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The Texas Two-Step? Just Don't Go to the Dance

posted by Bob Lawless

Suppose a company facing mass tort liability to U.S. citizens produced a piece of paper that read "Cook Islands Liability Extinguishment Corporation." The company then says to the tort victims, "We have formed this corporation under the law of the Cook Islands, which allows us to assign any liability we want there and extinguish it. And, that's exactly what we did with your tort claims." The legal response would surely be that the law of the Cook Islands does not govern the company's tort liability under U.S. law.

Yet, this is not dissimilar what has happened to citizens of Illinois and other states in the Johnson & Johnson talcum powder litigation. Essentially "old J&J" split into two companies--J&J Consumer and LTL Management. (The corporate structure is more complex, but those details are unnecessary to the point.) J&J's talcum powder liability went to LTL Management, and the bulk of the assets and other liabilities went to J&J Consumer. All this is authorized as a "divisional merger" under the Texas Business Organizations Code. In a procedure known as the "Texas Two-Step," LTL Management then filed bankruptcy to deal with the talcum powder liability. The rest of the company--i.e., J&J Consumer--went along its merry way pretending the liabilities it used to have are no longer part of it. Texas law here sets the rule for everyone.

In fairness, J&J did not leave LTL Management with nothing and claims there are financial resources to backstop the tort liability. A bankruptcy court last week refused to dismiss the LTL Management bankruptcy filing on grounds of bad faith and indeed controversially embraced the idea that bankruptcy courts are an appropriate place to handle mass-tort liability. I don't want to get into that debate. My question is why should I, as a citizen of Illinois, have to suffer the consequences of the Texas legislature's decision to allow divisional mergers? Well, as a lawyer, I know why, but I think that can be changed.

The reason I have to put up with the Texas two-step is the internal affairs doctrine. It says that the law of the state of organization governs the corporation's internal affairs. That is, because J&J Consumer and LTL Management were organized under Texas law, that same law governs how to divide up the companies asset and liabilities.

The internal affairs doctrine, however, is just a choice-of-law rule, and as lawyers are taught in law school, a choice-of-law is just another law that determines which jurisdiction's laws apply in a particular dispute. Most choice-of-law rules are judge made. Like any other judge-made rule, a state always can change a choice-of-law rule by adopting a statute providing otherwise. It seems to me that if Illinois (or Massachusetts or New York or California, to name a few possibilities) does not want its citizens' tort rights against a corporation to be governed by the divisive merger law of Texas, it can simply adopt a statute so saying. Such a law might provide, for example, that for purposes of liability Illinois tort law, the divisive merger is ignored. Indeed, nothing occurs to me why such a law could not apply to existing tort liability.

Adam had an earlier post explaining how fraudulent transfer law would (or would not) apply to a Texas two-step. Fraudulent transfer recoveries requiring lawsuits and happen years after the fact--and Adam's post explains the weaknesses in arguments that fraudulent transfer law even governs. Statutorily, changing the internal affairs rule requires none of that. It would allow tort claimants simply to proceed against the surviving companies after a divisional merger.

Some defend the Texas (and Delaware) divisional merger statutes as efficient and allowing companies to deal with liabilities without interfering with profitable operations. As an empirical matter, I disagree, but I see the contrary view. What is more difficult to defend is the idea that one state should be able to make this policy decision for everyone.


Even as currently understood, the internal affairs doctrine for the most part governs only disputes between shareholders and directors and officers. It doesn't typically have anything to say about tort claims. Successor liability principles, for example, come from the law of the state supply the tort rule, not from the law of the state in which the defendant corporation is chartered. There is mixed case law in this respect on veil piercing claims, but in general I don't see why we even need statutory change. (And note that at least some courts think the internal affairs rule, whatever its bounds, is constitutionally required.)

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