Even as the economy improves and states fill their coffers from more traditional revenue sources, many continue to turn to their abandoned and unclaimed property (AUP) laws to drum up additional funds. No state has generated more heat over the propriety of its audit methods than Delaware, the state of incorporation for numerous U.S. companies, yet other states are following its aggressive lead. They are hiring more contract auditors and widening their focus from large companies to smaller and different types of businesses. In Ohio, for example, even small medical practices have come under audit.
It is critical, therefore, that businesses of all shapes and sizes stay up to date on changes in the AUP arena. There have been some encouraging developments for businesses holding AUP, as Delaware's methodologies have come under some well-grounded and successful assaults of late. But it is not all good news.
Unclaimed Property in a Nutshell
AUP generally is defined as property held or owing in the ordinary course of business that the owner has not claimed for a certain period. AUP can include uncashed payroll and vendor checks, unapplied accounts receivable credit balances, dormant bank and brokerage accounts, unredeemed gift certificates and gift cards, life insurance policies, publicly traded securities with "lost" owners, customer refunds and rebates, benefit plan payments, and the contents of safe deposit boxes. The scope of the definition seems pliable, and it is not unreasonable to expect that states might attempt to expand AUP in the future to target areas such as the customer loyalty programs common to hotels, airlines, and some types of retailers.
Every state, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Guam, and some foreign countries have AUP laws. The laws generally require businesses holding AUP (holders) to turn it over to the state after the dormancy period expires. States ostensibly hold AUP in a custodial capacity until the rightful owner claims it, but often AUP eventually is treated as revenue in state budgets. In Delaware, AUP actually goes directly into the general fund and is not removed unless an owner makes a claim.
Most state AUP laws, including those based on the Uniform Unclaimed Property Act of 1981 or the Uniform Unclaimed Property Act of 1995,1have provisions that allow a state to estimate a holder's liability for AUP that the holder failed to report if the holder has not complied with the law's recordkeeping requirements.
Developments in Delaware
The past couple of years have seen some important developments in the ongoing litigation over Delaware's AUP audit methods. Delaware hires contract audit firms that estimate a holder's liability for the years for which records are not available, and the state claims the entire amount. It assumes the estimated liability is "no-address property"—meaning the owner is unknown or the holder lacks the owner's address records—that Delaware is entitled to claim as the holder's state of incorporation. Not surprisingly, this approach has increasingly come under attack in litigation that highlights the egregiousness of its application. Most notably, a federal district court recently found the state's method of estimating AUP liability violates the substantive due process requirements of the U.S. Constitution.
In Temple-Inland, Inc. v. Cook,2 the federal district court's ruling in Temple-Inland's favor in late June 2016 dramatically shifts the entire landscape for AUP estimations. The company filed a lawsuit in May 2014 against Delaware Secretary of Finance Thomas Cook, as well as the state's principal auditing firm, Kelmar Associates. It challenged the state's estimation methodologies and its claim to the entire estimated liability.
Though it does not invalidate the use of estimation, the court's opinion amounts to a scathing indictment of Delaware's methods. The state, according to the court, "engaged in a game of 'gotcha' that shocks the conscience."3 In particular, the court noted the following factors:
- The 22 years that Delaware waited to initiate the audit of Temple-Inland;
- The state's attempted exploitation of loopholes in the statute of limitation;
- The lack of notification to holders that AUP records should be retained for an extraordinarily long period;
- The lack of a legitimate state interest in retroactively enacting an estimation statute, other than raising revenue;
- The use of biased estimation techniques designed to increase estimated liability; and
- Holders' exposure to claims by multiple states for the same property.
But the court deferred its decision regarding an appropriate remedy, leaving it to the state to propose a remedy or appeal. Instead, soon after the ruling,Delaware and Temple-Inland filed a joint motion to dismiss the case based on a voluntary settlement agreement. Observers speculate that the state withdrew its liability assessment and paid the company's legal and court costs. Regardless, the failure of the ruling to include a remedy creates uncertainty as to how holders currently under audit in Delaware should proceed.
The ruling has implications beyond Delaware. Because of the case, more states now may estimate unclaimed property liability regardless of where a holder is legally formed. Previously, as a matter of practice, many states deferred to the holder's state of legal domicile when it came to estimating AUP liability.
Delaware is involved in several other AUP-related cases, including the following.
Card Compliant, LLC
Delaware has shown a growing interest in auditing gift card companies since the November 2015 ruling allowing this case to proceed against dozens of retailers and third-party gift card providers. Delaware ex. rel. French v. Card Compliant, LLC4was filed in a Delaware state court in 2013 as a qui tam (or whistleblower) action under the Delaware False Claims and Reporting Act (DFCRA).5 The complaint alleges that the retailers and the third-party gift card providers engaged in improper schemes to avoid reporting unredeemed gift card liabilities under Delaware's AUP law. On Nov. 23, 2015, the Delaware court ruled that the case could proceed (although some of the defendants were dismissed). Retailers domiciled in Delaware should expect the state's auditors to scrutinize the manner in which they issue and redeem gift cards.
Marathon Petroleum Corp. and Office Depot, Inc.
In Marathon Petroleum Corp. v. Cook6 and Office Depot, Inc. v. Cook,7both companies have one or more affiliates that issue and redeem gift cards. Many retailers have similar structures, with the affiliates typically domiciled in states that exempt gift cards from AUP laws, allowing retailers to honor gift cards indefinitely (and, of course, to keep any breakage for themselves).
Both Marathon and Office Depot sought injunctive relief, contending in their complaints that Delaware does not have jurisdiction over their non-Delaware affiliates, that Delaware's AUP law is preempted by federal common law, and that document requests that Delaware's contract auditor issued to the companies' non-Delaware affiliates were unreasonable searches that violated the Fourth Amendment. Although the court found that the plaintiffs' claims were ripe, Marathon's case was dismissed on Sept. 23, 2016, for failure to state a claim, while Office Depot's case remains outstanding as of this writing. Marathon has indicated it will appeal the decision.
JLI Invest S.A.
In the case of JLI Invest S.A. v. Cook,8two Belgian scientists were part owners of a biopharmaceutical company, and their shares were held by JLI Invest S.A. and LIN Invest S.A., two Belgian companies formed for this purpose. The biopharmaceutical company's transfer agent, Computershare, domiciled in Delaware, escheated the scientists' shares to Delaware, which promptly sold the shares for nearly $1.7 million without attempting to locate or contact the scientists.
The scientists did not learn of this until years later. Had they still possessed their shares, they would have received almost $14 million from Merck, which subsequently acquired the biopharmaceutical company. Delaware eventually offered the scientists $1.7 million; they accepted this amount but filed the lawsuit in July 2015 to recover the difference between that amount and the would-be Merck buyout. The state, without any statutory or case law authority, claims that foreign-addressed property escheats to the holder's state of incorporation.
Plains All American Pipeline, L.P.
In 2014, Kelmar, the Delaware auditing agent, notified Plains All-American Pipeline, a limited partnership formed in Delaware with a commercial domicile in Texas, that it would be auditing the company. Plains filed a lawsuit, Plains All American Pipeline, L.P. v. Cook,9 in June 2015, before the audit even began, claiming that Kelmar's request for information about subsidiaries organized outside Delaware constituted an illegal search and seizure in violation of the Fourth Amendment and violated the due process requirements, among other constitutional provisions. The company also challenged Delaware's right to use estimation. Interestingly, on Aug. 16, 2016, the same federal district that issued the decision in Temple-Inland ruled that the issues in the Plains complaint generally were not ripe for consideration because they were based on contingencies and not actual facts, since the audit had yet to occur. Plains All American Pipeline has appealed the district court's decision to the Third Circuit.
Few businesses can afford to ignore the constantly evolving AUP laws and their rules of engagement. Although AUP largely remains dynamic and unpredictable, one thing is certain—Delaware and other states will continue to pursue this revenue generator until the courts firmly and decisively rein them in.
1National Conference of Commissioners on Uniform State Laws (NCCUSL) Model Act of 1981 and NCCUSL Model Act of 1995. The NCCUSL approved significant revisions to the Model Act in July 2016.
3Id., slip op. at 34.
4State of Delaware ex rel. French v. Card Compliant, LLC, No. N13C-06-289 FSS (Del. Super. Ct. 6/28/13) (complaint filed).
5Del. Code tit. 6, ch. 12.
6Marathon Petroleum Corp. v. Cook, No. 1:16-cv-00080 (D. Del. 2/11/16) (complaint filed).
7Office Depot, Inc. v. Cook, No. 1:16-cv-00609-LPS (D. Del. 7/18/16) (complaint filed).
8JLI Invest S.A. v. Cook, No. 11274 (Del. Ch. 7/9/15) (complaint filed).
9Plains All American Pipeline, L.P. v. Cook,No. 1:15-cv-468-RGA (D. Del. 8/16/16).
Sarah McGahan is a senior manager, state and local tax, with KPMG LLP in Washington. Chris Hopkins is a partner and Thomas Wrocklage is a state and local tax manager with Crowe Horwath LLP in New York City. For more information about this column, contact firstname.lastname@example.org.