The US Court of Appeals for the Third Circuit in In re LTL Management, LLC ruled that the debtor was not in financial distress on its bankruptcy petition date, and therefore was not eligible for bankruptcy relief ( (3rd Cir. Jan. 30, 2023)).

Johnson & Johnson Consumer Inc., or "Old Consumer," sold healthcare products including Johnson's Baby Powder, made from talc, a mineral mined and milled into a fine powder. In recent years, tens of thousands of consumers of Johnson's Baby Powder sued Old Consumer, claiming that the product contained traces of asbestos that caused cancer and mesothelioma. By 2021 Old Consumer had suffered some courtroom defeats resulting in multimillion-dollar verdicts but had also succeeded in having many cases dismissed. Many cases settled.

In 2021, concerned about mounting payouts and litigation costs, Old Consumer split itself under Texas law into two new entities. LTL Management, LLC (LTL) held Old Consumer's talc liabilities, and a new Johnson & Johnson Consumer Inc., or "New Consumer," held all of the productive business assets, such as Band-Aid, Tylenol, Aveeno, and Listerine. LTL was allocated approximately $373 million in assets. However, the divisional agreement gave LTL the right to cause New Consumer and its J&J parent company to pay LTL cash to satisfy talc-related costs and expenses. There were few conditions and no repayment obligation. The floor for cash payments to LTL could not drop below $61.5 billion, which was New Consumer's value at the time of division, and the payments could increase as New Consumer's value increased.

Two days after the division into LTL and New Consumer, on October 14, 2021, LTL filed for Chapter 11 bankruptcy protection in the US Bankruptcy Court for the Western District of North Carolina.

The bankruptcy court transferred the case to the US Bankruptcy Court for the District of New Jersey, which denied motions to dismiss filed by talc claimants. A direct appeal to the US Court of Appeals for the Third Circuit was authorized. The Third Circuit reversed, holding that:

While not directly addressing the validity or value of a "divisional merger" under Texas law, commonly referred to as the "Texas Two-Step," the Third Circuit's In re LTL Management decision at minimum indicates that this pre-bankruptcy strategy will be examined closely for debtor eligibility, at least in the Third Circuit. The appellate court showed an unwillingness to accept the debtor's worst-case-scenario projections, and an unwillingness to allow a debtor to avail itself of the advantages of the bankruptcy system (such as consolidation of all claims into one court), simply because the putative debtor desired it.

In In re Aearo Tech. LLC, the bankruptcy court denied the debtor's motion for declaratory and injunctive relief to enjoin and stay pending ear plug litigation against the debtor's parent corporation, 3M. The court focused on an untapped indemnity agreement between the debtor and 3M, which wasn't conditioned on Aearo obtaining a stay of litigation against 3M (see 642 B.R. 891 (Bankr. S.D. Ind. 2022)). Within a short time after the Third Circuit's In re LTL Management decision, tort claimants filed a motion to dismiss the In re Aearo Tech. case under section 1112(b) based on a lack of good faith (see

If the Fourth Circuit and potentially others follow the Third Circuit's decision, it will not necessarily mean that debtors cannot utilize divisional mergers or similar pre-bankruptcy planning strategies. It would mean that liability-laden debtors with pre-bankruptcy funding arrangements would have to refrain from filing for bankruptcy until their liabilities were realized to a degree that they could show financial distress on the bankruptcy petition date. Alternatively, a split in authority could result in petitions for certiorari before the US Supreme Court.

For more information on pre-bankruptcy strategies in mass tort bankruptcies, see Practice Note, Mass Tort Bankruptcies: Overview.