Audit rights can come in handy

Why ask for audit rights? Because mistakes happen—and so do creative accounting, stonewalling, and even outright fraud. Audit provisions can help to detect, and thus to deter, all of the above. (The nuclear Navy has a saying: You don’t get what you expect, you get what you inspect.)

Consider, for example, the recent case of Zaki Kulaibee Establishment v. McFliker, No. 11-15207 (11th Cir. Nov. 18, 2014), where the appeals court reversed, as an abuse of discretion, a district court’s refusal to order an accounting. In that case:

• Zaki, a Saudi company signed a consignment agreement with ANI, a Florida company, under which the Florida company would sell what was expected to be around $500 million worth of aircraft parts and remit the proceeds, less a commission, to the Saudi company.

• The parties apparently didn’t have any parts-inventory procedure in place for confirming just what parts the Saudi company had shipped to the Florida company.

• A dispute over payment arose, during which the Saudi company tried repeatedly but unsuccessfully to get discovery to find out just how many parts the Florida company had really received and how many it had really sold. According to the appellate court:

ANI also manipulated the discovery procedures to prevent Zaki from discovering how many of its parts remained.

ANI retained possession and control of the remainder of Zaki’s parts—and along with them, the only conclusive means of determining the existence and extent of any damages.

Yet ANI repeatedly stymied Zaki’s attempts to conduct an inventory of those parts while simultaneously spinning out the discovery process for as long as possible.

Id., slip op. at 30 (extra paragraphing added).

• The parties’ contract included an audit provision, see id., slip op. at 5, but the district court refused to order an accounting.

• The appeals court reversed on that point—but it took the Saudi company years of litigation and who knows how much in legal fees to get even that far. The appellate court seems not to have relied on the contract’s audit provision, but instead on the Florida company’s fiduciary duty as a consignee. And if the contract hadn’t included an audit provision, who knows whether the appellate court would have taken the view it did.

Lesson for drafters: When the other side will have all the information needed to determine whether your client is getting everything to which it’s entitled, it’s a very good idea to include an audit provision.

I’ll be adding a summary of this case in the research notes for the Common Draft audit provisions.