By Isaac Houskamp
Due to Johnson & Johnson’s recent attempt to use the Texas’s divisive merger process to separate its talc powder tort liability into a separate entity and declare bankruptcy, the process has been under scrutiny in the court of public opinion and in bankruptcy court. This piece will offer a brief inquiry into the purpose of the divisive merger process in Texas and Delaware, as well as the differences between the two systems. The protections for creditors and potential future claimants will be examined to determine whether the process adequately protects stakeholders. Finally, potential reform mechanisms will be discussed.
Texas opened the door to divisive mergers in 2006 when it defined mergers to include “the division of a domestic entity into two or more new entities.”1 Each of these elements seem desirable in helping distressed companies restructure, especially if they are protective of other stakeholder interests. Because Texas has adopted the Uniform Fraudulent Transfer Act,2 companies are prohibited from making fraudulent transfers, which would seemingly protect creditor interests. However, Texas Business Organizations Code provides that a divisive merger involves separation without a transfer having occurred, which critics say may exempt it from the UFTA.3 The uncertainty about whether a divisive merger could qualify as a fraudulent transfer has resulted in criticism of the process. This criticism may be why Delaware law is different in several ways.
Delaware also adopted a provision allowing divisive mergers of LLCs in 2018.4 Third, Delaware law does not determine which entity will hold unallocated assets or liabilities, so litigation may be necessary to determine which entity holds them. In contrast, Texas law specifies that if an asset or liability is unallocated, it will be held jointly and severally by the surviving entities.5 The laws are also share some similarities. Both laws require a division contact and the entities to file certificates of merger or division with their respective Secretaries of State. These serve to provide notice of the division.
Based on the fact that Delaware adopted the law, it seems that there must be benefits to companies available through divisive mergers. There are potential downsides, but the ability to restructure out of court and create a new, more efficient entity while simultaneously allocating liabilities to an entity that may be able to deal with more quickly through bankruptcy is undoubtedly attractive to companies. The issue is whether or not it protects parties like tort claimants. If the parent company fully guarantees the liabilities of the new, liability holding company, then it seems that this is a desirable model. It gives companies added flexibility and efficiency in dealing with massive tort litigation while maintaining the profitable aspects of their business. The protections that are potentially provided by substantive consolidation and fraudulent transfer laws make the downsides less risky. While the protections are debatable, the Johnson & Johnson case seems to suggest that courts are aware of the downsides and are sympathetic to tort claimants and other creditors. Accordingly, courts are not likely to let large corporations use these provisions to dishonestly distance themselves from liability. If that is indeed the case, then divisive mergers seem to be a desirable addition to corporate law to provide companies flexibility in restructuring and preserve their socially beneficial parts.
There are some interesting implications for lenders who are seeking to retain their rights to be repaid and in collateral. The ability for lenders to limit damage to themselves through credit agreements should not be understated. Creditors should amend credit documents to seek approval rights for any attempt at a divisive merger and include it in all documents moving forward.
The difficulties come for tort claimants who do not have any agreement with the company before the company enters the divisive merger process. Instead, they must rely on the courts to protect their rights and ensure that their interests are protected when a company attempts to restructure. Bestwall is an example of one company that was able to use a divisive merger to separate its asbestos liability from the rest of its business and was still fully obligated to pay the asbestos claims.6 As the Bestwall Court stated, however, “Filing for Chapter 11 relief, especially in the face of asbestos or mass tort claims, need not be due to insolvency: attempting to resolve asbestos claims through a Chapter 11 plan and channeling injunction is a valid reorganizational purpose, of kind weighing against dismissal of a case as bad faith filing.”7 Additionally, being too solvent can undermine good faith, which proved to be the element that doomed Johnson and Johnson’s attempt to use the “Texas Two-Step.” 8 This speeds up the process, while also ensuring that an adversarial process occurs to give future, potentially unknown, tort claimants the best possible recovery.
Second, there are a few ways to reform the process to ensure the worries about divisive mergers are addressed. If Delaware adopts a system that is identical to Texas, it may result in more of these transactions taking place in Delaware (as long as the requirements of Delaware law are not grossly more stringent.) Coming up with a better system in Delaware may also result in Texas making reforms to match Delaware. These reforms may include designating a divisive merger as a transfer so that it will be governed by the Uniform Fraudulent Transfer Act or equivalent state law. While it may not change the law on the ground given that many creditors already structure agreements to prevent adverse transfers, it will give the system more legitimacy and calm those who are worried about companies exploiting the system. Another reform that is outside of the merger process, but important for the fair treatment of tort claimants is making the Future Claims Representative bargaining process more robust in order to ensure unnamed future claimants are adequately compensated, which is questionable now.9 These reforms would address the two most worrisome parts of divisive mergers: the potential of committing fraud against creditors, and the potential of using Chapter 11 to escape the full liability to future tort claimants.
While the divisive merger process has received a lot of attention lately, it seems that it is actually a quite effective tool for firms to restructure. While there are concerns for the fair treatment of tort claimants, it seems that the process itself offers flexibility for companies to move past their wrongdoing while attempting to make those who have suffered harm whole. There is a potential that the Future Claims Representative system does not adequately protect future claimants, but for the reasons discussed here, that in itself should not doom the process.
Tex. Bus. Org. §1.002(55)(A).) The provision was meant to give flexibility in restructuring. Divisive mergers allow business entities to reorganize assets and liabilities, efficiently divide entities, end a partnership, spin off certain assets and liabilities, restructure the balance sheet, or assign otherwise unassignable contracts. ((Jordan Chavez, Alex Kirincic, & Cameron Scales, Texas Two Step Creates Unique Restructuring Opportunities – But Not Without Challenges, Haynes Boone (Sep. 09, 2021), https://www.haynesboone.com/news/alerts/texas-two-step-creates-unique-restructuring-opportunity-but-not-without-challenges. ↩
Tex. Bus. Orgs. Code Ann. §§24.001-24.013. ↩
Will the Texas Two-Step Create New Restructuring Opportunities for Companies Facing Mass Tort Liabilities? Darrow Everrett LLP (May 2022), https://www.darroweverett.com/will-the-texas-two-step-create-new-restructuring-opportunities-for-companies-facing-mass-tort-liabilities/. ↩
6 Del. Code 18-217 (2018).) This law differs from the Texas provision in several ways. First, it only applies to LLCs. Second, it specifically notes that restrictions on transfer continue to apply through the merger, and that the divisive merger cannot be used to avoid assignment and transfer restrictions. ((Sarah Mclean & Todd Lowther, A Comparison of Divisive Merger Statutes in Delaware and Texas, Shearman & Sterling (October 24, 2018), https://www.shearman.com/en/perspectives/2018/10/a-comparison-of-divisive-merger-statutes-in-delaware-and-texas. ↩
In re Bestwall LLC, 606 B.R. 243 (Bankr. W.D.N.C. 2019).) One problem that arises is whether the damages awarded to future claimants through the bankruptcy process will be adequate. Claimants may be able to pursue substantive consolidation (to merge the company back into one entity) or argue bad faith if the divisive merger results in improper treatment of creditors. ((Will the Texas Two-Step Create New Restructuring Opportunities for Companies Facing Mass Tort Liabilities? Darrow Everett LLP (May 2022).) In the Chapter 11 process, courts weigh the existence of bad faith. ((In re Bestwall. ↩
Id at 49. ↩
In re LTL Mgmt., LLC, 58 F.4th 738 (3d. Cir. 2023).) These important elements required for declaring bankruptcy seem to weigh against the idea that companies can easily use the divisive merger process to damage the interests of tort claimants. Chapter 11 and a channeling injunction are valid for reorganization, as the Bestwall court makes clear. These checks prevent companies from using divisive mergers to disadvantage tort claimants, and instead, help companies to get through the process more quickly.
There are definite downsides to the system of divisive mergers and risks to creditors and tort claimants. Creditors are wary of the system as a potential to move assets away from them. However, knowing the landscape of restructuring and corporate governance, creditors can get out ahead of these issues by putting restrictions in credit agreements. As seen above, tort claimants are arguably protected by the bankruptcy system, and the bankruptcy system speeds up the process for a company in resolving the claims against it. This is a system that will likely stay in place, despite the controversy. The question then becomes, what is the best way for the process to work moving forward?
Delaware stepping into the space of allowing divisive mergers in limited contexts seems to suggest that corporate law may be heading in this direction as a whole. Unless there is a concerted effort against allowing divisive mergers, they may become even more common. First, there are already checks in place. The good faith requirement of Chapter 11 prevents companies like Johnson & Johnson from using the process for a potentially suspect purpose. Within the Chapter 11 process, the requirements of fair and equitable treatment also serve as a protection for tort claimants, along with the Future Claims Representative who litigates the case on their behalf. ((Frederick Tung, The Future Claims Representative in Mass Tort Bankruptcy: A Preliminary Inquiry, Chapman L. R. ↩