Interpreting audit rights in England and Wales when 'the milk of human kindness has long since evaporated'
Published on 31st Jan 2023
High Court casts helpful light on the scope of audit clauses in dispute over royalty distribution agreement involving Paddington Bear
Once a relationship becomes strained, any number of issues can arise. This is illustrated by the recent case of Pixdene Limited v Paddington and Company Ltd (2022), where an astonishing 10 issues were identified as needing resolution by the court from an audit clause which was fewer than 60 words in length. One might argue that the clause was so brief, it was always going to end in argument but, in fact, two audits took place without incident before the relationship soured and the scope of the clause was analysed so fully.
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 leave nothing to the parties to sort out, as their lawyers were of the view that they simply would not be able to come to any sort of common sense agreement. That means that we have clear answers from the court on a number of the specific questions raised on this audit clause, casting a helpful light on the scope of audit clauses and aiding the drafting of future clauses.
Facts and issues
The facts can be set out in short order: Paddington and Company Ltd (Paddington), as the owner of the intellectual property rights relating to Paddington Bear, entered into a royalty distribution agreement with Pixdene which had an existing right to a share of the merchandising income from the exploitation of the Paddington Bear merchandising rights.
The agreement contained an audit right to enable Pixdene to verify whether Paddington had complied with its obligation to pay Pixdene royalties. The clause 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."
Some of the issues that were addressed by the court included whether Pixdene itself had a right of inspection, whether Paddington had to permit the third party auditor to conduct the audit even if that third party auditor did not enter into a non-disclosure agreement that Paddington had provided, whether the audit inspection was limited to a physical on-site inspection of documents, whether the third party auditor could inspect only in the presence of Paddington's representatives and the questions of providing copies, re-inspecting previously inspected periods and redaction.
Did Pixdene itself have a right of inspection of the relevant documents?
No. The clause specified only a right for a third party auditor to inspect Paddington's documents. It did not specify that Pixdene may inspect those documents, although it would have been easy for the drafting to allow this.
So, should a right be implied? No. The implication of a term giving Pixdene a right of inspection was not obvious nor necessary and in fact may undermine the aim of the clause that the party inspecting was independent of Pixdene.
Third party auditor and NDA
The issue of whether Paddington had to permit the third party auditor to conduct the audit, even if that third party auditor did not enter into a non-disclosure agreement (NDA) that Paddington had provided, was no longer in dispute at the time of the trial. Paddington accepted that it could not require the third party auditor to enter into an NDA and that Pixdene's rights in the audit clause were not dependent on the NDA being entered into.
The drafting point to take away from this issue is that one should draft expressly if, as in most cases, the party being audited wants an express NDA in place before the audit takes place.
Physical on-site inspection
Was the audit inspection limited to a physical on-site inspection of documents in Paddington's offices during normal working hours, or could it be at a location chosen by the third party auditor?
Given the clause provided that inspection required "prior written notice", and was to be carried out "during normal working hours", the court held that this showed that the parties envisaged a physical inspection of documents by the third party auditor at a place under Paddington's control and which Paddington might reasonably choose.
It added that if inspection of documents was envisaged by setting up a data room at the auditor's offices, for example, then it would not be necessary to specify that inspection could take place only "during normal working hours" as there would be nothing to stop the auditor from working late or at weekends.
Presence of representatives required?
The court found that the audit clause did not require the third party auditor to inspect only in the presence of Paddington's representatives. It held that specifying an independent, third party auditor, with their own professional obligations, would be understood by a reasonable person to mean that such a person could be trusted to carry out the inspection professionally without requiring further supervision. Therefore, if a party were to permit an audit, but wanted to supervise it, this should be stated expressly.
Did the audit clause require Paddington to provide the third party auditor with copies of inspected documents?
Pixdene argued that the auditor was entitled to copies, including electronic copies, of all documents inspected as part of an audit.
The court agreed with Pixdene that without the right to take copies, the auditor would be forced to write their report from Paddington's data room and would not have any records of the documents it had audited and relied upon in making the report, to which professional obligations attach. Accordingly, the court answered "yes": the third party auditor could take copies as they considered necessary to enable production of the audit report, and for the purposes of maintaining appropriate records of their work.
Will this mean the end of references in audit clauses to being permitted to "take copies"? Probably not, given the cost of having this question answered in this instance.
Periods already inspected
Did the audit clause allow the third party auditor to carry out an audit inspection as regards a period that has already been inspected? The court held that the clause did not permit an audit of a previously audited period, stating that "not more than once per every two year period" means that once a two year period has been inspected, there is no further right of inspection.
The judge was of the view that the more common drafting of "not more than once every two years" did not necessarily have the same effect, as that limits the time period between inspections rather than the number of times that a two year period can be inspected. However, the judge also felt that carrying out a second audit would not be to "verify" compliance, but rather to "re-verify" compliance given the initial audit would already have taken place, and therefore would fall outside of the clause.
Did the clause permit Paddington to redact documents seen by the third party auditor?
Paddington wished to redact material that was not relevant to Pixdene's entitlement to royalties. Pixdene, however, argued that redactions were likely to be contentious, that Paddington had previously redacted documents liberally and without justification, and that the third party auditor would be under professional obligations to keep confidential information confidential and therefore that redaction was unnecessary.
The court held that Paddington was not able to redact information (except in relation to legally privileged information which it was not required to make available for inspection). It said that the auditor itself was only permitted to disclose to Pixdene information which was necessary to report on Paddington's compliance and the risk that confidential information would pass to Pixdene through the third party auditor was adequately mitigated by the auditor's professional obligations.
Osborne Clarke comment
In many commercial relationships, the right to audit can be key, particularly where the counterparty is providing a critical service or, as in this case, where revenue may depend on the counterparty performing its obligations accurately.
A right to audit is unlikely to be implied into a commercial agreement and therefore it is important to include the right expressly if you want to be able to inspect your counterparty's premises, books or records.
As this case shows, it is also important to consider the scope of any audit rights. A party should ensure that it has fully considered its audit needs prior to entering into the relationship and that the agreement expressly deals with issues such as the purpose for which an audit can be carried out; which records, books and premises can be audited; where an audit is to take place; the frequency of audits and which periods can be audited; how much notice must be given and whether the parties wish to have a representative present during an audit – as well as considering which party will cover the costs of an audit and what the consequences of the results of any audit will be.