will triumph over any Texas exclusion. A further suggestion: choice-of-law in fraudulent transfer actions is a difficult topic. I do not believe Texas courts have held that Texas law must govern a fraudulent transfer action in a Texas case. A Delaware UFTA action would escape the Texas two-step even for a case in Texas. I am reasonably confident that reincorporation of a Delaware corporation in Texas preparatory to a Texas-two-steps would be caught in a step transaction analysis.

[Izzy Goldowitz]

To Tom's last point, Raleigh v. Illinois Dept. of Revenue appears to settle most choice of law questions: the "rule of decision," in an Erie sense, is nonbankruptcy law unless the Code provides otherwise. See also Butner v. US and Vanston Bondholders v. Green.

But I see a powerful argument for adopting "bankruptcy common law" in a case like this, to prevent fraud.

Perhaps it could also be argued that the court should dismiss the case as the culmination of a series of steps leading to a bad faith filing.