What is the Texas two-step?

The Texas two-step legal strategy, also referred to as a Texas divisive merger, is a legal tool used by businesses involved in substantial litigation to settle their tort liabilities through the bankruptcy process.

As the name suggested, the strategy involves two steps. First, a business or company establishes one or more separate subsidiaries. Second, the company transfers all or the majority of its tort liabilities to one entity while transferring the original company’s remaining small assets to another subsidiary.

The subsidiary holding the tort liabilities can then file for bankruptcy, which protects the original company from the responsibility of paying any tort liability costs.

Tort liability is a legal obligation to compensate or provide a relief to someone or a party for wrongful act or damages caused. It is the result of a court sentence in which the guilty party is ordered to pay for the victim’s injury. Any general claims coming from civil lawsuits would generally fall under tort law.

The legal measure gained popularity and controversy because big corporations increasingly use it in civil lawsuits. Pharmaceutical giant Johnson & Johnson (JNJ) was the latest corporation that used Texas two-step to face civil lawsuits related to alleged asbestos in their baby powder that caused certain types of cancer.

The strategy has been criticised by members of the general public, the legal community and members of the US Congress. Critics claim the strategy allows businesses to dodge legal obligations to pay billions of dollars in damages without declaring bankruptcy.

Key points

The Texas two-step is a legal strategy to settle tort liabilities through bankruptcy process.
First, the company forms one or more separate subsidiaries. Some subsidiaries will take up the company’s liabilities, the others will assume assets of the original company.
The subsidiary(ies) holding the liabilities will file for Chapter 11 bankruptcy.
The strategy draws criticism because it shields corporations from fulfilling their legal responsibilities.

Texas two-steps explained

It is also called Texas two-step because it is a law in the state of Texas. The 1989 law permitted ‘divisive mergers’, which enable a company to split its assets and liabilities into separate entities.

The Texas Business Organisations Code makes it possible for the Texas two-step definition to include “merger” as “the division of a domestic entity into two or more new domestic entities or other organisations”, wrote Jordan Chavez, Alex Kirincic and Cameron L. Scales, associates at the Dallas-based Haynes Boones law firm in September 2021.

“At its core, a divisive merger is similar to a traditional merger. The agreement and plan of merger must clearly identify the assets and liabilities allocated to each entity involved.”

What is the controversy with Texas two-step?

So, why does Texas two-step bankruptcy draw controversy?

In the Johnson & Johnson case, the pharma company used the Texas law to create a new subsidiary, LTL Management which is responsible for managing legal claims related to the Company’s cosmetic talc.

LTL Management filed for Chapter 11 bankruptcy protection in October 2021. The US Bankruptcy Court for the District of New Jersey ruled in February 2022 that LTL’s filing was a valid, good faith filing under the Bankruptcy Code.

The bankruptcy court ruling helped Johnson & Johnson to avoid fighting more than 38,000 individual lawsuits that could be worth billions of dollars, according to Reuters. The Bankruptcy Court’s ruling is now under review by the Third Circuit Court of Appeals, according to LTL Management.

Johnson & Johnson’s case raised concerns from tort lawyers that it would trigger other corporations facing huge tort litigation to use the strategy to sidestep their responsibilities to pay compensation.

Curtis Huff, a former member of the Corporation Law Committee of the Texas State Bar who drafted the divisive merger, said the law was not intended to consolidate mass torts and file a bankruptcy petition.

“To facilitate transactions that are often very complex when you do spin offs of companies or to buy companies and to really just utilise the merger statutes as a means to effect what could be done through a series of just basic assignment and transfer documents with respect to assets,” Huff said in a podcast with Boston-based radio WBUR on 20 October 2022.

Rob Rasmussen, J. Thomas McCarthy Trustee chair in law and political science at the University of Southern California Gould School of Law, in the same podcast with WUBR stated the “bankruptcy code requires that a bankruptcy petition be filed in good faith”.

“You cannot file for bankruptcy solely to gain a litigation advantage, that what you really need is a company that's in financial distress.”

The bottom line

The Texas two-step bankruptcy is initially drafted to help companies dealing with complex merger and acquisition (M&A) processes. However, several corporations have used the law to settle tort litigation. The controversy is whether a company that faces the potential to pay financial damages could file for bankruptcy to avoid their responsibility.

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FAQs

How does the Texas two-step work?

A company creates a separate entity to handle its liabilities from lawsuits and file for bankruptcy. With the strategy, the original company will be protected from liabilities arising from the lawsuits, such as paying compensation for damages in tort litigation.