Within a month, the U.S. Supreme Court will hear Harrington v. Purdue Pharma, L.P.,[1] a case that (i) could radically change the potential for bankruptcy to serve as the preferred mechanism for corporations seeking to resolve mass torts, (ii) could significantly diminish the rights of mass tort victims, and (iii) might replace federal district courts with bankruptcy courts as the key decision-maker in major mass tort litigation – a transition that is not likely to improve the quality of justice in mass tort cases.

The Purdue Pharma case does not stand alone. Threatened by the multi-billion dollar liabilities that can quickly arise in a mass tort case, major corporations have also been exploring another use of bankruptcy courts to reduce mass tort liabilities. Known as the “Texas Two-Step,” this technique involves a “divisive merger” under which the corporation’s mass tort liabilities are placed in a single subsidiary, which then files for bankruptcy a day or two after the merger. This technique has, however, run into an obstacle in the Third Circuit, where a recent decision constrains a corporation’s ability to use this tactic.[2] This post will explore both these routes and the possible impact of the Purdue Pharma decision on them.

Mass Torts and Bankruptcy: The “Texas Two-Step”

Mass torts can involve a sudden and hyperbolic increase in claims against a corporation. Once, the choice was between resolving these claims in a class action (subject, of course, to a class member’s right to opt out) or in bankruptcy. But since Amchem Products v. Windsor,[3]  a class action covering most claimants in a mass tort case has become difficult (and potentially impossible) to certify. This has left the corporation facing a seemingly endless line of individual cases, aggregated in an MDL proceeding and settling at steadily increasing prices.

Defendants’ search for a bankruptcy solution has led them to experiment with the Texas Two-Step divisive merger]. The experience of Johnson & Johnson (“J&J”) is illustrative. The company began selling Johnson’s Baby Powder in 1894 and continued until the first successful actions were litigated beginning in 2013. By 2022, well over 38,000 ovarian cancer actions had been brought against J&J, most alleging that exposure to the talc content in J&J’s baby powder resulted in cervical or ovarian cancer and possibly mesothelioma. A $4.69 billion verdict awarded in a 2020 case accelerated this trend.[4] The principal Johnson & Johnson subsidiary producing baby powder, Johnson & Johnson Consumer Inc. (“JJCI”), paid out some $3.6 billion in claims and recognized financial statement charges of $5.6 billion in just the seven quarters preceding its bankruptcy filing in 2021.[5]

Fearing even higher costs in the future, J&J utilized a stratagem known as the Texas Two-Step. On October 12, 2021, JJCI assumed responsibility for all claims alleging that J&J’s talc-laden baby powder caused ovarian cancer or mesothelioma and then engaged in a series of transactions pursuant to which JJCI ceased to exist and two new LLC companies – LTL and Johnson & Johnson Consumer Inc. (“New JJCI”) – were created in its place. This transformation was accomplished pursuant to a divisive merger under the Texas Business Organizations Code, pursuant to which JJCI was terminated and the two new Texas LLCs, were created. LTL assumed responsibility for all of JJCI’s talc-related liabilities in return for certain rights under a funding agreement. Two days later, on October 14, 2021, LTL filed a voluntary bankruptcy petition under Chapter 11 in North Carolina bankruptcy court. Essentially, LTL was created as a special purpose vehicle with the only and undisguised purpose of filing for bankruptcy under Chapter 11.

Under the Texas Business Organizations Code, in a divisive merger in which the original entity does not survive, the liabilities of that entity are allocated to one or more of the new organizations, as provided in the plan of merger.[6]Not surprisingly, all J&J’s talc-related liabilities were allocated to LTL.

Relatively few states today authorize such divisive mergers,” but one of them is Delaware.[7] Because the majority of large U.S. corporations are incorporated in Delaware, corporations could presumably use its similar procedure. Still, under federal bankruptcy law, a bankruptcy petition is subject to dismissal for cause, under 11 U.S.C.S. Section 1112(b), unless it is filed “in good faith” (with the burden being on the debtor to show this). In fact, this good faith issue was litigated in the LTL case, but the bankruptcy court rejected this attack.[8]

On appeal, the Third Circuit unanimously reversed. First, it found that J&J’s subsidiary (before the two-step merger) “was a highly valuable enterprise” estimated by LTL to be worth $61.5 billion (excluding future talc liabilities), with many profitable products and brands.[9] Next, it turned to the role of “good faith” under Section 11 U.S.C. §1112(b) and noted that “[a] lack of good faith constitutes ‘cause,’ though it does not fall into one of the examples of cause specifically listed in the statute.”[10] The Third Circuit panel insisted on an objective test with the burden being placed on the debtor:[11]

Though a debtor’s subjective intent may be relevant, good faith falls “more on [an] objective analysis of whether the debtor has sought to step outside the ‘equitable limitations’ of Chapter 11.”[12]

It then found that a showing of “financial distress” was necessary for the debtor to show that its “petition serves a valid bankruptcy purpose supporting good faith.”[13] In particular, the Third Circuit held that it was insufficient to rely on “the magnitude of potential liability”[14] because that alone would not render any corporation insolvent. Because LTL had a “substantial equity cushion and a lack of evidence suggesting it had trouble paying debts or impaired access to capital markets,” its filing was “premature.”[15]

How will the Third Circuit’s test play out in practice? The Third Circuit also noted that:

Were the debtor facing “serious financial and/or managerial difficulties at the time of filing,” the result may have been different.[16]

Thus, there are two critical takeaways from LTL Mgmt: (1) a showing of financial distress is a necessity, no matter what the Texas Two-Step (or other statutes) say, and (2) the debtor who shows specific “financial or managerial difficulties” may be able to satisfy this burden. One has confidence that aggressive litigators representing the debtor, on reading this judicial language, will begin to plan how to present the requisite showing of financial and managerial difficulties.

On the other side, counsel who wish to assert a lack of good faith will emphasize this case’s language about the magnitude of potential liability being irrelevant and its insistence that bankruptcy was an “equitable” proceeding in which the court could presumably balance the factors on both sides. As a result, big cases may be coming to bankruptcy court.

Purdue Pharma: Can a Bankruptcy Court Release Third Parties Who Have Not Filed for Bankruptcy?

Purdue Pharma involves a fairly narrow issue: Can a bankruptcy court release third parties who did not file for bankruptcy as part of the settlement it approves without the consent of the parties whose claims are released? The case is controversial because of the involvement of the Sackler family, who long controlled the privately-held Purdue Pharma LLP. The U.S. solicitor general, who sought certiorari on behalf of the United States Trustee, has argued in her brief to the Court that, between 2008 and 2016, Purdue recognized that its insolvency was looming and paid out approximately $11 billion “to the Sackler family member trusts and holding companies” in “what one family characterized as a ‘milking program’.”[17] The result was that the Sacklers “drained Purdue’s total assets by 75%, reducing its “solvency cushion by 82%.”[18]

The fuller backdrop here requires recognition of three additional facts that the solicitor general also stressed: (1) between 1999 and 2019 (the year in which Purdue Pharma filed for bankruptcy), “nearly 247,000 people in the United States died from prescription–opioid overdoses;”[19] (2) at the time Purdue filed for bankruptcy in 2019, “over 400 actions against the Sacklers concerning liability for OxyContin had been filed” and the claims against the debtors and the Sacklers were estimated at over $40 trillion;[20] and (3) the Sacklers were then estimated to be “worth approximately $11 billion.”[21] Thus, they clearly needed protection – and they got it without having to file for bankruptcy themselves. In return for a contribution to the settlement that totaled $6 billion (after a last minute increase), the Sacklers received a release from the bankruptcy court that “would extinguish virtually all Purdue-related opioid claims against the Sacklers without the consent of the affected claimants.”[22] Bottom Line: The Sacklers still have $5 billion and escaped bankruptcy.

What did the claimants get in return? Even those who sustained catastrophic injuries will receive a gross amount of only between $3,500 and $48,000 (and that is before the deduction of all expenses, attorneys’ fees, and costs of administration).[23] Plaintiffs in modest, fender-bender auto collisions receive this much or more.

For the Sacklers, however, this was a good deal. Not only did they retain $5 billion (of their estimated $11 billion net worth), but they dodged claims for $40 trillion and a lifetime of unending litigation.

But how could a bankruptcy court approve such a settlement that stripped claimants of their right to sue the Sacklers (which many had exercised) without their consent? The short answer is the tort claimants might never have been able to pierce the defenses that the Sacklers had erected around their offshore trusts. Even if this prediction proves accurate, does it justify the bankruptcy court in releasing the victims’ claims without their consent? The solicitor general is arguing that the Bankruptcy Code gives the bankruptcy court no such authority. Indeed, the district court that heard the appeal of the bankruptcy court’s decision agreed and overturned its decision,[24] but the district court was overturned by the Second Circuit, which stressed the broad equitable authority possessed by the bankruptcy court.

Probably the strongest reason for reversing the Second Circuit is the perverse incentives its decision will create for controlling shareholders and other potential defendants. After the district court reversed the bankruptcy court, the Sacklers saw the need to sweeten their deal and agreed to pay an additional $1.675 billion (for a total of $6 billion) in exchange for the objectors’ agreement not to oppose the release.[25] This increase reflected the uncertainty then surrounding the legality of the nonconsensual release given by the bankruptcy court. But if the Supreme Court upholds such a nonconsensual release of claims in favor of a nonparty, the uncertainty will be dissipated, and releases in the future can be less favorable to tort victims.

Conversely, if the Supreme Court overturns the Second Circuit and finds that nonconsensual releases are unavailable, the Sacklers can still obtain a release, but they would have to negotiate with their victims (or file for bankruptcy), and such negotiations will likely cost them dearly.

As the solicitor general properly argues:

The court of appeals’ decision is a roadmap for corporations and wealthy individuals to misuse the bankruptcy system to avoid mass-tort liability.[26]

If controlling shareholders can obtain nonconsensual releases from the bankruptcy court covering their tort victims, then “the amounts paid by nondebtor tortfeasors in future bankruptcies will likely be lower – with a commensurate reduction in benefits to future bankruptcy entities.”[27]

The tradeoff here is sad and ironic: Allowing the bankruptcy court to give the Sacklers a release covering nonconsenting tort victims may give these victims a higher return than if these victims had to pursue the Sacklers around the globe, searching for offshore funds. But it will imply lower recoveries to future victims in future mass tort cases as defendants can now negotiate with the bankruptcy court to see what it will accept. And mass torts are not going away.

A Concluding Thought

Why did the Supreme Court grant cert. in this case? Most are puzzled, as the Court has not previously suggested that it was concerned about protecting tort victims or in reforming bankruptcy. One possibility – and this is frankly speculative – is that the Court has become skeptical of administrative agencies and lower courts changing the law without the prior approval of Congress. Just as the Court has recently fashioned a new doctrine – now known as the Major Questions Doctrine – to prevent administrative agencies from adopting new and important policies not specifically authorized by Congress,[28] so the Court may be equally suspicious of bankruptcy courts assuming new power to grant nonconsensual releases. In this light, the Court (or a faction of it) may be less interested in the specific rules of bankruptcy than in slowing down the pace of legal change. Whether it be a wise ruling or a foolish one (my vote is the latter), the bankruptcy court’s ruling that it could grant a nonconsensual release to a nonparty debtor is a “new” rule of law, and this Court may be skeptical of such law-making. Were Congress to pass such a rule, there would be little constitutional problem to its mind. But the political accountability of lesser bodies – agencies and courts – does trouble it.

Although Purdue Pharma’s issue of nonconsensual releases and J&J’s use of the Texas Two-Step are not closely related issues, the former may affect the latter: If the Court permits nonconsensual releases, it may be interpreted to be encouraging “creative” dispositions of mass tort cases. Both because bankruptcy courts are already too inclined to move in this direction and because there is no conceptual limit on the reach of the Texas Two-Step, this would give too much discretion to those with the poorest incentives.

ENDNOTES

[1] 216 L. Ed. 1300 (August 10, 2023) (granting certiorari and issuing stay).

[2] See LTL Mgmt., LLC v. Those Parties Listed on Appendix A to Complaint, 69 F.4^th 84 (3d Cir. 2023).

[3] 521 U.S. 591 (1997). For further and more recent evidence of this reluctance to certify a mass tort class action, see In re: Roundup Prods. Liab. Litig., 591 F. Supp. 3d 1004 (N.D. Calif. May 26, 2021).

[4] See Robert Ingham v. Johnson & Johnson, 608 S.W. 3d 663 (Mo. Ct. App. 2020).

[5] These numbers are taken from In re: LTL Mgmt., LLC, 2022 Bankr. LEXIS 510, 2022 W.L. 596617 (Bankruptcy Court, D.N.J. February 25, 2022).

[6] See Texas Bus. Orgs. Code Ann. Section 10. 008(a) et seq.

[7] See Del. Code Ann. tit. 6, Section 18-217(b) – (c). See also 15 Pa. Cons. Stat. 361; Ariz. Rev. Stat. Ann. 29-2601.

[8] See In re: LTL Mgmt., LLC., 2022 Bankr. LEXIS 510 at *2. Although J&J’s use of a divisive merger constitutes the most dramatic example of the Texas Two-Step, it is far from the first such use. In 2017, Georgia Pacific LLC split off an affiliate that was assigned its asbestos liabilities, which affiliate then filed for bankruptcy in the Western District of North Carolina. Similarly, in 2019, CertainTeed Corp. followed this same procedure to dispose of its asbestos liabilities, with the liability-laden affiliate again filing for Chapter 11 bankruptcy protection in the Western District of North Carolina.  These were done, however, under the special provision of the bankruptcy code that governs asbestos claims, section 524(g), enacted by Congress specifically for dealing with that set of mass tort claims.

[9] LTL Mgmt., LLC v. Those Parties Listed on Appendix A to Complaint, 64 F.4^th 84, at 95 (3d Cir. 2023). Indeed, for an estimate that J&J in its entirety was worth roughly $434 billion, see Samir Parikh, Mass Exploitation, 170 University of Pennsylvania Law Review (Online) 53 (Feb. 2022) at 57, n. 17; for a further critique of the bankruptcy approach, see Adam L. Levitin, Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances, 100 Texas L. Rev. 1070 (2022).

[10] Id. at 100.

[11] Id. at 101.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] See Brief for Petitioner in Harrington v. Purdue Pharma, L.P., (September 2023) at p.3.

[18] Id. at p.5.

[19] Id. at p.3.

[20] Id. at p.4.

[21] Id. at p.5.

[22] Id. at p.5.

[23] Id. at p.5.

[24] For the full history, see In re Purdue Pharma L.P., 633 B.R. 53 (Sept. 17, 2021). SDNY District Judge Colleen McMahon reversed the bankruptcy court, and the Second Circuit reversed her. See Purdue Pharma L.P. v. City of Grand Prairie, 69 F.4^th 45 (2d Cir. 2023). The Supreme Court has now granted certiorari. See supra note 1.

[25] Id. at p.45.

[26] Id. at p.45.

[27] Id. at p.46.

[28] See West Virginia v. EPA, 145 S. Ct. 2587 (2022).

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.