The Delaware Secretary of State has announced it will send letters inviting companies to enter the voluntary disclosure agreement (VDA) program. Invitees have 60 days from the date of the invitation to enroll in the VDA program. If a company does not enroll, it will automatically be referred to the Department of Finance for examination. Holders should consider whether the benefits of the VDA will offset the sacrifices required.
Delaware Secretary of State Knight recently announced the state’s plans to send out invitations to companies to enter the VDA program pursuant to 12 Del. § 1173(b).1 Invitees will have 60 days from the date of the invitation to enroll in the VDA program. If an invitee does not enroll in the VDA program within 60 days of the invitation mailing, the state will refer the company to the State Escheator for examination. Once a company receives a notice of an audit by the State of Delaware Department of Finance, it will not be eligible to enter into the VDA program.2
It is very important that a company not ignore the Secretary of State invitation to participate in the VDA program. Many recipients of these letters have ignored them on grounds that the company believes it is in compliance with Delaware law or believes it has had nothing to report to Delaware. Other companies have ignored the letters because only their parent holding company is incorporated in Delaware, but the operating entities are incorporated elsewhere and therefore they incorrectly believe that they can ignore the letter, only to later receive a notice of audit by Delaware’s State Escheator. Unfortunately, that letter is often followed by letters from multiple states joining into Delaware’s unclaimed property audit.
Before enrolling in the VDA program, companies should take into account the considerations below to determine whether the benefits of the VDA program will offset the sacrifices required:
(1) You may not challenge Delaware’s legal positions while in the VDA program
The most substantial issue in Delaware’s application of its unclaimed property law impacting holders is the state’s estimation methods, which have the potential to produce vastly inflated liability exposure. There are numerous other issues involving the State’s interpretation of its unclaimed property laws that unduly burden holders and that are subject to legal challenge. However, to finalize a VDA, holders must concede these issues in favor of the State.
In its June 2016 Temple-Inland decision, the United States District Court for the District of Delaware described Delaware as having “engaged in a game of ‘gotcha’ that shocks the conscience” in enforcing its interpretation of its unclaimed property laws.3
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 unclaimed property that was “troubling.”4
Since the court issued its decision, the state has modified the look-back period. However, even this change is arguably immaterial – a reduction to 15 years versus the 22-year look-back period considered by the court in Temple-Inland. The state has also added a record retention provision. However, the new provision does not address the years prior to 2016 where no record retention requirement existed. The state relies on the new record retention requirement to justify estimating a liability for periods for which records were lawfully destroyed before any such record retention requirement existed. More important, it is highly questionable whether a state can estimate the existence of unclaimed property without violating federal law, which preempts state law. Temple-Inland did not address that question, instead dismissing the claim for lack of standing. But the Third Circuit Court of Appeals reversed that ruling in Marathon Petroleum Corporation v. Sec’y of Finance, when it held that private parties have standing to enforce federal law in a dispute with a state.
Delaware has continued to press other questionable positions in addition to its use of estimation and its estimation methodology, and VDA participants will be agreeing not to challenge those positions. In particular, the VDA program may require companies to reopen years previously closed by the statute of limitations, require holders to remit foreign-owned property to the state, and improperly shift the burden of proof from the State to the holder. Within the VDA program, holders waive the right to challenge these positions in exchange for the interest and penalty relief offered as part of the VDA process. So the question is—is it worth it?
While it is true that holders can withdraw from the VDA program at any time, the state will refer any holder that withdraws to the State Escheatorto initiate an audit. Therefore, holders should be aware of legal positions material to their bottom line prior to signing up for the VDA program. To the extent that they intend to participate in the program, holders must be prepared to concede issues that others holders may challenge, perhaps successfully.
(2) You will be required to provide, with some exceptions, the same type of documentation as you would under audit
In prior correspondence, Delaware marketed the VDA’s “self-review” process as a “cheaper,” “less onerous,” and more “efficient” process than an audit.5 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.”6 Holders should consider that to date, participants in the VDA process have been subjected to a fairly formulaic and forensic 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 State’s regulations require holders to certify, via an officer of the company, that they have reviewed all available records. 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 participating in the VDA program, and subject them to allegations of fraud. Delaware has sued companies under Delaware’s False Claims Act (FCA) and there is no reason to believe it would not do so again under the right circumstances, especially where the FCA authorizes treble damages and recovery of attorneys’ fees and costs as a remedy. 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 he expects holders to review quarterly bank reconciliations, outstanding and voided checklists, and accounts-receivable aging reports, just as an auditor would. 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 transactions.8
However, there are some differences between the documentation required under the VDA program and in an audit. For example, unlike the contract auditors engaged by Delaware, the Secretary of State has not demanded detailed multi-state tax apportionment data from holders participating in the VDA program. Moreover, the VDA program allows for remediation testing—that is, companies are not required to produce every document supporting that a transaction is not unclaimed property, which would typically be required in audit.
Finally, one major benefit of the VDA program is the difference in “aging criteria” between the VDA program and an 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. We find that companies often do not retain the type of evidence the state requires to prove a voided check was not owed or was replaced with a new check.
On the flip side, holders should consider that the rationale underlying the 90-day aging criteria for voided checks used by the auditors is subject to legal challenge as improperly shifting the burden of proof. Checks are not subject to escheat in most states unless they are outstanding at least three years (sometimes one year in the case of payroll) so allowing a state to deem the mere identification of checks voided after 3 months as satisfying the state’s burden of identifying potential unclaimed property (which then shifts the burden to the company to prove the debt is not owed or was replaced) is arguably improper. If a replacement check is not cashed and the company cannot prove beyond doubt that it replaced a voided check, both checks will be treated as unclaimed property, resulting in double liability. In the context of an audit, a holder could seek judicial review of this standard. However, as discussed above, in the VDA, the holder agrees to apply the 90 day rule.
The Secretary of State’s guidance remains vague on which areas of the audit process, other than the aging criteria, will result in reduced compliance burdens for participants in the VDA.
(3) You will likely need to engage a professional adviser to conduct the Delaware portion of the audit for you
As discussed above, the State’s VDA Implementing Guidelines set forth specific expectations of what holders participating in the VDA program are required to review and research. In order to ensure compliance with the Secretary’s “rigorous” process, the state proclaims that holders are “encouraged” to hire a “professional” familiar with the State’s process and the work papers necessary to support it. The VDA program 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 program, 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 and requires the submission of a comprehensive report detailing all steps taken during the self-audit.
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, Delaware law imposes interest of up to 50% and penalties of up to $5,000 on unreported and underreported amounts (not the result of fraud) discovered via audit.10 Only half of the interest assessed in an audit may be abated for good cause by the State Escheator,11 whereas all interest and penalty is waived for a company that completes the VDA program in good faith.12
However, if a company chooses not to participate in the VDA program, it is very possible (if not likely) that it would be subject to a burdensome multi-state audit, which would require similar representation, perhaps for a longer period of time. Delaware audits are conducted by contract auditors whose compensation is contingent on the liability resulting from the audit. So once Delaware initiates an audit, the auditors typically solicit participation by as many states as can be enticed to join, which increases exposure.
(4) You may need to book a reserve sooner when participating in the VDA program
A holder’s attest firm 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.13Depending 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.14 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.”15
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 of the point where a completed sample population has been identified and analyzed, 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 program, the holder knows the estimation method to be used, and will be able to quantify the amount of loss much sooner than in an 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.
There are several significant issues to be considered by any holder receiving Delaware’s invitation to enter the VDA program. Indeed, entering the VDA program may not be the best decision for many holders. Therefore, holders receiving Delaware’s invitation should take the invitation seriously and take the time to weigh all options and risk factors. Most importantly, the analysis should be performed immediately upon receipt of the invitation so that a thorough and complete review can be completed before the 60 response period has lapsed.