Mediation, as commonly understood in the context of alternative dispute resolution, employs a neutral third party to facilitate negotiation and voluntary agreement between the parties. Unlike arbitration, the mediator does not conduct an evidentiary hearing, is able to “caucus” separately with each side, and does not impose a solution or issue a legally binding award.
Or so I thought, until I came across last week’s appellate ruling in Korangy v Malone, 2018 NY Slip Op 03767 [1st Dept May 24, 2018], in which the court affirmed an order dismissing claims by one 50% LLC member against the other 50% member based on the outcome of a prior, “binding mediation” conducted pursuant to a provision in the LLC’s operating agreement addressing member deadlock.
When I did a little online research, I found commentary about binding mediation — in which mediators usually impose a legally enforceable resolution only after they fail to produce a voluntary settlement — both negative (“a trap for the unwary”) and positive (“more cost effective than arbitration”). I also got the sense that the inclusion of mandatory, binding mediation clauses in commercial contracts, insofar as it has achieved any significant level of acceptance, mostly is confined to standardized transactions such as construction and reinsurance contracts.
Whatever their utility in those contexts, does it make sense to include an ex ante provision for binding mediation as a deadlock-breaking device in a shareholders or operating agreement, such as the one in Korangy v Malone? I doubt it, but let’s first take a look at the case.
The Korangy Case
Korangy involves a member-managed New York LLC formed by its two 50% members, Amir Korangy and Georgia Malone, to acquire and operate a particular commercial property in Riverhead, New York. Each member invested $700,000 initially.
In late 2015, the members refinanced the property. The new mortgage loan generated $683,000 in excess proceeds. Allegedly without obtaining Mr. Korangy’s consent, and over his objection, instead of taking 50% of the proceeds, Ms. Malone paid herself $450,000 including some expense reimbursement and $100,000 she claimed was due to her as compensation for her time and effort managing the property.
Deadlock. If at two successive meetings of the Members, the Members are unable to reach a decision by the required vote regarding a matter submitted for consideration by the Members at such meetings (a “Deadlock”), the Deadlock shall be mediated (the “Mediation”) within fifteen (15) days from the date a written request for mediation is made by any Member. The Mediation shall take place in the principal office and shall be in English. The Mediation shall be conducted before a single mediator to be agreed upon by the Members. If the Members cannot agree on the mediator, each Member shall select a mediator and such mediators shall together unanimously select a neutral mediator who will conduct the mediation. Each Member shall bear the fees and expenses of its mediator and all the Members shall equally bear the fees and expenses of the final mediator. The decision of the mediator shall be final and binding on the Members. [Emphasis added.]
It does not appear that Mr. Korangy and Ms. Malone held two successive member meetings before engaging a mediator, as required in Section 3.3.3. Nonetheless, they exchanged a series of emails in early 2016 in which both acknowledged the need to select a mediator, which they subsequently did in the person of accountant Michael Sullivan.
None of the correspondence explicitly referred to the mediation as binding, as stated in Section 3.3.3.
Mr. Sullivan received written submissions and conducted a mediation session in May 2016 with the two members and their respective counsel. Oddly, the record in the lawsuit initiated by Mr. Korangy in September 2016 contains no reference to a written decision by the mediator. What we do have is an affidavit from the mediator filed in the lawsuit in October 2016 in which he relates his prior — apparently oral — determination of the issues in Ms. Malone’s favor.
You may be asking at this point, if Mr. Korangy initiated, participated in, and lost the “binding” mediation, how could he possibly file a subsequent lawsuit ignoring the outcome of the mediation and claiming that Ms. Malone nonetheless was liable for breach of the Operating Agreement when she took the $450,000 distribution?
That essentially was Ms. Malone’s argument in her motion to dismiss the lawsuit. It also was Manhattan Commercial Division Justice Eileen Bransten’s view of the matter when she granted the motion in a bench decision in May 2017, commenting:
[T]his Court is not convinced by [Mr. Korangy’s] argument that despite the fact that he did not have to go to mediation, he decided to go anyway (in conformance with Section 3.3.3. of the Agreement) but now should not be bound by it. . . . [T]he Court finds [Mr. Korangy] knowingly submitted to the binding mediation and the claim of breach of contract based on [Ms. Malone’s] alleged improper self dealing from the refinancing proceeds is estopped and foreclosed having been considered and resolved by the mediator both parties selected.
Such also was the Appellate Division, First Department’s view of the matter in its decision last week affirming Justice Bransten’s order, in which it dispatched Mr. Korangy’s argument — that despite his voluntary participation there was no deadlock subject to binding mediation but, rather, that Ms. Malone breached the Operating Agreement when she unilaterally took the disputed funds — in a single sentence: “Taking the allegations in the complaint as true, plaintiff admitted the parties were deadlocked and the dispute was submitted to mediation.”
We’ll never know what would have happened had Mr. Korangy taken the position from the get-go that the dispute was not a deadlock subject to binding mediation under Section 3.3.3 and, instead of initiating mediation, had filed suit for breach of contract. Ironically, though, had he done so, and even if Ms. Malone was unable to convince a judge that the claim was subject to binding mediation, she could have invoked the broad arbitration provision in Article 13.1 of the Operating Agreement, requiring “any dispute, controversy or claim arising out of or relating to this Agreement” — other than a deadlock governed by Section 3.3.3. — to be submitted to arbitration with the American Arbitration Association.
Deadlock and Binding Mediation: A Bad Idea?
Don’t get me wrong. In general I’m a big fan of alternative dispute resolution, especially mediation of the traditional, non-binding sort, done with the right mediator at the right time.
I’m also keenly aware of the perils of deadlock when two co-equal owners of the business experience fundamental disagreements, hence the need to consider in the shareholders or operating agreement not only non-binding mediation, but also a provision for a permanent managing board with a third, independent director or appointing a pre-identified, trusted individual who knows the business, such as the company’s outside accountant, to cast a deciding vote.
Alternatively, the shareholders or operating agreement can define events of deadlock, preceded or not by non-binding mediation, as a trigger for a buy-sell process or a sale of the business.
But I am no fan of mandatory, binding mediation whenever there’s deadlock, as in Korangy. Deadlock can arise from an endless variety of bona fide, good faith differences in opinion over all manner of business decisions and goals, having nothing to do with malfeasance or breach of contractual or fiduciary obligations. It makes little sense to commit important business decisions to an outsider who has no relationship with the co-managers, no intimate knowledge of, or experience in, the business, and who owes no fiduciary obligation to the company or its owners.