Welcome to the 163rd Pari Passu newsletter.

In recent years, we’ve seen a surge of creative restructuring tools emerge as companies and creditors work to manage liabilities. Most notably, out-of-court solutions like double and triple dips as well as hunter-gatherer LMTs show just how far dealmakers are willing to push structural innovation to maximize recoveries and sidestep traditional creditor protections.

Today, we will be looking at an in-court example of another creative restructuring tool: the Texas Two-Step, a relatively new and controversial strategy designed to isolate mass tort liabilities through a divisional merger and a targeted Chapter 11 filing.

Originally founded as Prison Health Services in 1978, Corizon Health (Corizon) had been one of the largest players in the US prison healthcare industry for over four decades. At its peak, the company served nearly 500 facilities in 27 states [3].  

Corizon Health was formed from Valitas Health Service’s acquisition of American Service Group (ASG) for $250mm in 2011. Based in Minnesota, Valitas was the parent company of Correctional Medical Services, a provider of medical solutions in American correctional facilities located in Tennessee, ASG was also a prominent player in the correctional healthcare services industry. The resulting entity, Corizon, quickly emerged as one of the largest for-profit care providers in the prison system. Corizon combined the geographic coverage and operational expertise of both entities to offer dental, medical, behavioral, and mental health services to American correctional facilities. Corizon also provided pharmacy care through PharmaCorr, an institutional pharmacy provider. The company had over 10,000 employees and serviced more than 400 facilities at the time of the merger, generating annual revenues of around $1.4bn in 2011 [1]. 

During its lifetime, the company has undergone multiple changes in private ownership since the mid-2000s. Corizon’s history began in 2007, when private equity firm Beecken Petty O’Keefe & Company (BPOC) acquired Valitas, the Minnesota-based parent of Correctional Medical Services. Valitas subsequently acquired Tennessee-based America Service Group (ASG, also a prison healthcare company) in June 2011, and the combined entity became Corizon [1]. In 2017, alternative asset management firm Assured Investment Management (formerly BlueMountain Capital Management at the time of the transaction) acquired a majority stake in Corizon and executed a recapitalization that significantly reduced the company’s $300mm of debt [2]. By 2018, Corizon became the largest for-profit correctional healthcare provider, catering to around 15% of inmates nationwide [3]. In June 2020, Corizon was sold to Flacks Group, an investment firm focused on special situations. At the time of the Flacks acquisition (acquisition price not disclosed), Corizon had been generating annual revenues of $800mm and employed 5,000 employees [4] [6]. 

Corizon operated under its original name until May 2022, when the company underwent a divisional merger that resulted in two distinct legal entities. We will explain this complex legal process later, but for now, it’s important to remember the two entities born out of the merger: Tehum Care Services (which was assigned the majority of Corizon’s outstanding liabilities and service provider contracts) and YesCare (which was given most of Corizon’s assets, employees, and client contracts). 

Healthcare in correctional facilities was not widespread until the 1980s, following a 1976 Supreme Court ruling that deliberately ignoring an inmate’s health was a violation of the Eighth Amendment. Since then, prison private health services have grown to a $4bn industry, with healthcare expenses now ranking as the second largest expense for correctional facilities following personnel costs (salaries, overtime, and benefits for correctional officers) [27]. To manage these high costs, over 60% of America’s correctional facilities outsource their healthcare services to private companies. This trend has emerged for two key reasons: the perception that private healthcare is cheaper, and the ability to offshore potential legal and medical liabilities to third parties [5]. 

To understand how private healthcare providers like Corizon generate profit, it’s necessary to first look at how contracts are structured. Healthcare contracts between healthcare providers and state / local governments are usually won through a competitive bidding process, where the government will select the company with the lowest cost. Many correctional healthcare contracts (including that of Corizon’s) are structured around fixed per diem payments, meaning that agreements are not tied to health outcomes or service quality, just the number of inmates covered [5]. Corizon also vertically integrated its pharmacy services, PharmaCorr, to further increase profits. 

Corizon’s contracts specifically allocate around 75% of total costs to fixed expenses, consisting of administrative overhead and labor fees. This means that the majority of these contracts don’t need to cater to specific patient needs, and any portion of the budget not spent on care translates directly into profit for the private provider [7]. For example, from 2011 to 2012, Corizon cut annual healthcare costs for one of its Oklahoma facilities from $1.3mm to $600k by sending fewer inmates for care [6]. This reduction resulted in a direct margin expansion for Corizon, with jail profit margin rising from 15% in 2011 to over 20% in 2012 and 25% in 2013 [6]. In practice, it is evident how contracts like these provide very little incentive for providers to deliver more comprehensive care, especially when dollars invested have a direct negative impact on net income.

Very little public information is accessible regarding Corizon’s financial history. However, there are a few progressions that were available: in 2011, the company was generating $1.4bn in revenue[1]. Over the next few years, the company saw steady growth; from 2012 to 2015, revenues grew by around 15%, reaching $1.6bn in 2015 [8]. 

These profits were primarily driven by the cost cutting measures we just discussed as well as the company’s contract expansion during the 2010s, leading to a period of financial stability and profitability. 

While the period from 2011 to 2015 was largely healthy for Corizon, it did not come without legal disputes; between 2012 and 2017, the company was sued nearly 700 times for medical malpractice [3]. However, it wasn’t until 2015 onward that the legal challenges began to materially impact Corizon’s profitability and ability to maintain key contracts. Below is a timeline of major legal challenges and losses of prominent contracts before the company’s filing in 2023: 

2015: In California’s largest wrongful death civil rights case settlement, Corizon paid an $8mm settlement to the family of an inmate who was not given adequate treatment for alcohol withdrawal [8]. In the same year, Corizon also lost two of its largest contracts. In Florida, the state’s Department of Corrections terminated its five-year contract with Corizon early, cutting off a source of $230mm annual revenue [9]. In New York City, Corizon lost one of its largest contracts after 15 years of service when the city chose to end its three-year, $125mm contract for Corizon to provide healthcare at the Rikers Island jail complex. This decision followed multiple patient deaths under Corizon’s negligent care [10] [11]. 

2016: Corizon lost its contract with the New Mexico Department of Corrections, which had been under scrutiny after many inmates accused a Corizon doctor of sexual abuse; Corizon paid over $4.5mm in settlements related to these claims [12]. Alameda County in California terminated its three-year, $135mm contract with Corizon following public criticism over inadequate care and inmate deaths in county jails [13]. Corizon also lost its $5mm contract with Chatham County in Georgia, ending a 20-year period of service after facing preventable deaths [14].

2017: Corizon lost its $100mm annual contract with the Indiana Department of Corrections and laid off 700 employees [15]. In the same year, the company also agreed to a $2mm settlement in a class action lawsuit involving nearly 2,000 Florida inmates who were denied adequate medical treatment for hernias. 

2018: Corizon paid some of its most costly legal settlements to date in 2018. First, Corizon reached a nearly $4mm settlement with the family of a Colorado inmate who died from complications related to opioid withdrawal; this death was preventable with standard medical care [16]. Next, Corizon paid $10mm to the family of a female inmate in Oregon who died during detox after being denied proper treatment. This was Corizon’s largest known individual settlement [17]. In addition to mounting legal exposure, an audit by the Kansas Department of Corrections revealed a 20% staffing vacancy rate in Corizon-operated prisons, meaning that one in five positions were left unfilled, further compromising the quality and timeliness of care. This understaffing led to $6.5mm in fines from the state between 2015 and 2018 [18]. 

2019: Corizon lost its nearly $200mm annual contract with the Arizona Department of Corrections, ending its service as the state’s private healthcare provider after years of sub-quality care [6].

2020: The Kansas Department of Corrections terminates its $70mm contract with Corizon following performance and staffing shortfalls highlighted in 2018 [20] [21]. 

2021: Corizon lost a $1.4bn bid to contract for the Missouri State Department of Corrections [21]. 

As a result of increasing legal challenges and substandard care, Corizon lost more than 25 contracts and had been fined millions in fees by multiple Departments of Corrections, including penalties for understaffing and unpaid medical bills to hospitals and supply providers [19]. These lost contracts contributed to a revenue decrease from $1.6bn in 2015 to $800mm in 2020 and caused the number of facilities serviced by Corizon drop to around 150 by the time it was acquired by Flacks Group in June 2020, compared to the 400 facilities the company held in 2011 [3] [6]. 

Before we dive into Corizon’s move to Texas in 2022 to execute its Texas Two-Step strategy in bankruptcy court, let’s take some time to review what the Texas Two-Step is and how it is executed. As its name suggests, this strategy involves two steps [22]:

While divisional mergers can be executed in other states, Texas’s divisional merger laws are more flexible in that they allow a broader range of entity types (like LLCs, corporations, and partnerships) to go through with the merger. In comparison, states like Delaware only allow LLCs, not corporations, to do this. The Texas law also allows the company to split into one or more entities while allocating assets and liabilities freely without automatically triggering default provisions, like a fraudulent transfer. However, this doesn’t mean that all Texas Two-Steps are immune to fraudulent transfer claims; the transaction can still be unwound if the court finds that the merger was made with ill intent. As a quick reminder, a fraudulent transfer is a transaction made by a debtor with intentions to defraud creditors [30].

The Texas merger law was never intended to be used as a liability management tool [30], but was leveraged by lawyers at Jones Day in 2017, who invented the Texas Two-Step while working with Georgia-Pacific (a subsidiary of Koch Industries) to manage the company’s over 60,000 asbestos-related lawsuits. GP took advantage of Texas’s divisional merger law to split into two entities: New GP, which kept the operating business, and Bestwall LLC, which was assigned the tort asbestos claims and filed for Chapter 11. At the inception of this strategy, proponents of the Texas Two-Step argued that this was the fairest way for claimants to receive compensation; the alternative was suing for damages in civil court, where claimants would be served on a first-come first-served basis, unfairly benefiting those who filed before others [29].   

The reason why the Texas Two-Step is often used to deal with mass tort claims is that it allows companies to isolate overwhelming legal liabilities into a separate entity, halt any litigation through the bankruptcy process, and negotiate settlements without placing the operating business at risk. 

While it may seem like a cop-out for the liability entity to house all lawsuits, there are some legal and financial mechanisms that give this structure substance. The liability shell company does not generate revenue or hold financial assets, so it is given a funding agreement. A funding agreement is a legal contract that requires the company’s former parent, original company pre-merger, or the new operating entity to pay for certain claims that the shell company cannot. This contract guarantees a minimum amount of funds that will be available for victims and often also sets a cap based on the value of the new operating entity. This is important because, in bankruptcy, the filing entity has to demonstrate access to sufficient funds to support its reorganization plan; the liability entity can thus point to its funding agreement to argue that it has enough resources to fairly compensate claimants / creditors. After filing, the funding agreement (a legal contract to cover claims) also becomes part of the bankruptcy estate, meaning the court can compel payment under it like any other asset [22]. 

To understand how this works in practice, let’s take a look at a quick example:

Suppose we have PharmaABC, a company that develops and manufactures drugs. Let’s say that PharmaABC generates $1bn in annual revenue and $80mm in profits, giving it a valuation of $800mm based on a 10x multiple. Due to years of litigation over one of its products, it faces $5bn in potential tort liabilities related to alleged patient harm. Recall that companies do not have to be insolvent to file for bankruptcy; this will be an important detail to remember when we look at Corizon’s bankruptcy. 

PharmaABC reincorporates in Texas and executes a divisive merger, creating two new entities: HealthCo, which retains all operations and assets, and LiabCo, which is assigned the $5bn in legal claims. PharmaABC, the original company, ceases to exist. As part of this setup, LiabCo establishes a privately negotiated funding agreement with HealthCo since this process occurs outside of bankruptcy court. This agreement guarantees HealthCo will fund tort claims up to an amount between the range of an $800mm minimum (equal to PharmaABC’s estimated value before the merger) and a cap of $1.2bn; this range is determined out of court and is based on the approximate value of HealthCo as well as negotiations with creditors, the latter of which prevents the upper bound from being as low as possible. Additionally, the lower bound is a minimum on obligation, not a fixed amount that HealthCo must pay in a lump sum to LiabCo. LiabCo then files for Chapter 11 bankruptcy, and all tort claims are paused under the automatic stay. 

In court, LiabCo argues that while it has no operating revenue, it has access to a legally enforceable funding agreement capped at $1.2bn, which, recall from above, is based on the value of HealthCo and the negotiated cap value. However, this cap limits the maximum recovery pool for creditors, meaning that claimants may recover less regardless of the total value of their claims or the original company’s full asset base. Meanwhile, HealthCo continues to operate with no interruptions and is shielded from tort claims liability following the merger.