The Restructuring Report

Fraudulent transfers and actions to avoid them are second nature to both debtor and creditor attorneys. Although the exact requirements may vary amongst state and federal laws, a typical example includes a debtor that transfers its interest in some form of property to another party with the actual intent to prevent a creditor from collecting against that property. However, as unique as the state itself, a previously seldom-used loophole to fraudulent transfer law in Texas has jumped to the forefront of restructuring strategy—the Texas Two Step.

The Texas Two Step, a business restructuring strategy involving the conversion of a lone business entity into two or more separate entities under Tex. Bus. Orgs. Code § 10.001-008, presents a potentially powerful tool for debtor entities to sidestep the rights of creditors on the eve of bankruptcy. In splitting into multiple entities, the lone original entity can transfer the bulk of its liabilities (for example, mass tort liabilities) to one entity domiciled or incorporated in Texas (BadCo) while transferring the majority of its assets to any number of other entities (GoodCo). Then, BadCo files for bankruptcy seeking to finally deal with those liabilities while letting GoodCo continue, unharried. Overall, this entire transaction may sound like a ripe case of fraudulent transfer, the original entity transferring debts and assets in an attempt to prevent creditors from collecting; however, the Texas Two-Step dances over this assumption, holding that when a merger takes effect all rights, title and interests to the property are now owned by BadCo and GoodCo without any transfer or assignment having legally occurred. Tex. Bus. Orgs. Code § 10.008(a)(2)(C). Recognizing the potential of this quirk amongst state fraudulent transfer law, some debtors—including most recently Johnson & Johnson, which faces significant mass tort liability related to talc powder—have begun the Texas Two Step to escape their liabilities by filing a bankruptcy for just their BadCo’s that hold only their debts. With the inability to challenge this strategy by seeking to overturn the transfers, creditors are left with one question: what can they do?

Thankfully, creditors may still have a few options when faced with a Two-Stepping debtor. Before the merger takes place, a creditor may attempt to stop the machinations of the transaction through a preliminary injunction. However, as seen from at least one court ruling, a creditor may face an uphill battle in showing that the any such future transaction is more than presently speculative with current, concrete harm.

As a better strategy, after the transaction is complete, a creditor may scour the transaction documents themselves to determine whether the debtor met all of the requirements for a Texas Two Step under Texas law. If the debtor failed to meet even a single requirement, a creditor can attempt to challenge the transaction and have it overturned.

Finally, a creditor may attempt its own dance, circumventing the transaction and seeking relief from BadCo’s or the original entity’s shareholders by piercing the corporate veil. While this strategy does not allow the creditor to recover against the debtor itself, it presents a chance to pivot to the potentially deep pockets of the shareholders and/or create the pressure for an advantageous settlement.

As the Texas Two Step has only recently begun to gain steam as a new restructuring tool for debtor companies, the full effectiveness of this strategy in bankruptcy court remains a mystery. However, until further clarity is gained, creditors have options in defending their rights and collecting their lawful claims against a debtor. With the above-described tools in hand, creditors can help ensure that they are not left on the sidelines of the Texas Two Step and instead cut into this unique process.