The Texas Two-Step Controversy and Bankruptcy Forum Shopping

Introduction

The Texas Two-Step is the most contested bankruptcy structuring technique of the past decade, and the legal and political fight over it has reshaped how mass tort liability flows through the bankruptcy system. The structure uses a Texas state-law divisional merger to split a company into two pieces, with mass tort liability assigned to one piece and operating assets and a funding agreement assigned to the other. The liability-bearing piece then files Chapter 11, hoping to use the bankruptcy system to resolve the tort claims while the operating business continues outside bankruptcy.

This article walks through:

The structure relies on a specific feature of Texas state law: the divisive merger statute. Under Texas Business Organizations Code Section 10.008, a Texas corporation can divide itself into two or more corporations through a "divisive merger," with the original entity ceasing to exist and the new entities each receiving designated assets and liabilities. Crucially, a divisive merger is treated as a continuation of the original entity rather than a transfer, which means it does not trigger fraudulent transfer scrutiny in the same way a traditional asset sale would.

The typical Texas Two-Step has several steps:

1. Reincorporation in Texas: The target subsidiary reincorporates in Texas (or merges with a Texas entity) to gain access to the Texas divisive merger statute. 2. Divisive merger: The Texas entity divides into two new entities. One receives the operating business and a funding agreement; the other receives the mass tort liability. 3. Funding agreement: The healthy entity agrees contractually to fund the liability-bearing entity's claim payments up to a defined cap. 4. Chapter 11 filing: The liability-bearing entity files Chapter 11, typically in the Western or Southern District of North Carolina or another perceived-favorable venue. 5. Plan confirmation: The Chapter 11 plan establishes a settlement trust funded by the funding agreement, which resolves all tort claims in exchange for distributions.

Divisive Merger

A merger structure under Texas Business Organizations Code Section 10.008 in which a single entity divides into two or more entities, with each receiving designated assets and liabilities. Unlike a traditional spin-off or asset sale, a divisive merger is treated as a continuation of the original entity and does not trigger the same fraudulent transfer analysis. The structure is unique to Texas (and a few other states with similar provisions) and has become the foundational legal mechanism for Texas Two-Step filings.

The strategic appeal of the structure is significant. The healthy operating company stays out of bankruptcy, preserving operations, employees, and supplier and customer relationships. The mass tort liability gets resolved through a structured Chapter 11 process that limits the parent's exposure to a contractually defined funding amount. Plaintiffs' counsel objects on the grounds that the structure separates the wealth (in the healthy entity) from the legal jurisdiction (in the bankrupt entity), making it harder to obtain meaningful recovery.

Johnson & Johnson initiated the highest-profile Texas Two-Step in October 2021 when it created LTL Management LLC to hold its asbestos-containing talc powder liabilities. Through a Texas divisional merger, J&J transferred approximately 38,000 pending talc-related lawsuits to LTL. LTL then filed Chapter 11 on October 14, 2021 in the Western District of North Carolina, later transferred to the District of New Jersey.

The bankruptcy court initially declined to dismiss the case. Bankruptcy Judge Michael Kaplan rejected tort claimants' arguments that LTL's filing violated the good faith requirement for Chapter 11 filings. The decision was appealed, and on January 30, 2023, the Third Circuit Court of Appeals reversed and ordered the case dismissed on good-faith grounds. The Third Circuit's reasoning focused on the funding agreement: because J&J had committed to fund LTL's liabilities up to a substantial cap, LTL was not in any meaningful financial distress and therefore did not have a legitimate need for Chapter 11 protection.

J&J refiled the case in April 2023 with a modified funding agreement designed to address the Third Circuit's concerns. The refiling was also dismissed in July 2023 on similar good-faith grounds. J&J attempted a third structure in 2024 through a different subsidiary (Red River Talc), which was likewise dismissed.

After three failed attempts to use Chapter 11, J&J shifted strategy. The company proposed an approximately $8 billion present-value prepackaged consensual bankruptcy through a renamed entity (Red River Talc LLC, the rebranded LTL Management) designed to resolve 99.75% of pending talc ovarian cancer lawsuits with payments totaling approximately $10 billion nominal over 25 years. J&J also proposed a separate $505 million settlement with bankrupt talc suppliers Imerys Talc America and Cyprus Mines Corporation, comprising $225 million initial payment plus $280 million in insurance proceeds. The shift to a fully consensual prepackaged structure with claimant supermajority support represents the post-LTL pathway that mass tort defendants now follow.

The Aearo Technologies/3M earplug litigation followed a parallel but earlier trajectory: the Southern District of Indiana bankruptcy court dismissed the case as a bad-faith filing in June 2023 because Aearo was not in "financial distress." 3M ultimately settled the underlying claims for approximately $6 billion outside bankruptcy in August 2023, six times the amount originally proposed when Aearo filed in July 2022. The combined J&J (~$8B PV Red River Talc plan, rejected April 2025; subsequent tort-system litigation) and 3M ($6B) outcomes capture mass tort liability that was originally targeted for resolution through Texas Two-Step structures and ultimately resolved through alternative channels at premium pricing.

The Texas Two-Step controversy connects to a broader debate over forum shopping in bankruptcy. Companies filing Chapter 11 generally have substantial flexibility in choosing the venue under 28 U.S.C. § 1408, which permits filing in any district where the debtor has its principal place of business, principal assets, or where an affiliated entity has filed. The flexibility historically drove most large filings to either the District of Delaware (where most U.S. public companies are incorporated) or the Southern District of New York.

Beginning in 2020, the Southern District of Texas (SDTX) attracted an increasing share of large filings. By the first half of 2023, nearly 50% of all large commercial bankruptcy cases filed in SDTX. The court built a complex-case panel of judges with deep restructuring experience, and one judge in particular (David R. Jones) handled approximately 17% of all complex bankruptcy cases with over $1 billion in liabilities since 2020.

The forum-shopping dynamic plays out in several ways. Some debtors choose Texas for its perceived speed and predictability. Others choose specific judges within Texas based on prior rulings. Plaintiffs' counsel and tort claimants criticize the dynamic as enabling debtor-friendly outcomes that disadvantage smaller and local parties. The SDNY responded to forum-shopping concerns in 2021 by changing its judge-assignment rules so that mega Chapter 11 cases are randomly assigned among all nine bankruptcy judges regardless of courthouse location.

Several legislative proposals would limit Texas Two-Step structures and reduce forum shopping more broadly. The Bankruptcy Venue Reform Act, introduced in multiple Congresses, would require Chapter 11 cases to be filed in the district where the debtor has had its principal place of business or principal assets for the prior 180 days, eliminating the affiliate-filing pathway that enables most current forum shopping.

The Nondebtor Release Prohibition Act, also introduced in multiple Congresses, would codify the Purdue ruling by statute and explicitly prohibit nonconsensual third-party releases. The act has not been enacted but draws on the same policy concerns.

The Texas Two-Step structure has been substantially curtailed by the Third Circuit's good-faith analysis but has not been completely eliminated. Several smaller Texas Two-Step filings have proceeded through bankruptcy without dismissal, generally in cases where the financial distress of the divisive merger entity is clearer and the funding agreement is less generous. The structure remains theoretically viable but practically constrained.

For mass tort defendants considering bankruptcy, the post-LTL landscape pushes most candidates toward direct out-of-court settlement rather than divisional merger and Chapter 11. The combination of Purdue (no nonconsensual releases) and LTL (bad-faith filing for manufactured distress) closes most of the bankruptcy pathways that previously allowed mass tort defendants to obtain durable liability protection. The result is larger out-of-court settlements paid through traditional channels, with bankruptcy reserved for cases where the underlying entity is genuinely insolvent.

For interview prep, the key data points are: the October 2021 LTL filing, the January 2023 Third Circuit dismissal, the September 2024 Red River Talc Chapter 11 (~$8B PV / $10B nominal over 25 years; plan rejected April 2025), the $6 billion 3M settlement, and the October 2023 Judge Jones resignation. Together they capture the core narrative: an aggressive bankruptcy structure was rejected by the courts, a high-profile judicial scandal undermined the venue most associated with the structure, and the affected defendants ultimately paid to settle the underlying claims directly. The next article in this section drills into the 2026 outlook for the broader restructuring market.