Thursday, May 17, 2012

Ten Keys to Negotiating Audit Rights

An attorney asked me for a checklist to maximize his entertainment clients' audit rights.  Here are ten key questions to answer during deal point negotiations (the answers shown are suggestions to maximize a client's audit rights):
  1. Who can conduct an audit?  Ideally, anyone your client appoints.  Further, do not require that the auditor sign a nondisclosure agreement with the other side, or that it share the results of the audit with the entity that is audited.
  2. Who will pay for the audit?  The other side shall pay for audit (accounting and legal) costs if there is an underpayment to your client.
  3. What is the audit period?  Even though some agreements specify audit periods or periods for which the auditee (e.g., a licensee) must retain records, normally the audit period is effectively limited by the objection provision.  A typical agreement may state something such as:  “Statements are binding unless your written objection is received within two years of the date that the statement is due.”  Remember, longer or unlimited objection periods are usually better for the auditing party (e.g., a licensor), since there is little point in auditing anything to which the client no longer has a right to object.  If time limitations in the objection provision must be included, base them around the dates that accountings are received, not due.
  4. What documentation will be provided?  Specifying "free access" or "unlimited" is ideal for the auditing party.  Therefore, do not exclude from examination inventory reports, manufacturing information or "records that do not report sales."
  5. Where will audits take place?  On-site and/or remotely at your client's election.  Either way, require that information will be provided electronically.
  6. Which territories and affiliates may be audited?  Clients are usually limited to auditing the subsidiary with which they contracted.  However, the strongest audit rights include access to audit a licensee's affiliated entities (i.e., sister and parent companies).
  7. When can one audit?  With short notice and without requiring specific "objection" (many contracts require specific objection before an audit is conducted, which may be impossible).  Also, do not require notice of breach prior to taking legal action.
  8. What are the consequences of non-compliance? Include underpayment penalties and/or interest on late payments.
  9. Why audit? If a purpose for audits must be included, it should be to ascertain (non)compliance with the relevant agreements and should not be limited to verification of royalty accountings.
  10. What laws govern the agreement? Laws vary by state and territory, so it is important to appreciate the impact that local laws can have on the contract you are negotiating.  For instance, if a recording contract is subject to California state law, your artist client may have audit rights pursuant to state law, regardless of the terms of the contract.  Applicable state laws may also impact interest due, foreign tax withholding and other claims.  Further, in the event of a dispute, you may wish to ensure that the contract is subject to US law and not that of another territory.