Ensuring Proper Royalties: Monitoring Licensee Compliance to Licensing Requirements

Unlike most business processes and functions for which companies can implement controls to manage their risk, licensors must trust and rely on the internal control environment of their licensees to ensure intellectual property (IP) is protected and they are compensated fairly. Licensors must maintain professional skepticism to determine how to monitor the effectiveness of the licensee’s controls surrounding the protection and utilization of their IP while maintaining a symbiotic relationship.

Consider the following example: In the first quarter of 2007, a consumer electronics company that manufactures and distributes products through multiple channels discovered it had been paying royalties to the incorrect licensor. This had been occurring since the inception of the licensing agreement nearly two years earlier, with approximately $1.2 million disbursed incorrectly. All three companies involved were publicly held. The occurrence of such a major error raises many questions:

• How did this happen?
• Why did internal controls as mandated by Section 404 of the Sarbanes-Oxley Act fail to catch this error?
• Did any red flags emerge for the licensor when it did not receive required royalty payments?
• With regard to the company receiving incorrect royalty payments, was there a significant shift in royalty revenue from this licensee to this company? Did anyone at this company notice or wonder why?