At a Glance…

The Delaware Secretary of State recently issued a statement to businesses encouraging them to convert their unclaimed property audits to voluntary disclosure agreements (“VDAs”). However, the position presented by the State does not address all of the issues that a holder must consider when determining whether to convert its unclaimed property audits. Holders should consider whether the benefits of the VDA will offset the sacrifices required.

Delaware Secretary of State Bullock recently appealed to businesses to convert their unclaimed property audits to VDAs pursuant to 12 Del. § 1176(b), stating that it is “an excellent opportunity for many companies under audit.”[1] The Secretary lauded his program as “less expensive and less time-consuming,” “procedurally fair, efficient and business-friendly,” and as being “in the best interest of holders. He asserted that the VDA is “cheaper, faster and better,” and contended that a conversion to a VDA “makes the most business sense” for holders. He finished his pitch with the assertion that “every holder that is eligible to convert their unclaimed property examination into a VDA should absolutely do so.”

Each company must consider its own circumstances to determine whether the VDA is “less expensive and less time-consuming,” taking various factors into account. Among the other considerations that Secretary Bullock omitted to mention in his email, are the following:

(1) You will still be under audit

Contingent-fee audit firms that conduct Delaware audits usually do so on behalf of several states at once. The Delaware VDA program applies only to the Delaware portion of the audit. Consequently, electing a Delaware VDA will not make the auditors go away – they still represent the other states participating in the audit. Therefore, the auditors will likely still request much of the same documentation as when Delaware was a participating state. Further, because the auditors are compensated based on their recovery for the participating states, holders may see auditors begin to emphasize positions benefitting the remaining participating states more so than when Delaware was the auditors’ main focus.

For Delaware-incorporated holders, one positive aspect of removing Delaware from the audit is that research on transactions identified through the review process will be limited to those transactions with an address in the remaining participating states. For some companies, that change may make a significant audit difference. However, the remaining transactions will still be subject to review, but they will be reviewed through the Delaware VDA. Delaware stated that where the auditors have identified the scope of review for the audit, the scope upon conversion to a VDA is not negotiable and must include all entities and property types identified.[2]The VDA look-back period is the same as the look-back period for a Delaware audit.

(2) You will likely need to engage a professional adviser to conduct the Delaware portion of the audit for you

As stated above, Delaware markets the VDA’s “self-review” process as a “cheaper,” “less onerous,” and more “efficient” process than an audit. However, Delaware makes it abundantly clear that the holder is “expected to perform a rigorous self-review of its books and records for the entirety of the look-back period.”[3] Further, the State’s VDA Implementing Guidelines set forth specific expectations of what holders participating in the VDA are required to review and research. Notably, the VDA requirements, as they have been implemented by the Secretary of State, bear striking similarities to the requirements for the audit process. (See Number 3 below.)

In order to ensure compliance with the Secretary’s “rigorous” process, holders are “encouraged” to hire a “professional” familiar with the State’s process and the work papers necessary to support it. The VDA is adversarial and many of the requirements are standardized. As a consequence, companies participating in the VDA process are well-advised to engage an adviser who can be an advocate on their behalf on issues of law impacting the VDA, and who can adequately prepare and document any work papers for the required submission. Companies participating in the VDA, thus, may need the services of an attorney and a consultant, regardless of which they first engage. Make no mistake, however; the VDA “self-review” is, necessarily, a “self-funded” review.

Of course, holders should consider whether the costs involved in preparing a VDA submission may be offset by the interest and penalty relief granted through the VDA process. Specifically, 12 Del. § 1187 imposes up to 75% of interest and $5,000 of penalty on unreported and underreported amounts (not the result of fraud) discovered via audit. Only half of the interest assessed may be abated for good cause by the Secretary of Finance[4], whereas all interest and penalty may be abated for a company that files the notice of intent to convert its audit to a VDA.[5]

The Secretary of State included a provision in the VDA conversion form that assesses interest against holders who fail to complete the VDA process within the allotted two years. This change to the treatment of interest in the VDA illustrates how the lauded benefits of the VDA may be somewhat of an illusion.[6] Nevertheless, companies are well advised to weigh the potential interest reduction in estimating the potential cost of a VDA versus the cost of defending an audit. The difference may not be as stark as the Secretary of State claims, especially as the amount of interest at issue depends on the ultimate liability determined. (See Number 4 below.)

(3) You will be required to provide, with some exceptions, the same type of documentation as you would under audit

The Secretary asserts that the VDA is a “collaborative” effort, and that his office intends to work with holders based on their own unique set of circumstances. However, holders should consider that to date, participants in the VDA process have been subjected to a fairly formulaic review, and the Secretary has made clear that much of the methodology applied during the VDA process is not up for discussion.

In particular, the Secretary of State’s new regulations require holders to certify, via an officer of the company, that they have reviewed all available records. In his draft regulations, the Secretary of State indicates that any misstatement about record availability will be deemed to be made with the intent to mislead the Secretary.[7] Thus, under the Secretary’s current position, any error in certifying the existence of records could disqualify holders from the VDA, and subject them to allegations of fraud. At a minimum, the Secretary expects holders participating in the VDA process to have seven years of researchable records.

Further, the Secretary’s guidelines indicate that holders are expected to review quarterly bank reconciliations, outstanding and voided checklists, and accounts-receivable aging reports, just as they would be during an audit. The Secretary of State requires the holder to perform account tracing and testing, as well as reconciliation to the general ledger. The Secretary of State has promulgated specific rules concerning the use of statistical sampling. Further, the Secretary of State requests holder organization charts, federal tax returns, and documentary evidence of remediation, such as screen shots identifying the resolution of the outstanding transaction.[8]

However, there are some differences between the documentation required under the VDA program and in an audit. For example, unlike the auditors engaged by Delaware, the Secretary of State has not demanded detailed multi-state tax apportionment data in support of the VDA. Further, one major benefit of the VDA is the “aging criteria” difference between the VDA and the audit. This difference relates to the number of voided checks that holders must research to prove that they are not unclaimed property. While the auditors require all checks voided after 30 days of issuance to be included in the population of potential unclaimed property, the VDA gives holders a pass for any checks voided within 90 days of issuance.[9] This can have a significant impact both on the burden of research and the ultimate liability, especially for holders with higher volumes of payables.

On the flip side, holders should consider that the rationale for implementing a 30-day (or even 90-day) aging criteria for voided checks is subject to challenge based on the appropriate burden of proof. Thus, where the aging criteria have a material effect on the results of an audit, holders may want to consider a challenge to the aging criteria being applied by the auditor. This challenge is not available to companies participating in the VDA process. (See Number 4 below.)

The Secretary of State’s guidance remains vague on which areas of the audit process, other than the aging criteria, will be compromised for participants in the VDA. Where companies have encountered specific burdens associated with their audit, they should consider reaching out to the Secretary to discuss those issues in advance of noticing their intent to convert.

(4) You may not challenge many controversial issues concerning Delaware’s unclaimed property law while in the VDA

The biggest issue of the day in Delaware’s unclaimed property law is the state’s estimation methods, which have the potential to produce swings in liability amounting to hundreds of thousands of dollars or more. But numerous other issues involving the State’s interpretation of its unclaimed property laws are also subject to challenge. In June 2016, the United States District Court for the District of Delaware unequivocally stated that in enforcing its unclaimed property positions, the State has “engaged in a game of ‘gotcha’ that shocks the conscience.”[10] The court took issue with Delaware’s failure to apply the statute of limitations, its application of a 22-year look-back period, its lack of a record-retention statute, and its inclusion of property reportable to states other than Delaware in the basis for estimating Delaware liability. The federal district court in Delaware held that the estimation method produced “significantly misleading results,” based on an interpretation of the federal common law governing escheats that was “troubling.”[11] Since the court’s decision, the only one of the state’s problematic positions that has been modified for periods prior to 2017 is the look-back period. However, even the state’s modification to its look-back period is arguably immaterial – a reduction to 15 years versus the 22-year look-back period considered by the court in Temple-Inland.

Delaware has continued to press positions already subject to legal challenges, such as requiring holders to remit foreign-owned property to the state, and improperly shifting the burden of proof. Holders desiring to preserve their rights to challenge these questionable positions should consider that they will be required to concede any right to challenge these positions in exchange for the interest and penalty relief offered as part of the VDA process. For example, in Temple-Inland, the auditors found one check for $147.30 that was unreported to Delaware under the priority rules in the six years of bank records for two bank accounts, yet assessed $2.1 million. Under the law today, that court challenge would have eliminated interest and penalties because the assessment of $2.1 million was held to be unconstitutional. An interest assessment on zero due is zero.

While it is true that holders can withdraw from the VDA process at any time, any holder that so chooses will then be referred to the State to initiate an audit. That is, any holder that converts its audit to a VDA and then opts to withdraw from the VDA process will be back where it started. Therefore, holders should be aware of legal positions material to their bottom line prior to signing up for the VDA. To the extent that they intend to participate in the program, holders must be prepared to concede issues that others may challenge, perhaps successfully. As the “expedited audit” option is still available to holders under audit, a company should consider whether the expedited audit is a better option than the VDA. Interest and penalties are waived in an expedited audit, and the audit must be completed within the same two-year period applicable to a VDA; but at least a holder in an expedited audit retains its rights to challenge the audit methodology and result.

(5) You may need to book a reserve sooner when participating in the VDA

Holders attest firms may require the holder to make a financial statement disclosure and, if necessary, establish a reserve immediately following the holder’s application for participation in the VDA. Once a loss contingency is identified, a company must determine the likelihood that the contingency will materialize into an event impacting the company’s financial statements that would require the booking of a reserve.[12] Depending on the facts specific to the holder, the eventual VDA or audit payment to Delaware may have a significant enough impact to require the holder to book a reserve as soon as the payment is quantifiable.

The Financial Accounting Standards Board (“FASB”) uses the terms “probable,” “reasonably possible” and “remote” in defining the likelihood of a future event occurring.[13] Entrance into the VDA program makes the event of a payment to Delaware under the program a virtual certainty. That, in itself, does not mean that a reserve must be immediately booked for the VDA payment. The accounting for contingencies is a two-part test, the second part requiring the holder to determine if the amount of loss can be “reasonably estimated.”[14]

In most unclaimed property audits, it takes years to reach a point where the amount to be paid can be reasonably estimated. The audit needs to progress to receipt of a completed sample population analysis, and the determination of the error ratio for periods in which the holder does not have complete and researchable records. In comparison, the VDA program is intended to be completed within two years. With the VDA, the holder knows the estimation method to be used, and will be able to quantify the amount of loss much sooner than in audit. At that point, the company may be able to “reasonably estimate” the amount of loss and, thus, make the determination to book a reserve.

Holders wanting to defray reporting the financial impacts of the unclaimed property review should take the timing into account as part of their decision.

Clearly, there are competing issues to consider when deciding whether or not to convert an existing audit to a VDA. At the end of the day, a VDA may not be “in the best interests of holders,” despite the Secretary of State’s unqualified endorsement of his program.