Understanding the Most Favored Nation Clause

The “Most Favored Nation” or “MFN” clause, in business parlance, most often refers to a risk mitigating technique whereby a contracting party is guaranteed to get the best deal available, now and in the future. What it means is “we’ll enter into this deal now, but if I give a better deal to someone else, you’ll get the same deal.” Today’s post will discuss the application and crafting of a “Most Favored Nation” clause.

Background of “Most Favored Nation”

MFN clauses are found in consultant agreements, entertainment agreements, investment agreements, amongst others; however, most parties to such contracts are not “Nations.” Why then is the clause called “Most Favored Nation”? “Most Favored Nation” is a term rooted in international relations, and MFN treatment refers to a country’s guarantee that it would grant the same privileges and immunities it has accorded to its most favored nation to another country. The MFN clause was the part of a treaty that set forth such a guarantee in writing.

One of the most predominant uses of MFN treatment was in the realm of trade relations, and today, it serves as a cornerstone of international trade. The 1947 General Agreement on Tariffs and Trade (GATT 1947) is an important multilateral trade treaty between nations. Under Article I of GATT 1947, titled “General Most-Favored-Nation Treatment,” when a country grants benefits to another country, with regard to customs duties and other charges connected with the importing and export of a particular good, the country had to immediately and unconditionally grant all countries that were party to GATT 1947 the same benefits. The principle behind Article I was to prevent discrimination of goods based on national origin. Thus, both a designer handbag made in Brazil and one made in France, when imported into the United States, would have the same customs duty rate.

GATT 1947 was terminated with the founding of the World Trade Organization, and has been terminated and superseded by GATT 1994, one of the main treaties of the World Trade Organization system, and Article I of both GATT 1947 and 1994 are essentially the same.

Applications of “Most Favored Nation”

Since its inception in GATT 1947, MFN has crossed borders from the international trade arena into the world of business. Outside the realm of international law and relations, MFN clauses most commonly serve two purposes: (1) to bolster or preserve relationships with important customers, clients or vendors, and (2) to provide some assurances to early risk takers.

The idea behind MFN in the bolstering or preserving goodwill is quite self-explanatory. It makes sense that a customer purchasing the largest volume of a product should not be paying more per product than anyone purchasing a smaller volume. Likewise, if a party is the sole source of intellectual property required to manufacture a product, it also makes sense that the party should not be paying more for the product than anyone else. It should be emphasized, however, that just because something makes sense, does not mean that it is non-negotiable.

Regarding MFN in the early risk taker context, the idea is that someone would be more inclined to take a risk if there there is some assurance that the risk taker would not be treated less favorably in the future. This has a wide range of applications, including investment, consultant, and entertainment agreements. Here are some examples:

• MFN clauses have been used in financing agreements such as convertible notes and similar documents. Y-Combinator, for example, provides a SAFE (Simple Agreement for Future Equity) variation with an MFN clause, which is available here. The SAFE version allows early investors (through a SAFE) to evaluate later issues of convertible securities and elect to get the same deal as such issues.
• In consultant contracts, an early consultant (when a company is not as profitable), might be concerned that another consultant engaged to do similar work (when the company has become profitable), ends up with a better deal. An MFN clause can be utilized to assuage the earlier consultant’s fear. This can be utilized to obtain better talent earlier in a company’s lifetime.
• MFN clauses are profusely utilized in entertainment contracts. They are drafted to protect classes of artists, agents, producers, and publishers, as the need may arise. A big-name artist, for example, may want to be assured at least similar terms to other artists.

Drafting a “Most Favored Nations” Clause

The main problem I see when reading MFN clauses is that they often tend to be too vague. MFN clauses can create real problems if not tightly controlled. Even GATT 1994 provides exceptions to MFN treatment. For example, for national security purposes, and regional trade agreements (yes, some nations can get more favorable treatment than the most favored nation). Here are some considerations when drafting or negotiating an MFN commitment:

• Group of Nations: Prices are set based on certain metrics. The cost to sell in one country might be twice that of another country, and prices adjusted accordingly; different prices may be set depending on whether a product is sold to a reseller or the end user; discounts are given based on volume commitments; and sometimes seasonal or promotional discounts are given. A well drafted MFN clause needs to take these and related concerns into consideration. Thus, for example, the beneficiary of an MFN clause could be entitled to the same standard prices (i.e., excluding promotional prices) as New York resellers who have made smaller volume commitments. Some time ago, when I prepared a potential partnership agreement between an NGO and an intergovernmental organization (IGO), an MFN clause that assured the IGO equal treatment to other similarly situated IGOs, and then went on to define the standards under which an IGO would be considered similarly situated.
• Ultra Favored Nations: As previously mentioned, in international trade, some nations can get more favorable treatment than the most favorable nations. These nations usually are parties to a regional trade treaties (such as the North American Free Trade Agreement), wherein parties are given special benefits. Likewise, in business contracting, special concessions are sometimes given to clients in the nonprofit or educational sectors. It might not make sense for such concessions to also flow to commercial clients, especially since when dealing with the nonprofit or educational sectors, the grant of such concessions could be coupled with tax benefits not available to commercial clients.
• Bundle of Benefits: Remember that price is not the only factor. Two “nations” in the same group may be given different prices because, for example, one one requires work to be done in one week, while the other requires it to be done in one month. A client whom you have to be on-call 24-hours a day with may be given a higher price than one whom you don’t need to be. One consultant could be working 40 hours a week, while another could be working 10. An MFN clause needs to be drafted to ensure that the MFN beneficiary does not gain a greater benefit than anticipated.
• Administrative Burden: The SAFE document referred to above requires beneficiary investors to be given a copy of all related documentation every time the company issues a convertible security. While this might make sense in its context, since the issuance of convertible securities is not an everyday thing, a similar requirement would not make sense for a business model where sales quotes are made everyday. Likewise, it would not be wise to give an MFN beneficiary unlimited audit power to enforce the MFN clause, since such audits can slow business. The easiest approach is to tie MFN benefits to an easily verifiable metric, such as price lists.
• Confidential Information: A problem related to administrative burden is the protection of confidential information. For example, it might be OK to let the MFN beneficiary pay the same rate as another client, but it might not be OK to let the MFN beneficiary know who the other client is. If it is necessary to require audits, then audit processes must be structured in a way that limits the revelation of confidential or proprietary information.
• Time Limits: It is seldom a good idea to have a perpetual MFN clause. MFN clauses should be tied to a duration if possible.
• Conditions: Historically, MFN clauses could be classified as conditional or unconditional. The MFN clause in GATT 1994 is an example of an unconditional clause whereby benefits are granted to the beneficiary immediately and unconditionally. Conditional MFN clauses have also been utilized, which ensured that benefits granted to a third party in exchange for a particular condition being met by that third party would only be granted to the MFN beneficiary if the beneficiary fulfilled the same conditions.
• Reciprocity: Historically, MFN clauses could also be classified as unilateral or reciprocal. Having some form of reciprocal MFN treatment can help parties to determine the fairness of the MFN treatment originally requested.
• Antitrust: We are not all bona fide “nations” and therefore not immune to violating antitrust laws. In the European Union and the United States, the use of MFN clauses in certain sectors or in specific ways have been met with governmental allegations of antitrust violations. Thus, some care needs to be taken in evaluating whether the impact of an MFN clause could be considered to be anticompetitive in nature.

The “Most Favored Nations” clause has an extremely wide range of use, but must be used with a great amount of care. How do you think a MFN clause can be helpful in a transaction?

This blog post is provided for general informational purposes only. It is not legal advice, and should not be a substitute for legal advice. If you have questions or comments about the post, or would like to learn more about something in the post, please feel free to contact me.