The 'TLDR' takeaway:
A well-drafted audit clause is essential for the proper functioning of a royalty provision (particularly if the relationship between the parties deteriorates). A handy sample clause is included at the bottom of the post, but it should be reviewed and tailored for each specific deal.
As Intellectual Property Lawyers, we would certainly hope that our endeavours could be categorised (at least) as "nonstandard provisions of some complexity and sophistication, which appear to have been carefully and professionally drafted and closely negotiated". This phrase, from HHJ Clarke in Pixdene Ltd v Paddington and Company Ltd  EWHC 2765 (IPEC), can be contrasted with Pixdene and Paddington's more nonchalant approach to boilerplate drafting. As a result, the case serves as a useful reminder: (i) for IP lawyers to pay attention to the more 'quotidian' commercial clauses; and (ii) on English judicial consideration of interpretation and implied terms.
The case concerned a merchandising agreement relating to Paddington Bear. The parties entered into a short-form royalty distribution agreement consisting of just three recitals and nine clauses. The agreement entitled Pixdene to 10% of the final share of the Paddington Bear worldwide merchandising income (subject to various deductions). Despite the detailed provisions relating to ownership of rights (see HHJ Clarke's comment above), the audit provision leant more towards brevity -
“Clause 5. 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.”
Unfortunately, the relationship between Pixdene and Paddington broke down to the point where "the milk of human kindness has long since evaporated" (as expressed by Counsel for Pixdene). The parties subsequently became embroiled in a dispute over Pixdene's attempt to conduct an audit in 2019. The issues before the High Court all stem from the drafting lawyers' failure to account for normal audit practices in the clause and the resulting need for the clause to be interpreted to give it practical effect; with the uncooperative parties unsurprisingly arriving at differing interpretations.
Before we look at the decision in the case, it will be useful to remind ourselves, of the relevant law (as HHJ Clarke does adroitly in her judgement - see paras 14-16). The leading authority on interpretation being Arnold v Britton and the judgement of Neuberger LJ. When interpreting words in a written contract, the court:
- determines "what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean" (Chartbrook v Persimmon Homes) by looking at the chosen words in their documentary, factual and commercial context; and
- assesses the meanings of such words are then assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the agreement, (iii) the overall purpose of the clause and agreement, (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party's intentions.
It is worth remembering that 'commercial common sense' should not: (i) override an understanding that is clear from the natural meaning of the words; or (ii) be invoked retrospectively. The general rule 'lawyers do not make mistakes' (😬) applies: as the parties "have control over the language they use in a contract... [and] must have been specifically focussing on the issue covered by the provision when agreeing the wording of that provision". In addition, "a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed, even ignoring the benefit of wisdom of hindsight." The purpose of interpretation is to identify what the parties have agreed, not what the courts think they should have agreed.
- A term will not be implied unless, on an objective assessment of the terms of the contract, it is necessary to give business efficacy to the contract and/or on the basis of the obviousness test;
- The business efficacy and the obviousness tests are alternative tests. However, it will be a rare (or unusual) case where one, but not the other, is satisfied;
- The business efficacy test will only be satisfied if, without the term, the contract would lack commercial or practical coherence. Its application involves a value judgment;
- The obviousness test will only be met when the implied term is so obvious that it goes without saying. It needs to be obvious not only that a term is to be implied, but precisely what that term (which must be capable of clear expression) is. It is vital to formulate the question to be posed by the officious bystander with the utmost care;
- A term will not be implied if it is inconsistent with an express term of the contract;
- The implication of a term is not critically dependent on proof of an actual intention of the parties. If one is approaching the question by reference to what the parties would have agreed, one is not strictly concerned with the hypothetical answer of the actual parties, but with that of notional reasonable people in the position of the parties at the time;
- The question is to be assessed at the time that the contract was made: it is wrong to approach the question with the benefit of hindsight in the light of the particular issue that has in fact arisen. Nor is it enough to show that, had the parties foreseen the eventuality which in fact occurred, they would have wished to make provision for it, unless it can also be shown either that there was only one contractual solution or that one of several possible solutions would without doubt have been preferred; and
- The equity of a suggested implied term is an essential but not sufficient pre-condition for inclusion. A term should not be implied into a detailed commercial contract merely because it appears fair or merely because the court considers the parties would have agreed it if it had been suggested to them. The test is one of necessity, not reasonableness. That is a stringent test.
Reminding ourselves of clause 5 -
“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 court was asked to address various issues and the relevant questions for our purposes are below:
- Who can inspect? As clause 5 clearly referenced a "third party" auditor and the exclusion of this wording or inclusion of Pixdene would have been a simple drafting matter, HHJ Clarke found the wording to clearly and unambiguously exclude Pixdene from conducting the audit and implying a term to the contrary would be inconsistent with the express language. So far, so simple.
- Should Paddington provide copies of documents to Pixdene and/or the auditor? In respect of Pixdene: no (essentially for the same reasons as given above). However, HHJ Clarke did agree that clause 5 obliged Paddington to provide copies and not merely to make documents available for inspection (which Paddington argued), not on the basis of interpretation (the clause solely providing for inspection), but being implied "on the grounds of obviousness" and "necessary to give commercial and practical efficacy to clause 5".
- Where should the audit take place? Clause 5 does not specify a venue for inspection, despite the parties' disagreements HHJ Clarke decided that this could be implied understood as meaning any premises under Paddington's control which Paddington may reasonably choose (i.e. it would not be reasonable for this, in an English law agreement, to be an office of Paddington's in Ulaanbaatar).
- Do Paddington have a right to supervise the audit? Paddington argued that the inclusion of the term "during normal working hours" implied an obligation for the third party auditor to inspect only in the presence of Paddington's representatives. HHJ Clarke gave this short shrift and did not see it as necessary or obvious and that in fact "it would be quite usual to usher such an auditor into the data room and let him get on with it without supervision, to be ushered out again at the end of normal working hours".
- Should Paddington should provide the third party auditor with copy documents before attending at Paddington's offices for inspection "with any questions to be answered"? Despite Pixdene's arguments, it was held that clause 5 could not possibly be construed by a reasonable person to mean that Paddington is obliged to send the documents to the third party auditor (in some sort of pre-inspection) in advance of making the documents available for inspection. HHJ Clarke saw this as "driv[ing] a coach and horses through the purpose of this carefully chosen language of clause 5.
- To what extent can the auditor share documents with Pixdene? Paddington argued that it should be entitled to copies of all documents and Pixdene argued that reporting on issues was permitted but that no confidential or privileged information on which the auditor's conclusions are based could be shared. The judge construed the wording as not giving Pixdene a blanket right to receive copies, but only information required for Pixdene to understand: (i) the conclusion reached on the audit; (ii) the basis of that conclusion, and if an underpayment is found; (iii) what further sums are due from Paddington; and (iv) the basis of calculation of such sums, at all times only sharing such information gained from the inspection of documents as is necessary to report on these matters and not any legally privileged information.
- Can Pixdene re-audit a time period? Pixdene argues that the only time limit is to frequency and this does not preclude an auditor auditing periods that have already been the subject of an audit. Whereas Paddington claims there should be an implied term precluding this. HHJ Clarke draws a clear distinction between the natural and ordinary meaning of "not more than once per every two year period" and "not more than once every two years" with the former setting a maximum frequency per certain periods and the latter being solely concerned with frequency. It was further held that this is commercially practicable to prevent the burden of previous periods being constantly re-audited.
- Can Paddington redact documents? Essentially, HHJ Clarke states that were the documents being provided to Pixdene (which they aren't), there may be an implied term of redaction. However, as the clause clearly provides that only a third-party auditor (therefore a professional with professional obligations to treat confidential information confidentially) the right to redact is not necessary and cannot be implied.
The questions above show just how far apart the interpretations of parties can get when a business relationship breaks down. This cautionary tale shows that, while getting key IP clauses correct is important (obviously), the cost and/or time of drafting all elements of the agreement fully will vastly outweigh the significant cost of battling over ambiguity before a court. Each question posed could have readily been drafted to save on the costs of litigation and significant wasted management time. Not that every clause needs to be be longer or more complicated, mind. However lawyers should be able to critically analyse all clauses within a contract (including spotting those that are missing) and consider their importance to the deal (audit clues are key for royalty deals) and whether they are properly drafted to protect your client's or company's interests.
Sample royalty audit clause:
1.1 If the Licensor gives Licensee at least [NUMBER] Business Days' notice, the [Licensor and its [third-party] auditor(s) OR Licensor's third-party auditor(s)] may [during Business Hours]:
1.1.1 enter the Audit Premises; and
1.1.2 inspect, [and] audit [and take copies of] the books, records and reports of Licensee, and other documents (including without limitation any information technology system or systems owned or operated by Licensee) as necessary to verify the Licensee's compliance with the terms and conditions of this Agreement.
[1.2 Licensor shall exercise its audit rights under Clause 1.1 no more than [once for every [two] year period of the Term OR once every [two] years.]
[1.3 If Licensor [acting reasonably] requires an audit of Licensee in respect of a suspected fraud, the parties agree that the notice requirement at Clause 1.1 and Clause 1.2 are hereby waived.]
[1.4 [The Licensor OR Licensor shall ensure that it's auditor(s)] shall use [its/their] reasonable endeavours to ensure that the conduct of each audit does not unreasonably disrupt the Licensee.]
[1.5 Subject to the Licensee's confidentiality obligations, the Licensee shall provide [Licensor [(and its third-party auditor(s) and other advisers) OR Licensor's third-party auditor(s)]] with all reasonable co-operation, access and assistance in relation to each audit.]
[1.6 Licensee shall be entitled to redact documents provided to Licensor solely to the extent that such redactions do not relate to Licensee's obligations under and/or the subject matter of this Agreement. OR Licensor shall ensure that its third-party auditor(s) shall only report to Licensor such audit information as is strictly required for reporting: (i) the conclusion reached in the audit and the basis of such conclusion; and (ii) the determination of any underpayment and the basis of calculation of such sums, at all times only sharing such information gained from the inspection of documents as is necessary.]
[1.7 The Licensor shall pay the cost and expenses of any audit[, except where any audit identifies that the Licensee has made an underpayment equal to [PERCENTAGE]% or more of the actual amount owed to Licensor in respect of the period covered by the audit, in which case the [reasonable] costs and expenses of the audit shall be paid by the Licensee in-full on Licensor's demand.]
Audit Premises: means Licensee's [and any Group Company's [and any subcontractor's]] premises [in the Territory] [as reasonably selected by Licensee].
Business Days: means a day, other than a Saturday, Sunday, public holiday or bank holiday in [England], when commercial banks are open for ordinary business.
Business Hours: means the period from [09:00 to 17:00] (inclusive) on any Business Day.
Group Company: [Definition]