Making money from marmalade sandwiches: the interpretation of royalty audit clauses

Outside of the luxury sector, licensing plays an important role for many fashion brands as they look to expand the brand’s franchise and generate extra revenue.

In respect of the latter, clauses enabling the audit of specific income streams so as to determine the royalties or share of income which is due are critical. But whilst often overlooked during the negotiation of brand licensing agreements and merchandising agreements, audit clauses warrant careful consideration.

The importance of having a properly constructed audit clause was highlighted last week in a judgment concerning Paddington Bear.

Facts

The judgment concerned a royalty distribution agreement (“RDA”) for merchandise connected to the intellectual property of Paddington Bear.

Under the terms of the RDA, the claimant was entitled to 10% of certain merchandising income generated by the defendant which owned the Paddington Bear intellectual property.

In order to verify that the correct royalties had been paid by the defendant, the claimant appointed a third-party auditor which conducted audits of the defendant’s books in February 2014 and September 2017. No relevant issues arose from these audits.

In 2019, the claimant appointed a different third-party auditor to conduct a further audit of the defendant’s books. This third audit was not carried out, as there was a disagreement between the parties as to the rights granted by the audit clause in the RDA.

What did the audit clause say?

The audit clause (clause 5) of the RDA provided that:

“5. During the term of this Agreement a third party auditor may, upon prior written notice to Paddington [defendant] 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.”

Judgment

At issue was the proper contractual interpretation of the audit clause in the RDA. The court provided the following guidance as to what exactly the audit clause permitted:

• The claimant was entitled to choose a third-party auditor to carry out each audit under clause 5, which must be an entity that is distinct from and independent of either party (save for being instructed by the claimant) and with no commercial interest in the outcome of the audit.
• The claimant must give the defendant prior written notice of an audit under Clause 5 which must be given a reasonable time (being not less than 10 clear business days) before the proposed audit and must identify the relevant period for the audit inspection.
• 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 could not be an audit inspection in respect of a period that has already been the subject of an audit inspection pursuant to clause 5.
• An audit inspection must take place at a venue to be reasonably determined by the defendant within the defendant’s control and within normal working hours.

The judge went on to order that the defendant was 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 was met by the claimant and that the third party auditor keeps such copies confidential.

Further with reference to the issue of confidentiality the judge decided that the auditor was only permitted to disclose to the claimant such information gained from the audit inspection as was necessary to report on the following matters:

1. The conclusion reached on the audit (that is, whether or not the defendant had complied with its obligations under the RDA);
2. The basis of that conclusion, and if an underpayment is found;
3. What further sums were due from the defendant; and
4. The basis of calculation of such sums.

All other information received by the auditor was to be kept confidential.

Take home point

What the Paddington judgment highlights is that if a brand licence or merchandising agreement is unclear on the details of how audits are to be conducted, the contracting parties may be found to have different obligations or entitlements both in respect of the audit and, more particularly, the amount which is payable by one party to the other than was intended!

Checking that you have properly drafted and comprehensive royalty audit clauses may even be a business critical issue…