The strategy being explored by J&J is known as a “divisive merger” and it has been utilized where a company with massive tort liabilities splits the company into two companies and allocates the assets and liabilities however it pleases among the two successor entities. “Divisive mergers” are authorized under Texas law and are often referred to as the “Texas two-step.” The newly formed unit will hold all of the liabilities and that entity will then file for chapter 11.
This strategy has been used in recent years by several companies facing large numbers of asbestos claims. In 2017, Georgia-Pacific used the Texas law to break off an affiliate that retained asbestos-related liabilities, which then sought chapter 11 protection. In 2019, CertainTeed split off an asbestos affiliate, which shortly thereafter sought chapter 11 protection. In early 2020, Paddock Enterprises, the entity holding the liabilities of Owens-Illinois, filed for chapter 11 protection.
Plaintiffs’ attorneys are attempting to utilize the courts to block J&J, in advance, from implementing a divisive merger transaction. In August, lawyers for cancer victims asked the Bankruptcy Court for the District of Delaware to issue a restraining order against J&J’s proposed divisive merger as part of its oversight of the bankruptcy proceedings of Imerys Talc America, one of J&J’s former talc suppliers. The Judge denied the request on the basis that it would be improper, as part of Imerys’ bankruptcy case, to legally bar J&J from undertaking a hypothetical future restructuring.
Earlier this month, plaintiffs’ attorneys also filed a motion in the Superior Court of New Jersey, the state where J&J is headquartered, seeking a restraining order to prevent the transaction on the basis that it violates fraudulent conveyance laws. This request was denied on September 21 with the court noting that it cannot evaluate whether a future hypothetical transaction would constitute a fraudulent transfer. Similar state court actions will likely be unsuccessful for the same reasons stated by the Bankruptcy Court in the Imerys case and the Superior Court of New Jersey.
If J&J is successful in doing a divisive merger and filing for bankruptcy, these are some of the issues plaintiffs should be ready to address.
Fraudulent Transfer. Since the bankrupt “Newco” will hold the liabilities but no substantial assets, creditors will need to pursue J&J for recovery by arguing that the two-step resulted in a prima facia fraudulent transfer. That’s a pretty clear-cut argument to win, the question is who will get to make it. Under the Bankruptcy Code, those claims belong to the debtor, and the debtor can legally settle those claims under the very low “business judgement” standard of Bankruptcy Rule 9019. To wrest control of the fraudulent transfer action from the debtor, the plaintiffs will need to file an “STN motion” to gain standing. To succeed on an STN motion, the movant will need to establish that the debtor is either not pursuing the fraudulent transfer action, or cannot be trusted to settle it on an arms-length basis.
To preempt this, Newco will likely populate its board with “independent” directors to handle the litigation. The advent of independent directors appointed in anticipation of bankruptcy has come under scrutiny recently as some have argued this is merely a tool to divest creditors of their right to conduct their own investigation. In fact, in the Purdue bankruptcy, the only issue that Judge Drain appointed an independent examiner for was to scrutinize the independence of the board members who negotiated the resolution of fraudulent transfer claims against the Sackler family, which ultimately resulted in a $4.5 billion settlement. The examiner concluded that the board was independent.
Channeling Injunction. J&J likely wants to file for bankruptcy because only in bankruptcy can it obtain a “channeling injunction.” A channeling injunction directs or channels tort claims, including yet to be discovered claims, to a litigation trust funded by participating parties. This device has been utilized not only in asbestos cases (for example, Johns-Manville, W.R. Grace, Owens Corning, Celotex, Eagle Pitcher) but also in other mass tort product liability cases, such as Takata. It delivers finality to the debtors and potentially others. This would allow J&J to not have to worry about future talc claims; they could move on without the burden of the talc liability ad infinitum.
Plaintiffs often disfavor channeling injunctions because they prevent them from going after the debtor for new post-bankruptcy tort cases, and, instead, are limited to pursuing their claims against the trust. In all likelihood, a channeling injunction will be established, as has been the case in PG&E, Takata, and well as in asbestos bankruptcies. Bankruptcy Code section 524(g) codified channeling injunction provisions applicable to asbestos exposure cases; however, this section has since been used a guide to fashion relief in non-asbestos mass tort cases, including those listed above. In general terms, Bankruptcy Code section 524(g) provides a mechanism to channel known and unknown claims to a trust while satisfying due process concerns through procedural safeguards. One key provision is the appointment of a future claims representative to protect the interests of unknown claimants who would not otherwise receive adequate notice to be bound. Debtors facing non-asbestos mass tort liabilities, such as Mallinckrodt, have sought the appointment of a future claims representative to address the above due process concerns. Under the Bankruptcy Code, the bankruptcy court selects the future claims representative; however, in practice the selection responsibility is generally delegated to the debtor. This is also something plaintiffs can scrutinize.
Tort Claimants Committee. The Office of the United States Trustee will often appoint a separate official committee of tort claimants in cases involving substantial tort and non-tort liabilities. Official tort claimant committees have been appointed in Mallinckrodt, PG&E, and Boys Scouts of America. In addition, tort claimants have been appointed to official committees of unsecured creditors in numerous cases including Purdue Pharma LP and Weinstein Co. Official committees of tort claimants and official committees of unsecured creditors act in a fiduciary capacity for their respective contingencies and are key parties in plan negotiations in bankruptcy cases. The committee, as an estate fiduciary, will also take lead on the investigation into any potential fraudulent transfers in the event of a Newco filing. Expenses of Official Committee professionals, including a Tort Claimants Committee, are paid for by the debtor’s estate.
Plan Voting. This is perhaps the most powerful tool that plaintiffs will have. The one thing Newco may want more than to file for bankruptcy, is to get out of bankruptcy. Under the Bankruptcy Code, debtors must solicit acceptance by each impaired class of creditors. An impaired class is deemed to accept if the plan is approved by eligible creditors that hold at least two-thirds in amount and one-half in number of allowed claims that voted to accept or reject the plan (in asbestos cases, acceptance by 75% of voting known victim claims is required under section 524(g)). In addition, Bankruptcy Code section 502(c) allows the court to establish procedures for estimation of unliquidated claims with provisions for discovery, expert testimony and briefing. If plaintiffs work together in a coordinated effort, they can try to block Newco’s exit from bankruptcy unless they feel that the plan treats their claims in a fair and equitable way. This is not a surefire way to get everything you demand, the debtor still has tools at its disposal to override the votes of the plaintiffs. The debtor may be able to structure the plan to allow them to “cram down” the plan under Bankruptcy Code section 1129(b). Under this provision, a plan may be confirmed over its rejection by an impaired class “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” This power is dependent upon acceptance of the plan by at least one class of impaired creditors (not counting insiders).
Third Party Releases. Third party releases are one of the most controversial aspects of a bankruptcy plan. Non-consensual third party releases of non-debtors from any liability related to a bankrupt company are generally only granted if the released party makes a substantial contribution to the estate through the chapter 11 plan. The releases regularly drew the ire of the U.S. Trustee’s office but gained greater recent notoriety in the wake of the Purdue Pharma bankruptcy case and the release of the Sackler family from opioid related liabilities in exchange for an approximately $4.5 billion financial contribution. Derided as a vehicle to allow parties to take advantage of bankruptcy provisions without ever filing themselves, the contributions given in exchange for the releases can become a key source of recovery for victims, and in some bankruptcies, is the only source of recovery for creditors. In the context of J&J, insurance companies, J&J and its affiliates making a contribution to the victims’ trust will likely demand 3rd party releases in return. Plaintiff’s will need to scrutinize whether these entities are paying fair value for the releases they demand.
In conclusion, plaintiffs are rightfully wary of J&J’s Texas two-step. The worst thing that could happen if J&J proceeds with the two-step is infighting among the various plaintiff constituents (mesothelioma vs. ovarian cancer, etc.). If, however plaintiffs stick together and have a united front, they can collectively utilize the tools of the Bankruptcy Code, including its voting mechanisms, to exert significant leverage over J&J and Newco. This may result in a meaningful recovery for victims, and the payout will be quicker and easier.
Edward Neiger is the co-managing partner of ASK LLP, a bankruptcy and mass torts law firm. This article is the author’s opinion and does not constitute legal advice.