A recent judgment in the English Intellectual Property Enterprise Court (IPEC) had HHJ Melissa Clarke interpreting the meaning of a royalty audit clause. The case reference is Pixdene Ltd v Paddington and Company Ltd [2022] EWHC 2765 (IPEC).
The dispute was about a clause in a royalty distribution agreement that concerned income from merchandising the well-known character, Paddington Bear. Under the terms of the agreement, Pixdene was entitled to 10% of certain revenues generated by Paddington and Company Limited (referred to in the judgment as Paddington). Pixdene wished to audit Paddington’s books, to verify that the correct royalties had been paid. The audit clause read as follows:
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.
As the judge described it, trust had broken down between the contracting parties, and she was asked to assume that the parties would not be able to reach a common-sense solution. Therefore, detailed guidance was required from the court as to exactly what the clause permitted.
After reciting well-known English law about the interpretation of contracts, and the implication of terms, and considering the terms of the revenue distribution agreement, the judge made the following decisions:
i) Pixdene is entitled to choose a third party auditor to carry out each audit under clause 5, who must be an entity that is distinct from and independent of either party (save for being instructed by Pixdene) and with no commercial interest in the outcome of the audit;
ii) Pixdene must give Paddington prior written notice of an audit under Clause 5 which must be given a reasonable time (which shall not be less than 10 clear business days) before the proposed audit and must identify the relevant period for the audit inspection;
iii) An audit under clause 5 may involve a period of more than two years, however there cannot be more than one audit per two year period and there cannot be an audit inspection in respect of a period that has already been the subject of an audit inspection pursuant to clause 5;
iv) An audit inspection must take place at a venue to be reasonably determined by Paddington within Paddington’s control and within normal working hours;
v) Paddington shall be obliged to make such copies of the inspected documents as the third party auditor reasonably requests, and to permit the third party auditor to take copies himself, provided that the cost of such copies is met by Pixdene and that the third party auditor keeps such copies confidential;
vi) Pixdene is not entitled to inspect documents pursuant to clause 5 or, to be provided with copies of the same by Paddington;
vii) The third party auditor is only permitted to disclose to Pixdene such information gained from the audit inspection as is necessary to report on the following matters, and shall keep all other information confidential:
a) the conclusion reached on the audit (i.e. whether or not Paddington has complied with its obligations under the RDA);
b) the basis of that conclusion, and if an underpayment is found;
c) what further sums are due from Paddington; and
d) the basis of calculation of such sums;
viii) Paddington is only entitled to redact documents for inspection to the extent that they are legally privileged
IP Draughts suspects that the main lesson for the contract drafter is that standard audit clauses rely on the parties taking a common sense approach to the detail of how any audit will be conducted. In the absence of such an approach, a very detailed clause may be required, or at least one that addresses the following core issues:
- May the contracting party do the audit, or must it be an external auditor?
- What information is the auditor to have access to, and can they take copies of this information?
- What information is the auditor allowed to disclose to the contracting party that appoints them?
Mr Pettifog
Mark Anderson
Paul Maclennan
Stephen Brett
Victor Warner
IP Draughts 
Most decent templates include some of these points already. My template licence agreement includes the following text: The Licensee shall make such records and accounts available, on reasonable notice, for inspection during business hours by an independent chartered accountant nominated by the IP Company for the purpose of verifying the accuracy of any statement or report given by the Licensee to the IP Company under this Clause 4. The accountant shall be required to keep confidential all information learnt during any such inspection, and to disclose to the IP Company only such details as may be necessary to report on the accuracy of the Licensee’s statement or report.
Good post. But the existence of the court decision itself changes the drafter’s landscape. A solicitor might well want to make the client do the choosing between (a) trusting the parties to use ‘common sense’ if a dispute arises, and (b) using contract language that lays out the detail, or at least the ‘core issues’, of how any audit will be conducted. Assuming the solicitor explains what’s involved, the client is unlikely to say, when a problem arises, ‘Why didn’t you tell us the risks involved in the standard detail-free language?’