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Audit clauses merit a 'hard stare' following Pixdene v Paddington

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By Hannah Batten

31 Jan 2023 | 2 minute read

Royalties are a form of revenue sharing arrangement commonly (but not exclusively) used in intellectual property rights licences, whereby the recipient is entitled to a share of the paying party's relevant revenue. Revenues and the sums payable are generally calculated and reported by the paying party, so robust audit rights are a vital safeguard for the recipient, enabling them to verify the reported revenues and calculations and identify any underpayments.

In the recent case of Pixdene Ltd v Paddington and Company Ltd, the Intellectual Property Enterprise Court (IPEC) witnessed a 'surprising number of issues' with a 'short and simple' audit clause within a royalty distribution agreement. The judgment serves as a useful reminder of how important it is to ensure that audit clauses are clearly drafted, suitably detailed and reflect how the parties intend the rights to be exercised in practical terms and will be of particular interest to intellectual property rights-holders and licensors.

Background

In 2013, Paddington and Pixdene entered into a Royalty Distribution Agreement (the Agreement), under which Paddington (the owners of the intellectual property rights in Paddington Bear) were bound to pay Pixdene 10% of their final share of net merchandising income. An audit clause within the Agreement read:

“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.”

When Pixdene appointed an auditor in 2019, the wording of this clause led to a dispute about the scope of the rights granted by it, and the court was faced with a number of questions about its practical meaning.

In reaching its judgment, the court applied the established case-law on the construction and implication of contract terms (the key principles of which are set out below) before considering the interpretation of the audit clause itself.

Contractual construction

Commercial common sense and surrounding circumstances should not undervalue the documentary, factual and commercial context of words.

  • Arnold v Britton & Others

Implied terms

A term will not be implied unless it is necessary for business efficacy and/or on the basis of obviousness.

  • Marks & Spencers plc v BNP Paribas Securities Services Trust Co (Jersey) Ltd.

What exactly were the issues with the audit clause?

IssueJudgementKey points to note
Does the clause require Paddington to provide Pixdene and/or the auditor with copies of inspected documents?The court found that the clause entitled the auditor, but not Pixdene to copies. However, Pixdene was entitled to any information which was necessary for the auditor to explain its findings.It's important to clearly state who has rights to audit and/or obtain copies of documents (and to address the rights of the parties and their representatives separately). Although the auditor will likely have implied rights to copies to the extent reasonably necessary to prepare their report, there will be no equivalent implied right for the party seeking the audit (any omission in this respect will likely be regarded by a court as intentional).
What documents exactly fall under the scope of 'business records' which may be the subject of inspection as part of an audit? Whilst there was no definition of "business records" in the Agreement, the court held that Paddington was only obliged to provide its agreements and records which were relevant to the calculation of merchandising royalties relating to Paddington Bear. However, this extended to relevant documents that were within Paddington's control (as well as those in Paddington's possession). In the absence of a clear definition, the purpose of the audit will be relevant to determining the scope of the documents/ records that must be made available for inspection, and this will likely include those within the control of the party being audited (as well as those in their possession).
Is an audit inspection limited to a physical on-site inspection in Paddington's offices during normal working hours?The inclusion of "during normal working hours" meant physical inspection and at a place under Paddington’s control. However, this does not go as far as requiring the inspection to be in the presence of Paddington representatives. If a party requires the audit inspection to take place at a particular location, under particular circumstances or to have the right for a representative to oversee any audit inspection, then this should be expressly included in the contract as these matters are unlikely to be implied by the courts.
Does the clause allow an audit inspection in respect of a period which has already been the subject of a previous inspection? The words "once per every two year period" mean what they say; once a two-year period has been inspected there is no further right of inspection relating to that period. Reasonable notice of a proposed audit inspection must be given, and this must specify the period to which the inspection will relate.The obligation to provide reasonable notice of an audit may be implied, and although what is reasonable will depend on the circumstances, this is unlikely to be less than 10 business days.
To what extent is the auditor entitled to share information (in particular confidential information of Paddington or third parties), other than the conclusions of its audit, with Pixdene?Although the auditor is entitled to share the conclusions of their audit, the basis on which it reached those conclusions and the calculation of any additional sums due to be paid, the clause should not be construed as giving a right for Pixdene to have full access to the information seen by the auditor and nor should such a right be implied.Where a party does not itself have rights to carry out an audit, they are very unlikely to have implied rights to copies of all documents seen by the auditor (as this effectively amounts to the same thing).
To what extent is Paddington entitled to redact documents seen by the auditor, Pixdene and/or any of Pixdene's other professional advisors?Paddington is only entitled to redact documents to the extent that they are legally privileged. The fact that the auditor is subject to professional obligations of confidentiality and that (per the above) Pixdene had no right of access to the documents seen by the auditor meant that there was sufficient protection for Paddington's other confidential information.If an audit is to be carried out by an independent auditor with professional confidentiality obligations, it's unlikely that a court will imply rights to redact documents to be inspected (except in respect of legally privileged information). Such rights should be specifically included in an audit clause if required.

What does this case tell us?

The IPEC's judgment demonstrates the importance of paying proper attention to audit clauses – they should not be considered 'standard' or 'boilerplate' provisions – and careful consideration should be given to how the parties intend to conduct audits in practical terms.

It also provides useful guidance on a number of factors to consider and address when drafting or reviewing audit clauses, together with an indication of the approach a court might take where the clause itself lacks the detail and specificity needed to resolve (or avoid entirely) disputes over these issues.

Ultimately, the case demonstrates that 'short and simple' is not always the best approach to drafting commercial contracts – clarity and precision should be the priority.

If you would like to discuss the issues or consequences raised by this case, please do not hesitate to contact us.

Considering whether you need an IP audit? Please find our helpful guide here.  

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