The "its just Karahzan" argument holds no water. Different people play the game at different paces. What may be trivial content for some is important for others. At one point and time, Kara was a big deal to everyone.
That said, that's a harsh position to be in. The mage got the cloak and should have been satisfied with that and passed on the hat. That's in a perfect world dealing with completely rational and thoughtful people. It would be best to establish some ground rules on loot to begin with but realize not everything works out and you will still need to make some tough calls as a raid leader. Reserve yourself this power in what ever rules you make.
What if the mage was given the option to roll on the cloak OR the helm? And what if the lock already had the cloak? Well, roll on the helm and pick up the cloak by default, right? That kinda things happens in every loot system.
The best outcome would be for each player to get an upgrade item so I would suggest going with a "1 upgrade roll" rule.
your hat may be nice, but I have the little white tank top that says Legendary right across my boobs. I win. (or more correctly, H wins)