Should Fee Shifting Provisions Condition Recovery of Attorneys’ Fees on Participation in Mediation Before a Lawsuit is Filed?

To deter parties from taking frivolous positions in connection with contractual relationships, agreements often contain fee shifting provisions that entitle a prevailing party to recover reasonable attorneys’ fees in any litigation arising under the agreement. The downside of fee shifting provisions, of course, is that they may deter parties from pursuing even legitimate claims because the outcome of litigation is often uncertain and parties are concerned that, if they lose, they will be compelled to pay the other side’s attorneys’ fees.

One way to mitigate this risk is a provision obligating the parties to participate in mediation before commencing litigation, and conditioning recovery of attorneys’ fees in any later litigation on compliance with this obligation. Thus, a party that commences litigation without first attempting to mediate loses the benefit of fee shifting even if it prevails. The appeal of such provisions is that they channel parties into mediation, and thus provide parties with a meaningful opportunity to fairly resolve disputes before being compelled to assume the risk of having to pay the other side’s attorneys’ fees.

A recent unpublished California decision addressed the question of whether a defendant that participates in mediation before an action commences must mediate again before filing counterclaims later in the case. Ocean Tomo, LLC v. PatentRatings, LLC, No. G055429, 2019 WL 2462757 (Cal. Ct. App. June 13, 2019).

In Ocean Tomo, the litigants were co-owners of a patent rating service formed as an LLC. Section 19.4 of the LLC’s Operating Agreement provided that “subject to provisions of Article 18, in the event a dispute arises between any Member(s) and the Company or between the Members themselves, the prevailing party shall be entitled to recover reasonable attorney’s fees and court costs incurred.” Section 18.1 provided that members “pledge to attempt to resolve any dispute amicably without the necessity of litigation.” While the language is hardly a model of clarity, the courts nevertheless assumed Section 18.1 was intended to condition recovery of attorneys’ fees on an attempt to mediate.

The minority owner of the LLC became embroiled in a dispute with the majority owner. After the parties were unsuccessful in resolving the dispute through mediation, the minority owner commenced a lawsuit asserting breach of fiduciary and other claims. Several months later, the majority owner counterclaimed for breach of contract and other causes of action.

The trial court ruled in favor of the majority owner and awarded it attorneys’ fees under Section 19.4 of the Operating Agreement. On appeal, the minority owner argued that attorneys’ fees should not be recoverable to the extent attributable to the majority owner’s counterclaims because the majority owner had not sought to mediate before asserting those claims.

The appellate court disagreed, holding that the mediation that occurred before the minority owner filed suit satisfied the requirement to mediate before commencing litigation, and the majority owner was not required to attempt additional alternative dispute resolution before filing its counterclaims.

A more well-drafted provision conditioning recovery of attorneys’ fees on participation in mediation appeared in the residential real estate contract analyzed in an earlier California appellate opinion, Frei v. Davey, 124 Cal. App. 4th 1506, 22 Cal. Rptr. 3d 429 (2004), which was cited in Ocean Tomo. The analysis accompanying the Frei court’s enforcement of the provision offers some excellent observations concerning why mediation often succeeds in resolving a dispute after direct negotiations between the parties have failed.

The provision in Frei provided clearly and unambiguously:

Buyer and Seller agree to mediate any dispute or claim arising between them out of this Agreement, or any resulting transaction, before resorting to arbitration or court action . . . If, for any dispute or claim to which this paragraph applies, any party commences an action without first attempting to resolve the matter through mediation, or refuses to mediate after a request has been made, then that party shall not be entitled to recover attorney’s fees, even if they would otherwise be available to that party in any such action.

After the sellers sought to cancel the agreement to sell their house, the buyers sued for specific performance. The sellers prevailed and sought to recover attorneys’ fees. The trial court granted the request, but was reversed on appeal because the sellers had repeatedly ignored or rejected offers from the buyers to mediate before the litigation commenced.

The sellers contended that the parties’ negotiations before the case was filed were the equivalent of mediation. The court begged to differ, noting that the parties had been only $18,450 apart in their pre-litigation negotiations to settle the dispute. A mediator, the court noted, might have been able to bridge that small gap by stressing the cost of litigation to the parties if they didn’t settle. Instead, because the sellers spurned the buyers’ offers to mediate, the parties collectively spent over $500,000 in attorneys’ fees to pursue their litigation through trial and appeal.

Citing the case as a “textbook example of why agreements for attorney fees conditioned on participation in mediation should be enforced,” the court explained as follows:

[This case] should have been mediated at an early stage when the parties were only $18,540 plus expenses apart in their settlement positions. Hundreds of thousands of dollars in attorney fees have been spent and the parties have litigated through two trials and three appeals. The lesson? There is a good reason the mediation clause was in the Agreement . . . Negotiations between the parties are not mediation . . . in mediation, a neutral third party analyzes the strengths and weaknesses of each party’s case, works through the economics of litigation with the parties, and otherwise assists in attempting to reach a compromise resolution of the dispute.

The sellers also argued that a mediation was eventually conducted shortly before the initial trial date, but was unsuccessful. The court responded that a delay of almost a year between the buyer’s request to mediate, and the mediation conducted before trial, was unreasonable:

The purpose of the early mediation requirement is to minimize the costs of litigation and arbitration. To allow a party to wait one year until the eve of trial to accede to a request for mediation would defeat that purpose. Of course, there is value to conducting mediations, settlement conferences or other methods of alternative dispute resolution at various stages in litigation, whether before, during, or after trial. But when a contract conditions the recovery of attorney fees on a party’s willingness to participate in mediation before the litigation begins, the window for agreeing to mediate does not remain open indefinitely. The fact the mediation conducted shortly before the initial trial date was unsuccessful does not alter this analysis. Indeed, the mediation [prior to trial] might have been unsuccessful precisely because, by then, the parties had invested so much money in attorney fees and their positions had become entrenched (emphasis added).

All excellent observations that highlight why early mediation is often superior to direct negotiations as a dispute resolution mechanism. As Frei suggests, as an “agent of reality” without any stake in the outcome and a license to confer confidentially with both sides, a mediator can help parties overcome barriers to settlement they cannot surmount in face-to-face negotiations. By channeling parties to mediation, provisions that condition recovery of attorneys’ fees on participation in mediation help parties realize this value.