Delaware Hit With Another Lawsuit Challenging Audit Process

Photo by smokedsalmon on FreeDigitalPhotos.netPlains All American Pipeline, LP ("Plains"), a Delaware limited partnership formed in 1998, has filed a lawsuit against Delaware, seeking a declaratory judgment and injunctive relief from the state initiated unclaimed property audit. Like many other Delaware audits that have resulted in litigation, this audit was assigned to Kelmar Associates, a third party contingent fee auditor, who was also named as a defendant in this case.

Plains says that the entire unclaimed property audit process in unconstitutional, both facially and as it is applied to the company. The company objects to the audit selection process, the document requests and the estimation process. While other recent cases have focused on the results of an audit, this case focuses on the initiation of the audit and the boundaries for the state and its third party auditor.

Audit Selection

Plains objects to the method that Delaware uses to select companies for an unclaimed property audit, saying that it was chosen based on its perceived profitability and "not based on neutral criteria or any criteria bearing a rational relationship to a legitimate governmental interest." Plains says that the scoping requests, including tax returns, balance sheets, a profit and loss statements, are intended to determine which legal entities will be most profitable to Delaware and Kelmar, by selecting entities that are most likely to be subjected to the estimation process, whereby the amounts escheated go directly into Delaware's general fund, after Kelmar's percentage. Plains objects to this part of the process, saying that Delaware has not provided "reasonable notice" as required by state law.

Plains further objects to Kelmar's authority over the audit, unchecked by a state administrator or court oversight. All of Plains objections to date, made to Delaware audit manager Michelle Whitaker, have been summarily rejected seemingly without consideration. In practice, she has deferred all decisions to Kelmar. Kelmar decides the entities, the property types, the timing, and the methodology of the audit.

Document Requests

Plains says that the Delaware statute does not authorize the state to issue administrative subpoenas and no warrants have been issued for a physical inspection of the company's records. The company says that even if the state has the statutory authority to issue document requests, the actual requests issued by Kelmar exceed those permissible under the Fourth Amendment. Delaware has threatened penalties for failing to cooperate and comply with audit requests.

Kelmar routinely asks for documents dating back to January 1, 1981, based on a Delaware regulation issued in 2012. Even before that particular regulation, it was common practice for the state and Kelmar to audit companies' records dating back to 1981. This is contrary to the practice of most other states that have a more reasonable 10 year look back period, along with most corporate record retention policies that are between 7 and 10 years. Meanwhile, Delaware does not have an express statutory record retention requirement. It was not until July 2010 that Delaware provided statutory authority to estimate a holder's liability when records are insufficient to prepare a report.

Moreover, Delaware statutes do not protect the company's confidential records and the sharing of information between states. (Also of note for holders is the recent Prudential case where the auditor workpapers are the subject of a court battle in a class action shareholder lawsuit.) Kelmar, which is requesting a significant amount of confidential, sensitive and valuable corporate information, will not subject itself to a review of data security procedures and controls.

Estimation

The company, like other unclaimed property holders, objects to the estimation process, saying that it violates substantive due process rights and is an unconstitutional taking of private property for public use without compensation. Unlike the application of the 1995 model act, Delaware has taken the position that the 2010 estimation amendment does apply retroactively, effectively punishing a corporation for failing to maintain records that it was not legally required to maintain. The estimated liability is arrived at by taking what should have been or was reported to Delaware and all other states in years when records are available and then divided by the holder's total revenue during those same years to produce an escheat percentage. This is then multiplied by the revenues in the years when records are not available to determine an estimated liability. Plains says that this number is "an absolute fiction designed to maximize the revenue stream to the State and also Kelmar's coffers." Since 2013, Delaware has paid Kelmar in excess of $104 million.

Takeaways

Holders should not expect a magic bullet to solve the Delaware unclaimed property audit conundrum. Even if the court says that the current audit practices exceed constitutional and statutory boundaries, the state would most likely modify its practices to be able to continue to audit and collect unclaimed property from holders. Barganier continues to recommend as a best practice a comprehensive, nationwide unclaimed property compliance program. A compliance program is the best way to defend against an unclaimed property audit. Most states have said that one critical factor in deciding whether to audit a company is whether they have submitted annual reports, in areas that the company is likely to have unclaimed property. Annual reporting, both to Delaware and the other 49 states, places a company in the best position to argue against retroactive application of estimations and for the application of the statute of limitation and laches defenses.

Barganier will continue to monitor this and other cases to bring you any important developments.

Wall Street Journal: Plains All American Takes on Delaware Over Unclaimed Property

See Also:
Temple Inland Survives Motion to Dismiss
9th Circuit Affirms Dismissal of Taylor Case
Osram Sylvania Files Suit Against Delaware