Audit clauses – true construction and implied terms

Pixdene Ltd v Paddington and Company Ltd [2022] EWHC 2765 (IPEC)

The question

How did the court construe the wording of an audit clause when the parties to a royalty distribution agreement disagreed on who was entitled to inspect the relevant documents and what could be done with the documents?

The key takeaway

To avoid disputes about the true construction of audit clauses, parties should ensure that the audit clause is tailored to the specific transaction and factual background and that the scope of their respective obligations is clearly set out. A party seeking audit rights will want to focus on having broad rights to access data, information, systems, equipment and the premises. A party granting audit rights, however, will aim to limit disruption to their business, costs and will be looking to restrict access to confidential and commercially sensitive information.

The background

Pixdene had entered into a royalty distribution agreement (RDA) giving it a right to a 10% share of the net merchandising income from the worldwide exploitation of the Paddington Bear merchandising rights. The other party to the agreement, Paddington and Company Limited (Paddington), owns the intellectual property rights to Paddington Bear. A dispute arose between the parties which focused on the proper contractual interpretation of the RDA’s audit clause which provided:

“5. Audit

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.”.

Audits took place in 2014 and 2017 with no issues raised. However, in 2019, Pixdene appointed a different auditor, and the dispute arose concerning what the audit clause entitled Pixdene and the auditor to access.

Pixdene sought an order for specific performance requiring Paddington to perform its obligations under the audit clause. It also sought a declaration from the court on the general interpretation of the audit clause.

It was Pixdene’s case that the audit clause should be construed to require Paddington to send to Pixdene in advance of inspection all the documents which it was required to make available for inspection (effectively giving Pixdene a right to inspect) and to provide it with copies of inspected documents. Paddington submitted that the audit inspection was limited to a physical on-site inspection of documents in Paddington’s offices, during normal working hours and only in the presence of Paddington’s representatives.

The decision

The court dismissed Pixdene’s submission that the audit clause entitled it to inspect or receive copies of inspected documents from Paddington in advance of any inspection. The drafting very specifically covered only a third party auditor and this excluded Pixdene.

The court agreed with Paddington on the place and timing of the inspection but did not agree that the clause obliged the third party auditor to inspect only in the presence of Paddington’s representatives.

On the question of what information the third party auditor was entitled to share with Pixdene, the court found that the clause did not give Pixdene a blanket right to copies of inspected documents from the auditor but the auditor would be permitted to disclose information gained from inspecting documents that would enable it to report to Pixdene.

The court then considered whether Paddington was entitled to redact documents to be reviewed by the auditor. Paddington submitted that it should be permitted to redact “those parts of the said agreements and other business records which do not relate to the Claimant’s entitlement under the Agreement …”. The court disagreed, even in relation to confidential information, because the clause was silent on redaction and the limited disclosure permitted by the auditor (a professional with professional obligations to treat confidential information confidentially) under the clause provided adequate protection to Paddington. The court did, however, imply a term that Paddington could withhold legally privileged information from inspection.

The court also made useful findings on a number of other points. While it did not specify exactly how long the prior written notice of the audit should be, it confirmed that this notice should be given within a “reasonable time”. This should not be less than 10 clear business days before the proposed audit and must identify the relevant period for the audit inspection.

Why is this important?

Audit clauses that fall to be interpreted by the courts will have the usual rules of contractual construction applied to them. This case is particularly helpful in summarising the court’s approach to construction of audit clauses and to implying terms into them.

There was no great departure from the court’s normal approach of placing great importance on the natural meaning of words in contractual provisions (even if a term that is very imprudent for one of the parties has been agreed) and a reluctance to imply terms unless this is necessary to give business efficacy to the contract or on the basis of the obviousness test.

Any practical tips?

Where the audit clause provides for the auditing party to undertake audits via a third party, but the auditing party wishes to include its own right to inspect or receive copies of documents, this should be stated explicitly in the provisions of the agreement. There should also be clear reasons for it to do so because invariably this will be resisted by the party granting audit rights due to concerns about confidentiality and access to commercially sensitive information (which is one of the reasons why a third party auditor is often specified).

Cases relating to audit clauses and disclosure of information are generally fact specific, but a common theme is courts refusing to grant an order for access where an audit clause does not specify the access required, or provide sufficient information about the purpose of the audit and what will be done after access has been obtained. To avoid this, ensure audit provisions fit the type of transaction and individual circumstances, and encompass the scope of information and access required.

Where appropriate, consider stipulating the period of advance notice required to be given prior to inspection, to avoid any debate around what constitutes reasonable notice. Also consider exercising audit rights on a regular basis, as envisaged by the contract, rather than only in circumstances where a dispute has already arisen or an underpayment or non-compliance issue has been raised.

Spring 2023