On May 21, 2014, Temple-Inland, Inc. ("Temple-Inland") filed a complaint in the US District Court for the District of Delaware seeking injunctive and declaratory relief from Delaware's application of its unclaimed property laws. The complaint names as defendants three Delaware unclaimed property officials along with Kelmar Associates LLC ("Kelmar"), Delaware's primary third-party auditor, and states multiple causes of action which include a host of alleged Constitutional violations. At the heart of the case is the extrapolation methodology that Delaware has employed to estimate the unclaimed property liability of holders in years for which complete books and records are unavailable.
This is at least the second time a lawsuit has been filed against Delaware in federal district court challenging that methodology. Just last year, in Select Medical Corp. v. Cook, Select Medical Corporation sued Delaware alleging violations similar to those set forth in Temple-Inland's complaint. However, that case never reached trial and was ultimately settled after Select Medical Corporation was able to produce records that Delaware deemed adequate. As such, Temple-Inland's lawsuit could result in the first federal court decision on the validity of Delaware's extrapolation methodology used in its unclaimed property audits.
Temple-Inland is a Delaware-incorporated packaging company with operations in various states. In 2008, Temple-Inland was contacted by Delaware and notified that it would be subject to an audit administered by Kelmar for 1986 through 2009 ("Period at Issue"). Consistent with its internal record retention policy at the time, Temple-Inland only had complete books and records for its payroll and accounts payable disbursements dating back to 2003 and 2004, respectively. Accordingly, Kelmar only audited Temple-Inland's disbursement records for the 2004-2009 period ("Audit Period") and used an extrapolation formula to estimate a liability for the 1986 through 2003 period ("Estimation Period").
According to the complaint, the extrapolation formula that was used to estimate Temple-Inland's liability was comprised of an "escheat percentage" multiplied by Temple-Inland's revenue during the Estimation Period. This escheat percentage is described as a fraction, the numerator of which is the sum of property purported to be escheatable during the Audit Period, which included the value of unclaimed property that was escheated to other states, and the denominator of which is Temple-Inland's total revenue during the Audit Period. During the course of the audit, the application of this escheat percentage to the Estimation Period is alleged to have yielded an estimated unclaimed property liability in excess of $2 million, even though, according to the complaint, Kelmar only identified a single outstanding payroll check in the amount of $147.30 that should have been escheated to Delaware as unclaimed property during the Audit Period. Notably, while Delaware currently imposes a statutory requirement on domestic corporations to keep and maintain records for purposes of unclaimed property audits, such requirement was not enacted until 2010 — two years after Temple-Inland was initially contacted for audit.
The complaint alleges that the estimation methodology employed by Kelmar violates federal common law by ignoring the Supreme Court precedent established by Texas v. New Jersey and its progeny. In that case, the US
Supreme Court set forth a series of priority rules pursuant to which states determine their respective rights to intangible unclaimed property. These rules establish a first priority right to the state of the last known address of the property owner and a second priority right to the state of the holder’s domicile. Pursuant to these rules, Temple-Inland asserts that property must be specifically identified in order to be subject to escheat and that the estimation methodology is therefore inconsistent with Texas v. New Jersey.
Temple-Inland also alleges that Kelmar's estimation methodology unlawfully applies Delaware's 2010 document retention statute retroactively. The complaint alleges that such retroactive application violates the ex post facto clause and Temple-Inland 's due process rights. As stated in the complaint, a decision in Delaware's favor "would require that [Temple-Inland] pay a penalty for failure to maintain records in periods prior to 2010 when, at the time, there was no such obligation and [Temple-Inland] had no notice it was required to do so." In addition to the alleged common law and due process violations, the complaint also alleges that Delaware's estimation methodology violates the Full Faith and Credit Clause, Commerce Clause, and Takings Clause of the US Constitution.
The Underlying Problem
The facts surrounding Temple-Inland's complaint underscore the need for meaningful reform in the unclaimed property arena. Unclaimed property laws, which are enacted in all fifty states, were initially devised to provide a mechanism to reunite lost or abandoned property with its rightful owner. Under these laws, the state acts as a custodian of the abandoned property until the rightful owner claims it.
However, the unclaimed property law in Delaware appears to have evolved from its original purpose of custodial safekeeping to revenue generation. Indeed, according to estimates published by the Delaware Economic and Financial Advisory Council, unclaimed property is Delaware's third largest revenue source. Delaware's situation is unique, as it seems to have leveraged its position as the most popular state of incorporation to exploit domestic corporations on the unclaimed property front.
Delaware is typically the first choice among business organizations of states in which to incorporate because it is generally considered to have favorable corporate laws. However, as of late, the benefits of incorporating in Delaware may be overshadowed by Delaware’s unclaimed property audit positions, which are frequently perceived as aggressive. The escheat priority rules arguably allow Delaware to receive all intangible unclaimed property for which the owner’s last known address is unknown from Delaware-incorporated entities. As Temple-Inland's complaint illustrates, a holder will often have no contact with Delaware other than the fact that it is incorporated there, and aggressive enforcement tactics have led to unfair results.
Once an audited is initiated, Delaware holders have been confronted with practical hurdles when asked to produce books and records dating back almost three decades. Moreover, the retention of third party auditors on a contingent fee or commission basis only appears to have exacerbated theproblem because such arrangements incentivize aggressive audit behavior by outside firms seeking to inflate their own bottom line.
The Road to Reform
In an apparent effort to repair its business-friendly image, the state has made substantive revisions to its unclaimed property law over the past year. Delaware Senate Bill 228, enacted on June 30, 2014, significantly reduced the penalties that apply to holders who fail to file an unclaimed property report. Previously, a holder who failed to file a report would be subject to a penalty equal to 5% per month of the amount of unclaimed property required to be shown on the report and capped at 50% of the amount due. Senate Bill 228 has reduced that penalty to 5% per month, or $100 per day, with a $5,000 cap. More importantly, the proposed legislation completely eliminates the interest on unreported unclaimed property—an often significant amount that holders were historically required to pay.
In addition, Delaware has introduced a bill that would curtail the state's use of third party auditors. Senate Bill 215, which is currently before the Senate Banking Committee, would forbid the Delaware State Escheator from paying outside auditors on a commission basis. In addition, the bill would prohibit audit contracts from extending beyond three years.
While these changes are a positive step towards a fairer system, the Temple-Inland case should be closely monitored because an ultimate resolution in Temple-Inland’s favor could potentially have the most significant impact to Delaware’s unclaimed property administrative practices.