Intellectual property licences and other forms of revenue sharing agreements (in which a share of an income stream is paid on to another party) commonly contain clauses permitting the party receiving payment to audit the party making the payment, so that the receiving party can verify that it is being paid what it is properly owed.
The paying party will often try to limit the extent of such audit rights, to minimise disruption to its business. It may, for example, seek to limit how often audits can be conducted or the information that an auditor can inspect, and may even seek to make the other party meet its expenses in complying with the audit. Conversely, the party seeking to exercise audit rights will want wide-ranging, regular access to documents and premises, to satisfy itself that revenue is being properly accounted for.
As with any other type of contractual rights, it will be important for the parties to agree the extent of audit rights and ensure that the contractual language sets out clearly and succinctly what those rights are. If it is necessary to go to Court for a ruling on contractual interpretation or whether terms should be implied, then something has gone wrong with the contractual drafting. It is not easy to predict how the Court will rule and how far it will choose to imply terms not included in the drafting.
A salutary example is provided by the recent case of Pixdene Ltd v Paddington & Co Ltd  EWHC 2765 (IPEC), in which the Court had to consider the audit rights in a royalty distribution agreement related to Paddington Bear merchandising.
The owners of the intellectual property in Paddington Bear (“Paddington”) were bound to pay Pixdene Ltd 10% of the merchandising royalties under the distribution agreement. The audit clause read as follows:
“During the term of this Agreement a third party auditor may, upon prior written notice to Paddington and not more than once per every two year period, inspect the agreements and any other business records of Paddington with respect to the relevant records or associated matters during normal working hours to verify Paddington’s compliance with this Agreement.”
Pixdene argued that this clause:
- gave Pixdene a right to inspect Paddington’s documents; and
- required Paddington to provide Pixdene and/or the third party auditor with copy documents before attending Paddington’s offices for inspection.
However, the Court found that the express reference to a “third party” auditor was clear and unambiguous and therefore could not be construed as providing Pixdene itself with a right of inspection. Moreover, the fact that the audit clause provided that inspection required prior written notice, and was to be carried out “during normal working hours,” showed that the parties, at the time of agreeing the clause, were envisaging a physical inspection of documents by the third party auditor at a place under Paddington’s control.
Paddington, for its part, claimed it had a right to redact information from documents prior to inspection. However, the Court found that Paddington’s confidential information was sufficiently protected by providing the inspection right only to a third party auditor with professional obligations, and by limiting the subject matter of the auditor’s report to a simple verification of compliance by Paddington. In the absence of express wording, Paddington had no right to redact relevant agreements and business records disclosed for inspection by the auditor (except in a very limited case, namely legally privileged information).
So where audit rights are concerned, the Court may apply an interpretation of the clause which is not entirely what one or more of the parties understood or perhaps intended. In this case the Court’s interpretation was a narrow one based on a literal reading of “third party”, favouring Paddington. However, from this interpretation the Court also derived a further principle which favoured Pixdene, namely that there was no implied right for Paddington to redact information.
In conclusion, it is vital for each party to consider carefully what rights and obligations it expects to be created by such audit provisions, and to instruct specialist solicitors to negotiate and implement a form of words that will achieve the desired end should the matter come before the Court. Of course, with a clearly written clause it is far less likely that the Court will ever need to become involved.
This article is not a substitute for specific legal advice, which should be taken before acting on any of the topics covered. Please do contact me if you would like an initial discussion of your situation.