By Dan Levine and Mike Spector

(Reuters) – Legal professional Greg Gordon, a accomplice on the Jones Day legislation agency, provided an progressive answer to Johnson & Johnson (NYSE:) and different main firms that confronted mountains of lawsuits alleging their merchandise sickened or killed individuals: They might use the chapter system to drive all plaintiffs into one settlement.

It required fancy authorized footwork — making a subsidiary to shoulder all of the legal responsibility, then placing that new firm into Chapter 11.

Plaintiffs’ legal professionals attacked the gambit, often known as the “Texas two-step,” charging it amounted to a bad-faith chapter submitting and a fraudulent ploy to defend the father or mother firms’ property. Not so, Gordon advised judges overseeing bankruptcies testing the novel technique. The father or mother companies, he stated, would give these subsidiaries loads of cash — billions of {dollars} — to compensate plaintiffs.

It seems that Gordon’s play to reassure chapter judges created a brand new authorized downside. The third Circuit Court docket of Appeals on Monday stopped the music on J&J’s two-step, ruling that its cash-flush subsidiary had no professional declare to chapter safety as a result of it wasn’t in “monetary misery.”

The ruling forces J&J again into trial courts to battle almost 40,000 lawsuits and casts a cloud over the legality of the Texas two-step technique. The plaintiffs allege J&J’s talc merchandise, together with Child Powder, induced most cancers, which the corporate denies.

The enchantment courtroom judges’ reasoning underscored what some authorized consultants name an inherent contradiction: bankruptcies being executed by multinational companies price billions of {dollars} that have been in little hazard of operating out of cash to pay plaintiff-creditors. The panel dismissed the principle argument underpinning Gordon’s and the businesses’ major protection of the technique. The businesses had contended the bankruptcies served the better good of all events, together with plaintiffs, by delivering honest payouts extra effectively and equitably than the “lottery” provided by trial courts.

The choice rejected “the concept that a worthwhile firm can drive personal-injury claimants out of jury trials, and right into a chapter courtroom, merely by arguing that doing so is extra environment friendly than the civil justice system,” stated Melissa Jacoby, a professor at College of North Carolina College of Legislation with experience in chapter legislation.

Gordon and Jones Day didn’t reply to requests for remark. A lawyer for Johnson & Johnson’s subsidiary stated in an announcement that the corporate would search a rehearing of the panel’s resolution by the complete third Circuit courtroom. The lawyer, Neal Katyal, stated the potential value of preventing the lawsuits justified the chapter submitting.

Reuters final 12 months detailed the key planning of Texas two-steps by Johnson & Johnson and different main companies in a collection of stories exploring company makes an attempt to evade lawsuits by way of bankruptcies.

The judges’ reasoning on J&J, as a precedent, heightens the authorized hurdles for firms pursuing the novel technique. The ruling might depart two-stepping companies caught between the conflicting calls for of chapter courts and the appeals courts which can be prone to hear extra challenges to the tactic.

Chapter judges, for his or her half, are loath to approve any transfer that blocks collectors from tapping debtor property. Their courts crack down on companies that attempt, as an illustration, to defend cash by transferring it out of firm accounts earlier than submitting for Chapter 11, often known as a fraudulent switch of property. Plaintiffs opposing two-step bankruptcies have alleged the tactic quantities to a inventive fraudulent switch as a result of it shields the agency being sued by shifting its liabilities to a brand new shell firm.

Gordon stated at a chapter attorneys’ convention final April that J&J and three different companies making an attempt two-steps countered such considerations by agreeing to “limitless” funding of their subsidiaries. The brand new models had ample money to pay claims, the reasoning went, so fraud couldn’t probably be the intent.

“We don’t even need to have an argument” about fraudulent transfers, Gordon stated.

Gordon’s technique labored in chapter courtroom however arrange J&J for failure when it confronted the third Circuit appeals panel. J&J’s assertions that it generously financed its subsidiary, LTL Administration, undercut any declare of monetary peril, the judges dominated.

“We take J&J and LTL at their phrase and agree” that the subsidiary had loads of cash, wrote Circuit Decide Thomas Ambro, explaining why LTL didn’t qualify for chapter. The choose famous that J&J’s promise of limitless funding was primarily an “ATM” for the subsidiary, insulating it from “any risk to its monetary viability.”

50 YEARS OF LITIGATION?

Johnson & Johnson now finds itself dealing with the identical mountain of litigation that prompted its chapter gambit.

Gordon, on the chapter convention, described the lawsuits as “fully unmanageable” and a dire risk to J&J that would go on for many years. The corporate’s prices of verdicts, settlements and authorized charges soared to about $4.5 billion in 5 years, he stated.

“How do you litigate 40,000 circumstances? How do you take care of the actual fact you’re getting 10,000 extra per 12 months, and so they’re anticipated to proceed for the following 50 years?” Gordon requested. “What do you do about that as an organization, irrespective of how huge you might be?”

Johnson & Johnson, with a market capitalization of greater than $400 billion, argues that the avalanche of lawsuits posed a severe monetary risk. “The present state of affairs, with a big quantity of present and future claims, and a plaintiff bar enterprise mannequin primed to generate extra, is precisely the kind of ongoing and future monetary misery that courts have acknowledged as serving a sound chapter objective,” Katyal, the lawyer for J&J’s subsidiary, stated in an announcement to Reuters.

J&J faces a steep problem in in search of to overturn the chapter dismissal, two authorized consultants stated. The total third Circuit is unlikely to reverse Decide Ambro as a result of he’s an skilled in chapter legislation, stated Jacoby, the College of North Carolina legislation professor. And the U.S. Supreme Court docket usually intervenes solely when there are conflicting selections amongst courts of enchantment, stated Lindsey Simon, a College of Georgia College of Legislation professor.

The third Circuit is the one appeals courtroom that has weighed in thus far, however different circuits might quickly take up challenges to comparable chapter filings.

‘CREATIVE LAWYERS’

Along with J&J, 4 different companies have pursued subsidiary bankruptcies geared toward halting dangerous-product lawsuits. Three of the companies executed Texas two-steps, with the assistance of Gordon and Jones Day: international development big Saint-Gobain and producers Georgia-Pacific and Trane Applied sciences (NYSE:). (The technique will get its identify from the Texas legislation used to divide the corporate being sued into two, creating the subsidiary that absorbs legal responsibility.) 3M Co executed an analogous chapter maneuver to hunt refuge from about 290,000 claims over allegedly faulty army earplugs.

Saint-Gobain, Trane Applied sciences and 3M declined to remark. Georgia-Pacific didn’t reply to inquiries.

The third Circuit ruling doesn’t instantly have an effect on these circumstances, however different courts might quickly weigh in. The seventh Circuit Court docket of Appeals is anticipated to listen to arguments in coming months on a problem to the 3M subsidiary’s chapter. As an alternative of making an organization, as in a Texas two-step, 3M assigned its lawsuits to an current subsidiary. The targets have been the identical: To halt the lawsuits and drive plaintiffs right into a chapter settlement.

An Indiana chapter choose final 12 months, nonetheless, broke with typical apply by permitting the lawsuits to proceed in opposition to 3M whilst its subsidiary’s Chapter 11 case continued, primarily defeating the purpose of 3M’s maneuver.

If the seventh Circuit sides with 3M and points an opinion contradicting the third Circuit resolution, it might increase the possibilities of a Supreme Court docket intervention. If 3M loses, it might strengthen case legislation in opposition to such chapter gambits and additional discourage firms from pursuing them.

A problem to the Georgia-Pacific Texas two-step, in the meantime, is continuing within the 4th Circuit. After a North Carolina choose rejected a plaintiffs’ problem alleging the chapter was filed in dangerous religion, plaintiffs’ attorneys made a special argument — one echoing the 3M case. The litigation, they asserted, ought to be allowed to proceed in opposition to Georgia-Pacific as a result of the father or mother firm didn’t file for chapter. That subject is now pending earlier than the 4th Circuit appeals courtroom.

The third Circuit panel famous it didn’t intend to outlaw the Texas two-step outright. Decide Ambro went out of his strategy to reward legal professionals corresponding to Gordon for “being ingenious” and “experimenting with novel options.”

Nonetheless, the authorized guard rails in Ambro’s ruling will make it rather more troublesome for firms to execute Gordon’s playbook, stated David Molton, a Brown Rudnick LLP lawyer representing talc plaintiffs who challenged the J&J tactic.

Ambro put “fairly agency gates” on chapter techniques geared toward halting defective-product litigation, Molton stated. “What Decide Ambro did say is: ‘I’m not right here to put off inventive legal professionals, however I’m right here to inform you when that inventive lawyering goes outdoors the bounds, I’m going to place a cease to it,” Molton stated.