Time to Inspect your ‘Audit’ Clauses

118 Data Resource Limited and (1) IDS Data Services Limited, (2) Susan Margaret Macfarlane and (3) Kevin Sharpe [2014] EWHC 3629 (Ch) (5 November 2014)

Summary

This summary judgment decision highlights the importance of and the need for careful drafting of a right to inspect/audit clause.

Introduction

This case concerned an application for summary judgement for specific performance of an ‘audit’ clause in a written agreement.  The case was heard by Mr D Halpern QC (sitting as a deputy judge of the Chancery Division of the High Court) who dismissed the application, holding that the clause was not sufficiently clear for specific performance to be granted.  The alternative remedy sought of early disclosure was also not permitted because, as a matter of contractual construction, the court was not satisfied that the claimant was entitled to the information sought.

Background

118 Data Resource Limited (“118”) and IDS Data Services Ltd (“IDS”) are business rivals who both operate in the field of sharing and licensing contact details of businesses in the UK.  The parties entered into a written agreement (the “Agreement”) under which 118 granted IDS a licence for the limited use of 118’s contact database (the “Database”), including a limited right to grant sub-licences with certain restrictions (for example, certain named competitors of 118 could not be sub-licensed).  It transpired that IDS had, in fact granted a sub-licence of part of the Database to one of its rivals in breach of this provision, a fact 118 had become aware of having acquired the rival in question at a later date.

The Agreement contained the following audit clause:

“[IDS] undertakes and agrees with [118] that it will … permit any duly authorised representative of [118] on reasonable prior notice to enter into any of its premises where any copies of [the Database] are used, for the purpose of ascertaining that the provisions of this Agreement are being complied with.”

118 applied to the court for summary judgment for the specific performance of this clause.

The Decision

The court highlighted that in the context of the Agreement as a whole, the clause lacked clear contractual meaning and listed the following as areas of particular uncertainty within the clause:

(1) Access is permitted to “any duly authorised representative” of 118.

Who is to be given access?   How many people are anticipated, and, in particular, has IDS taken the risk that an authorised representative may be a 118 employee, despite potential issues that this may raise with regard to the disclosure of commercially sensitive information to its competitor?

(2) Access is to be given to “any of its premises where copies of [the Database] are used”. Which premises are meant?

Is reference to premises (plural) just a drafting error (as the agreement restricted IDS from storing more than one copy of the Database on its server which was in a single location)? Customer contracts were kept at the server location for a period of time and then archived off-site.   It was common ground that 118 had no right to gain access to the archive but only to the main office.  However, the court considered whether the phrase simply defined the location or whether it had any effect on the purpose of access, i.e. limiting the nature of what may be inspected as well as defining the location.

(3) Access is to be given “for the purpose of ascertaining that the provisions of the Agreement are being complied with”. What does this mean?

On 118’s interpretation, access was permitted with regard to all provisions of the Agreement, including the terms on which data is sublicensed to third parties.   IDS argued that it referred to the provisions relating to the storage or use of the Database only.  In the context of the rest of the Agreement, the court preferred IDS’s argument on this point for two reasons.  First, under a separate clause, the court had held that 118 had the right to vet the standard terms of IDS’s licences but was not permitted to vet individual sub-licences (which might permit 118 to see IDS’s confidentially sensitive information such as the identity of the customer or prices charged).  The court was not willing to consider that the inspection clause conferred an additional right which was not given by the wording of the separate clause.  Second, referencing the part of the clause defining the premises to be searched, the court saw no good reason for permitting a search of the place where the Database was stored if that gave 118 a carte blanche to search for anything which was on those premises, whether or not connected with the storage or use of the Database. On balance, the court considered that those words limited both the nature of what could be inspected as well as defining the location.

(4) What is 118 permitted to do once it has gained access?

Having limited the purpose of inspection to policing the storage and use of the Database, the court then had to consider the boundaries.

Mr D Halpern QC considered that the clause clearly imposed some kind of obligation on IDS to permit access to the server in order that 118 could carry out the investigation but queried what kind of access was permitted?

The court considered that there had to be a restriction to ensure that the search was limited to material related to the use of the Database (such that it was not permissible to search for commercially sensitive information relating to IDS’s customers or commercially sensitive information that was protected by legal professional privilege) and that 118 must be prevented from using the material for other purposes.

Yet, the clause contained no mechanism to address the above considerations and left the Court with the task of ‘filling in’ the gaps in the clause. The court held that this went beyond the steps that it would be willing to take in order to make the clause workable, as to do so would involve the re-writing of the agreement which it considered it was impermissible.

Moreover, the court said that even if a breach were discovered, the Agreement was silent as to the consequences. There was no guide, for example, as to whether 118 could remove data and, if so, what could be done with it. Again, substantial rewriting of the parties’ agreement would be required.

Accordingly, whilst it was apparent that some breach of contract had been committed, Mr D Halpern QC was not satisfied that the clause, on his interpretation of it, had the meaning which 118 ascribed to it, at least for the purposes of an application for summary judgement.

The court stressed that for specific performance to be granted (which will only be the case where damages would not be an adequate remedy) an even higher degree of certainty as to the construction of the clause is needed. The terms of a contractual obligation must be sufficiently precise to be capable of being specifically enforced.  This was not the case here.

Comment

This decision makes it clear that the wording of an audit clause needs to be considered carefully when preparing an agreement and that a ‘one size fits all’ or ‘short form’ approach may be dangerous.

Parties should think carefully about what the purpose of the audit right is and make sure that the clause is drafted so as to clearly permit audit and inspection for that identified purpose.   In doing so, care should be taken to ensure that the provisions of the audit clause do not contradict the content and intention of other clauses in the agreement, for example, provisions designed to protect commercially sensitive information and, where appropriate, should draft suitable safeguards designed to protect the trade secrets and other commercially sensitive information which the audited party would never wish to be disclosed to the inspecting party.

It is a reminder that the drafter should:-

  1. clearly state who can carry out the inspection (for example, can a party’s own employees carry out the audit or must an independent third party be engaged for this purpose) and whether there are restrictions on numbers;
  2. specify in clear terms the purposes for which the audit may be carried out;
  3. specify what books, records and other documents can be inspected and any limitations;
  4. identify what location or locations may be accessed to carry out the audit;
  5. address how concerns over consider whether the auditing party can take and remove copies of inspected documents/data;
  6. consider the consequences of a breach being discovered in terms of remedies (such as termination; reimbursement of audit expenses and, where the audit relates to auditing of financial obligations, payment of shortfalls and interest,); and
  7. address how any dispute over the findings of an audit are to be resolved (for example, an expert determination of a royalty calculation dispute).

As always, the drafting of the clause will depend on the commercial deal and specific facts, but this decision highlights the need to properly consider and negotiate an agreement’s audit clause, with detailed and specific references rather than more general ‘catch-all’ wording.