Audit rights: an 'after Paddington' drafting checklist for keeping clauses clear
Published on 14th Mar 2023
Tips on what drafting issues should be considered by the party that is more likely to be audited
Audit rights can be critical and, when issues arise, precise drafting will help the court understand the intention of the parties. In the recent case of Pixdene Limited v Paddington and Company Ltd (2022), the High Court cast helpful light on the scope of an audit clause in a dispute over a royalty distribution agreement involving Paddington Bear. The court identified 10 issues that needed resolution from an audit clause of less than 60 words in length. The judge was asked to give as much guidance as possible as to what the audit clause required or entitled the parties to do and to leave nothing to the parties to sort out, as they were not likely to come to a common-sense agreement.
The court delivered clear answers on a number of the specific questions raised on this audit clause, from which we have developed a checklist of issues to consider.
The 60-word clause
The audit clause in question stated: "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."
The relevant agreement was entered into between Paddington and Company Ltd (Paddington), owner of the intellectual property rights arising out of Paddington Bear, and Pixdene Limited, which had a right to a share of the merchandising income from the exploitation of the Paddington Bear merchandising rights.
What are the drafting issues and what should the party likely to be audited consider?
- Consider a right to redact confidential information
The court held that only redaction of legally privileged information was permitted, not of other information which the party being audited might want to keep from the other party (the court said that the auditor’s professional obligations would prevent it from passing on any information beyond what is necessary to produce the audit report).
✓ Ensure that any audit is limited to books and records that are relevant for the purpose of verifying the audited party’s compliance with the agreement or other agreed audit purposes.
✓ Expressly provide a right for the audited company to redact from the books and records being inspected any information which is outside the scope of the audit.
- Consider ensuring that the inspection will only take place in the presence of one of your representatives
The court was not persuaded that the third-party auditor could only inspect in the presence of Paddington's representatives. It found that by specifying a “third-party auditor” the parties had envisaged that that auditor could be trusted to carry out the inspection professionally without requiring further supervision.
✓ Ensure you have the right to accompany and escort any third-party auditor while on your premises and that they will not unreasonably interfere with your normal course of business.
- Consider ensuring it will be a physical on-site inspection
The courts considered whether the audit clause limited the audit to a physical on-site inspection of the documents, in Paddington’s offices and during normal working hours. The courts considered that by specifying that the inspection would take place during "normal working hours", the parties had envisaged both a physical inspection as well as such inspection taking place at Paddington’s offices.
✓ State expressly that the audit must take place during normal working hours, or state expressly that it will be a physical on-site inspection at your premises.
✓ If you intend the inspection to take place at a different place or time, for example, by setting up a data room at the auditor's offices, state this expressly.
- Limiting the right to take copies of inspected documents
The court agreed with Pixdene that the auditor was entitled to take copies of the inspected documents, and that this could be implied into the clause, so that the auditor would have records of the documents it had audited and relied upon in making the report.
It seems reasonable that an auditor is permitted to take copies of the inspected documents where necessary to enable production of the audit report. It is common to see an express right for an auditor to "take copies". It seems that this express wording may not be required.
✓ If you wish to prevent the auditor from taking copies, state expressly that the right of access does not include taking copies of the inspected documents.
- Ensure your counterparty cannot itself inspect the documents
While Pixdene argued that it should have the right to receive all documents Paddington was required to make available for inspection in advance, the court saw this as a blurring of the lines between the parties. It considered the drafting that a “third party auditor” had a right of inspection, meaning that Pixdene should not have direct access to Paddington’s documents itself, and nor would a right of inspection be implied.
✓ Make sure the clause states that an independent third auditor only will carry out the inspection.
- Ensure the auditor cannot re-inspect previously audited periods
Provided that there was no more than one audit within a two year period, Pixdene argued that an auditor may audit periods which have already been the subject of an audit. The court agreed with Paddington that the drafting meant that an audit inspection could not cover a period that had already been audited.
✓ Ensure the purpose of the audit is to verify compliance with the agreement (which should exclude auditing for re-verification).
✓ Be aware that drafting for an audit to take place "not more than once every two years" may not prevent re-auditing as that limits the time period between inspections rather than the number of times that a two-year period can be inspected.
✓ If concerned, state expressly that periods that have been inspected cannot be re-inspected (save, perhaps, if any audit evidences any material non-compliance).
- What else to consider?
✓ Ensure written notice of a reasonable period must be given, for example, 10 working days.
✓ State how often an audit can take place (and which periods it can cover).
✓ State the purpose of any audit.
✓ Ensure you provide, where relevant, that any auditor will not be a competitor of the audited party.
✓ Provide that each auditor will enter into an NDA with the audited party prior to any audit (and will undergo any relevant security clearances) .
✓ Consider limiting the number of days, each year, that an audit can be carried out.
✓ State expressly which party will pay for each audit (both the third-party costs, and the internal costs of complying with an audit).
Osborne Clarke comment
As with many clauses in commercial contracts, there is a huge amount of detail that can be included in an audit clause. This case emphasises that taking a short-form approach may leave the parties in dispute over the extent of the rights granted and the scope of any limitations on those rights. That said, parties will often take a risk-based approach in order to reach agreement on the extent of audit rights granted.
Melissa Woodfield and Thuvaraka Balamurali, a Trainee Solicitor and a Paralegal with Osborne Clarke, co-authored this Insight with Victoria Gwynedd-Jones.