Must be broke, court says

You have to actually be broke to file for bankruptcy protection — at least that’s what a federal appellate court ruled Monday.

Driving the news: The court dismissed the bankruptcy filing by a subsidiary of corporate giant Johnson & Johnson. J&J created the unit — dubbed LTL Management — for the express purpose of holding legal liabilities and then filing for Chapter 11.

Why it matters: The ruling undercuts the emerging corporate strategy of using bankruptcy to excise costly liabilities when the organization itself is perfectly solvent.

• “Because LTL was not in financial distress, it cannot show its petition served a valid bankruptcy purpose and was filed in good faith,” a three-judge panel said in its unanimous ruling.

Catch up quick: J&J faces some 38,000 lawsuits from people and their survivors claiming that the company’s talc-based powder caused cancer. J&J has repeatedly denied the allegation.

• Critics say that transferring the litigation claims to the new subsidiary and placing that unit in bankruptcy was a tactic to cap J&J’s exposure to the liabilities.

State of play: At the time it put newly formed subsidiary LTL Management into bankruptcy in October 2021, J&J had an equity value of more than $400 billion, a AAA credit rating, and $31 billion in cash and marketable securities.

• That means it almost surely had ample liquidity to pay LTL’s obligations — and can’t instead use the bankruptcy process, the court ruled. When LTL filed for bankruptcy, J&J was worth at least 25 times more than its estimated total product liabilities over the next 24 months, the ruling stated.

What they’re saying: That companies need to be financially distressed to qualify for bankruptcy is a “common sense assumption,” University of North Carolina bankruptcy law professor Melissa Jacoby tells Axios.

• “This is a vindication of the rule of law and the role of the civil justice system,” Jacoby says. “Bankruptcy plays a very important role in our legal system, but it’s for extraordinary circumstances.”

The big picture: Organizations and companies have been getting more creative about how they attempt to leverage the U.S. Bankruptcy Code to their advantage.

• In 2021, a judge dismissed the National Rifle Association’s Chapter 11 bankruptcy because the NRA — by its own admission — wasn’t facing financial troubles. The NRA sought bankruptcy in an attempt to delay a lawsuit by the New York state attorney general seeking to disband the organization.
• 3M, the conglomerate, placed its Aearo Technologies subsidiary into bankruptcy, hoping to use the process to speed a settlement of more than 230,000 lawsuits from military service members who accused Aearo earplugs of causing hearing loss.

How it works: When an organization files for bankruptcy, creditors have to negotiate collectively with the debtor in pursuit of a settlement — often for pennies on the dollar in the case of litigants, who are considered unsecured creditors.

• J&J had agreed to provide $2 billion through a trust to pay claims — an amount the alleged victims said was insufficient.

The Third Circuit said it doesn’t intend to “discourage lawyers from being inventive.” But, it said that J&J’s finances mean it has no right to access the tools of bankruptcy court — which allow debtors to restructure and slash liabilities without facing further legal attacks.

The other side: J&J said in a statement that it will appeal the ruling, rejecting the Third Circuit’s contention that the company did not file the case in good faith.

• “As we have said from the beginning of this process, resolving this matter as quickly and efficiently as possible is in the best interests of claimants and all stakeholders,” J&J said. “We continue to stand behind the safety of Johnson’s Baby Powder, which is safe, does not contain asbestos and does not cause cancer.”

What’s next: If the Supreme Court doesn’t agree to hear J&J’s appeal, the company will be forced to address its liabilities on a case-by-case basis in court, out of court, or through a massive civil settlement.

• “J&J has no special right to put talc victims in a bankruptcy box,” Bailey Glasser attorney Brian Glasser, who is representing the official committee of talc claimants in the bankruptcy, said in a statement. “It now has to face these claims in front of juries around the nation.”

The bottom line: “The bigger a backstop a parent company provides a subsidiary, the less fit that subsidiary is to file” for bankruptcy, the Third Circuit ruled.