The Texas Two-Step's Liquidation Problem
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.
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