Bankruptcy document with wooden gavel

Third Circuit Court of Appeals Rejects Johnson & Johnson’s Bankruptcy Plan to Handle Their Baby Powder Litigation

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On January 30, the U.S. Court of Appeals for the Third Circuit dismissed the talc bankruptcy filing of Johnson & Johnson’s subsidiary, LTL Management, LLC. After hearing arguments in September, the Third Circuit ultimately reversed the decision from New Jersey Bankruptcy Court and held that LTL was not in the financial distress required because of the value and quality of its assets and was therefore ineligible to petition the bankruptcy court for relief under Chapter 11.

Johnson & Johnson’s plan, as a corporate restructuring or “divisional merger,” that under Texas law, involves the division of an entity into two or more new entities, and when the original entity does not survive the merger, it allocates its property, liabilities and obligations among the new entities according to a plan of merger and, on implementation, its separate existence ends. This process has previously been tried by companies with more success, such as Bestwall and Aldrich Pump LLC.[1]

In this case, Johnson & Johnson Consumer, Inc., which itself is a wholly owned subsidiary of Johnson & Johnson, divided itself into two separate companies: LTL and “New Consumer” and then had the liability-bearing company—LTL—declare bankruptcy in the Bankruptcy Court for the Western District of North Carolina, with funding from New Consumer to pay for the talc litigation claims. That court subsequently transferred the case to the bankruptcy court for the District of New Jersey.

A group of the talc plaintiffs then filed a motion to dismiss LTL’s bankruptcy filing alleging that it was filed in bad faith. Section 1112 of the Bankruptcy Code governs a motion to dismiss a Chapter 11 bankruptcy or convert it to another chapter. The debtor, the United States Trustee, or a “party in interest,” may move for dismissal under this section. A party in interest may move to dismiss a Chapter 11 bankruptcy under § 1112(b). The Bankruptcy Code does not define the full scope of who may qualify as party in interest, although § 1109 of the code includes creditors and creditor committees as parties in interest.

A court may dismiss a bankruptcy upon a showing of cause. The terms of the code do not authorize dismissal on the ground that the debtor did not file for bankruptcy in good faith, but courts generally accept it as an example of cause. The lack of a good-faith requirement in the code gives circuit courts flexibility in how to rule on motions to dismiss based on an absence of good faith. The Third Circuit places the burden on the debtor to show good faith, while the Fourth Circuit requires a showing of the debtor’s objective bad faith and the objective futility of any possible reorganization.

The claimants’ motion to dismiss was subsequently denied, but the plaintiffs appealed directly to the Third Circuit. It is this declared bankruptcy that the Third Circuit Court of Appeals dismissed, holding that the New Consumer-funded LTL did not meet the prerequisite for bankruptcy, namely that it must first be in a state of financial distress.

As we reported in October, the three panel Third Circuit heard oral arguments on the plaintiffs’ appeal on September 19. In their decision, the Third Circuit laid out its standard for determining whether bankruptcy filings are in good faith or not.

Chapter 11 bankruptcy petitions will be “subject to dismissal under 11 U.S.C. section 1112(b) unless filed in good faith.” Section 1112(b) provides for dismissal for “cause.” A lack of good faith constitutes cause, though it does not fall into one of the examples of cause specifically listed in the statute. Because the code’s text neither sets nor bars explicitly a good-faith requirement, we have grounded it in the “equitable nature of bankruptcy” and the “purposes underlying Chapter 11.” Once at issue, the

burden to establish good faith is on the debtor….“[T]wo inquiries … are particularly relevant:” “(1) whether the petition serves a valid bankruptcy purpose[;] and (2) whether [it] is filed merely to obtain a tactical litigation advantage.”

“We start, and stay, with good faith,” U.S. Circuit Judge Thomas Ambro wrote for the unanimous three-judge Third Circuit panel.

Examining LTL’s petition under this standard, the Third Circuit ultimately concluded that “a debtor who does not suffer from financial distress cannot demonstrate its Chapter 11 petition serves a valid bankruptcy purpose supporting good faith.” The court went on to hold that “good faith necessarily requires some degree of financial distress on the part of a debtor.” Absent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose.

In reaching their decision, the Third Circuit Court of Appeals determined that LTL was notin financial distress. In particular, the panel noted that LTL’s assets included the right to receive almost $62 billion from Johnson & Johnson and New Consumer under a funding agreement executed at the time of the divisional merger. Compared to the $4.5 billion in estimated aggregate costs from the talc litigation, the Third Circuit failed to see where the distress lied. Given that its assets outweighed its potential liability as of the petition date, the Third Circuit Court held that LTL was not in “financial distress.”

The Court, however, did leave the door open in the event circumstances changed that might necessitate a future filing and did not intend to dissuade future companies from attempting the same plan:

“That said, we mean not to discourage lawyers from being inventive and management from experimenting with novel solutions. Creative crafting in the law can at times accrue to the benefit of all, or nearly all, stakeholders. Thus we need not lay down a rule that no nontraditional debtor could ever satisfy the Code’s good-faith requirement.”

Going forward, Johnson & Johnson is left to decide whether it wants to file for an en banc review by the full Third Circuit or file a petition for certiorari before the U.S. Supreme Court.

Read the full decision here.

[1] Bestwall LLC v. Those Parties Listed on Appendix A to Complain and John and Jane Does 1–1000 (In re Bestwall LLC), 606 B.R. 243, 246–51 (Bankr. W.D.N.C. 2019); DBMP v. Those Parties Listed on Appendix A to Complaint and John and Jane Does 1–1000, Adv. No. 20-03004 (Bankr. W.D.N.C. Jan. 23, 2020); Aldrich Pump LLC & Murray Boiler LLC v. Those Parties to Actions Listed on Appendix A to Complaint and John and Jane Does 1–1000 (In re Aldrich Pump LLC, et al.), Adv. No. 20-030401 (Bankr. W.D.N.C. June 18, 2020).