Fraudulent transfers and actions to avoid them are second nature to lawyers for debtors and creditors. While the exact requirements may vary under federal and state laws, a typical example includes a debtor who transfers their interest in some form of property to another party with the actual intention of preventing a creditor from collecting that property. However, as unique as the state itself, a previously rarely used loophole in Texas fraudulent transfer law has come to the forefront of restructuring strategy: the Texas Two Step.
The Texas Two Step, a corporate restructuring strategy involving the conversion of a single business entity into two or more separate entities under Tex. Bus. org. Code § 10.001-008 presents a potentially powerful tool allowing debtor entities to circumvent creditors’ rights on the eve of bankruptcy. By splitting into multiple entities, the original single entity can transfer most of its responsibilities (e.g., mass tort liabilities) to a Texas-domiciled or incorporated entity (BadCo) while transferring the majority of its assets. to a number of other entities (GoodCo). Then BadCo files for bankruptcy seeking to finally take care of those responsibilities while letting GoodCo carry on without worrying. Overall, this whole transaction may look like a mature case of fraudulent transfer, with the originating entity transferring debts and assets in an attempt to prevent creditors from collecting; however, the Texas Two-Step dances on this assumption, believing that when a merger takes effect, all rights, title and interest in the property now belong to BadCo and GoodCo without all the transfer or assignment having taken place legally. Tex. Bus. org. Code § 10.008 (a) (2) (C). Recognizing the potential for this oddity among the state’s fraudulent transfer law, some debtors, most recently including Johnson & Johnson, which faces mass talcum powder tort liability, have started the Texas Two Step to escape their responsibilities by filing bankruptcy only for their Les BadCo who only hold their debts. Unable to question this strategy by seeking to reverse transfers, creditors are left with a question: what can they do?
Fortunately, creditors may still have a few options when dealing with a two-step debtor. Before the merger takes place, a creditor may attempt to stop the machinations of the transaction with a preliminary injunction. However, as at least one court decision, a creditor may face an uphill battle to prove that such a future transaction is more than currently speculative with tangible and current harm.
As a best strategy, once the transaction is complete, a creditor can go through the transaction documents themselves to determine if the debtor has met all of the requirements for a Texas Two Step under Texas law. If the debtor has not met even one requirement, a creditor can attempt to challenge the transaction and have it reversed.
Finally, a creditor can do their own thing, bypass the transaction and seek redress from the shareholders of BadCo or the originating entity by piercing the corporate veil. While this strategy does not allow the creditor to recover against the debtor himself, it does present a chance to pivot into potentially deep pockets of shareholders and / or create pressure for a beneficial settlement.
As the Texas Two Step has only recently started to gain momentum as a new restructuring tool for debtor companies, the full effectiveness of this strategy in bankruptcy court remains a mystery. However, until more clarity is achieved, creditors have the opportunity to defend their rights and collect their legitimate claims against a debtor. With the tools outlined above in hand, creditors can help ensure that they are not left behind in the Texas Two Step and instead are involved in this unique process.