Audit clauses are an important tool in IP agreements, intended to allow a licensor to check that the licensee is complying with the terms of the licence agreement and, in particular, paying the correct royalties. The case of 118 Data Resource Limited v IDS Data Services Limited & Others involved an audit clause in a database licence agreement.
The judgment reinforces the message that parties should be clear about the specific rights being granted, as the court will not go further than necessary to imply terms which are not set out expressly in the agreement. Similar considerations will apply to the audit clause in any IP licence agreement.
It is important to bear in mind that the application by 118 was for summary judgment for specific performance of the rights it claimed were granted by the audit clause. The trial judge may take a different view.
118’s business includes the sale and licensing of its database of contact details of UK businesses (the “database”). IDS's business also includes the sale and licensing of contact details of UK businesses. 118 granted a non-exclusive non-transferable licence to IDS to use the database, for the purpose of direct marketing and commercial sub-licensing (the “agreement"). The agreement imposed restrictions against granting (1) sub-licences to business rivals of 118 and (2) any sub-licence which exceeded 300,000 records to any one customer.
118 agreed not only to provide IDS with a copy of its database but also to check IDS's own database and update that. 118 sent an update every month and a complete updated database every quarter. Both those updates contained both 118’sdatabase and IDS's database combined, but there were indications in the file which identified the source of each record.
There was evidence that IDS had breached the terms of the licence. 118 wanted to use the audit clause “for the purpose of ascertaining that the provisions of this agreement are being complied with.”
Clause 4.7 of the agreement provided that : "[IDS] undertakes and agrees with  that it will … permit any duly authorised representative of  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."
The question was what rights 118 had under the agreement to ascertain whether IDS was complying with the terms of the agreement.
THE APPLICABLE PRINCIPLES
In answering that question, the court was guided by the principles set out below.
In interpreting an agreement, the court's function is to ascertain the meaning which the agreement would convey to a reasonable person, having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract.
Accordingly, the interpretation of the relevant provision in an agreement depends upon an understanding of its context within the agreement as a whole.
The court's function is not to seek to improve upon the agreement or put right any inadequacies. Nonetheless the court recognises that draftsmen may make mistakes, may use occasionally inappropriate language and may fail expressly to address eventualities which may later occur.
The implication of terms is part of the process of ascertaining the meaning of an agreement.
The usual starting point is that the absence of an express term means that nothing has been agreed to happen in relation to that event. Where the parties have made express provision regarding some matter, it is extremely difficult for either of them to say that a term should be implied in regard to that very subject-matter. That is even more difficult where the clause was drafted by lawyers and negotiated between legally advised parties. That said, implied terms may be necessary to spell out what the agreement means, where the only meaning consistent with the other provisions of the agreement, given the relevant background, is that something is to happen.
Necessity to give business efficacy to a contract is not the only relevant type of necessity. The express terms of an agreement may work perfectly well in the sense that both parties can perform their express obligations, but the consequences may contradict what any reasonable person would understand the contract to mean. In such a case an implied term is necessary to spell out what the contract actually means. The court will take into account the practical consequences of deciding that it means one thing or the other and is highly likely to reject an interpretation which would frustrate the apparent business purpose of the contract.
There is a difference between implying a term which adds to a contract (where the test is one of necessity) and implying a term in an otherwise complete agreement where there is an obvious gap in the machinery which needs to be filled. In the latter case, the court recognises that the parties have not fully stated the terms and the court will readily imply terms in order to make it workable. This is frequently done by building on an express or implied obligation to act reasonably.
Commercial common sense
Common sense may enable the court to choose between alternative interpretations not merely where one would "flout" it, but where one makes more common sense than the other. But this does not elevate commercial common sense into an overriding criterion. Still less does it subject the parties to the individual judge's own notions of what might have been the most sensible solution to the parties' conundrum. The court should not re-write contracts to achieve what it perceives to be a "sensible" or reasonable commercial result.
A term will not be implied if each party could reasonably have its own opinion of the commercial common sense of the situation. For a term to be implied, all reasonable people would need to agree that "commercial common sense" must dictate the proposed implied term. It has to be the only meaning consistent with the other provisions of the agreement. It must be obvious that the parties would have agreed the suggested implied term. Applying the "officious bystander” test, a term will be implied if both parties would have said, "Of course” if asked, at the time of the agreement, whether the implied term sought should be included.
Where commercial entities enter into an agreement, the court will strive to give it a meaning and not hold it void for uncertainty- particularly where the agreement is a detailed written agreement between two commercial entities that was plainly intended to have binding effect.
In reaching its decision as to the meaning of clause 4.7 of the agreement, the court had to take into account the fact that 118 was sharing its database with a business rival and the commercial reasons for that. 118 received a substantial fee and presumably believed that it was possible to prevent IDS from competing and using the database in ways that were unacceptable to 118 by ensuring - by some form of policing- that IDS did not exceed the terms of the licence. On the other hand, IDS would have wanted to ensure that 118 did not have an unrestricted ability to gain access to its know-how and confidential information in the course of policing the Agreement. The court had to bear in mind the tensions created by those competing interests when interpreting the Agreement. A different conclusion may have been reached in different circumstances.
ACCESS - BY WHO?
Although IDS agreed to permit access to "any duly authorised representative" of 118 in the singular, the definitions clause provided that the singular should include the plural, unless the context otherwise required. Accordingly, access was not limited to one person from 118, but it was permissible, by implying a term that 118 must act reasonably, to read the contract so that 118 was not entitled to swamp IDS with a whole army of representatives.
Although there was an obvious risk that 118’s own employee(s) might learn something to 118’s commercial advantage by gaining access, as IDS had agreed to take the risk that access might be by 118’s employee(s) and the agreement did not expressly prevent 118 from sending its own employees or oblige it to send an independent third party, 118 was entitled to send its own employees.
ACCESS - TO WHERE?
IDS had agreed that access was to be given to "any of its premises where copies of [the database] are used".
Clause 3.2 provided that: "[IDS] shall ensure that, save for archiving purposes, only one copy of the [data] is physically stored and that it is held separately from any other data in a secure environment and [IDS] is expressly prohibited from allowing any other party whatsoever from producing (sic) copies of the [database]."
It was agreed that "physically stored" did not refer to storage in hard copy form but meant storage on a computer and that data may be stored on one server only. The database was stored on IDS's one server in its offices in Glasgow. Contracts with customers were kept at that location for a few months, after which they were archived off-site. 118 accepted that ithad no right to gain access to the archive but only to the main office.
ACCESS - FOR WHAT PURPOSE?
118 argued that access was to be given "for the purpose of ascertaining that [all of] the provisions of this agreement are being complied with", including the terms on which data was sublicensed.
IDS argued, and the court agreed, that clause 4.7 related to the storage or use only of the database.
In reaching that conclusion, the court noted that the agreement permitted 118 to approve IDS's standard licence agreement with its customers before it released its data to customers, but that did not permit 118 to see IDS's commercially sensitive information such as the identity of its customers or the prices; and concluded that clause 4.7 was not intended to confer that additional right.
The court decided that there was no good reason for permitting a search of the place where the database was stored so as to give “118 carte blanche to search for anything which happens to be on those premises, whether or not connected with the storage or use of the database (para 25).” The court considered it to be more likely that the words “where any copies of [the database] are used” in clause 4.7 were intended to limit the nature of what may be inspected as well as defining the location which may be inspected.
WHAT CAN BE DONE AFTER ACCESS HAS BEEN GAINED?
The agreement did not say what 118 was permitted to do once it had gained access. The agreement was silent about how the inspection would take place and what data 118 was and was not allowed to inspect. The intention of the clause was to enable 118 to police the use of the database. That clearly imposed some obligation on IDS to permit access to its computer in order that 118 could carry out the permitted investigation.
The court considered that there must be some restriction to ensure that 118:
- searched only for material relating to the use of the database;
- did not search for:
- commercially sensitive information relating to IDS's customers, or
- any material relating to the use of the Database which was protected by legal professional privilege and
- was prevented from using the material for purposes other than the audit.
There was, however, no mechanism in the agreement to deal with any of that and the judge thought the task of filling the gaps would involve re-writing the agreement and so was impermissible. However, any use of the information obtained pursuant to clause 4.7 would be subject to the contractual provisions and equitable provisions relating to confidential information.
Further, if 118 carried out a search and discovered (or considered that it had discovered) a breach, the agreement was silent as to what steps 118 was permitted to take thereafter. It would involve substantially rewriting the parties' bargain to permit 118 to remove data and provide what 118 may then do with that data; and so this was also impermissible.
The judge was satisfied that 118 had the right to enter IDS's office in Glasgow for the limited purpose of policing the storage and use of the database and whether the database was being stored and used in accordance with the terms of the licence - namely that the database was “held separately from any other data in a secure environment.”
118 did not have the right to gain access for the purpose it wished - namely for “ascertaining that [all of] the provisions of this agreement are being complied with.”
IDS accepted that, if it entered into a sub-licence with a customer to provide a limited database which included extracts from 118’sdatabase, the database would be a document which 118might be entitled to see, since the definition included the database "or any part thereof".
118’s application substantially failed because no or insufficient detail was provided about the purpose of the audit, how it would take place and what use could be made of the data obtained.
Clear words would be needed, particularly as the parties are competitors, to allow 118 unrestricted access to IDS’s data.
This judgment shines a spotlight on the need for parties to spell out clearly the terms of their agreement, and illustrates that broad - but vague - audit clauses may well not be enforceable. In order to be effective, and to adequately protect the licensor’s rights to check that the licensee is not breaching the agreement and that the licensee’s rights are adequately protected, an audit clause needs to be drafted with sufficient particularity to the individual circumstances of the agreement in question.
As this case demonstrates, an audit clause should set out:
- The purpose for which the audit may be carried out.
- What information may be inspected?
- What information may not be inspected? Access should not be allowed to commercially sensitive information and legally privileged information.
- What consequences should flow if a breach is discovered by the audit?
- Should data be delivered up, if a breach is discovered?
- What use can be made of information obtained as a result of the audit?
- Who may carry out the audit- the other party or an independent third party?
- Where may the audit be carried out?
In addition, an audit clause should set out:
- The frequency with which audits may be carried out.
- The time at which audits should be carried so as to minimise the disruption to the business, and, last but not least,
- Who should bear the cost of the audit.
This article was published in Commercial Litigation Journal in February 2015.