On July 23, 2024, a bipartisan group of senators and representatives introduced the Ending Corporate Bankruptcy Abuse Act of 2024 (the Act). This proposed legislation aims to curtail the use of an increasingly common controversial corporate bankruptcy strategy known as the “Texas Two-Step,” which has been employed by several major companies, including Johnson & Johnson, to address mass tort liabilities.
The Texas Two-Step typically involves a company using a “divisional merger” to split into two entities: One company (BadCo) assumes or is given the liabilities, including mass tort liabilities, while a separate company (GoodCo) is given the operating and valuable assets. BadCo then files for bankruptcy protection receiving the protection of the automatic stay as to litigation against itself. BadCo then seeks, and has historically been granted, an extension of the automatic stay stopping litigation against GoodCo. Thus, GoodCo (and its assets) remains outside of the bankruptcy proceeding while receiving the protections of the automatic stay. This allows both entities to avoid paying creditors while the bankruptcy remains pending, while the debtor negotiates with creditors in the hopes of reaching a confirmable plan that resolves the liabilities as to both BadCo and GoodCo. While creditors have at times been able to pursue avoidance actions, such as fraudulent transfer actions, in connection with the divisive merger, resolution of such litigation during the bankruptcy proceeding can take years.
Key Provisions of the Proposed Act
1. Presumption of Bad Faith: The Act would add additional examples of causes for dismissal, including if the filing of the petition or the continuation of the case is (i) objectively futile or (ii) in subjective bad faith. It further provides that the court shall presume that a bankruptcy has been filed in bad faith if the debtor manufactured venue for the case.
The Act would require the court to conclusively presume that a petition was filed or is continuing in subjective bad faith if:
- The purpose or effect of the filing is to gain a tactical litigation advantage, impose undue delay upon creditors, or cap the amount of liability of the debtor to certain creditors where the debtor or any affiliate has the ability to pay such claims in full as they come due;
- During a four-year period before the filing, the debtor was the subject of a divisional merger or similar transaction;
- During a four-year period before the filing, the debtor engaged in a transfer of substantial assets to or for the benefit of or incurred substantial obligations from or for the benefit of an affiliate; or
- The Debtor lacks a valid reorganization purpose.
In making the decision, the court would be instructed to give weight to the position of any appointed creditors’ committee.
2. Limitation on Automatic Stay: The bill would prohibit extending the automatic stay or granting an injunction or litigation pause for non-bankrupt affiliates where the debtor was involved in a Texas Two-Step maneuver within the previous four years. This provision applies specifically to cases involving more than 100 tort claims.
3. Burden of Proof: The debtor would bear the burden of proving that the bankruptcy filing is not in bad faith.
4. Time Limit for Reorganization: The Act would alter the time frame during which a debtor must show a reasonable likelihood that it can confirm a plan from a “reasonable period of time” to two years when trying to convince a court not to convert or dismiss the case based on unusual circumstances establishing that conversion or dismissal is not in the best interests of creditors.
Potential Implications
If enacted, this legislation could significantly impact corporate strategies for managing mass tort liabilities:
1. Increased Scrutiny: Bankruptcy courts would be required to more closely examine the motivations behind complex corporate restructurings preceding bankruptcy filings.
2. Reduced Effectiveness of the Two-Step: By limiting the ability of a bankruptcy court to extend the automatic stay for the benefit of non-debtor affiliates, the Act would remove a key benefit of the Texas Two-Step strategy.
3. Higher Bar for Bankruptcy Filings: The presumption of bad faith could make it more challenging for companies to use bankruptcy as a tool for managing mass tort liabilities.
4. Potential for Earlier Resolutions: The time limit on showing a likelihood of rehabilitation could pressure companies to reach settlements with claimants more quickly.
Conclusion
While the Act has bipartisan support, its passage is not guaranteed. However, its introduction signals growing scrutiny of corporate bankruptcy tactics and may foreshadow increased legislative and judicial attention to these issues. Companies facing significant tort liabilities should closely monitor the progress of this legislation and consider its potential impact on their risk management and litigation strategies. Even companies not currently considering such strategies should be aware of this legislation, as it reflects a changing landscape in bankruptcy law that could affect various corporate restructuring approaches.