Contract compliance: bringing clarity to shades of grey

A well-designed contract compliance programme can help to identify grey-market risks while enhancing the monetisation of IP and contractual agreements in numerous ways. Leading practice points to the need for a robust programme that is transparent and supported at every level

By David Marston and Kim Wiatrak - PwC

“Uncertainty will always be part of the taking charge process.” Harold S Geneen, US business leader (1910–1997)

In the fast-paced, ever-changing global business world, companies across all industries are scrambling to protect their brands and intellectual property. Among the most insidious threats to corporate integrity are the grey market and the issue of compliance with contractual agreements between partners and customers.

These concerns are prompting a growing number of boards of directors to ask: “What are we doing to protect our products and intellectual property that’s in the channel?” Leading practice points to the need for a robust programme that is transparent to business partners and supported at every level within your organisation.

Yet many companies continue to lag in assessing grey-market risks and overall contractual agreement compliance related to IP licensing or the use of intellectual property embedded within specific products and solutions. The agreements also typically address approved market and pricing parameters, thereby drawing the boundaries around possible grey-market issues.

This article focuses on the underlying principle of what constitutes an effective contract compliance programme and how this can be important to good corporate governance as a strategic and competitive business decision for you and your business partners. A welldesigned contract compliance programme can help to identify grey-market risks while enhancing the monetisation of your intellectual property and contractual agreements in numerous ways.

Licence compliance basics
Let us first address what licence compliance is and is not. At its best, compliance involves a systematic programme that deliberately addresses and mitigates the risk of misuse or misreporting of a licensed product based on the terms and conditions of existing contracts. An effective programme aims to:

• Improve and protect the economic impact of intellectual property and intangible assets.
• Flesh out contractual, pragmatic, real market use issues (not theoretical issues).
• Send a message that your organisation takes IP protection seriously.
• Promote compliance with the organisation’s controls and business processes, such as Sarbanes-Oxley compliance.
• Identify areas of grey-market risk to keep the playing field level for all partners and customers.
• Address widespread issues of underreported licensing revenues.
• Drive incremental revenues that have a direct bottom-line impact.
• Enhance the organisation’s ability to forecast future revenue streams more accurately.

Imagine you could peek through a window into a business partner’s environment to see how it is using your organisation’s technology or intellectual property, and the value it is able to derive from it. You would very likely come away with vital information to help you arrive at timely and more strategic business decisions.

Although most of our clients truly believe they are up to speed in this area, our experience tells us that most do not really know what is happening when it comes to their contractual terms and conditions. They might not realise that information developed during a licence compliance inspection – notwithstanding any non-disclosure agreement and subject to the terms and conditions of the respective agreements – can be used to:

• Redesign and upgrade features or functionality.
• Identify new uses.
• Uncover illicit territorial expansions.
• Modify existing licensing metrics that have become less relevant or effective over time.

This, of course, assumes that the organisation has a licence compliance programme in place and that it is operating as designed.

Successful design feeds competitive advantage
A licence compliance programme should be clearly defined with designated ownership that includes:

• Authority and responsibility.
• Top-level executive sponsorship.
• A laser focus on customer relationships.
• Clear escalation paths, as needed.

The other critical foundation for success is the inclusion of a well-written and effective ‘right to audit’ clause, including a books and records provision with a minimum look-back window in all applicable third-party contracts. Plugging revenue leakage, protecting intellectual property and adding incremental revenue to the organisation’s bottom line is an area of opportunity on which any shrewd Csuite or board should be focused and fully supportive. The competition is likely already engaged in such a programme and reaping the benefits – including getting the word out to the market that they take this matter seriously. In addition, return on investment for most licence compliance programmes is estimated to be on average eight to 10 times the direct costs of programme execution.

Leading contract compliance programmes leverage legal, product marketing, finance, compliance and sales’ collective knowledge to understand better what the organisation’s risks are and how to address them. Companies that have this integrated approach are tuned into the current licensing models and capable of identifying potential issues with reporting, contract language and product misuse. Additionally, the collective mindset is more adept at working through those issues with business partners to facilitate a holistic approach to customer satisfaction.

Invoking the audit right clause
Once an audit rights clause is invoked, a licence inspection will generally be conducted by an independent third-party accounting firm, which will provide a fact-based report that can include quantitative and qualitative findings. It is imperative that well-structured and documented settlement procedures are in place to enable a timely close and receipt of any moneys due. These procedures will include proper trigger points for negotiation, which might include late fees, interest and settlement of the audit fees. If a business partner is found to be failing to comply with the terms and conditions, the settlement process allows for both parties to understand the reasons why, thus further enhancing the long-term relationship.

From the perspective of a business partner, receiving an audit notification letter is never a joyous occasion; but it is an eventuality that your organisation should anticipate and be equipped and able to deal with proactively. Being prepared and cooperating with the requests of the independent accountant can make the process run more efficiently, thereby minimising disruptions and condensing the overall timeline to completion. It is good practice to identify appropriate executive sponsorship for the licence compliance inspection and determine who within the organisation will be accountable for ensuring a successful delivery and thorough analysis of the findings. It is in the best interests of both business partners that expectations concerning scope, process/procedures, access to individuals, and books and records be addressed at the onset.

In theory, these audits should not be greatly time consuming, as the partner’s books and records have already been created as part of the normal business process. A timeline for completion should be agreed upon, with milestone dates, tasks and interdependencies highlighted as necessary. Good communication is key to facilitating a smooth and relatively pain-free compliance audit. One leading practice is to perform a ‘self audit’ so that any known issues can be identified before the independent auditor’s site visit. The upside for business partners is a clean bill of health, coupled with the ability to understand internal processes and controls related to identifying and monitoring their portfolio of licensed products better. In addition, you and your partner or customer will be able to address any grey areas in the contract and clarify them for the future.

Many companies that resist putting a licence compliance programme in place assume that it is an adversarial practice that can tarnish customer relationships. However, in performing thousands of reviews globally for a host of cross-industry companies (including those in the biotechnology, software, hardware, semiconductor and communications sectors), we have seen the contrary to be true. After a cooling-off period, an organisation with an effective licence compliance programme will launch customer satisfaction surveys to collect feedback from business partners on the experience.

The results, while surprising to some, are typically positive and indicate an enhanced level of product and licensing understanding, partner interaction and communication. The best way to measure the impact of such a programme is to analyse future sales data and ask: “Did we have any customers leave us due to our programme? Post-audit, are our customers continuing to use our IP or products, and what is the revenue trend line?” Our clients tell us that they typically see no negative impact on future revenue streams.

The mantra that works here is ‘trust, but verify’. Experience demonstrates that most licensees are not trying to defraud the licensor. Misreporting and/or misuse occurs in 90% of inspections due to circumstances such as:

• Accounting mistakes and/or inaccurate system-generated royalty reports.
• Clerical errors, such as when new products are incorrectly excluded from royalty reports.
• Contract interpretation differences (ie, standard discount or net sale deductions).
• Lack of defined calculation and reporting process. • Staff turnover and limited understanding of contractual terms and conditions.
• Communication breakdowns between engineering and those responsible for royalty monitoring and reporting.
• Mergers/acquisitions where contract terms may be ambiguous.
• Poor controls over licence deployment and lack of a software asset management tool for tracking.
• Weak internal controls over the proper upkeep and retention of appropriate books and records to support licensing requirements.

‘It’s all good’
So, is what is good for the goose really good for the gander? Can an effective licence compliance programme really benefit both your company and your business partners? Indeed it can. Companies that have licence compliance programmes are capitalising on many tangible benefits.

One area in which we have seen a distinct benefit to both the company and the partner is mutual transparency.

This becomes evident with regard to contractual rights between parties. Often, existing contracts have been drafted by individuals who are no longer at either the company or the partner. Agreements might date back three years, five years, a decade or more. Given the rapid pace of technological change, these parties would not have been in a position to contemplate certain technology uses when the agreement was originally drafted. The spirit of the agreement can become lost and sections once deemed clear fall open to interpretation. Effective compliance programmes seek to iron out these differences through enhanced agreement terms that clearly define frequent problem areas such as payment terms (ie, deductions to net sales) and reporting requirements, including templates. Once interpretation issues are identified, it behoves the company to negotiate an agreement that benefits both parties by including a periodic ‘true-up’ discussion.

Often, customers feel that they have no voice or direct line into the company and wonder whether their relationship is valued. This is clearly not the mindset or strategy that drives business and strong revenue growth. Most organisations that launch a compliance programme are surprised to learn that this attitude applies to their operations. The benefit realised lies in the elevated state of awareness and ability to remedy the situation, thereby opening the lines of communication. These touch points give rise to improved business partner relationships and a better understanding of one another’s position, as well as a realignment of customer satisfaction.

Neutralising the grey market with a black-and-white compliance programme
Perhaps the most significant competitive advantage that an effective licence compliance programme affords both parties is the means to combat and potentially limit grey-market activity. The grey-market sale of legitimate products in unauthorised territories or to unauthorised parties hurts business partners and consumers alike. The grey market takes on many forms, such as incentive abuse, diversion of discounts, diversion of products, warranty and service abuse, counterfeit products and used/refurbished products being sold as new.

To that end, PricewaterhouseCoopers and the Alliance for Grey Market and Counterfeit Abatement conducted a survey and in October 2009 released a white paper entitled “Service Blues – Effectively Managing the Multi-billion Dollar Threat from Product Warranty and Support Abuse”. The survey indicates that more than 90% of the “participants agree or strongly agree that the issue of service abuse has become more important over the past five years, and… believe the issue will become even more important over the next five years”.

What is staggering is that “only 35% of survey respondents believe their companies clearly communicate and enforce a specific global program that includes policies and controls designed to prevent and detect service abuse”. The financial impact of warranty service abuse to survey participants was estimated at US$10 billion, which represents the low end of the scale.

Regulatory realities
No discussion of effective compliance programmes, IP protection and competitive advantage would be complete without a look at government regulations such as the Foreign Corrupt Practices Act and the UK Bribery Act and their enforcement by the US Department of Justice and Securities and Exchange Commission. We have seen more and more scrutiny of companies over the past few years across a spectrum of industries, including healthcare, energy and, more recently, technology. Business leaders need to know who their immediate business partners are and also understand who those partners interact with downstream. This is true for US companies doing business abroad as well as their subsidiaries, joint ventures and companies subject to local foreign jurisdictional rules and regulations.

A company that has tiered distribution channels must establish due diligence procedures for existing and new partners. The risk of turning a blind eye to this can result in civil and criminal charges and, even worse, mar the organisation’s brand and reputation. The DOJ and SEC expect companies to perform certain levels of risk assessment, to document their procedures and to have proper and effective monitoring methods in place.

The competitive advantage lies in a company’s ability to harness various data sets with an eye to compliance and, from a sales channel perspective, to elevate relevant information so the entity can make better and more strategic business decisions. This can be the crème de la crème of a robust plan for ensuring compliance with laws and regulations. Effective licence compliance programmes embed the concepts of unauthorised parties and territories into the work plan in an attempt to identify and isolate those parties that should be terminated.

No organisation is alone in this endeavour. Experience has proven that business partners are keenly aware of which companies enforce licence compliance, fail to enforce it or enforce it with less commitment or vision than other companies. This network, although informal, is very real and may be reason enough to put a compliance programme in place.

Cut your company’s global risk exposure
If your company is operating without a licence compliance programme, it might seem daunting to consider where to start and what the next steps should be. Experience indicates that when individuals reach out to peers (not necessarily direct competitors) in their industry to discuss this topic, they experience a high level of collaboration. It can be a wonderful way to gain insight into the leading practices, benefits and challenges of launching a programme. You also can find specialists to assist with the design, launch and execution of a compliance programme. If your company already has a programme in place, outside consulting firms can provide benchmarking, gap analysis or programme management to improve efficiency and effectiveness.

As the business world continues to evolve, companies should take the policing of their contractual and IP rights seriously. There is no way to eliminate completely grey-market risks, unauthorised IP use or partners’ contractual violations. However, a systematic, robust contract compliance programme is one of the surest ways to reduce such risks.