MFN and its avatars
Most Favoured Nation or MFN finds its origin in international trade relations. The WTO (World Trade Organisation) rules stipulate that all trade partners must be accorded the same treatment. Accordingly, if an advantage, favour, privilege or immunity is granted by a contracting party/ state to one partner/ state, the same is required to be immediately and unconditionally accorded to all other contracting parties/ states.
The MFN principle gained some momentum recently with a Supreme Court order in the Nestle SA case that dealt with the application of MFN clauses in treaties between India and other countries. One of the questions of law in the Nestle matter was whether a change in position of law pursuant to a DTAA (Direct Tax Avoidance Agreement) executed between two countries would come into force immediately upon execution of the DTAA. The Hon’ble Supreme Court has now ruled that absent a formal notification the same would not be effective.
While the interpretations and consequences of the judgement are certainly gathering some interest, MFN clauses in general are also very common in several other transactions/ contracts.
Equity transactions:
In investment transactions like SAFE (simple agreement for future equity) and convertible notes, MFN is an important principle. This MFN clause is sought by an investor to ensure that the investor will be entitled to the most beneficial and favorable terms that the investee company may offer to any other investor/s in the future. It gives comfort to an investor with an MFN clause that it will not be at a disadvantage at having accepted some of the terms offered by the investee company in good faith. If therefore the investee company at a later date offers another investor better or more beneficial terms, the investee company would be obliged to extend such better and more beneficial terms to the original investor as well.
For SAFE and convertible notes, the MFN clauses would include the discount rate and valuation cap. For other investments, the MFN clauses would include a liquidation preference of capital invested in a distribution waterfall, and a priority to exit with a target return.
While certain investment agreements may have this clause, it is also common for such provisions to be waived in subsequent rounds. The scenario could be a fund-raise at a critical juncture for the investee company, and the new investor will not accept extension of certain of its specific favorable terms to prior investors if such prior investors are not willing to invest at the same valuation and take the equity risk as the new investor. In such cases, the MFN provisions are waived and the more favorable provisions are extended to only those investors who are willing to participate and invest in that investment round at the agreed valuation.
MFN clauses are also common for investors in funds, and to this effect fund managers typically provide the necessary confirmations and assurances to the investors by executing side letters confirming their mutual understanding.
Financing transactions:
In financing transactions, when lenders extend fresh finance to a borrower entity, it is not unusual for them to seek an MFN clause stating that if the borrower extends better terms to other lenders subsequently, the same will automatically extend to the first lender.
Similarly, when a borrower seeks flexibility in utilizing any add-on borrowings or seeks additional credit, existing lenders also seek MFN provisions whereby the better terms applicable to such additional credit also extend to prior financings extended to the borrower. The lender is able to justify the higher risk with the better terms that will now apply even to the funds previously lent, and ensuring that the prior funds are not seen as unprotected or having depreciated in value.
Such MFN terms can include interest rate, security cover, negative covenants, and equity conversion rights.
Commercial contracts:
In commercial contracts which are long term in nature or of significant value and/or volume, the MFN (or most favored customer) clause could stipulate that a seller of a service or a product, or a licensor will extend the best terms that it may offer to any other customer or licensee in the future.
It is also not uncommon for MFN clauses to be extended by retailers to end customers, where the retailer promises that if the customer finds a better price in the market, he can come back to the retailer and seek the difference. Such terms convince the customer that he is getting the best deal, and is also protected from subsequent price adjustments due to changes in the market.
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Negotiated and market determined: In summary, it is always the market and the business scenario that determines if an MFN clause finds its place in a contract. The party in a better negotiating position is able to have it incorporated or push back any such ask.
What is equally critical though is that the consequences of such MFN clauses even if in separate side letters are fully understood since it could have a material impact on how a particular MFN trigger would play out if and when the event unfolds. It is therefore important to have in place adequate safeguards along with clear and unambiguously drafted provisions to ensure that MFNs while intended to have additional rights for one or more select investors or parties, does not conflict with the other substantive covenants in the agreement applicable to the other investors or stakeholders.
