Beyond the Court: Mediation in Restructuring and Insolvency Cases

Beyond the Court: Mediation in Restructuring and Insolvency Cases

(Closing keynote address delivered at the SGRI Conference 2024)

By Hon. Robert D. Drain, US Bankruptcy Judge, S.D.N.Y. (ret), Of Counsel, Skadden, New York

Thank you for the opportunity to address SGRI’s second conference.  The SGRI is yet another example of Singapore’s leadership in the law and practice of business reorganization and insolvency, and it’s an honor to speak with you.

I’ve been an insolvency practitioner since 1984, including over 20 years as a bankruptcy judge in the U.S. Bankruptcy Court for the Southern District of New York.

I’ve learned this lesson, which, like all important lessons, is deceptively simple: the causes and effects of financial distress are so many, and the problems that such distress creates so varied – reflecting the great range of our capacity for success and failure, as well as the number of parties often affected by incidents of financial distress -- that they cannot be addressed just in the confines of the courtroom. Indeed, most often they should be addressed elsewhere, in negotiation, with, of course, the backdrop of potential litigation if that turns out to be the best alternative to a negotiated agreement. In other words, usually a mediocre, yet tailored, settlement is better than the chance for a good judgment, or even than a good judgment itself.

One might respond, isn’t bankruptcy by its nature the end of negotiation -- even of appeals to mercy – the failed trader’s bench broken in the marketplace? To this sophisticated audience, in contrast to much of the public who view financial distress as something to be punished unless it is their own distress, I expect the answer is clear. With the exception that one would rarely, if ever, negotiate with a fraudster, exploring business and legal solutions out of court almost always enhances value, even if insolvency proceedings may best implement the chosen solution.

This includes liquidations. Witness perhaps the largest business failure in modern times, the collapse and liquidation of Lehman Brothers, whose plan of liquidation was carefully negotiated to create a bespoke liquidation framework and which included the resolution of hundreds of complex disputes by tailored “settlement-before-litigation” procedures.

Perhaps more controversial -- at least less often considered and much less often rigorously analyzed in the context of financial distress -- is whether and, if so, to what extent, an alternative dispute resolution superstructure is warranted? A panel at this conference has already discussed whether and how arbitration might resolve insolvency-related disputes, which leaves for me consideration of formal mediation as an alternative to insolvency litigation, on the one hand, and ad hoc negotiation, on the other.

The term “mediation” is well defined by Ken Feinberg, a superior mediator, as “a cooperative process in which the parties themselves fashion a mutually acceptable resolution of their dispute with the help of a neutral third party.”[1] Fundamentally it is voluntary – there is no requirement to settle -- and it is essential that the parties trust the mediator as a neutral facilitator.

Within the basic construct of a consensual process facilitated by a neutral person, mediation (a term that I use interchangeably with “conciliation,” although some view conciliation as requiring a formal proposal by the neutral) encompasses various styles and techniques, sometimes employed by the same mediator, as well as varying degrees of structure and levels of pressure to achieve agreement.

In the context of financial distress, mediation can be used to try to resolve discrete, or “X vs. Y” disputes, such as objections to claims or litigation to avoid allegedly preferential or fraudulent transfers, and, in addition, multi-party, or “plan” disputes, such as over the determination and allocation of value throughout the capital structure or the settlement of major litigation the form of which may affect the ultimate plan and thus multiple parties beyond the parties to the immediate dispute.

Mediation can be used before the commencement of insolvency proceedings, in the early stages of insolvency proceedings, or later in the proceedings as factual developments give the parties and mediator a better context within which to negotiate. And it can be tried more than once (although a mediator should not suggest that to the parties).

Mediation can also be incorporated in a plan as part of a process to address the subsequent liquidation of claims against, or the pursuit of claims by, the debtor’s estate.

In sum, beyond the two basic requirements that mediation is voluntary and the mediator is a neutral facilitator at the parties’ service, mediation is highly flexible.

Over the last 25 years, mediation in all the foregoing forms has become commonplace in the realm of financial distress in the U.S., except for mediation in out-of-court, pre-bankruptcy workouts. Interestingly, during the last decade European states such as France, Spain, and Portugal incorporated mediation in their law in just that pre-insolvency proceeding context,[2] and Brazil now recognizes mediation not only in advance of judicial reorganization, with the prospect of an accompanying temporary injunction of enforcement, but also during reorganization/insolvency court processes.[3]

The right time for and extent of mediation in distressed situations, as with most questions raised by the relatively recent development of mediation in the context of financial distress, is largely a matter of logic and anecdote: I am not aware of rigorous surveys regarding the use of mediation in financial distress except for a test program by the District Court of Amsterdam.[4] I expect, though, that because much of the world’s use of mediation in insolvency and pre-insolvency contexts is still, in the words of Professor Bob Wessels (albeit some years ago when speaking just of the EU), “in its infant’s shoes,”[5] mediation will increasingly be employed in the distressed context as practitioners and courts worldwide develop trust in it.

Is the U.S. mediation experience translatable to other jurisdictions? The answer is not intuitively obvious. Negotiation is the ultimate expression of the parties’ agency. While negotiating with the backdrop of a litigation alternative, parties have the freedom to structure their own agreement to limit risk and cost and fine-tune the outcome to the facts of the business. Why, then, would they invite a third party into the process, especially one who introduces himself or herself with the often dreaded words, “I’m from the government [or the court] and I’m here to help,” which in other contexts all too often registers as “I’m not going to be happy until you’re unhappy”?

Asking why trust developed in the U.S. in mediation in the context of financial distress helps answer the question whether its use will grow elsewhere. The perceived need for a neutral third party’s involvement dawned on us in the light of some or all of (1) a vacuum that no one else was filling, (2) time constraints, (3) cost concerns, and (4) a desire to ensure the confidentiality of negotiations. The last three reasons of course apply to insolvency negotiations generally, with or without a mediator, but it became clear that a formal mediation procedure, supported by an order setting the parameters of the mediation in terms of the issues to be covered, the mediation’s duration, who pays the mediator, and provisions to ensure confidentiality, gives the parties comfort that their negotiations will be conducted within clear, reliable, and desired parameters. Also, with the rise of an active market in buying and selling distressed debt, holders of large amounts of such debt realized that they needed a clearly delineated time in which to stop trading and negotiate the actual resolution of the case. Mediation puts a structure around that effort.

The first reason for the growth of mediation in U.S. cases -- the existence of a vacuum among those who would otherwise resolve among themselves the issues at stake – was often critical, however.

A mediator can fill different types of vacuums in the insolvency context. First, some important bankruptcy courts simply became too busy to preside over the litigation of key issues. (This was the reason for what I believe to have been the first multi-party “plan” mediation in chapter 11, in which I participated as a lawyer, the Loewen case, presided over by the only judge then sitting in the busy bankruptcy court in Delaware.) Other U.S. bankruptcy judges then concluded that carving out a period for the parties to focus in a structured way on settlement could be more efficient than rushing into an expensive and time-consuming litigation or merely telling the parties that they should consider settlement.

Second, in larger cases parties often were too diverse, or their negotiating leverage too evenly balanced, to work out a negotiated solution by themselves, analogous to the protagonists in more than one John Woo movie who end up pointing guns at each other as they circle in stalemate. While the debtor-in-possession and plan exclusivity concepts underlying chapter 11 were intended to put the debtor in control of plan formulation and confirmation, the rise over the last 20 years of multiple tranches of near comprehensively secured debt evened out that leverage while also leading to more intercreditor disputes, with the attendant vacuum in settlement negotiations to be filled by a mediator.

Third, I expect that you would not be shocked that some key parties in U.S. bankruptcy cases were not always well represented, or, if well represented, were not dispassionate, clear headed, and willing to take counsel’s advice, or simply lacked the analytical tools to manage a complex negotiation without some help. In such situations their fallback, unless a neutral party was added to the mix, was just to say “no” and await the court’s ruling, often with unhappy results that could be avoided through mediation.

Lastly, in the international context, uncertainty about the applicable law and the ultimate enforceability of the court’s judgment encouraged parties to fill the vacuum with negotiation facilitated by someone with experience in, or at least diplomatically able to ask the right questions about, the pertinent transnational context. Hence the utility of section 27(a) of the UNCITRAL Model Law on Cross-Border Insolvency, which recognizes the court’s ability to appoint a third party, in this case a mediator, to assist, under its direction, in cooperation and coordination with foreign courts and parties.

An early example of such a transnational mediation (or, rather, more than one mediation) occurred in the multi-jurisdictional Nortel cases over the allocation of the global sale proceeds.  Those mediations did not in fact end in an agreement, but I would argue that such a result had its benefits: does not the delay and huge cost that ensued until the Nortel cases’ litigated conclusion, which, by the way, was a close-run thing, argue for more mediated agreements in the future? I can attest that transnational mediation can in fact work, based on my own experience in the China Fisheries case, which involved a mediation conducted remotely and by phone among a U.S. chapter 11 trustee, multi-national bondholders, Hong Kong liquidators out of Australia, and a Taiwanese parent company with respect to a multinational debtor whose most valuable assets were in Peru.

All these considerations led courts and parties in U.S. bankruptcy cases over the last twenty or so years to turn increasingly to mediation. They wouldn’t have done so, however, unless, far more often than not, mediation actually worked, either producing a comprehensive agreement or at least narrowing many issues to just one or two for the court to resolve. That has been the experience both in X vs. Y disputes -- especially when there are many of the same kinds of issues in the same case, such as raised by multiple preference avoidance claims, financial close-out claims like those in the Lehman Brothers case, or personal injury claims – and in multi-party, plan mediations.

No doubt several insolvency regimes rely far more heavily that in the U.S. on third parties such as liquidators, monitors, or administrators to manage the negotiation and claims resolution processes. Those who practice in such jurisdictions may well argue that there is no vacuum, therefore, for a mediator to fill – the court-appointed insolvency professional can manage things. The other three reasons for mediation will still apply in such cases, though: efficiency and cost reduction can be enhanced by a court-sanctioned, confidential process facilitated by a trusted neutral, especially in X vs. Y disputes where the liquidator, trustee, or other court-appointed person in control is one of the parties and thus clearly not neutral. The confidential nature of mediation also may be especially attractive in parts of the world where there is a premium on maintaining outwardly cordial commercial relationships and the parties wish to continue doing business together, or at least not to give each other a public black eye.

Moreover, a more facilitative, neutral third party can be especially useful in cases of small and medium sized businesses, whose owners often lack the expertise to manage their exit from financial distress and whose creditors commonly question the debtor’s credibility. Neither the debtor nor creditors may trust a third-party administrator or liquidator as much as a neutral third-party facilitator who can objectively analyze and describe the situation and suggest ways that the parties may consider resolving it. This has been the model in U.S. “Subchapter V cases” for small businesses – where a trustee is appointed at the start of each such case neither to run the business nor to investigate and prosecute claims against the debtor, insiders and otheres but, rather, to understand the debtor’s operations and relationships with creditors and suggest a credible way out. It is a model that has resulted in remarkably improved outcomes for small business debtors and their creditors nationwide.

Finally, even in liquidator, administrator, or monitor-led regimes, the court may still be too busy to conduct a litigation alternative or may have concluded that the parties would benefit from considering a settlement rather than heading to difficult all-or-nothing litigation and that they would benefit from some outside, neutral help.

So, having concluded that mediation would be a valuable alternative to litigation in the context of financial distress whatever the jurisdiction, can best practices be proposed for it, or is its development to be based only on trial and error?

No doubt organizations like the SGRI, the Judicial Insolvency Network, and INSOL, as well as country-specific bodies such as India’s IBBI, have much to add in analyzing mediation in the context of financial distress and developing best practices for its use.[6]

Let me suggest three sets of considerations for best practices, as well as a few recommendations for cultural change to build trust in mediation as an effective tool in the context of financial distress.

First, one should focus on the initiation of mediation. Again, a hallmark of mediation is its voluntary nature. The goal, therefore, is to develop a culture in which the request to mediate is not a sign of weakness and a court’s suggestion to mediate not an imposition, but, rather, viewed as an opportunity for the parties. Such a culture won’t develop without leadership from both bench and bar. With such a culture, bench and bar may move to accept mediation even as a standard practice in certain settings -- such as in transfer-avoidance litigation or in relatively standardized protocols for liquidating lots of similar claims -- that can be governed either by local rules[7] or practice directives or in relatively standardized orders proposed on notice to the affected parties.[8] Trust also should grow, if properly nurtured, in the efficacy of multi-party “plan” mediations where warranted by the facts of the particular case.

Another key to acceptance is that mediations be inclusive: all those directly affected by the proposed issues to be mediated should be invited to participate. The risk will be on them, then, if the case ultimately moves forward with a settlement that they did not help to negotiate and may only be able to try to defeat, rather than modify.

Should the court ever direct a mediation or laws or rules mandate one? I would not preclude these options (just as I would not require the court to grant every request to mediate in the insolvency context) but, given the importance of encouraging parties to want to mediate, coercion should be used rarely in place of the more customary recommendation by the court that the parties mediate, unless it is clear that the bar has come to believe, based on a history of success, that some issues should always be mediated.

The second area for “best practices” implementation is largely an outgrowth from the first: standardization of the structure and rules for mediation in a commonly used form of mediation procedures order or, perhaps, mediation guidelines or a practice directive. Such a basic, accepted structure will give the parties confidence that mediation will be used reliably and productively.

Generally such an order, guideline or practice directive would (a) identify (i) the mediator or mediators, (ii) the issues to be mediated, (iii) the date by which the first mediation session will be held and the date on which the mediation shall end unless earlier terminated by the mediator or extended by the parties and mediator or by the court on application, (iv) whether and for how long the court will hold litigation in abeyance, (v) by whom the mediator will be compensated, at what rate or other formula, and whether the mediator will have to apply to the court for compensation from the debtor’s estate, and, if so, under what standard, or, alternatively, providing a means for mediation parties to object to the mediator’s compensation; (b) require that a decision-maker for each party appear at all mediation sessions unless excused by the mediator; and, importantly, (c) otherwise leave to the mediator’s discretion, after consultation with the parties, how to conduct the mediation -- including the type of preparation (such as the submission of confidential mediation statements and pre-session conferences with the parties’ professionals, to inform the mediator of the issues, the parties’ prior negotiating positions, and proposed next steps); the sequencing of mediation issues to be addressed; whether any informal discovery is warranted before the mediation proceeds; the conduct of any in-person sessions (meetings with all parties together, separate, shuttle diplomacy, follow-up calls, assignments to the parties, etc.); and how to ensure that the parties’ agreement doesn’t leave any material gaps.

Such standardization should nevertheless leave room for adjustment by the parties and mediator in the light of the case at hand. For example, in a case with esoteric factual issues, the mediator may require his or her own expert, or, if governmental entities are involved, the order may provide for prompt access to the ultimate decision-maker instead of having someone at that level of authority -- rather trusted underlings who can make recommendations -- present at the mediation sessions. In addition, while mediation may be helpful in cases of significant public interest -- giving the parties space in which to negotiate candidly, in confidence -- the court and mediator should take into account that people in such cases also feel the need to be heard publicly and the public at large requires assurance that confidential mediation will not become a forum for backroom deals among favored parties. Recently in such cases, for example, bankruptcy courts have permitted non-evidentiary public statements by victims or survivors either at the start of mediation or after its successful conclusion.

Clearly timing considerations are critical: no one wants a mediation to become a waste of time; on the other hand, through no fault of the parties or mediator, achieving an agreement may take more time than first thought. The court therefore may want to build in periodic status updates, albeit without any details of the negotiations’ substance, and in any event should require that the mediator promptly cause a brief report to be filed on the docket after the mediation has terminated, stating whether it resulted in an agreement.[9]

Certain other features of a standard form of mediation order warrant focus. Confidentiality, and the candor, creativity, and agency that come with it, are critical to successful mediation – both that the mediator will not communicate a party’s position to another unless authorized by the party to do so and that the mediator will not communicate with the presiding judge except to state that the mediation did or did not result in an agreement. Mediation orders therefore should provide for the continued confidentiality of information disclosed in the mediation, with certain well recognized exceptions such as for information that has become public in another way. (It can also be useful to confirm in the order, however, that a mediation party can choose to disclose outside of the mediation its own information or proposals.)

Notwithstanding the importance of confidentiality, many believe that there should be an exception to the mediator’s duty of non-disclosure if the mediator concludes that a party has acted in bad faith in the mediation. It is widely agreed, though, that to protect mediation from gamesmanship over requests to impose sanctions for allegedly bad faith conduct,[10] a mediator’s ability to call out a party for bad faith, presumably on the case docket, should be narrowly prescribed and very rarely used. For example, it would not be bad faith for a mediation party to refuse to settle, even if the mediator believes that settlement is in its interest. Rather, bad faith in the mediation context encompasses truly disruptive behavior or an unwillingness to involve someone with decision-making authority, that is, while purporting to participate in the mediation, in effect not to participate at all.

Lastly, the mediation order should confirm, if this is a feature of applicable law, that the mediator has qualified immunity, as well as stating the standard for disqualifying the mediator, which, given that mediators are neutrals, should follow the standard for recusal of a judge.

References to a mediation order obviously assume that the mediation is occuring in the context of an insolvency case. Local rules, guidelines, or a practice directive, however, can confirm that all the foregoing are applicable to pre-insolvency proceeding mediations, assuming that some designated court or arbitration panel can sanction non-compliance.

Third on the list of “best practice” considerations are ways to ensure the effectiveness of a mediated agreement, which is especially important in a transnational setting. For pre-insolvency-proceeding mediations in a transnational context, the Singapore Convention on International Settlement Agreements Resulting from Mediation provides an obvious framework for subsequent international recognition by those states bound by the Convention, as would an agreement to memorialize the settlement in an arbitration under the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, although in each case the settlement may still be subject to later scrutiny as a potentially avoidable preference or other avoidable transfer.

Even if the settlement does not raise international enforcement issues, promptly documenting it, with the parties’ express confirmation of their agreement, is so critical that the standard form of order or practice directive or guideline should require it.

I have saved for last the most important consideration: defining the desired qualities in a mediator. You may note that I did not add “and how to train mediators.” This is because after a proper definition is generally agreed – and proper compensation made available in return for the mediator’s service – effective mediators will be readily identifiable. On the other hand, because deep experience is a necessary requirement, effective mediators cannot be trained out of whole cloth. (Indeed, even the best mediators keep learning, the most famous example perhaps being Ken Feinberg’s increased empathy while allocating compensation to victims of the 9/11 attacks.) I would leave the function of quality control to the market: the parties generally will identify and seek out the best mediators for their disputes. Only if they cannot agree on a particular mediator should the court appoint one, or, better yet, provide the parties with a list of qualified mediators from which to choose or choose from such a list provided by the parties..

A thought experiment may help define the mediator’s key skill set: can a generative AI program be an effective mediator? It may have one of a mediator’s necessary skills: the ability to predict within a reasonable range the litigated outcome of a dispute, although even here the human element underlying a particular judge’s anticipated ruling may be beyond generative AI’s ability to comprehend. Generative AI also might develop various scenarios for resolving a dispute, including a multi-party dispute, in creative, “win/win” ways. But absent further advances, AI cannot detect the parties’ signals, “read the room,” and sense how best to guide the participants -- each with their own quirks, biases, and agendas -- to an agreement. And, no doubt, those differences exist – just ask a group to play a series of $100 games.[11]

Effective mediators have a sixth sense -- derived from knowledge of the issues, of people, and of negotiation dynamics -- of the probable ultimate settlement and how it will be achieved. That sense rarely gets triggered without the mediator being a superb listener and facilitator, and the mediator needs to be open to its adjustment as the mediation progresses.

Sitting and retired judges no doubt have some of the necessary characteristics of effective mediators. For example, from their experience deciding litigation they usually have good predictive powers. They also carry with them enhanced respect. They will not be effective mediators, though, unless they internalize the difference between the judicial skill of making a ruling and the mediation skill of searching for and facilitating a settlement. Much the same may be said of non-judicial mediators who have extensive litigation experience: a deep knowledge of the dispute’s underlying subject matter is not enough if they lack the drive to facilitate, to suggest, not tell, to encourage the parties’ problem solving, not demand an outcome.

Of course there will be some exceptions to this basic consideration. I have conducted a mediation, for example, when the parties eventually said, “Please, Judge, just tell us what we should do.” It also may seem appropriate, as the parties approach impasse, to make a mediator’s proposal. But there is real risk in doing so. If one of the parties doesn’t agree to it, the mediator may have to scramble to convince the others to keep searching for an agreement. A better approach upon an impasse may be to inform the parties that the mediation will terminate unless they propose a range for a possible settlement within which they can proceed. Under that approach, while the parties are focused on the need for a resolution, the ultimate outcome will be their own, negotiated within their agreed range.

At times it makes sense to break other mediators’ norms, too, such as “be patient,” “don’t lose your temper,” “keep the parties talking,” but such deviations should be taken only in the context that the parties are present to see if they can reach an agreement, and the mediator is present only to help them do so. This is why bullying or painting an unrealistically dark picture of a party’s litigation alternatives rarely if ever work.

Credibility is the mediator’s most important asset and begins with the mediator instilling trust in the parties that he or she believes they themselves can reach a mutually satisfactory agreement. When exercised repeatedly, such credibility more than anything else will lead to the development of a mediation culture, with all its attendant benefits.