By Dan Levine and Mike Spector
(Reuters) – Attorney Greg Gordon, a partner at the Jones Day law firm, offered an innovative solution to Johnson & Johnson and other major companies that faced mountains of lawsuits alleging their products sickened or killed people: They could use the bankruptcy system to force all plaintiffs into one settlement.
It required fancy legal footwork — creating a subsidiary to shoulder all the liability, then putting that new company into Chapter 11.
Plaintiffs’ lawyers attacked the gambit, known as the “Texas two-step,” charging it amounted to a bad-faith bankruptcy filing and a fraudulent ploy to shield the parent companies’ assets. Not so, Gordon told judges overseeing bankruptcies testing the novel strategy. The parent firms, he said, would give these subsidiaries plenty of money — billions of dollars — to compensate plaintiffs.
It turns out that Gordon’s play to reassure bankruptcy judges created a new legal problem. The 3rd Circuit Court of Appeals on Monday stopped the music on J&J’s two-step, ruling that its cash-flush subsidiary had no legitimate claim to bankruptcy protection because it wasn’t in “financial distress.”
The ruling forces J&J back into trial courts to battle nearly 40,000 lawsuits and casts a cloud over the legality of the Texas two-step strategy. The plaintiffs allege J&J’s talc products, including Baby Powder, caused cancer, which the company denies.
The appeal court judges’ reasoning underscored what some legal experts call an inherent contradiction: bankruptcies being executed by multinational firms worth billions of dollars that were in little danger of running out of money to pay plaintiff-creditors. The panel dismissed the main argument underpinning Gordon’s and the companies’ primary defense of the strategy. The companies had contended the bankruptcies served the greater good of all parties, including plaintiffs, by delivering fair payouts more efficiently and equitably than the “lottery” offered by trial courts.
The decision rejected “the idea that a profitable company can force personal-injury claimants out of jury trials, and into a bankruptcy court, merely by arguing that doing so is more efficient than the civil justice system,” said Melissa Jacoby, a professor at University of North Carolina School of Law with expertise in bankruptcy law.
Gordon and Jones Day did not respond to requests for comment. A lawyer for Johnson & Johnson’s subsidiary said in a statement that the company would seek a rehearing of the panel’s decision by the full 3rd Circuit court. The attorney, Neal Katyal, said the potential cost of fighting the lawsuits justified the bankruptcy filing.
Reuters last year detailed the secret planning of Texas two-steps by Johnson & Johnson and other major firms in a series of reports exploring corporate attempts to evade lawsuits through bankruptcies.
The judges’ reasoning on J&J, as a precedent, heightens the legal hurdles for companies pursuing the novel strategy. The ruling could leave two-stepping firms caught between the conflicting demands of bankruptcy courts and the appeals courts that are likely to hear more challenges to the tactic.
Bankruptcy judges, for their part, are loath to approve any move that blocks creditors from tapping debtor assets. Their courts crack down on firms that try, for instance, to shield money by moving it out of company accounts before filing for Chapter 11, known as a fraudulent transfer of assets. Plaintiffs opposing two-step bankruptcies have alleged the tactic amounts to a creative fraudulent transfer because it shields the firm being sued by shifting its liabilities to a new shell company.
Gordon said at a bankruptcy attorneys’ conference last April that J&J and three other firms attempting two-steps countered such concerns by agreeing to “unlimited” funding of their subsidiaries. The new units had ample cash to pay claims, the reasoning went, so fraud couldn’t possibly be the intent.
“We don’t even want to have an argument” about fraudulent transfers, Gordon said.
Gordon’s strategy worked in bankruptcy court but set up J&J for failure when it faced the 3rd Circuit appeals panel. J&J’s assertions that it generously financed its subsidiary, LTL Management, undercut any claim of financial peril, the judges ruled.
“We take J&J and LTL at their word and agree” that the subsidiary had plenty of money, wrote Circuit Judge Thomas Ambro, explaining why LTL did not qualify for bankruptcy. The judge noted that J&J’s promise of unlimited funding was essentially an “ATM” for the subsidiary, insulating it from “any threat to its financial viability.”
50 YEARS OF LITIGATION?
Johnson & Johnson now finds itself facing the same mountain of litigation that prompted its bankruptcy gambit.
Gordon, at the bankruptcy conference, described the lawsuits as “completely unmanageable” and a dire threat to J&J that could go on for decades. The company’s costs of verdicts, settlements and legal fees soared to about $4.5 billion in five years, he said.
“How do you litigate 40,000 cases? How do you deal with the fact you’re getting 10,000 more per year, and they’re anticipated to continue for the next 50 years?” Gordon asked. “What do you do about that as a company, no matter how big you are?”
Johnson & Johnson, with a market capitalization of more than $400 billion, argues that the avalanche of lawsuits posed a serious financial threat. “The current situation, with a significant volume of current and future claims, and a plaintiff bar business model primed to generate more, is exactly the sort of ongoing and future financial distress that courts have recognized as serving a valid bankruptcy purpose,” Katyal, the lawyer for J&J’s subsidiary, said in a statement to Reuters.
J&J faces a steep challenge in seeking to overturn the bankruptcy dismissal, two legal experts said. The full 3rd Circuit is unlikely to reverse Judge Ambro because he is an expert in bankruptcy law, said Jacoby, the University of North Carolina law professor. And the U.S. Supreme Court typically intervenes only when there are conflicting decisions among courts of appeal, said Lindsey Simon, a University of Georgia School of Law professor.
The 3rd Circuit is the only appeals court that has weighed in so far, but other circuits could soon take up challenges to similar bankruptcy filings.
In addition to J&J, four other firms have pursued subsidiary bankruptcies aimed at halting dangerous-product lawsuits. Three of the firms executed Texas two-steps, with the help of Gordon and Jones Day: global construction giant Saint-Gobain and manufacturers Georgia-Pacific and Trane Technologies. (The strategy gets its name from the Texas law used to divide the company being sued into two, creating the subsidiary that absorbs liability.) 3M Co executed a similar bankruptcy maneuver to seek refuge from about 290,000 claims over allegedly defective military earplugs.
Saint-Gobain, Trane Technologies and 3M declined to comment. Georgia-Pacific did not respond to inquiries.
The 3rd Circuit ruling does not directly affect these cases, but other courts could soon weigh in. The 7th Circuit Court of Appeals is expected to hear arguments in coming months on a challenge to the 3M subsidiary’s bankruptcy. Instead of creating a company, as in a Texas two-step, 3M assigned its lawsuits to an existing subsidiary. The goals were the same: To halt the lawsuits and force plaintiffs into a bankruptcy settlement.
An Indiana bankruptcy judge last year, however, broke with typical practice by allowing the lawsuits to proceed against 3M even as its subsidiary’s Chapter 11 case continued, essentially defeating the point of 3M’s maneuver.
If the 7th Circuit sides with 3M and issues an opinion contradicting the 3rd Circuit decision, it could raise the chances of a Supreme Court intervention. If 3M loses, it could strengthen case law against such bankruptcy gambits and further discourage companies from pursuing them.
A challenge to the Georgia-Pacific Texas two-step, meanwhile, is proceeding in the 4th Circuit. After a North Carolina judge rejected a plaintiffs’ challenge alleging the bankruptcy was filed in bad faith, plaintiffs’ attorneys made a different argument — one echoing the 3M case. The litigation, they asserted, should be allowed to proceed against Georgia-Pacific because the parent company did not file for bankruptcy. That issue is now pending before the 4th Circuit appeals court.
The 3rd Circuit panel noted it did not intend to outlaw the Texas two-step outright. Judge Ambro went out of his way to praise lawyers such as Gordon for “being inventive” and “experimenting with novel solutions.”
Still, the legal guard rails in Ambro’s ruling will make it much more difficult for companies to execute Gordon’s playbook, said David Molton, a Brown Rudnick LLP lawyer representing talc plaintiffs who challenged the J&J tactic.
Ambro put “pretty firm gates” on bankruptcy tactics aimed at halting defective-product litigation, Molton said. “What Judge Ambro did say is: ‘I’m not here to do away with creative lawyers, but I’m here to tell you when that creative lawyering goes outside the bounds, I’m going to put a stop to it,” Molton said.
(Reporting by Dan Levine and Mike Spector; editing by Brian Thevenot)