Don’t let audit clauses leave you in “deepest darkest Peru”

Given the tumultuous relationship the parties shared, the court was asked to provide as much guidance as possible on what the audit clause did or didn’t oblige or entitle them to do. The court had to give that direction without leaving anything to the common sense of the parties to sort out between them. It was well established between the parties that they would be unable to use common sense to solve the issue.

Although interpretation cases regarding audit clauses are usually highly context specific, this case provides a useful foundation for drafters as to how much detail should be considered when drafting this type of clause; as well as what needs to be expressly included and what doesn’t. The case also serves as a useful reminder that the extent of any audit rights will turn on the exact wording of the clause and the wider content the clause is surrounded by.

Please contact Matthew Lingard if you need any advice or assistance in relation to the drafting and/or negotiation of audit clauses within a royalty distribution agreement, or if you have any queries about the points raised in this briefing.

Audit clauses – background to the Paddington case

Paddington and Company own the intellectual property rights in and arising out of the beloved Paddington Bear. Pixdene has an existing right to a share of the net merchandising income from the worldwide exploitation of the Paddington Bear merchandising rights.

The dispute between the parties related to the proper construction of the audit clause which was drafted in a fairly typical way. The clause provided:

“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”.

In the first two audits, no issues arose when Pixdene appointed a third party auditor to carry out audits in 2014 and 2017. But when a third audit was to be carried out in 2019, the parties disagreed about the extent of the rights granted by the audit clause.

This disagreement was in large part due to the lack of trust the parties had in one another. Pixdene’s counsel neatly put this in their oral submissions by saying that: “the milk of human kindness has long since evaporated between them“. In particular, issues arose around: who precisely was entitled to inspect the documents; whether documents could be redacted to hide confidential information; whether copies could be taken away from the rights holder’s premises; and what constituted other business records.

While the court was surprised by the number of issues the parties had with such a typical audit clause, the court found it less surprising, given that neither party trusted the other.

What did the court decide?

The court provided the requested guidance and made certain determinations about what obligations and entitlements the clause put on either party.

In relation to Pixdene, the court said:

• It was entitled to choose a third party auditor, who must be an entity that is distinct from and independent of either party as well as have no commercial interest in the outcome of the audit, to carry out each audit;
• It was required to meet the costs of any copies taken by the third party auditor; and
• It was not entitled to inspect documents or be provided with documents that had been provided to the auditor by Paddington and Company.

And in relation to Paddington and Company, the court said:

• It was able to reasonably determine the location of the audit;
• It was obliged to make such copies of the inspected documents as the third party auditor requested; and to allow them to take copies themselves, provided the copies were kept confidential; and
• It was only entitled to redact documents for inspection to the extent they were legally privileged.

As to the third party auditor, the court confirmed that the auditor was only allowed to disclose to Pixdene such information gained from the audit inspection as was necessary to report on the following, and should keep all other information confidential:

• The conclusion reached on the audit;
• The basis of the conclusion;
• If an underpayment was found, the further sums due from Paddington and Company; and
• The basis of calculation of those sums.

Impact of the decision

The court made several key declarations in relation to the audit clause which will be of particular interest to drafters and those interpreting existing audit clauses. Any party seeking to rely on an audit clause in the future will need to take the court’s interpretation into account. If any party seeking to enter into an arrangement that includes a right to audit wants to make sure their rights differ from the court’s view, then they will need to expressly state this right in the contract. For example, the auditing party may want a right to inspect the documents underlying the audit.

As always, when drafting and negotiating audit clauses, the devil is in the detail; that is making abundantly clear what will be accepted and expected when an audit arises.

If you need any support or guidance on anything raised in this briefing, please contact Matthew Lingard.

[1] Pixdene Limited v Paddington and Company Limited [2022] EWHC 2765 (IPEC)