"Famous Last Words"

Negotiating the Audit Clause - Part 1 (May 2007)

Dear Readers:

Whenever an agreement provides for accounting and payment of future income based on sales or other revenue derived from the work, it is important to retain the right to review the publisher's books and records for accuracy. This is why there is an audit clause in many contracts.

It would be unfair to assert that publishers are intentionally dishonest in preparing royalty statements. But errors do occur and contracts may be interpreted by the publisher's royalty accounting staff in the way that most favors the publisher (regardless of the intent or understanding of the persons who negotiated the deal).

At GDC 2007, I discussed a typical publisher-friendly audit clause and identified 16 places where negotiation should be considered. Over the next two months, we will review and discuss these issues.

The place to start our discussion is a typically publisher-friendly first-draft-of-contract audit clause. Each of the areas we will consider is footnoted below.

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 1: This language as presented requires that the person conducting the audit be a certified public accountant (CPA). While it is absolutely vital that your auditor have experience in royalty accounting and auditing, and preferably experience in games industry accounting practices, many capable and experienced auditors are not CPAs. In fact, in the United Kingdom and remainder of the EC, the title of Certified Public Accountant may not even exist. When selecting your auditor, make sure he or she has royalty audit experience in the entertainment industry. This is not a job for your bookkeeper or family tax preparer. But a capable auditor may not necessarily be a CPA. Limiting the audit to a CPA may be an attempt by a game publisher to raise developer costs associated with an audit. CPAs are at the top of their profession. Their rates may be higher than those of an equally or more highly qualified non-CPA auditing professional.

Footnote 2: The compensation to which you agree with your auditor is none of the business of the game publisher. Publisher representatives have told me that they “do not want contingent-fee auditors engaging in a fishing expedition.” My response is that a contingent fee auditor is certainly not going to spend any more time than is necessary once it is determined that the statements are correct! Restricting how a developer compensates its auditor is one step a publisher can take to make an audit potentially more expensive and potentially more financially risky for a developer.

Footnote 3: A further restriction that the auditor can not then be engaged in another examination of the publisher's books and records can further limit developer's access to its first choice auditor and drive up developer's cost. Auditors typically sign non-disclosure agreements (more on that later) with publishers before they are given access to publisher's books and records. The fact that an auditor may then be engaged in another inspection may mean the auditor is extremely capable and in demand. It may also mean the auditor has current experience working with the royalty accounting department that may reduce the time (and cost to developer) to conduct developer's inspection. If the publisher refuses to remove this limitation, at the very least, developer must ask that publisher stop the clock for purposes of determining which statements can be audited (more on that below) so that developer does not run out of time waiting for its auditor of choice to complete the earlier inspection and become available.

Footnote 4: An examination of the publisher's sales records may not tell the whole story in determining the accuracy of accounting statements. An auditor may need to see and analyze manufacturing records, warehouse inventory records, pick and packing slips, returns authorizations, credit slips, invoices and other records that together make the paper trail that results in your accounting statements. The only limit on the records that should be made available is whether they are reasonably related to the auditor's purpose – which is to verify the accuracy of accounting statements and payments. Denying access to certain classes of records, particularly to an auditor who has signed a non-disclosure agreement to keep the records confidential, makes it less likely that a thorough and accurate audit report can be prepared.

Footnote 5: Audit clauses will contain a “statute of limitations” controlling how far back an inspection can go. The clause we are using as our example sets a one year limit. One year is frequently the term found in game development agreements. Game publishers (and others in other entertainment industry segments) argue that it is a burden to maintain these accounting records, personnel change, and the farther back anyone goes, the greater the chance that records will be incomplete, inaccurate, lost or damaged., etc. The problem with this is that tax returns can generally be audited by the Internal Revenue Service for up to three years from the date of filing. Records must be maintained for at least that period of time. Publishers' attempts to restrict the period in which royalty statements may be audited is an attempt to put economic pressure on the developer to either undergo the expense of an audit on an annual basis, or lose the right. I believe that given the need to maintain records for IRS purposes, asking the one year period to be increased to three years is reasonable. Game publishers, in my experience, strongly resist any extension beyond two years. And it should always be remembered that no mater what the agreement says in connection with limiting this period, if there is litigation, and fraud is alleged in how royalties have been accounted and paid, the statute of limitations contained in the agreement may be disregarded by the court who may order earlier records be made available.

Footnote 6: Publisher agrees to make its books and records available at its “principal place of business,” or the location where it maintains the books and records to be examined. In an age, and in an industry, that is truly global, it is always wise to provide that the location be in the United States (if a US-based developer), or UK or other EC location (if the developer is EC based). While generally unnecessary, in some instances, depending on the culture and home country of your publisher, it may be worthwhile to specify that documents will be provided in the English language.

Footnote 7: This month we have begun a review of typical audit clause language. Our analysis has taken a strong view toward clauses that makes our sample a very publisher-friendly provision. But we are going to end this month with language that every developer might embrace: “No statement may be audited more than once.” Audits are all consuming in both monetary and focus terms. It is extremely important to engage a qualified auditor who can do the job thoroughly and effectively the first time. Unless there is an extremely good reason, neither side should ever be forced to go through this exercise more than one time for any statement! By engaging a qualified experienced professional, the job can be done right the first time!

We will continue this analysis next month.