The Use of 'Most-Favored-Nation' Clauses in Settlement of Litigation

Abstract:     
Many settlement agreements in lawsuits involving either multiple plaintiffs or multiple defendants include so-called "most-favored-nation" clauses. If a defendant facing multiple claims, for example, settles with some plaintiffs early and settles with additional plaintiffs later for a greater amount, then the early settlers will receive the more favorable terms as well. These MFN provisions have been prominent in the recent MP3.com case, as well as tobacco litigation, class actions, and many antitrust lawsuits. This paper considers a defendant who is facing a large group of heterogeneous plaintiffs. Each plaintiff has private information about the (expected) award that he or she will receive should the case go to trial. MFN clauses are valuable because they commit the defendant not to raise his offer over time. This has two important effects. First, holding overall settlement rate fixed, MFNs encourage earlier settlement. Second, depending upon the distribution of plaintiff types, MFNs can either increase or decrease the overall settlement rate. Social welfare implications are discussed, and alternative theories, including the strategic use of MFNs to extract value from future plaintiffs, are explored.

JEL Classifications: K41, D82, D74

Working Paper Series