Are debtors ready to dance? How corporate debtors like Johnson & Johnson are starting Texas in two steps and how creditors can step in

Fraudulent conveyances and actions to avoid them are second nature to debtor and creditor attorneys. Although the exact requirements may vary between state and federal laws, a typical example includes a debtor who transfers their interest in some form of property to another party with the actual intent of preventing a creditor from recovering that property. However, as unique as the state itself, a previously rarely used loophole in Texas fraudulent conveyance law has moved to the forefront of the restructuring strategy: the Texas Two Step.

The Texas Two Step, a corporate restructuring strategy involving the conversion of a single business entity into two or more separate entities under Tex. Bus. Org. Code § 10.001-008, presents a potentially powerful tool for debtor entities to circumvent the rights of creditors on the eve of bankruptcy. By splitting into multiple entities, the single originating entity can transfer the bulk of its liabilities (e.g., mass tort liabilities) to a Texas-domiciled or incorporated entity (BadCo) while transferring the majority of its assets to a number of other entities (GoodCo). Then, BadCo files for bankruptcy seeking to meet those liabilities while letting GoodCo continue, unharassed. Taken together, this whole transaction may look like a mature case of fraudulent conveyance, with the originating entity transferring debts and assets in an effort to prevent creditors from collecting; however, Texas Two-Step dances to this assumption, believing that when a merger takes effect, all right, title and interest in the property now belongs to BadCo and GoodCo without any transfer or assignment having taken place legally. Texas Bus. Org. Code § 10.008(a)(2)(C). Recognizing the potential for this quirk in the state’s fraudulent conveyance law, some debtors — most recently including Johnson & Johnson, which faces significant mass tort liability related to talcum powder — have started the Texas Two Step to escape their responsibilities by filing bankruptcy for only their BadCo who only hold their debts. Unable to challenge this strategy by seeking to reverse transfers, creditors are left with a question: what can they do?

Fortunately, creditors may still have a few options when faced with a two-step debtor. Before the merger takes place, a creditor can attempt to stop the machinations of the transaction through a prior injunction. However, as shown by at least one court decisiona creditor may face an uphill battle in demonstrating that any such future transaction is more than currently speculative with concrete and present harm.

As a best strategy, once the transaction is complete, a creditor can go through the transaction documents themselves to determine if the debtor has met all of the requirements for a Texas Two Step under Texas law. If the debtor has failed to meet a single requirement, a creditor may attempt to dispute the transaction and have it voided.

Finally, a creditor can try their own dance, circumvent the transaction and seek redress from the shareholders of BadCo or the originating entity by piercing the corporate veil. While this strategy does not allow the creditor to recover against the debtor themselves, it does present a chance to pivot into the potentially deep pockets of shareholders and/or create pressure for a beneficial settlement.

As Texas Two Step has only recently begun to gain momentum as a new restructuring tool for corporate debtors, the full effectiveness of this strategy in bankruptcy court remains a mystery. However, until more clarity is provided, creditors have the option of defending their rights and recovering their legitimate claims against a debtor. With the tools described above in hand, creditors can help ensure that they are not left out of Texas Two Step and instead cut out of this unique process.