Cash Flow

CFOs Should Heed Delaware’s Unclaimed Property Maneuvers

Delaware has long been known as a business-friendly state, but its practices regarding so-called unclaimed property have soured its reputation in r...
Christopher J. HopkinsSeptember 12, 2013

Delaware has long been known as a business-friendly state, but its practices regarding so-called unclaimed property have soured its reputation in recent years. CFOs and other executives who work for companies incorporated in Delaware need to be aware of some challenging audit practices the state has for unclaimed property assessments.

Over the past decade, the state has extracted billions of dollars from unsuspecting companies formed under Delaware law, largely based on speculative and unsubstantiated estimation methodologies. With mainstream press such as The Wall Street Journal and Forbes beginning to take notice of the problem, companies have more momentum than ever to aggressively challenge Delaware’s unclaimed property assessments.

What’s At Stake
Unclaimed (or abandoned) property is generally defined as property held or owing in the ordinary course of business that the owner has not claimed for a certain period of time (the dormancy period). Unclaimed property can include uncashed payroll and vendor checks, unapplied accounts receivable credit balances, dormant bank and brokerage accounts, unredeemed gift certificates and gift cards, and life insurance policies and securities with “lost” owners. Businesses holding unclaimed property (known as “holders”) must turn it over to the state after the dormancy period expires. States are generally required to hold unclaimed property in a custodial capacity until the rightful owner claims it.

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Unclaimed property is Delaware’s third-largest source of “revenue” (the state actually refers to unclaimed property collections as “revenue”), averaging more than three times annual corporate income tax receipts. From 2010 to 2012, Delaware collected $1.24 billion in unclaimed property revenue – much of which was estimated – with amounts collected going directly into the state’s general fund.

Several cases challenging Delaware’s unclaimed property assessments have been filed in the Delaware Court of Chancery – and settled – over the past few years. For the most part, however, these cases did not directly address the weak link in the state’s assessments: estimating a “reasonable” unclaimed property liability.

Deficiencies in Delaware’s Estimation Process
But Delaware’s approach to estimation suffers from multiple deficiencies. To begin with, the state apparently has never issued formal rules or guidance for estimating an unclaimed property liability. Without authoritative guidance, and under the guise of examining a company’s compliance with Delaware’s unclaimed property laws, the contract audit firms the state employs are effectively left to their own devices when it comes to determining an audited company’s unreported estimated liability. An obvious problem is that these firms are compensated on a contingency fee basis, creating a clear conflict of interest.

The only statutory requirement for estimating unreported unclaimed property is that the approach be “reasonable.” (It is interesting to note that, prior to enacting this law in 2010, Delaware had no statute permitting the estimation of a liability.) However, the methodologies wielded by the state and its contract audit firms arguably are anything but reasonable. An audited company should certainly question whether it is reasonable to do any of the following:

* Estimate a liability going back 30 years

* Issue an assessment against a company that has appropriately complied with Delaware’s unclaimed property reporting rules during periods when the company actually had contemporaneous books and records

*Issue an assessment against a company that has complied with the unclaimed property reporting requirements in states where it has owner name and address records

* Claim the entire amount of an estimated liability even when a company has had no employees, customers, or vendors in Delaware and virtually no other business contact with the state

This last point is especially egregious: The audit firm estimates a holder’s liability for the years when records are no longer available, and Delaware claims the entire amount. The state assumes that the entire estimated liability represents “no-address property,” which Delaware, as the holder’s state of incorporation, is entitled to claim.

Consider this example: Company ABC is incorporated in Delaware but conducts all of its business activity in State X. Because it never had unclaimed property in Delaware, it appropriately has not filed any unclaimed property reports with the state. Delaware audits the company back to 1981 and (not surprisingly) finds that it does not have accounting records dating that far back. Delaware and its auditors then use existing records to estimate a liability back to 1981 and claim the entire estimate, ignoring the fact that Company ABC never had actual business activity in the state.

It’s hard to argue that such an approach is reasonable on its face, but consider, too, that unlike most other states Delaware does not have:

* Recordkeeping requirements for unclaimed property

* Holder due diligence rules, where a holder is obligated to attempt to contact an owner prior to paying unclaimed property to the state

* Reporting requirements (except for banking organizations) requiring a company to file a report if it had no unclaimed property to report

Statutory, regulatory, and judicial authority for Delaware’s estimation assumptions seem to be nonexistent. And Delaware has never officially articulated the view that it is entitled to claim an entire estimated liability. Moreover, no federal or Delaware court has ever ruled that estimating an unclaimed liability is permissible. In fact, whether an estimate is even unclaimed property is subject to debate. After all, unlike an uncashed check or share of stock, estimated unclaimed property is a fiction – there is no actual unclaimed property owner, making the basis for the state’s custodial claim questionable.

Don’t Admit Defeat
The prolonged and resource-consuming unclaimed property audit process can wear companies down, prompting them to simply throw in the towel and either pay the estimated liability or reach a settlement to avoid the threat of penalties and interest. While those actions are understandable, these companies should strongly consider aggressively challenging Delaware’s approach, particularly its untenable and unsupportable estimation methodologies. In addition to pointing to the lack of authority for the methodologies, companies can cite the growing criticism as the ugly little unclaimed property secret of this state – once considered a friend to business – receives greater attention.

Christopher J. Hopkins is a partner with Crowe Horwath LLP.