In recent years, a controversial strategy known as the "Texas Two-Step" has been making waves in bankruptcy law. This tactic has been employed by major corporations, most notably Johnson & Johnson (J&J), to handle massive litigation liabilities—often in cases where a company is solvent and otherwise financially healthy. The Texas Two-Step involves a corporate restructuring that separates liabilities from assets, followed by a strategic bankruptcy filing to limit financial exposure for the original company. While some courts have allowed this maneuver, others are challenging its legitimacy, leading to a critical constitutional debate on what exactly constitutes “bankruptcy.”
This debate has far-reaching implications, potentially redefining the scope of federal bankruptcy protections. So, let’s dive into the constitutional foundations of bankruptcy and explore whether solvent companies like J&J truly belong in bankruptcy court.
The Constitutional Foundation of Bankruptcy Law
The United States Constitution grants Congress the power to establish “uniform laws on the subject of Bankruptcies throughout the United States.” This mandate has provided a framework for Congress to create laws that help debtors manage overwhelming debts, distribute assets fairly to creditors, and, ideally, give debtors a fresh start. But the question that has emerged in light of recent cases is whether this constitutional power should extend to companies with no credible financial distress or threat of nonpayment.
From the beginning, bankruptcy law in both England and early America was understood as a relief mechanism for debtors unable or unwilling to meet their obligations. The Supreme Court has long upheld this definition, framing bankruptcy as a collective process designed to handle debtors who present a risk to creditors through nonpayment, whether due to insolvency or unwillingness to pay. Essentially, the bankruptcy system was built to intervene when there is a threat to creditors—something that doesn’t typically apply to solvent companies.
The Texas Two-Step: A New Use of Bankruptcy
The Texas Two-Step is a creative approach that involves a company restructuring itself under Texas law to separate its assets from its liabilities. Typically, this is followed by a newly created entity with few or no assets filing for Chapter 11 bankruptcy. The strategy allows the original company to shield its assets from creditors and potentially cap its liability exposure in cases involving large-scale lawsuits, like mass torts.
Johnson & Johnson has become the most prominent user of the Texas Two-Step, creating a subsidiary to handle claims related to its talc products while protecting the parent company’s assets. This tactic has raised ethical and legal questions: If J&J is financially capable of paying these claims outside bankruptcy, is it appropriate for its subsidiary to seek bankruptcy protection?
Solvent Companies and Bankruptcy: A Constitutional Dilemma
In cases like J&J’s, the courts have faced the question of whether solvent companies belong in bankruptcy court. According to the Supreme Court’s traditional interpretation, the essence of “bankruptcy” is tied to financial distress or nonpayment risk. Historically, bankruptcy has been reserved for entities unable to meet their financial obligations. A solvent company seeking bankruptcy protection challenges this basic premise and raises an important constitutional question: Does the Bankruptcy Clause extend to cases where there is no credible risk of nonpayment?
Courts differ on this issue. For example, the Third Circuit recently dismissed J&J’s first bankruptcy case involving its talc subsidiary, citing a lack of financial distress. By contrast, courts in North Carolina have permitted similar cases to proceed, interpreting the requirement of financial distress less strictly.
Should Bankruptcy Be a Tool for Liability Management?
Proponents of the Texas Two-Step argue that bankruptcy can provide an efficient way to manage massive liability claims, ensuring fair treatment for all claimants. However, critics assert that this strategy represents an abuse of the bankruptcy system, turning it into a liability shield for corporations that are financially stable. They argue that permitting solvent companies to access bankruptcy relief undermines the system’s purpose and erodes trust in bankruptcy as a tool for genuine financial distress.
Allowing solvent companies to file for bankruptcy could set a precedent, enabling other corporations to offload liabilities while retaining profits, potentially at the expense of creditors and plaintiffs seeking restitution.
Moving Forward: Clarifying the Boundaries of Bankruptcy
The Supreme Court has historically emphasized that bankruptcy is a “subject” with clear limits: it’s designed to handle debtors who cannot pay their debts. But as companies continue to test these boundaries, the Court may need to weigh in to clarify the constitutional scope of bankruptcy protection. In the meantime, conflicting rulings in different circuits create uncertainty and the potential for forum-shopping, where companies select jurisdictions more favorable to their interests.
Conclusion: The Future of Bankruptcy Law and the Texas Two-Step
The Texas Two-Step strategy is a wake-up call, highlighting the need to examine how bankruptcy law applies to financially solvent companies. The core purpose of bankruptcy is, and arguably always has been, to manage situations of genuine financial distress. Allowing solvent companies to use this process for liability management raises both ethical and constitutional issues that may fundamentally reshape bankruptcy law.
As we await further guidance from the courts, one thing is clear: the boundaries of bankruptcy law are being tested, and the outcome of this debate will have lasting consequences for corporate accountability, creditor rights, and the very nature of the bankruptcy system.
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