31 Aug 2005

Most favoured customer clauses

by Andrew Bruton, Audine Bartlett

There is significant potential to be in breach of the Trade Practices Act, and a defence may not be available if the court finds the clause is practically unenforceable.

What are MFC clauses?

"Most favoured customer" ("MFC") clauses impose an obligation on a supplier to give a "favoured" customer a price which is at least as low as the best price which is given to its other customers (or "on no less favourable terms"). They come in various guises but are commonly encountered in commercial agreements in the energy and resources sector.

Can MFC clauses be construed as anti-competitive?

Yes. The operation of an MFC clause can work in a way that is anti-competitive.

Arguably the purpose of MFC clauses is simply to maintain a presence in a highly competitive market place. You would think that if a favoured customer is using its buying power to force a supplier to sell to it at a lower price then end consumers would profit as a result of conduct which forces prices down. This proposition is flawed, however, when you consider that:

  • a buyer may not necessarily pass on the lower prices to its customers; and
  • consumers may not be better off because the buyer forces the supplier to sell to it at a lower price by reducing its own demand for the product from the supplier (ie. in effect punishing the seller for not offering it the best price).

Two main competition issues arise with regard to MFC clauses. First, MFC clauses facilitate "price uniformity" which is a tendency for prices to remain both rigid and higher than would otherwise be the case. The supplier has less incentive to renegotiate its prices with its various customers because MFC clauses increase the cost of negotiation by obliging the supplier to offer the renegotiated price to all customers benefiting from the MFC clause.

Second, MFC clauses disadvantage smaller competitors who might otherwise be able to bargain for a lower price than the dominant purchaser's price. The supplier could be discouraged from lowering its prices for a small purchaser if it has to reduce its price for its dominant purchaser as well. The result is that such conduct creates barriers to entry into the market.

Can use of MFC clauses place you in breach of the Trade Practices Act?

Yes. You can potentially breach sections 45 and 46 of the Trade Practices Act 1974 (Cth) (TPA) as a result of applying MFC clauses in commercial contracts.

Section 45: Prohibition against reaching and giving effect to anti-competitive agreements

An agreement between a supplier and a purchaser is unlawful pursuant to section 45 if it has the purpose or likely effect of substantially lessening competition. These types of contracts, arrangements or understandings are unenforceable if made. Section45(2) of the TPA states:

"A corporation shall not:

(a) make a contract or arrangement, or arrive at an understanding, if:

(i) the proposed contract, arrangement or understanding contains an exclusionary provision; or

(ii) a provision of the proposed contract, arrangement or understanding has the purpose, or would have or be likely to have the effect, of substantially lessening competition …"

Commentary on section 45 suggests that the 'substantiality' to which competition is lessened is to be evaluated on the basis of the nature of the arrangement itself and its tendency. Relevant to assessing the anti-competitive effect of an arrangement will be market concentration, as its impact will be greater in a concentrated market than in a less concentrated market. Also, an assessment of the condition of market entry is important. If an arrangement has the tendency to strengthen the barriers to entry, it is less likely to be accepted by the courts. The effect of the arrangement on both actual and potential competition is relevant.

However, it is often difficult to classify the effect of MFC clauses under section 45, and whether they breach section 45 will depend on the commercial circumstances of each case.

Section 46: Misuse of market power

Dominant purchasers could be faced with allegations of misuse of market power if they leverage off MFC clauses.

Section 46 prohibits an entity holding a substantive degree of market power from taking advantage of that power for the purposes of eliminating or substantially damaging a competitor, preventing market entry or deterring a person from engaging in competitive conduct.

‘Market power’ means capacity to behave in a certain way (which may include setting prices and granting or refusing supply), persistently free from the constraints of competition (see Queensland Wire Industries Pty Ltd v The Broken Hill Proprietary Co Ltd (1989) 167 CLR 177). Barriers to entry are a common reason for the existence of market power. Section 46 does not require an entity to have monopolistic power, as long as the market power exercisable is substantial.

Section 46(1) provides that:

"A corporation that has a substantial degree of market power in a market shall not take advantage of that power for the purpose of:

(a) eliminating or substantially damaging a competitor of the corporation or of a body corporate that is related to the corporation in that or any other market;

(b) preventing the entry of a person into that or any other market; or

(c) deterring or preventing a person from engaging in competitive conduct in that or any other market."

Section 46(4) makes it clear that market power includes power as either a supplier or as an acquirer of goods and services in the market. Section 46(3) provides that for the purposes of section 46, to determine the degree of power that an entity has in the market, the court must have regard to the extent to which conduct of the entity is constrained by the conduct of competitors, or persons from whom the entity acquires goods in that market.

Case law

There is no case law directly on point with regard to the anti-competitive effect of MFC clauses in Australia.

However, there have been numerous US cases which have dealt with MFC clauses. They all turn on their own facts, but they leave open the possibility that these types of clauses have the potential (in some instances) to hinder the development of alternative delivery systems, thereby interfering with the introduction of competition. In Reazin v Blue Cross & Blue Shield of Kansas Inc 1990-1 Trade Cases 68-970 the Tenth Circuit Court of Appeals indicated it viewed MFC provisions as an anti-competitive device that harmed competition.

In this case, the hospitals were dissuaded from giving discounts to heath insurers other than Blue Cross because the hospital would be forced to also give a lower price to Blue Cross. Without a discount, Blue Cross's competitors were unable to offer lower priced health insurance and could not break into the market.

However, US cases turn on the interpretation of US anti-trust law where the court determines "unfair methods of competition" to be illegal. Therefore, the test is not the same as that applied in Australia.

What are the implications for contracts?

If determining whether MFC clauses should be incorporated into commercial agreements it's advisable to ask the following questions:

  • Could the clause facilitate or result in actions which could substantially lessen competition in the relevant market? (section 45)
  • Does the beneficiary of the clause have substantial market power, such that the operative effect of the clause could result in a misuse of market power by that entity? (section 46)
  • Could the operative effect of the MFC clause give rise to the possibility of collusion between customers so as to facilitate price fixing arrangements which could operate to the detriment of the supplier?
  • If the MFC clause is incorporated into the contract could the supplier have a valid counter-argument under the TPA to avoid giving its best price to a customer, thereby giving rise to questions of enforceability?

Ultimately, caution is the best approach when considering whether to apply an MFC clause to a contract. To enforce an MFC clause it is necessary to know exactly what competitors are paying and given the nature of confidentiality provisions in contracts this may be difficult, if not impossible, to establish. There is significant potential to be in breach of the TPA, and a defence may not be available if the court finds the MFC clause is practically unenforceable.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.