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The Third Circuit Rules On The LTL Management Divisive Merger

On Behalf of | Feb 1, 2023 | Firm News

On October 14, 2021 (the “Petition Date”), LTL Management LLC (“LTL” or the “Debtor”), filed a bankruptcy petition in the United States Bankruptcy Court for the Western District of North Carolina.  The case was subsequently transferred to the Bankruptcy Court for the District of New Jersey (the “Bankruptcy Court”) on October 25, 2021.

Prior to the Petition Date, Johnson & Johnson (“J&J”) performed a complex corporate restructuring under the Texas law allowing for divisive mergers.  Johnson & Johnson Consumer Inc. (“Old Consumer”) merged into a new limited liability company under Texas law.  This new entity then performed a divisive merger which caused Old Consumer to no longer exist.  The result was that Old Consumer transferred its talc-related liabilities and certain assets to the Debtor, and the other liabilities and assets were transferred to another entity (the “Non-Debtor LLC”).  The Debtor then converted to a North Carolina LLC and changed its name to LTL Management LLC.  Two days later, the Debtor filed its bankruptcy petition and the Non-Debtor LLC merged into a newly created New Jersey corporation (“New Consumer”).

The LTL bankruptcy case was preceded by the filing of tens of thousands of talc-related lawsuits against Old Consumer and J&J.  These lawsuits were based on the claim that talc products sold by Old Consumer contained asbestos which resulted in thousands of individuals developing various forms of cancer.  While Old Consumer was successful in defending many of these cases, it did sustain significant losses in several cases.  For example, there was a $4.69 billion verdict awarded to 22 plaintiffs against Old Consumer and J&J.  See Ingham v. Johnson & Johnson, 608 S.W.3d 663, 680 (Mo. App. 2020) (affirming an award of $550 million in compensatory damages and $4.14 billion in punitive damages (which was later reduced to $1.6 billion)).

Further, in 2021 Old Consumer and J&J also suffered $26 million and $27 million adverse judgments.  Because of the range of potential liabilities associated with other potential large jury awards, Old Consumer conducted the aforementioned divisive merger which ultimately ended with the placing of LTL in chapter 11 bankruptcy.

The Texas divisive merger statute is codified in the Texas Business Organizations Code (“Tex. Bus. Orgs.”).  Tex. Bus. Orgs. § 1.002(55)(A) states that a “merger” includes “the division of a domestic entity into two or more new domestic entities or other organizations.”  Further, Tex. Bus. Orgs. § 10.003 provides that the agreement and plan of merger must include “the manner and basis of allocating and vesting the property of each organization that is a party to the merger among one or more of the surviving or new organizations.”  Interestingly, Texas law provides that the property allocated to each newly created entity vests without “any transfer or assignment having occurred.”  Tex. Bus. Orgs. § 10.008(a)(2)(C).  Notwithstanding, the aforementioned statute does not “abridge any rights or rights of a creditor under existing laws” including “the Uniform Fraudulent Transfer Act,” which Texas has adopted.  Id. §§ 24.001-24.013.  As such, the Texas divisive merger statute defines a division of any type of entity as a merger.  This approach differs from Delaware law which only allows for divisive mergers of LLCs.

As previously stated, LTL initially filed its bankruptcy petition in the Western District of North Carolina, even though its contacts with the state were minimal.  Interestingly, the divisive merger statute has been used by several companies facing mass tort liabilities and all have filed for bankruptcy protection in the Western District of North Carolina.  The reason for filing in this jurisdiction likely relates to the standard the Fourth Circuit uses to determine a bad faith dismissal of a chapter 11 filing.  The Fourth Circuit has held that in order for a chapter 11 to be dismissed as bad faith, it must be both (a) objectively futile and (b) filed in subjective bad faith.  Carolin Corp. v. Miller, 886 F.2d 693, 700-01 (4th Cir. 1989).  This dismissal standard has been described as “one of the most stringent articulated by the federal courts.”  In re Dunes Hotel Assoc., 188 B.R. 162, 168 (Bankr. D.S.C. 1995).  By comparison, courts within the Third Circuit focus on whether the petition serves a valid bankruptcy purpose and whether the petition is merely filed to obtain a tactical advantage.  See In re 15375 Mem’l Corp. v. BEPCO, L.P., 589 F.3d 605, 618 (3d Cir. 2009) (citing NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), 384 F.3d 108, 119-20 (3d Cir. 2004)).

On October 25, 2021, the Bankruptcy Administrator for the Western District of North Carolina moved to transfer the case to the District of New Jersey.  On November 16, 2021, the court entered an order transferring the case.  As a result of the transfer of venue, on December 1, 2021, the Official Committee of Talc Claimants filed a motion to dismiss the Debtor’s chapter 11 case [the “Motion to Dismiss”) [Docket No. 632].  The Motion to Dismiss alleged, inter alia, that LTL exploited the bankruptcy process to shelter J&J from talc liability.  On February 25, 2022, Chief Judge Michael Kaplan of the Bankruptcy Court issued a ruling denying the Motion to Dismiss (the “Bankruptcy Court Opinion”) [Docket No. 1572].  In his ruling, Chief Judge Kaplan stated “[l]et’s be clear, the filing of a chapter 11 case with the expressed aim of addressing the present and future liabilities associated with ongoing global personal injury claims to preserve corporate value is unquestionably a proper purpose under the Bankruptcy Code.”  Bankruptcy Court Opinion at 16.  Further, Judge Kaplan wrote “this is not a case of too big to fail . . . rather, this is a case of too much value to be wasted, which value could be better used to achieve some semblance of justice for existing and future talc claimants.”  Id. at 47.  Focusing on the tort system and the desire of some plaintiffs to have a jury trial, Chief Judge Kaplan stated that the tort system has “struggled to meet the needs of the present claimants in a timely and fair manner,” and that “[t]he system is ill-equipped to provide for future claimants.”  Id. at 24.  Chief Judge Kaplan also viewed it as “folly” to think that “the tort system offers the only fair and just pathway of redress.”  Id. at 27 (emphasis in original).  As such, the bankruptcy petition was found to be filed in good faith because it served a valid bankruptcy purpose by resolving the talc related liability by creating a trust for claimants under 524(g) of the Bankruptcy Code.  This ruling was directly appealed to the Third Circuit which heard oral arguments on September 19, 2022.  The appeal was heard by U.S. Circuit Judges Thomas L. Ambro, L Felipe Restrepo and Julio M. Fuentes.

On January 30, 2023, the Third Circuit issued its opinion dismissing the chapter 11 petition of LTL (the “Third Circuit Opinion”).  The Third Circuit Opinion reiterated the requirement that chapter 11 petitions be filed in good faith.  To determine if this good faith requirement exists, courts in the Third Circuit focus on two inquiries: “(1) whether the petition serves a valid bankruptcy purpose[;] and (2) whether [it] is filed merely to obtain a tactical litigation advantage.”  Third Circuit Opinion at 34 (quoting BEPCO, 589 F.3d at 618).  Regarding the first inquiry, a valid bankruptcy purpose “assumes a debtor is in financial distress.”  Id. (quoting Integrated Telecom, 384 F.3d at 128).  Thus, in order to satisfy a “bankruptcy purpose,” as that term is used in the first element of a good faith analysis, the entity must currently be in financial distress.  This requires that the financial distress be apparent and immediate.  “[A]n attenuated possibility standing alone that a debtor may have to file for bankruptcy in the future does not establish good faith.”  Id. at 38 (quoting In re SGL Carbon Corp., 200 F.3d 154, 164 (3d Cir. 1999) (internal quotation marks omitted)).  Importantly, the Third Circuit acknowledged that mass tort liability can place an entity in peril.

In determining financial distress, a court “must always weigh not just the scope of liabilities the debtor faces, but also the capacity it has to meet them.  Third Circuit Opinion at 42.  Further, only the assets and liabilities of the debtor should be analyzed to determine financial distress.  Even if the steps taken to form LTL were considered a single integrated transaction, the financial condition of Old Consumer does not factor into this analysis.  Only the Debtor’s assets and liabilities are analyzed because it is the entity “in bankruptcy and subject to its good-faith requirement.”  Id. at 44.  This is particularly important in this case because LTL’s assets differ from that of Old Consumer.  LTL assets include, inter alia, (a) equity interests in Royalty A&M LLC, valued at approximately $367.1 million, (b) $6 million in cash, and (c) most importantly, the right under a funding agreement (the “Funding Agreement”) to access up to $61.5 billion from New Consumer and J&J.  Old Consumer had no access to the $61.5 billion contained in the Funding Agreement.  This fact was determinative in the Third Circuit’s analysis of financial distress.  The payment right to LTL gave it access to J&J’s balance sheet which had over $400 billion in equity value, AAA credit rating, and $31 billion in cash and securities.  Id. at 47.  Thus, the Bankruptcy Court focusing on how the talc litigation affected Old Consumer to the exclusion of LTL’s access to the Funding Agreement was legal error.

The Third Circuit also took exception to the Bankruptcy Court’s calculations in determining the future liabilities of the Debtor.  The Bankruptcy Court held that LTL’s future legal fees to defend cases would be approximately $190 billion.  Third Circuit Opinion at 48.  The Third Circuit noted how the Bankruptcy Court used all worse-case scenarios in its analysis and did not account for settlements, successful defenses, etc.  Id. at 49.  This went directly against the record which showed several successful defenses and settlements in the talc litigation.  The Bankruptcy Court merely assumed that most would go to trial and succeed.  As such, the Bankruptcy Court’s conclusion that talc liabilities exceed LTL’s ability to pay for them was faulty.

Interestingly, the Third Circuit noted that in the over five years of litigation, aggregate costs were $4.5 billion (less than 7.5% of the $61.5 billion Funding Agreement asset).  Id. at 50.  Thus, LTL was highly solvent at the time of filing.  In support, the Third Circuit quoted the Funding Agreement saying LTL held “assets having a value at least equal to its liabilities and had financial capacity sufficient to satisfy its obligations as they become due in the ordinary course of business, including and [t]alc [r]elated [l]iabilities.”  Id. at 51.

Finally, the Bankruptcy Court held that even if the petition was not filed in good faith, unusual circumstances authorized denying dismissal.  The Third Circuit stated there were no unusual circumstances in this case.  As a result of failing to satisfy the first element in a good faith analysis, the LTL bankruptcy petition is now dismissed.  The Third Circuit declined to rule whether LTL satisfied the second element of a good faith analysis of whether the filing was used as a “litigation tactic.”

© 2023 Cousins Law LLC.  All rights reserved.  The purpose of this update is to identify select developments that may be of interest to readers.  The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured.  This update should not be construed as legal advice or opinion and is not a substitute for the advice of counsel.