September 01, 2010

In today’s economy where intellectual property is often important to the commercialization of a product or service, licensing IP rights between third parties (often between competitors) has become commonplace. However, most, if not virtually all, of these agreements rely upon the licensee to self report royalties, and many licensees do not do a very good job of it. In fact, it has been reported that 80% - 90% of licensees reported royalties incorrectly while underpayments ranged, on average, from 10% to 25%. If reported and paid correctly, those previously unpaid royalties would have directly impacted the licensor’s bottom line profitability. In an environment where companies are doing everything they can to increase profitability, taking steps to ensure compliance with existing license agreement terms should not be ignored.

It is not surprising that underreporting occurs when you recognize that there are numerous causes. For example, mistakes do happen and licensees are not immune to this reality. Also, some licensees do not exercise due care in capturing information necessary to accurately report royalties. This is particularly true when the licensee is a large global organization and the royalty obligations are considered small. However, a relatively immaterial amount to a licensee can be quite material to a licensor. Often, poorly drafted agreements, where certain terms or conditions are ambiguous or open to interpretation, can be the cause of underreporting. More often than not, underreporting is caused by a combination of the above.

Royalty Audits Identify Underreported Royalties

The right to audit the licensee is almost always granted under the license agreement, although certain licensors tend not to exercise that right. The fact is that royalty audits often identify underreported royalties for a number of reasons, including incorrect royalty calculations and unlicensed sales. Some auditors have suggested that royalty audits always identify some form of underreporting by the licensee. Regardless of whether that is true, there are numerous advantages to performing a royalty audit beyond the identification of underreported royalties. Often, when an auditor does find underreported royalties, the underreported royalties are sufficient to trigger provisions in the agreement that shift the cost of the audit to the licensee.

Benefits Beyond Recovering Underpaid Royalties

Even if a royalty audit does not identify any unreported royalties or unreported royalties that rise above the cost recovery provision, there are still benefits to having performed the royalty audit. For example, a proactive royalty audit (i.e., one that is initiated before any sign of a red flag) can enhance the business relationship between licensor and licensee. For one, the proactive royalty audit puts the licensee on notice that the terms of the license agreement will be enforced and adhered to from the outset of the relationship. It also provides increased transparency between the parties and can be a tool for identifying weaknesses in the license agreement prior to any subsequent disagreements. Furthermore, the royalty audit can demonstrate to external auditors compliance with Sarbanes Oxley and other regulations. It can also facilitate the creation of stronger internal controls for the licensor and licensee. Finally, a royalty audit provides increased knowledge and information flow to both parties which can only help to enhance the ongoing business relationship and working environment.

A reactive royalty audit, on the other hand, tends to be in response to a specific incident that may call into question the practices of the licensee. While the reactive royalty audit may not provide the same non-monetary benefits of a proactive royalty audit, it nonetheless tends to yield higher monetary returns to the licensor since there is a higher likelihood of identifying underreported royalties when a red flag has been raised.

Common Findings from a Royalty Audit

Once a royalty audit has concluded there is usually a report issued by the auditor that includes findings from his or her fieldwork and subsequent analysis. A non-exhaustive list of some of the most common findings follows:

  • Misinterpretation of the agreement
  • Clerical errors
  • Incorrect foreign exchange conversation rates
  • Improper deductions from gross sales
  • Unaccounted for returns
  • Unapproved discounts
  • Incorrect royalty rates
  • Misallocation of sales price among bundled products
  • Missing inventory
  • Untimely royalty reports

Given the numerous ways in which royalties could be misreported, it is not surprising that underreporting is quite common.

What to Expect in a Royalty Audit

When preparing for a royalty audit, it is helpful to understand the steps involved. A routine royalty audit will generally consist of at least four main phases that involve the auditor working with outside counsel and the client. In the first phase, the auditor generally gains an understanding of the relationship between the parties and often does so by reviewing the license agreement(s), any submitted royalty report(s), and any correspondence between the parties. The auditor may also interview employees of the licensor responsible for the administration and compliance of the agreement. This information can usually be provided by the licensor without any involvement of the licensee. This phase can usually be completed in a short time, depending on the volume of information provided by the licensor and the sophistication and duration of the relationship between the parties.

In the second phase, the auditor will prepare document requests and questions for the licensee that are intended to elicit information not normally presented in the royalty reports or readily available from the information provided during the first phase. The second phase is typically accomplished remotely (i.e., not at the licensee’s facilities). After reviewing and analyzing the data and information, the auditor may choose to either supplement his or her request for additional information from the licensee or begin field work at the licensee’s facilities. Assuming the documents are provided and the questions are answered in a timely manner this phase of the royalty audit should also be completed in a short time.

During the third phase, the auditor often performs on site field work which typically consists of interviewing employees of the licensee responsible for the administration and compliance of the license agreement. Additionally, the auditor will often personally inspect the control environment surrounding the reporting of the royalties as well as investigate areas of concern identified during the initial two phases of the royalty audit. Depending on the level of cooperation between the parties during this phase, the auditor may conclude his field work or request additional documentation or clarification of certain information. The amount of time necessary to complete this phase of the royalty audit can vary significantly depending upon cooperation of the licensee, the number of license agreements involved, the volume of transactions, the accuracy of information, and complexity of the agreement(s).

The final phase generally consists of analyzing all of the data and information and consolidating those analyses into a report. Whether that report is a formal, written variety, or an oral presentation greatly depends on the agreement and the relationship between the parties. If, on the one hand, the parties are in agreement that there is a high likelihood of underreporting based on an unintentional mistake then a less formal oral presentation is more likely. If, on the other hand, the parties are already on a contentious footing then a more formal written report will likely be necessary. Regardless, the report often provides a description of the procedures the
auditor followed and any findings gleaned from those
procedures and, where possible, an amount quantifying the underreporting of any royalties.

The costs associated with a royalty audit will encompass the time of the professional(s) and any out of pocket expenses incurred by the professional(s). The cost of a routine royalty audit will vary depending on the complexity of the licensing agreement(s),
the amount of time required for, and the location of, the field work (e.g., two days of field work in the same city is significantly less costly than a week in a foreign country), and the number of transactions to be reviewed.

Recommendations When Entering into New Agreements

One of the first steps in protecting and improving bottom line performance in connection with self-reporting agreements is to recognize that these contracts presuppose a loss of control over revenues. A well written licensing agreement is very important in ensuring an open and prosperous relationship between a licensor and licensee as well as ensuring more control over revenues traditionally lost to a self-reporting party.

One recommendation to drafters of license agreements is to resist the temptation to use boilerplate language and be as specific as possible regarding the real world business functions parties are subject to once the ink has dried. For example, a drafter should provide specific percentages or dollar amounts instead of using the phrase “reasonable and customary.”

Likewise, the drafter should consider including penalty clauses for failing to report all licensed sales. Penalty clauses for violations will help deter the self-reporting party from violating the terms of the agreement and provide a basis of restoring the relationship.

As a final recommendation, resist the temptation to use the invoice price as the basis for the royalty. All too often a licensee will take numerous deductions from their list price before they arrive at the invoice price thereby enabling the licensee to significantly influence the royalty obligations. To the extent possible, provide a clear definition of acceptable deductions from list price along with unambiguous percentages or dollar amounts.

Conclusion

Because of stricter government regulations and increased bottom line performance expectations, parties to a self-reporting agreement should be aware that there is value beyond monetary recovery in performing a royalty audit. That royalty audit will more likely than not uncover some combination of mistake, negligence, or intentional underreporting of royalties. Also, based on actual statistics, there is a good chance that the cost of the audit will be covered by the discovery of underreported royalties and/or paid by the licensee if the amount of underreporting rises above a certain threshold.