IBBI Moots Voluntary Mediation by Operational Creditors at Pre-filing Stage

[Aryan and Sakshi are students at Symbiosis Law School Pune.]

On 4 November 2024, the Insolvency and Bankruptcy Board of India (IBBI) issued a discussion paper (Paper) suggesting that operational creditors (OCs) could explore mediation before filing insolvency applications under Section 9 of the Insolvency and Bankruptcy Code 2016 (Code). As part of this Paper, the IBBI has also presented a draft of the IBBI (Insolvency Resolution Process for Corporate Persons) (Third Amendment) Regulations 2024, whereby the OCs can undergo voluntary mediation, as per the Mediation Act 2023, prior to filing a Section 9 application. In case the mediation fails, the mediator will annex a non-settlement report (NSR) to the application for initiation of the corporate insolvency resolution process (CIRP).

Ex-facie, this proposal seems promising in that it uses an effective tool like mediation to ensure party-centric solutions without involving the overburdened Adjudicating Authority (AA). However, integrating mediation in specialized matters like insolvency necessitates carefully devising solutions, wherein the key objects of the Code remain undisturbed. 

In this post, the authors seek to answer three questions: (a) Is pre-filing mediation suitable? (b) Is pre-filing mediation more suitable for operational or financial creditors? (c) Should pre-filing mediation be made voluntary or mandatory?

Pre-filing Mediation: Suitable or Not?

Aligns with objectives of the Code 

Mediation is a private/confidential process that aids parties in arriving at a mutually beneficial settlement within a specific timeframe. In this regard, multiple objectives of the Code seem to be met. First, unlike insolvency litigation wherein the corporate debtor (CD) gets stigmatized, mediation—being a confidential process—ensures that market reputation and investor confidence in the CD remains undeterred, thereby protecting the CD’s interests while yielding a favorable outcome for the creditor. Second, being a time-sensitive process, mediation helps crystallize a mutually beneficial settlement within a strict timeline, preventing asset value erosion and steep creditor haircuts.

As per the Economic Survey of India (2024-25), conclusion of CIRP takes an average of 582 days—excluding time taken for application admission and time excluded by the AA—against the stipulated 330-day outer limit. When the CIRP is plagued by delays caused by the promoters or dissenting creditors, the value of the CD erodes to the extent where creditors incur steep haircuts—averaging 73% in FY24—or the CD is pushed into liquidation, as evidenced by 45% of such cases resulting in liquidation during the same period. Thus, pre-filing mediation helps parties to arrive at a mutually beneficial settlement with better efficiency compared to CIRP, which remains open in the event mediation fails. 

In-Personam nature 

Before the insolvency application is admitted by the AA, CIRP carries an in-personam nature, involving only the creditor who filed the application and the CD. At this stage, it is a private matter between two parties, and no third-party is involved. However, once the insolvency application is admitted, the nature of the proceedings becomes in-rem. In in-rem proceedings, rights and interests of all stakeholders—including other financial and operational creditors— must be considered. It thus becomes a collective proceeding, aimed at resolving the overall insolvency of the CD, not just the individual claim of the applicant creditor. 

By virtue of involving fewer parties, pre-filing mediation is less complex and time-saving, facilitating a mutually agreeable settlement. Moreover, privately mediated pre-admission mediated settlement agreements (MSA), unlike post-admission ones, will not be subject to multiple litigations and objections raised by third-party right-holders.  

Applicability of the Mediation Act 2023

The pre-filing stage of CIRP falls outside the scope of the Code because no application of “default” is filed at this stage. Since no application is filed, the insolvency proceedings do not commence, and thus, the AA has no role to play.  Thus, unlike the subsequent stages of CIRP, the discussion paper notes that this stage falls under the Mediation Act 2023. 

By virtue of falling under the ambit of the Mediation Act 2023, pre-filing mediation must be voluntary and confidential as highlighted in Sections 5 and 22, respectively. Moreover, the MSA remains final and binding on the parties, with no scope for future challenge. This allows both parties to privately settle the matter with a mutually beneficial binding outcome. 

Pre-filing Mediation: Suitable for Operational or Financial Creditors (FCs)?

The Code, under Chapter I, recognizes two types of creditors: FCs and OCs. Paragraph 5.2.1 of the Report of the Bankruptcy Law Reforms Committee aptly distinguishes between them, stating, “FCs are individuals or entities whose connection to the organization is solely based on a financial agreement, like a loan or debt instrument. OCs, on the other hand, are those whose claims against the entity arise from operational transactions.” 

The Paper rightly highlights that most OC-CD disputes are contractual and can be resolved without involving the AA. Moreover, unlike FCs—who are interested in the insolvency resolution of the CD—OCs primarily seek debt repayment, not restructuring.

But, why this difference?

This difference in the underlying intent stems from the pro-FC design of the Code. While the FCs have representation on the committee of creditors (CoC) and higher priority as per the waterfall distribution, OCs lack CoC representation and are among the residual recipients in liquidation. With inadequate representation on the CoC and low-rung priority in liquidation, often face significantly higher haircuts compared to FCs, which severely undermines their ability to recover claims.

In fact, a recent study conducted by EY in collaboration with Chandiok & Mahajan revealed that the median recovery of claims for OCs is as low as 6%. To add fuel to the fire, the 2020 Amendment, which raised the default threshold to Rs. 1 crore for filing insolvency applications, further disadvantages OCs. Unlike FCs, they cannot file joint applications, leaving smaller OCs with limited recourse. 

Thus, the impression one gets is that insolvency resolution is neither an OC’s objective nor within their control. In which case, pre-filing mediation offers OCs a faster and more efficient path to settle contractual issues before resorting to formal insolvency proceedings. 

The Report of the Expert Committee, constituted to study adoption of mediation in insolvency, suggests that Rule 5 of the IBBI (Application to AA) Rules 2016 (AA Rules) be amended to allow the OCs to opt for mediation before filing a Section 9 application. This stands to reason because, in the 10-day window under Section 8 of the Code, the CD is required to repay the debt or notify a dispute in response to the demand notice sent by the OC. 

Now, if the CD fails to repay or respond, the OC can first pursue mediation before approaching the AA. If successful, both parties will save time and cost. If it fails, the mediator’s NSR helps approach the AA for initiating insolvency proceedings. However, if a settlement were to crystallize post-institution but pre-admission, the AA can confirm the settlement and withdraw the CIRP, under powers conferred by Rule 8 of the AA Rules. Hence, the OC is uniquely placed to settle with the debtor before the admission of CIRP. 

Pre-filing Mediation: Mandatory or Voluntary?

One of the key principles of mediation is voluntariness and the absence of coercion. 

While voluntary mediation helps parties to settle of their own accord and opt out if mediation is unsuitable, mandatory mediation—though seemingly antithetical to the principles of mediation—helps prevent frivolous matters from occupying the precious time of the already overburdened AA. 

So, what is the correct approach?

To answer this question, we must consider the poor experience with mandatory pre-institution mediation under the Commercial Courts Act 2015. A recent working paper issued by the Economic Advisory Council revealed that between 2020 and 2022, 31% of total mediation applications were pending for more than the statutory period of three months, and 96-98% of disposed cases involved parties refusing to participate. Based on this evidence, the working paper concluded that pre-institution mediation has become a mere formality, with parties simply waiting out the mandatory period before pursuing litigation. 

Another reason for the failure of pre-institution mediation is the lack of infrastructure—without sufficient institutions and empaneled mediators, the mediation ecosystem suffers from the same delays and inefficiencies as litigation. Mandating mediation without adequate infrastructure forces parties into an ineffective process, leaving them worse off. 

In time-sensitive matters like insolvency, mandatory pre-institution mediation can cause unnecessary delays and wastage of resources. Thus, it is reasonable to conclude that voluntary pre-filing mediation is better suited for insolvency.

Recommendations  

Pre-default mediation mechanism

It is essential for the Code to adopt a proactive approach towards resolving disputes by incorporating a mechanism for early detection of financial distress. Businesses facing short-term financial imbalances (up to 15 days) may voluntarily enter mediation with creditors, which remains confidential and free from judicial intervention. Such mediation can address unliquidated claims, single-creditor disputes, plan mediation for restructuring deadlocks, and group mediation for intra-group claims. If the financial distress continues beyond 45 days, court-assisted mediation may be initiated upon any creditor’s application. A panel comprising a judge, a lawyer with relevant expertise, and a financial consultant may be constituted to advise on restructuring measures, including super-priority loans and debt-restructuring. Both these stages are triggered at the possibility of a corporate default. However, if the imbalance persists beyond 45 days, time-bound mediation ensues for a maximum of 4 months, with a possible two-month extension under the Commercial Courts Act 2015. Finally, a restructuring plan (RP) should be submitted to the AA after receiving approval from 66% of the CoC. As prerequisite, the RP must offer a higher recovery rate than traditional CIRP proceedings and comply with Sections 30 and 31 of the Code for RP approval. 

Reconciling a discrepancy  

Draft Regulation 2BA of the IBBI (CIRP) Regulations 2016 enables an OC to undergo mediation for resolving commercial disputes under the Mediation Act 2023. However, Mediation Act 2023 defines “commercial disputes” by reference to the Commercial Courts Act 2015, which excludes insolvency matters. To address this inconsistency, the authors recommend removing the term “commercial” from the current text of the regulation to ensure the applicability of the Mediation Act 2023 to insolvency-related mediations.

Way Forward 

The proposal, if accepted, will provide a fillip to exploring mediation in other aspects of insolvency. While insolvency mediation is an intricate issue, proactive proposals will facilitate stakeholder dialogue and aid in resolving inconsistencies.