How to Negotiate, Prepare for, and Conduct a Licensing Audit

One of the most frequently overlooked clauses in a licensing agreement is the audit clause. A badly worded clause may leave the Licensor struggling to discover and collect unpaid royalties if the Licensee omits or underestimates revenue collected. At the same time, an overreaching clause leaves the Licensee exposed to business interruption and possible bad publicity. Here is a look at the licensing audit from both the Licensor’s and Licensee’s perspectives.

1.   Audit Provision in the Contract

To reserve the right to audit, the license agreement must have an express audit provision. In drafting, consider the following goals:

Licensor’s Goals:

• Allow the Licensor’s representatives or agents to conduct the audit.
• Ensure full cooperation of the Licensee in providing all necessary documentation in an organized manner so the audit can proceed efficiently.
• Require the audit to be on-site at the Licensor’s customary site for maintaining its books and records.
• Negotiate a means of extracting the necessary information, whether by photocopy, note taking, etc.
• Provide a penalty against the Licensee in the event the audit reveals significant unreported royalties (usually defined by a percentage discrepancy). The penalty can include reimbursement of auditing fees and costs, including attorney fees.

Licensee’s Goals:

• Require Licensor to provide notice to the Licensee of its intention to challenge the royalty reports.
• Require Licensor to provide an agreed upon amount of notice, usually a few business days, before coming in to conduct the audit to minimize business interruption.
• Requires the Licensor to identify the royalty reports at issue.
• Limit how often the Licensor can request an audit.
• Consider a confidentiality clause as part of the audit procedure.

2.  Details of Royalty Reports

Licensor Goal: In order to help with monitoring of royalty reports, the contract should enumerate the precise information needed in the reports rather than leaving the form of the report in the Licensee’s discretion.

Licensee Goal: Consider a clause where royalty reports become incontestable after two years in any deal with multiple renewals or unlimited or lengthy terms.

3.  Internal Steps to Take

Licensor Steps:

• Take active steps to monitor royalty reports and ensure that audit requests are timely before a report becomes incontestable.
• Use an auditor who is persistent. Licensees may not always cooperate in providing documents.
• Use an auditor who is accessible. Audits are done on a tight timetable, and auditors must be fully available during that time frame.
• Keep records of who is present during the audit and how information is presented.

Licensee Steps:

• Beware overreaching requests for information, but do not be obstructionist.
• Have an employee designated during an audit to communicate with Licensor’s agent and to be on-hand during the audit.
• Keep records of who has access to Licensee’s records.
• Remember the Licensor must have a reason it has requested an audit. Consider what that might be and do an internal investigation simultaneously.

4.  Demanding Unpaid Royalties

Licensor Best Practices:

• Present a comprehensive report that supports any claims for unpaid royalties.
• If applicable, establish that the royalties owed meet any threshold requirement for reimbursement of audit fees and costs.
• Consider how smoothly any dispute arises when renegotiating any term extensions or renewals of the license.
• Be prepared to litigate or arbitrate any unresolved dispute while the license continues, and increase monitoring activity.

Licensee Best Practices:

• If a discrepancy is truly an oversight, make prompt remuneration to the Licensor and take steps to assure Licensor of corrective measures for the future.
• If there are no discrepancies of significance, consider whether the Licensor was on a fishing expedition or just being cautious. Consider strengthening the audit clause when a contract is renegotiated if the Licensor was just fishing.
• Attempt to negotiate any claim of unpaid royalties by linking to future relations with the Licensor.
• Review internal bookkeeping procedures to avoid errors in the future.
• Take steps to avoid publicity by the Licensor.