Less than a month ago, a federal court judge said that Delaware's unclaimed property audit process "shocks the conscience." Yet here we are again, talking about audit practices and requests that are unconstitutional, irrelevant, and over broad. And potentially open up the holder to potential disclosure of trade secrets and other confidential information and even potential liability in the event of a data security breach. This time Delaware is playing its game of "gotcha" with the office supply store Office Depot, Inc., a Delaware corporation.
Delaware and Kelmar Follow Audit Playbook to a T
Office Depot completed a Delaware Voluntary Disclosure Agreement in 2001, in which Delaware released all claims for prior reporting periods. Office Depot then filed an annual compliance report with Delaware every year, starting with the report due on March 1, 2001. In 2002, Office Depot created a Virginia Limited Liability Company, North American Card and Coupon Services, LLC (“NACCS”), with its principal place of business in Boca Raton, Florida. NACCS was created to issue stored value gift cards. The agreement gave NACCS a nonexclusive contract to promote and sell gift cards with Office Depot trademarks and names in exchange for 1% commission. In exchange, Office Depot agreed to accept the gift cards as tender for merchandise and services at the retail stores. NACCS also acquired the existing Office Depot gift card business. Office Depot is the sole member of NACCS.
On February 6, 2013, then State Escheator Mark Udinski initiated an audit of Office Depot and assigned the case to Kelmar, which at the time received approximately 90% of the unclaimed property audits for Delaware. In the ten-year period beginning in 2004, Delaware paid Kelmar $207,217,260 in fees.
Kelmar began its examination and determined that Office Depot and subsidiary The Office Club, Inc. were to be the primary focus of the examination. However, less than two months after communicating that decision, Kelmar issued its first request for information relating to stored value cards. Office Depot complied with the initial request, but that was not sufficient for Kelmar, who issued further requests about the gift card operations. The lengthy request was the same request issued to Marathon Oil, who has also filed litigation on the same issues.
After further objections and Office Depot’s refusal to turn over the requested records for which Delaware could not claim property, Kelmar sent a letter to Office Depot that Delaware would refer the matter to the State’s Attorney General’s office for enforcement actions. This is the same letter, on the same date, that Marathon Oil received after their objections to the same stored value card requests.
Predictably, Kelmar also made other objectionable requests. As in other audits, Kelmar requested all unclaimed property reports filed by Office Depot. Despite the fact that Delaware should be able to produce any reports that a company has filed with it, the company was required to produce these reports, beginning with the 2001 VDA agreement. When Office Depot objected to the request for the non-participating states, Kelmar responded on behalf of Delaware stating that an estimation for periods where records do not exist, then the filings will be included in the calculation as holder-identified liabilities. This practice was one of several that the judge in Temple-Inland said “shocks the conscience” in violation of a company’s right to substantive due process.
In February of this year, Whitaker sent a letter to Office Depot threatening penalties and “additional remedies” if the company did not comply to both the stored value cards request and the prior reporting request. Office Depot, through legal counsel, objected to the requests as not relevant since the state is barred by the statute of limitations for assessing any deficiencies and that Delaware lacks standing to claim under the priority rules. These objections were ignored and on June 24, 2016, Kelmar sent an email to Office Depot to advise the company that the matter had been referred to the AG’s office.
As other lawsuits have noted, the Delaware unclaimed property law does not provide for any type of pre-compliance review. Only after the final request for payment is made can the assessment, including liability, penalties and interest, be reviewed. At that time, the Delaware Court of Chancery’s review is limited to whether the determination was supported by substantial evidence in the record. Therefore, a holder’s federal preemption and Constitutional claims cannot be reviewed by the Court of Chancery and is outside the scope of appeal.
Office Depot notes that the auditor cannot ensure that information will remain confidential in light of the New Jersey federal court’s decision in Prudential to force Verus Financial to turn over its audit file. As such, state law confidentiality protections would not apply. Office Depot says that the requested information is “highly confidential, competitive, and proprietary information.”
Reporting Priority Rules
The Supreme Court established priority rules for reporting unclaimed property and preempted state laws to the contrary. The Supreme Court in Texas v. New Jersey said that the first priority is to the state of the owner, as determined by the holder’s books and records. If there is no name or address, then the second priority is to the holder’s state of incorporation.
In this case, the gift card entity NACCS is a Virginia LLC with a principal place of business in Florida. The entity does not collect the names and addresses of purchasers or recipients of gift cards. Without the names or addresses, only Virginia has standing to claim the gift cards, but it exempts such cards from reporting if certain requirements are met (notably, no expiration dates or fees).
When New Jersey attempted to claim cards in violation of the Supreme Court’s priority rules, the Third Circuit Court of Appeals said that “the ability to escheat necessarily entails the ability not to escheat.” Further, the Supreme Court did not intend to “give states the right to override other states’ sovereign decisions regarding the exercise of custodial escheat.”
False Claim Act Only State Alternative for Enforcement
Delaware has turned over this matter to the Attorney General’s office for enforcement. However, the state does not have authority to enforce a summons for the production of documents or enforce a summons in a court of law. Delaware has admitted that its only recourse is to file a lawsuit under the False Claims Act.
If you recall, Delaware is currently prosecuting a case against 86 companies for failing to report gift cards as unclaimed property as part of a qui tam lawsuit. In that case, the state is seeking treble damages and attorneys’ fees and costs.
As a result, Office Depot would have to incur the cost of complying with the audit requests, suffer significantly increased liability, penalties and interest before objections could be heard and resolved by a court. Further, even if the information was deemed irrelevant to the audit, the auditor could be forced to reveal such information at a later time to third-parties.
- It is apparent that Delaware, and its main auditor, is on the hunt for gift cards and other stored value cards. As discussed, this is the third major lawsuit in Delaware regarding gift cards sought by the state, likely in violation of the priority rules. As the state continues to attack these special purpose entities, holders should take the time to ensure that their gift card programs are in full compliance with the law. Advances in technology and changes to state and federal law and regulations may have altered assumptions that were valid at the time of implementation. All assumptions and conclusions should be evaluated to ensure that these changes have not made your gift card program non-compliant. Proper planning and execution of your compliance program is still the best defense to an unclaimed property audit.
- Holders should be aware of the overbroad requests from Kelmar and other auditors that are common during unclaimed property examinations. As we saw in Prudential and mentioned here, even if you win on the audit, the auditor may later be forced to reveal confidential workpapers. Everything from vendor lists and contracts, employment agreements, and customer information could potentially be disclosed. Every release of information should be carefully evaluated against the state’s authority and need for such information and the potential for future disclosure, including security data breaches and potential liability therefrom.
- It may seem like the time and effort to complete a voluntary disclosure agreement and subsequent annual compliance is all for naught if you are then subject to a burdensome audit. However, the win in Temple-Inland and other similar cases can all be traced back to their compliance posture. If an audit comes to litigation, you want to be able to walk into a courtroom and tell a judge that you did everything right and the state’s actions “shock the conscience.”
- Unclaimed property compliance is a mess of 50 different state laws and numerous court cases and the audits are even more complicated. While we may be getting more guidance from recent court cases, there is no definitive resource for understanding how to navigate this process. Barganier can leverage our experience working with Fortune 100 companies on their compliance programs and audit defense to guide you through your own process. Learn from the wins and losses of those before you so that you can focus on your core business interests.
If it feels like you've read this post before, it's probably because the facts are so similar to the Marathon Oil case - just a shorter audit period this time for Office Depot before we got to the litigation. It is a shame that it appears every audit has to lead to litigation, when the attorneys fees keep taking a big hit out of the state budget that is already in crisis. For a state that looks to take some major hits to its third largest source of revenue, you would think it could not afford to keep litigating these cases.
As a side note, the data security provisions in the model unclaimed property act were among the most contested in state commentary and commissioner activity at the Uniform Law Commission meetings in Stowe, Vermont earlier this month. The states do not want to be responsible for protecting the data that is divulged during the audit nor the holder it comes from.