Legal problems are not new for Johnson & Johnson (JNJ -1.10%). In both 2020 and 2019, the company spent more than $5 billion in litigation-related expenses. But with deep pockets, Johnson & Johnson was able to absorb those costs. Arguably, its most pressing legal issue today is related to its talc liabilities.
However, the company appears to have dodged a bullet here as well by deploying a controversial move to limit its potential liability. But in doing so, it may have created a dangerous precedent for other healthcare companies to follow suit if they get in trouble. And that could make investing in the industry even riskier than it already is.
Image source: Getty Images.
Just how big was the potential liability?
Johnson & Johnson could have very well paid out billions upon billions in payouts to people who claimed they contracted cancer from using the company's baby powder products that contained talc. In 2018, a jury in Missouri awarded 22 women a total of $4.6 billion in a joint lawsuit, but an appeals court would eventually reduce that amount to $2.1 billion. That averages out to an award of $95 million per person.
Given that the number of lawsuits related to talc are now around 38,000 (and that figure is likely to rise in the future as more people get sick), it's easy to see how litigation could potentially destroy the business. While Johnson & Johnson is big, it isn't invincible; in 2021, its net earnings were $20.9 billion and its current assets totaled $61 billion.
Even if those 38,000 lawsuits averaged a settlement of just $9.5 million (10% of that earlier average), that could result in a staggering $361 billion in awards -- without even factoring in other legal fees. That's almost as big as the company's market cap, which is approximately $460 billion.
However, it can be difficult (if not impossible) to estimate how many of those lawsuits would get thrown out and how many might result in just nominal fees. And there's significant leeway for the company to be able to avoid reporting such a significant liability, and thus, warning investors. Johnson & Johnson discloses on its latest annual report that it "records accruals for loss contingencies associated with legal matters, including talc, when it is probable that a liability will be incurred and the amount of the loss can be reasonably estimated."
Given how many lawsuits it's facing, investors couldn't have expected the company to reasonably estimate how much its liabilities may total. But either way, there's little doubt that Johnson & Johnson likely would have been facing tens if not hundreds of billions of dollars worth of expenses from these cases.
Texas two-step bankruptcy to the rescue
Johnson & Johnson has found a way to limit its losses by putting its talc liabilities in a new company, LTL Management, and then bankrupting it. The move is legal under Texas law, referred to as the "Texas two-step." While the plaintiffs have protested against its use, a federal judge in February allowed the company to proceed with it. Doing this prevents the possibility that Johnson & Johnson incurs an insurmountable amount of legal fees.
Steven Wolens (former legislative member), who wrote the bill decades ago, which was designed to help companies divide their assets and liabilities, said it was never intended for such use. He adds, "Had we known in 1989 that provisions could be dubiously interpreted for entities to avoid known liabilities, such as those causing severe and permanent injuries and deaths, it would never have passed with the Texas two-step provision."
Investors could face more risk if other companies follow suit
With the courts appearing to side with Johnson & Johnson, the path looks to be clear for the company to evade the responsibility it would have otherwise had to face. For healthcare investors as a whole, this has the potential to set a dangerous precedent in an already risky industry where volatile stocks can live or die by the success or failure of a single product.
Perhaps the best example of that is the biotech company Biogen. When its Alzheimer's treatment, Aduhelm, obtained accelerated approval from the Food and Drug Administration (FDA) last year, its shares soared to a high of $468.55 the following day -- 64% higher than the previous day's close. But amid controversy about the drug's effectiveness, the stock has now plummeted to less than half of that value.
Ocugen is another example of a stock that's taken investors on a roller-coaster ride. Hopes for its COVID-19 vaccine have faded with the FDA recently declining to grant it Emergency Use Authorization for pediatric use. What was once a promising growth stock is down 48% in just six months. Moderna, meanwhile, which was a relatively unknown healthcare company before the pandemic began, has soared more than 800% since 2020, all thanks to its successful COVID-19 vaccine.
By allowing the Texas two-step to be deployed, companies wanting to be the next Moderna could see this as a way to take on more risk for the sake of rolling the dice and winning big on a new drug or product. There's no way to tell today what might be the next success story versus a colossal failure. And by giving companies a potential path to take on more risk, the danger could rise exponentially for investors.
A Reuters report previously uncovered documents that showed Johnson & Johnson knew for decades that its baby powder products occasionally contained asbestos. However, the company did not report the findings to regulators or the public and the courts seemingly believe the company hasn't acted in bad faith, which could be concerning to stakeholders.
Not only do the victims of Johnson & Johnson's talc products lose in this ruling, but so might investors, as it could pave the way for businesses to take on unscrupulous activities that focus on profits over quality and safety, ultimately making investments riskier in the process.
