NET(net), Inc.

Customer Audits of Your Contracts by jigordon
May 4, 2009, 9:32 am
Filed under: audit, license grant, warranty

I was recently asked whether I would ever allow a customer to audit my contracts.  The simple answer is No!

Of course, the original question wasn’t this simple.  The person asking the question had some interesting constraints.  Specifically, they were licensing software on an exclusive basis, with exclusivity carved out by geographic region.  So a prospective customer wanted to review the vendor’s contracts to make sure that they weren’t getting into an overlap situation.  My answer was still No!

First, contracts are, even at a fundamental level, based on trust and honesty, and not based on a lack thereof.  If you don’t trust the person you’re contracting with, the contract isn’t going to help you too much.  In other words, you can’t contract trust.  It just doesn’t work that way.  So if the vendor in this situation was going to be dishonest in overlapping exclusivities, what would make the customer think that they would allow the customer to actually audit all of the agreements?  A dishonest vendor would simply hide a portion of the contracts that they didn’t want discovered.

Second, with minor exception (such as during due diligence in a M&A transaction), I would never allow anyone to review my contract files.  There’s too much confidential information – and general poking around to see what’s in them isn’t a narrow enough reason to go looking.  In fact, even if the looking was just at license grant language, I still think you’re potentially revealing too much information (exclusivities for geographic regions aren’t the only way to restrict licenses and perhaps you also license based on user counts – allowing others to see the full license grant can give them a sense of pricing, perhaps).

Third, there’s a better way to handle the situation:  provide a warranty and a specific remedy for breach of this particular warranty.  Warrant that you are providing an exclusive license in exchange for specific consideration (probably money, but perhaps something else).  If you (vendor) breach this warranty, the sole and exclusive remedy could be the repayment of the specific amount of consideration provided for the exclusivity.  So, imagine a situation where you license exclusively by country (perhaps your product handles some sort of sales-related transactions).  In exchange for an exclusive license, the customer pays you an extra $1,000,000 in license fees and that this also adds into the annual maintenance costs.  If you later decide to break a previously-licensed country into smaller bits, you simply would have to pay back the $1M plus the accrued/paid maintenance fees for the breach.

Now, this sounds like it may provide you with license to later break the agreement – no, I’m not suggesting that, I am however suggesting that you promise not to and a specific penalty for doing so.


3 Comments so far
Leave a comment

Your point about trust being fundamental to the initial transaction is well taken. Contracts do not create good faith between parties, but they can be used to communicate, allocate, and manage and expectations, concerns, and risks.

Regarding the warranty, I think it is a good example of using the contract to communicate. However, I don’t think the warranty serves any particularly unique purpose as the there is no greater liability or responsibility if there is a breach of warranty than there would be if there was a breach of the exclusive licensing provision. The real issue seems to be how to fashion a remedy for the particular breach, or better yet, one that builds in some kind of security into the agreement which does not rely on the expense of litigation as the sole means for enforcement.

Thanks for the post.

Comment by Douglas Griess

Thanks for the comment Douglas!

I suggested crafting it as a warranty because if I was the vendor in this particular situation, I wouldn’t want my failure to provide an exclusive license to void (or potentially void) the entire transaction. Rather, if there’s a specific warranty, a specific remedy, and a statement which says that such remedy is the sole and exclusive remedy for breach of that warranty, then I don’t have to worry about a breach of contract suit. In fact, I shouldn’t have to worry about a suit at all – the warranty remedy is what the licensee gets. And then the remainder of the license continues – maintenance fees and all (including maintenance calculated at the rate of the license fee paid).

If, however, there’s a breach of contract, I could end up with no license at all. Not good for me as a vendor. 🙂

Comment by Jeff

Your suggested approach makes sense in terms of fixing damages in case of a breach, but does not address the issue of discovering and documenting such breach. I see two possible approaches to this , both of which I have seen implemented in practice. 1) Limit the scope of the audit to the clauses of the contracts relevant to the matter, and allow the Licensor to blackline the rest. 2) Conduct the audit through a proxy (auditors or similar, preferably subject to mandatory statutory confidentiality obligations). The proxy would be allowed unfettered access, but only be allowed to report breaches and relevant documentation of such back to the Licensee.

Comment by Martin Clausen

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: