01 Jun 2016

I want it all: the contractual effect of audit clauses

By Nick Cooper, Kate McNally

Contractors should consider audit clauses carefully during the negotiation of a contract.  

"Audit clauses" are becoming increasingly common in commercial contracts. However, like all boilerplate clauses they require careful drafting as they can impose onerous, and sometimes unexpected, obligations.

An audit clause is essentially an agreement to provide documents. Typically it gives a principal the right to "audit" a contractor's books and records in respect of the contractor's compliance with its obligations under a contract. 

In Transport for Greater Manchester v Thales Transport & Security Limited [2012] EWHC 3717 (TCC) a court ordered specific performance in relation to an audit clause.

The claimant (TGM) and defendant (Thales) had entered into an agreement for Thales to supply TGM with a new tram operating system.  The initial contract price was £22 million. After significant delays, Thales submitted a claim for an extension of time within which to deliver the system and an additional £42 million. Without attempting to apportion blame Justice Akenhead observed, rather understatedly, that something with the agreement had obviously gone seriously wrong.  

Justice Akenhead acknowledged that while the claims were large they "raise[d] matters which are commonly raised on construction or engineering claims: alleged variations, late instructions or information, lack of co-operation and delays".

Thales wanted to proceed with an adjudication as quickly as possible. This was of great concern to TGM as the relevant adjudication process required a decision within 28 days of the matter being referred ‒ and, as Justice Akenhead noted, such a process can produce a relatively "rough type of justice".

TGM requested an array of documents from Thales to verify its claims.  Thales refused and TGM, not unexpectedly, initiated proceedings seeking specific performance of the audit clause contained in the agreement between the parties.

What did the audit clause say?

In the TGM case the audit clause provided, amongst other things:

27.1 The Supplier shall for a period of at least 12 years … maintain accurate, up-to-date and complete records relating to its obligations under this Agreement  ("Records") (in a form suitable for inspection under clause 28) relating to the performance of its obligations under this Agreement including:

(a) the acquisition and properties of all materials, parts and items of equipment included in the manufacture and/or supply of the Deliverables;

(b) the design and/or the supply and installation of the Deliverables….

[emphasis added]

Clause 28 contained something of a "catch-all" that provided in part:

28.1 In addition….[Thales] shall submit… such other information, records or documents in its possession or control or in the possession or control of any auditors….as [TGM] or such Auditor may reasonably request…and which relates to the Records.

The obligation to "maintain" records

By clause 27, Thales was under an obligation to maintain "accurate, up-to-date and complete" records for 12 years.

Most companies retain documents for at least six years , as most causes of action must be commenced within six years of the event which triggers a claim. Further, section 286(2) of the Corporations Act 2001 (Cth) requires companies to keep certain financial records for seven years.

This gives rise to questions about the interaction between a contractual and the legislative obligation, for example:

  1. Can project documents be intermingled with other corporate documents? By way of example only, does each employee need to save all emails regarding a project separately?  
  2. After the project has been completed, can hard copies of relevant material be scanned and saved on the company's system or must all hard copy documents be stored for 12 years?

What does "relating to" mean?

Clause 27 refers to documents "relating to" Thales' obligations under the contract and its performance of its obligations under the contract.

Justice Akenhead noted that the reference to "performance" would also encapsulate documents going to Thales' failure to perform its obligations. Further, the words "relating to" had a more expansive scope than words such as "limited to".

A contractor bound by an audit clause in terms similar to clauses 27 and 28 may expect that they will only have to store and, upon request, hand over "primary" or "source" documentation such as the relevant contract, invoices from suppliers etc.

However, in the TGM case the records falling within the scope of the audit clause were much broader. They included a record of hours worked by a team of designers and, perhaps more surprisingly, documents created months later including internal reports or audits done by Thales to try to identify why the project was over time and over budget.

What can the principal use the records for?

The scope of documents falling within clause 28 are subject to certain constraints, including:

(a) that a request must be made;

(b) the request must be reasonable; and importantly

(c) the request must be for either

(i) auditing any information supplied or

(ii) verifying Thales' compliance with its obligations under the contract.

Justice Akenhead noted that the word "auditing" within the contract was akin to "vetting" or "checking".

Clarity around audit clauses: considerations

If a draft contract contains a boilerplate audit clause, consider the following:

  1. Is it clear from the clause what records fall within its scope? Should you limit the scope?(for example, documents "limited to the contract, invoices and time sheets");
  1. Does the clause contains words which may inadvertently expand the scope: such as "relating to" or "any other documents an auditor may reasonable require"?
  2. Should you specifically carve out documents you do not want to make available ‒ such as internal emails / internal audits?
  3. How will confidential documents be dealt with?
  4. Can you refuse inspection based on privilege?
  5. What use can the principal make of the records provided?
  6. Does the audit clause provide any extra burden on you, and if so, who bears the cost of same? For example, if you are required to store hard copy documents for 12 years, who pays the storage costs? If it would take 1,000 hours to collate and check the records who pays this cost?

For contractors, the TGA case serves to illustrate the importance of considering audit clauses carefully during the negotiation of a contract.  An audit clause can impose a significant compliance burden. Its scope may also be much broader than it initially appears. 

This article was first published in Governance Directions, June 2016

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.