Maximizing Royalties Through Strategic Licensing Audits

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Chris Neumeyer is Managing Partner of AsiaLaw, a firm of international attorneys servingthe needs of companies doing business in Asia,

with an emphasis on technology and intellectualproperty rights. Mr. Neumeyer has more than20 years of experience negotiating and drafting

complex agreements, resolving licensing disputes,managing domestic and cross-border litigation,and handling a wide range of commercial and

corporate transactions and disputes. Licensed inUS state and federal courts, he has been based in

Taiwan since 2000.

After convincing an entity to license ones intel-lectual property rights and reaching agreement onthe royalty rate, it might be tempting to proclaimmission accomplished and prepare to kick backand watch the royalties roll in. Of course, that wouldbe a mistake. To avoid leaving cash on the table, bestpractice dictates finishing off with a carefully draftedlicensing agreement and a sound program of moni-toring and auditing of licensees.

It is widely acknowledged that most licenseesunderreport and underpay royalties, often by a widemargin. A 2013 study by IP auditing firm, Invotex,showed underreporting by 89 percent of all licens-ees, with one-third underreporting by more than50 percent and one-fourth by more than 100 percent.

Underreporting comes in many forms, but generallyfalls into three categories: (1) intentional attemptsto deceive, (2) unintentional errors, and (3) differ-ences in contractual interpretation. All three maybe addressed through sound auditing practices. (SeeBox 1.)

While some licensors may be wary of auditinglicensees due to fear of causing offense or concernsover audit costs, those concerns mostly are unwar-ranted. Most licensees recognize that audits are anormal part of doing business; and most audits pay

for themselves. An audit will likely reveal significantunderpayment and the licensee will likely be liablefor the costs. Moreover, a regular auditing programsends a broad message, improving compliance byall licensees. The audit may identify improper usesof intellectual property that should be addressed, orcontract language that should be improved. It mayprovide grounds to amend or terminate an agree-ment or evidence to support litigation. It even mayimprove relations with some licensees, by address-ing issues forthrightly rather than letting themlinger.

As with most things, preparation is the key. Inparticular, when negotiating the terms of a licensingagreement, it is important to ensure that provisionsrelating to royalties, records, reporting, and auditsare clear and comprehensive, to minimize potential

Maximizing Royalties throughStrategic Licensing AuditsChris Neumeyer

Box 1Causes of Underreporting Royalties

Genuine disagreement over contractual interpretation

Intentional understatement of sales volume or revenue

Intentional overstatement of allowable deductions

Use of convenience estimates without support Disregard of contractual minimums or maximums

Accounting system flaws or mathematical errors

Improper treatment of bundled licensed products

Excessive or inappropriate price discounts

Unaccounted for sales by foreign affiliates

Incorrect transfer pricing or FOREX rates

Unaccounted for sub-licensing


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disputes; and, when determining the targets, scope,timing, and manner of conducting audits, strategicplans should be employed.

Define Royalty

Obligations ClearlyA few years ago, Eastman Kodak granted a license

to a Taiwan company, Asia Optical (AO), authorizingAO to make and sell digital cameras using Kodakspatents. When Kodak tried to audit AO, pursuant tothe terms of their agreement, AO reportedly refusedto cooperate, claiming it owed no royalties on prod-ucts that it manufactured for others because Kodakcould seek compensation from AOs customers; andit owed no royalties on products manufactured inChina or Taiwan, because none of the licensed pat-ents were located there. Kodak sued and the court

rejected both of AOs arguments, awarding Kodak$33.7 million in past royalties.1 Theres nothingunusual about that casein fact its fairly typicalbut it demonstrates the importance of definingprecisely in the licensing agreement exactly how tocalculate royalties to reduce potential disputes dur-ing audits.

Of course, the ideal means of ensuring full paymentis to structure royalties in a single up-front payment,but thats rarely possible. Instead, royalties usuallyare based on units sold or a percentage of net salesrevenue of licensed products. To calculate net salesrevenue, most agreements allow certain deductionsfrom gross revenue, such as costs of taxes, duties,insurance, transportation, and customer returns.However, disputes often arise over deductions, sothe means of calculating royalties and deductionsshould be defined clearly. In addition to listing allow-able deductions, one can list prohibited deductions,such as sales commissions or marketing costs. It isalso prudent to include a cap on deductions, such as5 percent of gross revenue. However, licensees willsometimes deduct the full cap without proof that theyincurred the deductions, so the agreement shouldstate that any claimed deductions must be actually

incurred.The agreement should state that royalties are

based on arms-length sales prices to end customers,to deter licensees from calculating royalties based ondiscounted transfer-prices between the licensee andits affiliates. It should state that royalties are based ongoods shipped to customers, not payments received,and should precisely define how foreign currencyshall be converted.

Define Record and ReportingObligations Clearly

The licensing agreement should require thelicensee, its affiliates and sublicensees (if allowed) tomaintain, for at least five years, books and records suf-ficient to verify licensees royalty obligations. During

negotiations, the licensor should determine preciselywhat records will be needed and seek confirmationthat licensee can and will maintain such records, sothose exact requirements can be incorporated intothe agreement.

Reporting obligations also should be clearlydefined, including stating when reports are dueand what information must be included in each.A detailed template of the required report may beattached as an exhibit. For each licensed product, thereport may be required to state the following types ofinformation:

Product description, model, and serial number. Units manufactured, sold and returned. Names of seller, purchaser, and manufacturer. Dates and places of sales. Unit price, quantity sold, and gross revenue. Currency, exchange rate, deductions, and net

revenue. Names of sub-licensees and consideration

received from each.

The agreement should require licensee to furnish areport within 30 days after termination or expirationof the licensing agreement, identifying all licensedproducts disposed of since the prior report and allremaining inventory, including work-in-process, oflicensed products, and require the licensee to make afinal payment accordingly.

Define Audit Rights andObligations Clearly

The audit provision also should be comprehensive,describing the following types of matters:

How many audits allowed per year and howmuch advance notice.

Right to audit licensee, its parent, subsidiaries,and subcontractors.

Unrestricted right to select independent CPA oflicensors choosing.

Right to audit books, records, and physicaloperations.


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Right to review, make copies, and keep copies ofdocuments.

Right to interview relevant employees; obligationto make them available.

Scope includes manufacturing, sale, use, and dis-posal of licensed products.

Scope unrestricted as to time period.

Audit right continues beyond expiration or termi-nation of the license.

The agreement should provide that any under-reported sums identified in an audit shall be dueand payable within a certain period with interestcompounded monthly and, in the event that underre-porting exceeds a certain threshold (e.g., the lesser of$___ or ___ percent of net revenue in a given period),licensee shall be required to pay all costs of the audit,including auditor fees and licensors attorney fees. Itmay state that crossing such threshold constitutesa material breach, authorizing termination of the

agreement at licensors option. It also may includea dispute resolution provision, along the lines of thefollowing:

If Licensee disputes any findings in the finalreport of the auditor selected by Licensor, thenLicensee shall notify Licensor in writing within30 days of receipt of the report, in which casethe parties shall jointly appoint, within a fur-ther 30 day period, an independent certifiedpublic accountant to review the findings of thefirst auditor and either confirm its findings orissue new findings, at Licensees expense, andsuch new findings shall be final, binding andnon-appealable. If the new findings indicate

an underpayment of more than 5 percent, theunpaid royalties shall be paid with interest andthe costs of both audits within 30 days.

Determine Targets

StrategicallyThe agreement should grant licensor broad dis-

cretion to determine the timing of audits. For largeagreements or when the licensor wishes to send astrong message, the agreement can require an auditat the end of the first year, with costs to be sharedequally by licensor and licensee. Such early auditsmay be less complex and less costly than later onesand may improve future compliance. Additionallylicensees may be more likely to cooperate if the auditappears to be a regular business practice, as opposedto an apparent gathering of evidence for litigation,

after a dispute has arisen.In other cases, the licensor may wish to establish

a default schedule of auditing licensees every threeto five years, punctuated by special audits when sus-picions arise. To detect problems, licensors shouldmonitor royalty reports regularly, noting any late pay-ments, miscalculations, erratic fluctuations, or puz-zling trends. From the beginning, licensors shouldidentify appropriate contact persons and establishdialogues with licensees, requesting answers toany questions and seeking to better understandrelevant issues and recognize potential red flags.(SeeBox 2.)

Does the licensee have operations in multiple coun-tries, so employees receiving data may be unaware of

Box 2Potential Red Flags for Underreporting

Late, incomplete or erroneous royalty reports

Steadily declining, illogical or erratic sales patterns

Poor response to requests for information or clarification

Poor sales compared to the industry or other licensees

Poor sales compared to licensees public statements

Claim that related products are outside scope of the license Changes in licensees accounting system

Changes in royalty reporting personnel

New or discontinued licensed products

Complex distribution channels

Changes in licensed product model numbers

Licensee subject to regulatory investigations

Licensee experiencing financial distress


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the licensing terms or fail to transmit it to those com-piling reports? Has there been a change in personscompiling reports? Are the licensees sales consistentwith its annual reports and other public statements?Are they consistent with other licensees and theindustry in general? How large is the license? Howlarge is the licensee? Has it completed a major corpo-

rate transaction, or is it facing financial difficulties?When was the last audit? Were there problems in pastaudits? By evaluating such factors, the licensor mayprepare a strategic plan for targeting licensees andissues most likely to be fruitful.

Work with anAppropriate Auditor

When selecting an auditor, licensors should lookfor experience, local language fluency, and familiarity

with local customs and laws. The auditor also shouldbe independent. SanDisk Corporation retained anaccounting firm to audit a licensee and the auditorfound $40 to $66 million in underreported royalties.The licensee refused to pay, claiming the figures wereincorrect and the auditor was biased, because theauditor had close business relations with SanDisk.Eventually, SanDisk admitted the auditor was biasedand unpaid royalties actually did not exceed $5.3 mil-lion.2The matter probably could have been resolvedmore efficiently if SanDisk had hired an independentauditor as required.

As for financial arrangements, an auditors feesmay run from a few thousand dollars to $50,000or more, depending on the scope, complexity, andlicensee cooperation (or obstruction), but it maybe possible to control costs by starting with a lim-ited audit or negotiating a fee cap with the auditor.Auditors will sometimes work on a contingencybasis, but such an arrangement may look suspect ifthe matter ends up in litigation. Of course, the licen-sor may also save costs by first attempting to resolveany issues directly with the licensee through letters,phone calls, or meetings.

Once an auditor has been retained, the licensor

should provide it with copies of the licensing agree-ment, royalty reports, and other relevant informa-tion and discuss the assignment to facilitate betterunderstanding of audit scope and potential areas ofconcern. A list should be prepared of informationrequired from the licensee; requests may relate to itsaccounting system, royalty calculations, manufactur-ing, inventory, sales, returns, sub-licensing, pricing,and customers. The licensor should send the request

list to the licensee along with notice of the audit anda request for available audit dates.

Overcome Challenges

through PersistenceFor the most part, no audit goes without a hitch. Thelicensee may claim certain documents and witnessesare unavailable, such as those of subsidiaries andsubcontractors. Royalties may be calculated based onlow, inter-company transfer prices or alleged purchaseorders, with no way to confirm whether orders arecomplete or correct. Sales may be made through foreignsubsidiaries and not reported at all. The licensor or itscounsel should be available during the audit to assist theauditor with any questions or challenges. The licenseeshould be reminded that it may be liable for audit costsand increased obstacles will only increase the costs.

Sometimes obstacles cannot be overcome, but atleast the process will confirm that problems exist andhelp pave the way for other actions. When licensingfirm Tessera Technologies audited Sony Corporation,pursuant to an agreement covering Tesseras portfolioof semiconductor patents, it discovered several mil-lion dollars in underreporting, but claimed that Sonyrefused to cooperate further. This prompted Tesserato reverse-engineer numerous Sony products, find-ing that Sony was purportedly selling hundreds oflicensed products that it failed to report. Tessera filedsuit for $93 million in unpaid royalties and the mattersettled shortly before trial.3

An audit often will take place in several stageswith multiple visits lasting up to a year, or longer.Eventually the process should be concluded. Theauditor should discuss its preliminary findings withthe licensor and licensee, attempting to resolve anyfinal issues, before the auditor prepares a finalreport, for delivery to both parties. If the final reportshows underpayment, the licensor should follow-uppromptly with a firm demand to the licensee, makingclear that it takes the results seriously and requirescertain actions by certain dates. Depending on the cir-cumstances, the licensor may then attempt to negoti-

ate a settlement, terminate, or amend the licensingagreement, or initiate litigation, in each case relyingon information gained through the audits.

ConclusionPrudent companies routinely implement compre-

hensive measures to identify and control risk in all


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areas of business. There is no reason why they shouldtreat licensing differently, trusting unrelated thirdparties to faithfully execute the compliance functionand strictly perform in accordance with the terms oftheir agreements. Licensing audits should be morethan knee-jerk reactions to problems; they should

be a regular component of the companys compre-hensive, pro-active, risk-management programs. Bypreparing for and handling audits in this manner,licensors can best protect their intangible assets andmaximize the revenue to which they are contractuallyentitled.

1. Eastman Kodak Co. v. Asia Optical Co., No. 12-3206-cv (2d Cir. May 1,2013).

2. See PNY Technologies, Inc. v. Miller Kaplan Arase & Co., No. 2:14-cv-04150 (Dist. N.J. June 30, 2014) (suit filed by licensee against auditor forfraud and related charges).

3. Tessera, Inc. v. Sony Corp., No. 5:11-cv-04399 (N.D. Cal. 2011).

Copyright 2015 CCH Incorporated. All Rights Reserved.Reprinted from The Licensing Journal,January 2015, Volume 35, Number 1, pages 1822,

with permission from Wolters Kluwer, New York, NY,1-800-638-8437, www.wklawbusiness.com

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Maximizing Royalties Through Strategic Licensing Audits