Clause and Effect

Record companies were incensed two years ago by a judge’s decision to award $50 million to Universal Music Group.

The judge had ruled that MP3.com, an online music service, had violated Universal’s copyright by allowing users to listen to music online. Universal, along with four other record companies, had sued the Internet upstart. But Universal’s rivals had settled when MP3 presented them with an apparently unbeatable deal.

MP3 would settle with all five companies for a reported $20 million each. But if MP3 were ever to settle on better terms with another record label in the future, then the early settlers would also receive the better terms.

This “most-favored nation” clause proved irresistible to Universal’s rivals. But the companies hadn’t figured on Universal winning its lawsuit against MP3 and receiving a judgment worth more than twice what they had settled for. Since the $50 million was a “judgment” rather than a “settlement,” the most-favored nation clause did not apply - and the other companies were shut out of the winnings.

“Most-favored nation” clauses - used not only by MP3 but in tobacco litigation, class actions, and many antitrust lawsuits - have been criticized as detrimental to the settlement process. But Kellogg Professor Kathryn Spier, an economist who studies the strategy of legal contracts, argues that such clauses can serve the greatest good for all parties concerned - plaintiffs, defendants, the legal system and the public.

Spier notes that MFN clauses level the playing field for all but the plaintiffs with the strongest cases. This avoids the 11th-hour bargaining that many defendants - especially those with weak cases - engage in with the goal of achieving the highest possible settlement.

“MFNs get the settlement off the courthouse steps,” explains Spier. “Plaintiffs with weaker cases often reject a defendant’s early offers to settle because they anticipate, correctly, that the defendant’s offers will rise over time. But delay is inefficient. Protracted litigation involves time, energy and legal costs. It also distracts companies from their core lines of business and can negatively affect the reputations of the companies involved.

“By settling early, the defendant will benefit, the early settlers will benefit, the legal system will benefit and the public will benefit. Everybody will be made better off, except possibly those who will go to trial.”

But if those plaintiffs have a strong case, they may well benefit from a favorable judgment in court. As for those plaintiffs who believe they missed out on a potential windfall by settling early, Spier notes that “hindsight is 20-20.”

“Whenever you pursue litigation, it’s a coin toss whether or not you’re going to win,” she says. “At the time the record companies settled with MP3, it seemed unlikely they would be getting more than $20 million. Without that MFN clause, the companies might not have been able to reach a settlement at all.”

Spier has presented her research on MFN clauses at leading law schools and has been researching the strategy of legal contracts for nearly 15 years. Two questions guide her thinking: Why are contracts structured in a given way? And, who benefits from the way they are structured?

In the case of MFN clauses, she says, most parties do benefit.

“Some people say MFNs are not a win-win because we’re letting these defendants off too easily,” Spier says. “The purpose of a legal system is to provide an adequate deterrent to bad behavior. However, there are better ways to do that than forcing them to bear the costs of delays, which turn out to be costly for everyone.”