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The Texas Two-Step's Liquidation Problem

posted by Adam Levitin

This post is a joint post by Hon. Judith K. Fitzgerald (ret.)[*] and Adam Levitin

The Texas Two-Step has been the latest fad in mass tort bankruptcies, used, among others, by Johnson & Johnson, Georgia-Pacific, and, in a variation, 3M. The essential elements of the Texas Two-Step are the segregation of the debtor's mass tort liabilities in a non-operating subsidiary, which then enters into a funding agreement with the parent company to cover the mass tort liabilities up to some level. The subsidiary then files for bankruptcy and seeks to have the court stay the mass tort litigation against the non-debtor parent. If this maneuver is successful, the non-debtor parent goes about its normal business,[1] as do all of its creditors ... other than the mass tort victims. Meanwhile, the non-operating debtor subsidiary—whose sole creditors are mass tort victims—just sits in bankruptcy indefinitely.

The basic strategy behind a Texas Two-Step is “delay to discount”: the extended delay of the bankruptcy process pressures tort victims and their counsel to accept discounted settlement offers. The non-debtor parent feels no urgency for the bankruptcy to end because litigation is stayed against it. Moreover, the parent is able to continue its normal operations without being subject to bankruptcy court oversight or even to the regular expenses of defending the mass tort litigation. And because the debtor is a non-operating entity, it is under no pressure to emerge from bankruptcy. The debtor and its parent are both happy to let the bankruptcy drag on as long as necessary. In other words, the Texas Two-Step is an underwater breath-holding contest where the debtor has a snorkel. 

The ultimate end-game in a Texas Two-Step bankruptcy, however, is obtaining releases for the non-debtor parent (and other affiliates), bolstered by a channeling injunction that precludes tort victims from bringing suit against the parent and affiliates after the bankruptcy. There’s a fly in the ointment, however. A channeling injunction under section 524(g) requires that the debtor receive a discharge, and the debtor entity in the traditional Texas Two-Step case is not eligible for a discharge because it is a non-operating corporate entity that will be liquidating.

Specifically, section 524’s language regarding the “effect of discharge” provides that the court may, in connection with an order “confirming a plan of reorganization,”[2] issue “an injunction in accordance with this subsection to supplement the injunctive effect of a discharge.” In other words, a section 524(g) channeling injunction is available only if there is a plan of reorganization that includes a discharge of the debtor. The 524(g) injunction is a supplement; it cannot be accessed as a free-standing injunction. Moreover, this specific language would seem to preclude a similar effect through the court’s powers under section 105(a)[3] or otherwise.

The plan in a Texas Two-Step case will typically be a liquidating plan, not a reorganization plan. To be sure, those terms are not defined in the Bankruptcy Code, but the debtor entity concocted for a Texas Two-Step is, by definition, not an operating entity. Instead, the Two-Step debtor is a special purpose vehicle created with the sole purpose of assuming its affiliates’ mass tort liabilities and filing bankruptcy to absolve the affiliates of responsibility for the toxic circumstances they created. The debtor will be the “bankruptcy proximate” entity, while the formerly liable affiliate companies will go about business as usual, free from bankruptcy court oversight. 

In a Texas Two-Step, the debtor entity typically will conduct no operations, have no stand-alone employees, and have no assets other than those needed to cover the administrative expenses of the bankruptcy. In addition to these minimal assets, the debtor entity may also be covered under some insurance policies and be party to a contingent funding agreement with its affiliates. But the debtor is not the beneficiary of either the insurance policies or the funding agreement. The insurance policies are available only to pay creditors’ claims, and so too the funding agreement. Moreover, the funding agreement will be accessible only once the debtor has exhausted its other assets. In short, there is nothing to reorganize. Even if the bankruptcy itself is considered the business of litigation management, there will not be any on-going business other than implementation of a plan; there will be no operating debtor entity after plan consummation; there will be no unliquidated assets as all assets must be devoted to paying claims. Thus, the plan is necessarily a liquidating plan and the debtor will not receive a discharge.

Under these circumstances, a Texas Two-Step debtor simply is not eligible for a discharge. Section 1141(d)(3) provides that confirmation of a Chapter 11 plan does not result in the discharge of a debtor if the debtor would not be eligible for a Chapter 7 discharge, “the debtor does not engage in business after consummation of the plan,” and the plan” provides for the liquidation of all or substantially all of the property of the estate.” Corporate entities are never eligible for a Chapter 7 discharge,[4] and as we have seen, the Two-Step debtor does not engage in business after (or even before) the consummation of the plan. The only remaining question is whether the plan provides for the liquidation of all or substantially all of the property of the estate, and the answer there is assuredly in the affirmative: funding agreements require that all of the debtor’s other assets be exhausted before they can be accessed, and once the other assets have been transferred to the trust or otherwise used to pay claims, the funding agreement and any insurance policies will be drawn down under the plan. In all, there are no remaining assets.

What we see, then, is that inasmuch as a Texas Two-Step debtor is not eligible for a discharge under section 1141, the non-debtor affiliates are not eligible for a supplemental channeling injunction. To be sure, ineligibility for a channeling injunction does not preclude voluntary non-debtor releases, but such releases can be granted only by existing creditors, not by future creditors, and when the liability is in the form of personal injury or wrongful death claims, individual creditors cannot be compelled to grant releases.

Section 524(g) is not a panacea for debtors ineligible for a discharge or for their corporate sponsors. The Texas Two-Step strategy may save non-debtor affiliates millions in defense costs while courts wrestle with balancing the bankruptcy goal of equality among present and future creditors in the mass tort class with saving a legitimate business. But there is no legitimate business for the Texas Two-Step debtor, which ends its existence without a discharge and without the ability to give its affiliates what they want: a way to shield their assets from public scrutiny while abnegating responsibility to pay fair value (and, indeed, for solvent affiliates, that means full value) for the injuries they caused.

[*] Professor in the Practice of Law, University of Pittsburgh School of Law; Shareholder, Tucker Arensberg, P.C. Professors Fitzgerald and Levitin are both retained as consultants for parties or counsel for parties in certain pending mass tort cases; their opinions are their own.

[1] Of course, if litigation against the non-debtor affiliates is not stayed, as in the bankruptcy of 3M’s subsidiary Aearo Technologies, LLC, Case No. 22-02890-JJG-11 (Bankr. S.D. Ind.), the entire strategy falls apart.

[2] Section 524(g) is one of rare occasions on which the Code uses the term “plan of reorganization”.

[3] “Congress enacted 11 U.S.C. 105 because they knew that they could not envision all matters dealing with a bankruptcy court or the creativity of attorneys. However, this Court is of the opinion that 11 U.S.C. 105 should be used sparingly and then only to supplement the Bankruptcy Code, not supplant the Code.” In re One Times Square Assocs. Ltd. P’ship, 159 B.R. 695, 702 (Bankr. S.D.N.Y. 1993), aff'd, 165 B.R. 773 (S.D.N.Y. 1994), aff'd sub nom. In re One Times Square Assocs., 41 F.3d 1502 (2d Cir. 1994).

[4] 11 U.S.C. § 727(a)(1).

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