Third Circuit Dismisses J&J Affiliate LTL's Talc Liability Chapter 11 Filing; "Good Faith" Under 1112(b) Requires Financial Distress

• Published date: 10 February 2023
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Author: Ms Ingrid Bagby, Michele Maman, Casey Servais and Christopher M. Floyd

Executive Summary:

On January 30, 2023, the U.S. Court of Appeals for the Third Circuit (the "Court") issued an opinion in In re LTL Management, LLC, No. 22-2003, 2023 WL 1098189, at *1 (3d Cir. Jan. 30, 2023) ("LTL Management"),¹ in which Judge Thomas L. Ambro reversed the prior ruling of the U.S. Bankruptcy Court for the District of New Jersey and dismissed Johnson & Johnson, Inc. ("J&J") affiliate LTL's chapter 11 petition. Specifically, the Court ruled that because the chapter 11 debtor (LTL) "was not in financial distress, it cannot show its petition served a valid bankruptcy purpose and was filed in good faith under Code ' 1112(b)."² In determining that LTL's attempt to compartmentalize its parent company's (J&J) talc liability ran afoul of Bankruptcy Code section 1112(b)'s good-faith standard, the Third Circuit creates a question as to the ability of prospective debtors to use the chapter 11 process to manage mass tort litigation risk ' particularly in cases involving a well-capitalized parent.

Factual and Procedural Background:

LTL Management, LLC ("LTL") is a subsidiary of J&J. J&J is a global healthcare giant that owns a diverse portfolio of global healthcare brands and product lines, including Band-Aid and Tylenol. At the time of LTL's bankruptcy filing in October 2021, J&J had a market capitalization in excess of $400 billion and held $31 billion in cash and marketable securities, which contributed to its perfect AAA credit rating.

Johnson & Johnson Consumer Inc. ("Old Consumer") was a wholly owned subsidiary of J&J that produced and sold Johnson's Baby Powder, a skincare product manufactured from talcum powder or "talc" ' a mineral that is mined and then milled into a fine powder. Baby Powder was first sold by J&J in 1894 and became one of the company's best-selling products. Although Baby Powder was sold directly by J&J for most of its product life, in 1979 J&J transferred the Baby Powder business to Old Consumer, which continued to sell talc-based Baby Powder until the product was discontinued in the U.S. and Canada.

Recently, customers and users of Baby Powder have filed a flurry of lawsuits across numerous jurisdictions³ against Old Consumer and J&J alleging that the talc contained in Baby Powder caused ovarian cancer and mesothelioma. Beginning in 2013, a series of lawsuits resulted in jury verdicts for plaintiffs who alleged that Baby Powder contained trace amounts of asbestos and caused ovarian cancer and mesothelioma. At the time of LTL's bankruptcy filing in 2021, over 38,000 ovarian cancer actions and over 400 mesothelioma actions were pending against Old Consumer and J&J. Before the Petition Date, J&J and Old Consumer had already paid out approximately $3.5 billion for talc-related verdicts and settlements, in addition to nearly $1 billion in defense costs.

The "Texas Two-Step":

In October 2021 J&J undertook a pre-bankruptcy, multi-step divisional merger transaction (under Texas law) in order to capture all of the company's asbestos liability in a newly-created subsidiary (LTL). Specifically, J&J deployed a legal maneuver colloquially known as the "Texas two-step" transaction, in which Old Consumer, through a series of intercompany transactions, split itself into two new entities: (1) LTL, which would principally hold Old Consumer's liabilities relating to the talc litigation; and (2) Johnson & Johnson Consumer Inc. ("New Consumer"), which would hold the productive business assets previously held by Old Consumer. LTL then filed for chapter 11 bankruptcy.

As summarized by Judge Ambro, the "stated goal was to isolate the talc liabilities in a new subsidiary so that entity could file for Chapter 11 without subjecting Old Consumer's entire operating enterprise to bankruptcy proceedings."⁴

Relatedly, J&J, New Consumer, and LTL executed a Funding Agreement, pursuant to which LTL had the right to cause J&J and New Consumer, jointly and severally, to pay it cash up to the value of New Consumer (estimated at $61.5 billion) to satisfy any talc-related costs and normal course expenses. LTL's payment right under the Funding Agreement "gave LTL direct access to J&J's exceptionally strong balance sheet."⁵ The Court characterized LTL's rights under the Funding Agreement as "a funding backstop, not unlike an ATM disguised as a contract," that LTL had the ability to draw upon to satisfy its future talc liabilities.⁶

LTL's bankruptcy filing and subsequent bankruptcy court litigation:

On October 14, 2021 (the "Petition Date"), LTL filed a chapter 11 petition in the U.S. Bankruptcy Court for the Western District of North Carolina. Shortly thereafter, the case was transferred to the U.S. Bankruptcy Court for the District of New Jersey (the "Bankruptcy Court"), where the case was assigned to Judge Michael B. Kaplan.⁷

During the Bankruptcy Court proceedings, the Official Committee of Talc Claimants, together with certain other talc personal injury claimants (collectively, the "Talc Claimants") moved to dismiss LTL's bankruptcy case on the basis that it was not filed in good faith.⁸ In an opinion issued February 25, 2022, the Bankruptcy Court denied the motions.⁹ First, the Bankruptcy Court (applying Third Circuit case law) held that LTL had filed its bankruptcy petition in good faith for purposes of section 1112(b). The Bankruptcy Court ruled that LTL's bankruptcy filing served a valid bankruptcy purpose that was consistent with Bankruptcy Code section 524(g) because, through its chapter 11 filing, LTL sought to resolve asbestos-related talc liability by...