Audit clauses can be a useful tool for verifying compliance with contractual obligations, especially on compliance, pricing and payment issues. But what are the key drafting considerations? In this briefing, we look at things to 'bear' in mind following two disputes involving audit clauses in commercial contracts, one of which centred around Paddington Bear merchandising rights.
- What are audit clauses and when are they used?
- Lessons from case law
- Drafting audit clauses – key considerations
- More information
What are audit clauses and when are they used?
An audit clause is a contractual provision that allows one party to inspect or review the financial accounts and records of another party for verification purposes, including compliance with contractual obligations. Audit clauses are often used in relation to the following:
- Royalty payments - for example, where one party licenses intellectual property (IP) to another party in return for a percentage of the revenue generated from exploitation of the licensed IP. Audit clauses in this context allow the party receiving royalties the right to verify the accuracy of the reported sales and, from that, the royalty calculations.
- Cost-based pricing – for example, where the supplier's pricing is based on its costs plus a margin, audit clauses will often be used by the customer to verify the accuracy of the costs that the supplier claims to have incurred.
- KPIs and other targets – for example, where the customer is entitled to receive service credits for a supplier's failure to meet Key Performance Indicators (KPIs) or other targets, an audit clause will allow the customer to verify the underlying data on whether those targets have been met.
Lessons from case law
Pixdene v Paddington and Company (the Pixdene case)
This case (from 2022) concerns a royalty distribution agreement ("RDA") relating to Paddington Bear merchandising rights. Paddington and Company Ltd, which owned the IP rights in and arising out of Paddington Bear, had granted Pixdene a contractual right to a share of the net merchandising income from the worldwide exploitation of the Paddington Bear merchandising rights. The contract contained an audit clause allowing Pixdene to appoint an auditor to check that it was receiving its full entitlement. A dispute arose as to the scope of the rights granted to Pixdene by the audit clause.
Transport for Greater Manchester (TGM) v Thales (the Thales case)
This case (from 2012) concerned a contract for Thales to provide a tram operating system to TGM. Thales had claimed increased costs and an extension of time for work carried out. TGM wanted to check that these claims were justified and sought the production of certain documents pursuant to an audit clause in the contract.
Although the cases are separated by 10 years, some common themes emerge in terms of how the court approached the audit clauses:
Lesson 1: the purpose of the audit clause is key
In the Thales case, the court was particularly concerned to ensure that in requesting the information, TGM was acting within one of the purposes for the request specified in the audit clause itself. TGM said that it had requested certain information so that it could review the claims for additional costs. The court found that this was a legitimate purpose under the clause, covered by the wording "for the purpose of ...verifying the supplier's compliance with its obligations under this Agreement". Similarly, in the Pixdene case, the courts looked to the purpose of the audit clause, which was to verify Paddington's compliance with the RDA. However, in both cases the court was also concerned to ensure that the information requested did not go beyond what was necessary for the purpose of the clause – and that the exercise did not become a "fishing expedition".
Lesson 2: commercially sensitive information will often be disclosable
In the Pixdene case, the court found that any information that is legally privileged can be redacted. However, it was held that no right to redact confidential information would be implied by the courts, since all information which was relevant to the purpose of the audit would need to be disclosed to the auditor. In Thales, the court upheld the vast majority of TGM's requests for information, including relevant board minutes of Thales group companies and documents which Thales claimed were commercially sensitive. The court took the view that TGM's confidentiality obligations were sufficient to address Thales' concerns.
Lesson 3: who can inspect and under what conditions
In the Thales case, the audit right was widely drafted and allowed TGM's own staff to carry out the the inspection. In the Pixdene case, by contrast, the clause only allowed inspection by a third party auditor – and the court rejected Pixdene's argument that the auditor was entitled to share all inspected documents with Pixdene and its advisers. However, the judge was satisfied that the parties must have intended that the auditor would be entitled to disclose to Pixdene the conclusion reached on the audit, the basis of that conclusion, whether an underpayment had been found, and if so, how much and how the sum was calculated.
The audit clause in the Pixdene case also restricted the inspection of documents to "normal working hours", so the court implied that the inspection must take place at Paddington's offices, since there would otherwise be nothing to prevent the auditor from working outside of those hours. However, the auditor was not prevented from taking copies of the relevant documents for reasons of practicality and commercial efficacy and because Paddington were protected by the fact that the auditors are independent and bound by professional duties. There was no implied right for the auditor to be supervised whilst inspecting the documents.
Lesson 4: specific performance may be available
Specific performance involves the court ordering a party to carry out a particular action (or series of actions). Although it is generally difficult to obtain in relation to most contractual obligations, the court ordered it in the Thales case because damages would clearly have been an inadequate remedy. In the Pixdene case, the court made a declaration setting out how the audit clause should be interpreted – but if Paddington refused to allow Pixdene access in accordance with that interpretation, Pixdene would still have the option of returning to court to seek an order for specific performance.
Drafting audit clauses – key considerations
Key considerations for parties seeking to rely on an audit clause
- Clearly define the purpose of the audit, ensuring that it explicitly covers off all anticipated justifications for carrying out an audit. Bear in mind that the purpose is likely to impose certain limits on what information can be obtained.
- As well as including a broad, general inspection right, consider including specific examples of the types of document which can be inspected (especially if there is a concern that the other party may resist disclosure of certain materials).
- Where it is envisaged that the audit will be carried out by a third party, ensure that they can share all relevant information with you and your advisers.
- Ensure that copies of documents can be taken away for further consideration off-site (subject to suitable measures being taken to preserve confidentiality).
- Usually, contracts state that the party seeking to rely on the audit will bear the costs of the audit. However, consider reversing this position where a material error or discrepancy is found on behalf of the other party, or sharing costs in complex outsourcing arrangements where audits are required on a more frequent basis to verify compliance with performance-related obligations.
Key considerations for parties who are subject to an audit clause
- Define the purpose of the audit as narrowly as possible.
- To limit the other party's access to sensitive information, consider specifying that the audit can only be carried out by an independent third party, who is only entitled to share their conclusions and basis for arriving at them with the other party (rather than all information disclosed as part of the audit).
- Consider whether certain categories of documents should be expressly excluded from the audit. However, keep in mind that the redaction of potentially sensaitive business information may not be possible if it would undermine the purpose of the audit, especially where an independent third party auditor has been appointed.
- Consider whether additional conditions should be imposed on the audit e.g. material deemed to be particularly sensitive can only be inspected on-site and copies cannot be made.
- Ensure that the party being subject to the audit clause bears the costs of the audit.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
