"Famous Last Words"

Negotiating the Audit Clause - Part 2 (June 2007)

Dear Readers:

Last month we began our analysis of the publisher-friendly audit clause.

DEVELOPER may appoint an independent Certified Public Accountant1 who is not working on a contingent fee basis2 and who is not then engaged in any other examination of PUBLISHER'S books and records3 to examine PUBLISHER'S sales records4 for the preceding four (4) full quarters5 for the sole purpose of checking the exactness of the statements mentioned herein. The audit shall take place at PUBLISHER'S principal place of business or at such other location where Publisher maintains books and records to be examined hereunder6. Such audit shall be carried out initially at the expense of DEVELOPER, not more than once every year, and no statement may be audited more than once7. Before being given access to PUBLISHER'S records, the CPA must sign a confidentiality agreement in a form to be provided by PUBLISHER8. The CPA shall not make any copies of the documents provided by PUBLISHER9. The dates and terms of the audit must subject to the availability of PUBLISHER personnel and fixed by mutual agreement between the Parties10. The Parties agree that the audit shall take place no less than forty-five (45) days from prior to or after the half-yearly closing dates of PUBLISHER's accounts11. DEVELOPER shall provide PUBLISHER with the report of the CPA promptly following the end of the audit12. If PUBLISHER disagrees with such report, PUBLISHER shall have the right to produce a counter-report on audited transactions. If DEVELOPER audits any statement and that audit does not disclose any discrepancy then PUBLISHER'S payments are deemed to be conclusive and DEVELOPER waives any right to claim additional payments for that statement13. In the event the audit reveals that PUBLISHER underpaid the royalties payable with respect to the period for which the audit was performed by an amount in excess of ten percent (10%)14 of the amount owed, the reasonable cost of such inspection (not exceeding $10,000)15 shall be borne by PUBLISHER. If DEVELOPER determines that PUBLISHER has overpaid any amounts for any statement then DEVELOPER will advise PUBLISHER promptly and will refund those amounts to PUBLISHER within 60 days of that discovery16.

 

Footnote 8: It is not uncommon for an auditor to be asked to sign a confidentiality agreement with the publisher. After all, the auditor wants access to extremely confidential financial records in connection with the review. Unauthorized disclosure of such information by the auditor, if the publisher is a public company, could be considered a non-public material disclosure and result in securities law problems for the publisher. But even if we accept the need for the auditor to sign a confidentiality agreement and to treat publisher material as confidential, unless there is some requirement that the non-disclosure agreement be “reasonable,” and in-line with general games industry standards, the publisher may use this requirement as a means to scare away qualified auditors. Some publisher nondisclosure agreements, proffered in connection with audits, are so restrictive that no qualified auditor could sign them. This tactic could be used to further limit, and drive up the cost of, developer's audit. A further collateral issue here is the treatment of the auditor's report. There is no doubt that the report should be treated as confidential. But in the most restrictive audit clauses (not here, thankfully!), and in some non-disclosure agreements that auditors are asked to sign, there may be restrictions on the auditor's ability to share the audit report with the developer. These limitations must be resisted by developers and their counsel.

Footnote 9: Language footnoted here prevents the auditor from making copies or extracts of publisher documents. The inability to do so severely hinders the auditor's ability to do the job. Since the auditor has already (presumably) signed a non-disclosure agreement and has agreed to maintain the confidentiality of publisher's documents and information, there should be no restriction on the auditor's ability to gather and collect information. A lot of the analysis is done at the auditor's office. If the auditor can not take copies, or extract information from publisher materials, the ability to do the job is severely compromised. Subject to the auditor's agreement regarding confidentiality, publisher should co-operate to provide all information requested by the auditor so as to permit the auditor to do its job as efficiently and professionally as possible. Refusal to allow the auditor to copy, and make extracts from, publisher material, hinders the effort, drives up the cost for the developer, and may make it impossible to fully determine the accuracy of the statements.

Footnotes 10 & 11: Publishers, particularly public companies, have financial and securities reporting obligations under law. All publishers have (generally, quarterly) accounting obligations arising out of their dev agreements. If a developer plans to audit, it is recommended to be aware of the statute of limitations requirements (discussed last month), and give plenty of notice to the publisher. The best time for a developer audit is when publisher's royalty accounting personnel are not preoccupied with preparation of accounting statements, and/or financial disclosures and releases required by law. Make sure your audit clause provides a window when publisher personnel will be available; then give plenty of notice. In a well coordinated audit, publisher personnel will have had sufficient time to assemble the records that developer's auditor will want to see. And a supervisor from publisher's royalty accounting department will be available to answer questions and hunt down records that are requested and may need to be located.

Footnote 12: I do not believe developer should ever agree to provide the publisher with a copy of the audit report. Developer's audit report constitutes the confidential work product of its own professional representative. There may be issues raised that go beyond the simple accuracy of the statements. From the perspective of developer's counsel, the content of the report is none of the business of the publisher – unless it discloses a royalty payment shortfall. If that is the case, then developer must provide sufficient information to document its claim. When negotiating this part of the clause, rather than agreeing to turn over a copy of the report, it is preferable to provide that “DEVELOPER shall provide PUBLISHER with sufficient information to document its claim (if any) within a reasonable time following the end of the audit.” The contents of the report should remain the confidential information of developer.

Footnote 13: Footnote 13 relates back to our discussion of developer being limited to one bite of the apple in auditing each statement. It is important to do a complete, thorough job; to know the inside and outside of your statement after your inspection. If you are not able to make a claim after completion of your inspection, it is reasonable to accept the account as stated. And if you later discover the reason you were not able to recognize a royalty shortfall is because of fraud on the part of your publisher, language such as this may not preclude a later claim.

Footnote 14: Record industry audit clauses have historically not had any language providing for reimbursement of audit fees should underpayment thresholds be passed. In the games industry, the negotiation of the level of underpayment at which the publisher should pay audit costs is accepted. Ten percent (10%) seems to be a common starting point in publisher first drafts. I believe developers have a right to expect statements to be 100% accurate! Some compromise on this issue to lower the shortfall amount at which point publisher pays the audit bill is common.

Footnote 15: This clause attempts to cap the amount of fees that will be reimbursed by the publisher to $10,000 under every circumstance. In a major audit of several quarterly statements, this number may well be inadequate. I believe that no cap should be provided. If there is no royalty shortfall, or the shortfall is small so as not to exceed the threshold for audit fees to become the responsibility of the publisher, then the publisher has nothing to fear! And if preliminary results suggest everything is in order, the developer will certainly hold a tight rein to control its costs. The best way for a publisher to avoid being shouldered with the cost of developer's audit is to provide accurate statements!

Footnote 16: Language added regarding developer's duty to report and repay overpayments uncovered by developer's audit is outrageous and should be strongly resisted! We should never forget this is developer's audit, not publishers! The audit report is developer's and its auditor's confidential work product. It is not developer's duty to uncover and report shortcomings in publisher's royalty accounting or systems. Developer is not publisher's auditor! If, for some reason, developer is particularly giving, and willing to consider some sort of reporting and repayment obligation (which, to be clear, is not recommended), at a minimum, reimbursement might be in the form of publisher's right to recover the overpayment only as a proportional credit against future royalties (and not, for emphasis, against development advances), and only after the full costs of developer's audit are taken as a credit against the amount of the overpayment. After all, it would certainly add insult to injury to require developer pay for the audit that results in uncovering overpayments that must be reported and repaid to publisher!