It’s been less than 48 hours since the latest bombshell dropped in Delaware, after US District Court Judge Gregory Sleet said that Delaware was playing a game of “gotcha” with holders. But what does this mean for you, the corporate unclaimed property holder?
Delaware receives approximately one-eighth of its annual operating budget from unclaimed property revenues and is the third largest source of revenue. It is estimated that some 90% of the unclaimed property collected by Delaware is either owner or address unknown property. Without an owner to claim it, there is no chance that this property will be paid out by Delaware, leaving the state with a windfall.
First, know that while the decision to grant the motion for summary judgment was issued this week, the case is far from over. The decision has such drastic repercussions for Delaware that it is almost guaranteed that an appeal will be forthcoming. Of course, if the 3rd Circuit Court of Appeals agrees with the District Court, it will be even stronger precedence against Delaware.
Assuming that the decision is not overturned on appeal, what’s next?
Ongoing Unclaimed Property Audits
There are approximately 425 companies currently under audit by Delaware for unclaimed property. Companies involved in an ongoing Delaware audit are currently dissecting the opinion to see how it will affect their audits. Many companies that have had some history of compliance will benefit from the discussion on statute of limitations. The Court directly rebuked the State’s policy that it could audit if no report was filed, even though it did not require and even actively discouraged negative reports.
Other holders will benefit from the analysis on the record retention requirements and the estimation process. The Court did not prohibit estimation in audits, but it did put some guidelines around how the estimation is to be performed. The estimation must have the same qualities and characteristics during the reach back period as during the base years. Delaware has had a common practice of determining what the liability in the base period is for all states, not just Delaware, and then extrapolating that out for the entire look-back period. Delaware would then claim the entire amount for itself. In Temple-Inland, this produced an absurd result when the final assessment was with $50,000 of the amounts the company actually paid to the 49 other states, when it did have the records available. The Court rejected this methodology as unreasonable.
Voluntary Disclosure Agreements
Many companies are currently in the Secretary of State VDA program in order to initiate or bolster a compliance program and avoid an unclaimed property audit. The VDA program is essentially a self-audit program, so many of the same audit issues will arise in the VDA process. The nature of the estimation and record retention requirements could be affected by contract law in addition to the statutory and common law governing audits. However, the Court addressed these issues on constitutional grounds, so holders may be wise to consult with their subject matter experts on how the case applies to their individualized cases.
Ongoing and Future Annual Compliance
This case has made clear that the Barganier philosophy that “the best defense to an audit is a strong compliance program” is correct. Statutes of limitation are best applied when a company has a filing history. Estimations are avoided when a company has properly retained name and address records. Barganier maintains that the best practice recommendation is to continue annual reporting in all 50 states.
The Court made sure to clarify two points:
- Estimation is not limited to the second priority state of incorporation. Thus, companies should set record retention policies to correspond with all state specific statutes of limitation and record retention requirements.
- Indemnification is not an adequate remedy for the holder. A state will only indemnify a holder when another state has a superior right to claim the property. When the property is estimated, another state cannot establish their superior rights to the property.
The holder still bears the burden of compliance with a litany of crazy and sometimes conflicting statutes. Delaware still maintains that it may claim property where the address is not a complete mailing address, but yet enough information is available to identify the state where the owner resides.
In order to offset a portion of the anticipated decline in revenue from unclaimed property, Barganier expects that Delaware will become much more aggressive on assessing penalties and interest for non-compliance. Over the past several years, there has been some back-and-forth in the state legislature over the penalty and interest provisions. Expect that the next volley will be to increase the potential penalties. Again, a best in class compliance program will protect you from burdensome assessments.
Future Unclaimed Property Audits
You didn’t think that this was the death blow to unclaimed property audits, did you? In recent years, we have already seen a de-emphasis on Delaware audits. Verus Financial went after the life insurance industry with great success, without using estimation. Verus is now in the midst of their review on financial institutions. Barganier sees this trend of specialized auditing continuing into the future, with auditors focusing on specific property types (securities, general ledger) or industries (life insurance, banks, manufacturers).
Barganier has also watched many up-start audit firms come on the scene in the last handful of years. These audit firms are not the behemoths that Kelmar is – they represent small number of states, usually targeting name/address first priority properties. With better record retention policies and shorter audit periods, Barganier expects that the audit cycle will shorten. Companies should expect more frequent audits but cover smaller periods of time. Michigan has already passed legislation permitting a streamlined audit approach to speed up the audit process.
You’ve heard it once, you’ll hear it again. Delaware, Kelmar, and unclaimed property are not going away. The best audit defense is still an annual compliance program. Even with the hit to Delaware, don’t expect that the risk from unclaimed property assessments to go away. The risk will change and evolve away from Delaware and expand to the other states. Audits, although not as burdensome, may become more frequent.
And no, Barganier does not expect that the Uniform Law Commission’s efforts to pass a new revised uniform unclaimed property act to actually increase uniformity. But that’s a story for next week.