What is a "most favored nations" provision in a contract? Why are they important? What happens if they're violated? These are questions that many attorneys may be asking themselves, and for good reason. Most favored nation provisions can have a significant impact on royalty and profit participation calculations, especially in entertainment and intellectual property licensing deals, as well as investment deals and international treaties, to name a few examples. In this blog post, we'll take a closer look at what most favored nation provisions are and how they can lead to audit or other damages claims.
What is a "Most Favored Nations" Provision in a Contract?
A "most favored nation" provision (also known as an "MFN") is a clause that is included in contracts to ensure that one party receives the same treatment as other parties which may have leverage to negotiate more favorable terms. The "most favored nations" provision in a contract is based on the principle of equality. It is designed to promote fairness and to prevent one party from taking advantage of parties that may not know the extent of the most favorable terms it can negotiate. MFNs are commonly used in international trade agreements, but can also be found in other types of contracts, such as investment agreements, licenses, and other agreements covering for musical works and sound recordings.
With respect to licensing transactions, the MFN clause protects a licensor from receiving less favorable terms than other licensors. For example, if Licensor A has an MFN clause in its contract with Licensee B, and Licensee B separately gives Licensor C more favorable terms, then Licensor A is entitled to receive the same, more favorable terms as Licensor C. The same principles can be applied to other sorts of transactions including investment agreements and treaties between nations (from where the term "Most Favored Nations" originates).
Why are Most Favored Nations Clauses Important?
By requiring that all parties be treated equally, the most favored nation provision helps to level the playing field and to protect the interests of all involved.
The purpose of most favored nation provisions is to encourage free and fair trade - and encourage parties to feel comfortable signing off on a license or other contract - by ensuring that all trading partners are treated equally and by mitigating the risk that a more favorable deal could have been negotiated. Most favored nations clauses can also be used as a tool to pressure licensors to lower their royalty rates (or pressure countries to lower their trade barriers, such as tariffs, and improve their labor and environmental standards). Most favored nation provisions are an important part of the global trading system and help to promote free and fair trade.
What Happens if The MFN Clause is Violated?
When a most favored nations clause is contravened, it can have a number of serious consequences. First, it can damage the relationship between the parties involved, creating an atmosphere of suspicion and mistrust, making future agreements more difficult to negotiate. It can even lead to economic retaliation. As an example concerning treaties between nations, countries who discover a counterparty failed to honor the MFN provision in a treaty may impose punitive tariffs or other trade barriers in response to such breach. As another example, music publishers may refuse to grant reduced rate licenses - or any licenses - to a licensee who is found to have double crossed the licensor by failing to increase royalty rates in accordance with the terms of the MFN clause.
Second, when a "most favored nation" provision is contravened, the party (e.g., a licensor or country) which suffered less favorable terms than agreed is damaged and can bring a law suit, enforce contractual trade sanctions, or take other enforcement measures to claim actual and possibly penalize the licensee or other party that did not honor the MFN agreement. (Actual damages are amounts to make a party "whole" for the injuries it sustained as a result of a contractual violation. In addition, sometimes courts award punitive damages to punish or penalize the party responsible for the violation, and many contracts provide for penalties in the event of a breach).
How to Enforce "Most Favored Nations" Provisions
MFN clauses are typically identified through an audit process (one reason why it is important to carefully negotiate the audit clauses in your agreements), although violations can be disclosed in other ways. For example, if two parties are in litigation, as part of the discovery process documents produced by a party may disclose the terms of its agreements with other parties, allowing MFN clause compliance to be evaluated. As another example applicable to international trade agreements between nations, a government official or designated third party reviews individual countries' customs data to ensure that it is providing the same benefits to all trading partners with MFN status.
If an audit finds non-compliance with an MFN provision, or such non-compliance is disclosed in another way, I find in my experience working with legal counsel that the best approach is to first try to settle the claims through diplomacy and/or the audit and breach notice provisions set forth in the agreement. For example, as an auditor, my audit report will disclose my findings and the legal team will demand payment for the damages I identify in the audit report. Given that may failures to comply with most favored nations clauses are the result of inadequate royalty reporting systems, non-compliance is often unintended, and this gives the parties a chance to fix the problem and maintain a business relationship.
However, if the party that failed to comply with an MFN clause is uncooperative, enforcement can be challenging. Generally, the damaged party will need to pursue legal action such as arbitration or a trial in court or a tribunal in order to procure a legal order to the violating party to pay damages and, potentially, other consequences (e.g., termination of the underlying contract).
Actions for Attorneys to Take to Help Clients:
If you have a client who has suffered damages as the result of an MFN violation, please call my consulting and forensic accounting firm, Boschan Corp., at (424) 248-8866. We have experts on staff who can help you determine (based on the available information or through auditing or litigation support) whether your client may have a viable damages claim and, if so, what that claim might be worth. Better yet, when you are negotiating your clients' contracts, it can be prudent to get our feedback on some of the language including the audit provision and definitions. Please don't hesitate to contact us to take advantage of our expertise in most favored nations provisions, audits and damages claims. Thank you for reading.