Delaware and its third-party auditors intend to continue using the same controversial estimation techniques in unclaimed property audits, as described in newly proposed regulations, even after a federal court found a virtually identical audit methodology to be unconstitutional in 2016. After facing widespread criticism about the enforcement of its unclaimed property laws, the Delaware legislature recently enacted a wholesale revision of its unclaimed property statute, but left open to the Department of Finance the specifics of the audit and estimation methodologies. In the newly proposed regulations, the Department appears to have put into writing mostly the same process that has generated such controversy in recent years. Given Delaware’s reliance on unclaimed property as a significant source of state revenue, this proposal suggests an intention to continue ongoing battles with the business community, with litigation the likely result.
The Delaware statutory overhaul and new regulations came as a result of a federal court decision in 2016 holding that Delaware violated a holder’s constitutional due process rights by issuing an unclaimed property assessment based on an estimated liability back to 1986, in Temple-Inland v. Cook, 14-cv-654 (D. Delaware June 28, 2016). The court held that the specific audit estimation method employed by the state’s third-party auditor, Kelmar Associates, was a “gotcha” that “shocks the conscience.”
The court in Temple-Inland identified six “troubling” aspects of the assessment and held that Delaware violated the holder’s constitutional due process rights by (1) waiting 22 years to audit Temple-Inland and then issuing an audit assessment for a 17-year period back to 1986; (2) avoiding the six-year statute of limitations by “exploit[ing] loopholes” under dubious circumstances; (3) giving holders no notice that they needed to retain unclaimed property records for periods beyond standard retention periods to defend against “unmeritorious audits” using estimation; (4) failing to articulate a reason other than raising revenue for retroactively applying a 2010 statute that authorized the use of “reasonable estimates”; (5) calculating an estimate on a 50-state basis and claiming the full amount for Delaware; and (6) subjecting Temple-Inland to potential “multiple liability.”
Following the federal court decision, Delaware began a process of overhauling its unclaimed property laws to address some of the significant criticisms from the court and the business community. A new statute, enacted in early 2017, made some key changes in an effort to address some of the concerns. Specifically, Delaware added a new statute of limitations that limits the lookback period for audits and voluntary disclosure agreements (VDAs) to 10 reporting years (15 years total). This is longer than the former statute of limitations (three years from the date a report was filed, or six years for underreporting of 25% or more), but offers protection to companies that have not filed reports and also takes away the loopholes that Delaware and its auditors had used to circumvent the shorter period, which they sought to do frequently under the old statute. Consistent with the 10-year lookback period, the new statute adds a record retention period of 10 reporting years (15 years total).
The legislation did not, however, clarify the estimation methodology. Instead, the statute directs the State Escheator to promulgate regulations regarding the method of estimation. Although it was already widely expected that Delaware would continue to take the controversial position that it can estimate a 50-state liability for companies incorporated in Delaware (for the periods where complete records are no longer available), the question leading up to the release of the proposed regulations was what other changes Delaware might propose in an effort to address the issues raised by the federal court and to smooth the edges on its controversial techniques. The answer: none.
The newly proposed regulations appear to accomplish nothing more than put into writing a description of the same methods Delaware’s auditors were using before the Temple-Inland decision. Indeed, in a regulatory impact state, the Department of Finance describes the purpose of the new regulations as providing “a framework for holders of unclaimed property to better understand existing processes.” Similar to the old process, the regulations describe an audit technique in which an auditor will review potentially unclaimed items for a sample period for which the holder has complete and researchable records (using a defined base period and a stratified sampling to calculate a statistical error rate), and then use the results of the sample to assess an estimated liability for earlier years. Most significantly, for companies incorporated in Delaware, the state continues to assert the power to review all of the holder’s data, regardless of the state, and to issue an estimated assessment for a 50-state liability on behalf of only Delaware.
As a result, the method described in the proposed regulations arguably solves none of the “troubling” issues identified by the federal court decision in Temple-Inland. Although the lookback period has been shortened and a record retention period added to the statute, holders facing a potential 15-year lookback period have been given no prior notice of these provisions, and Delaware appears to assert the right to apply them retroactively. For companies incorporated in the state, Delaware proposes to continue disregarding state-by-state information during the base period for the purpose of assessing a national estimated liability, thereby using estimation “where characteristics that favored liability [are] replicated across the whole, but characteristics that reduced liability [are] ignored,” which was one of the primary problems identified by the court in Temple-Inland. Finally, an estimation method that awards all estimated property to Delaware—regardless of the address of the property in the base period—will continue to expose holders to a risk of multiple liability if another state asserts the right to take custody of unclaimed property during the reachback years.
Rather than attempting to address the concerns identified by the federal court, Delaware's proposal appears to signal a desire to relitigate the estimation issue in future challenges to audit assessments. If these rules are promulgated without significant revision, litigation is likely to follow, at least eventually. The proposal is open for comment through May 3, 2017, and is to be finalized by July 1. It is also possible that the Delaware legislature may take up further amendments to the unclaimed property law in the next session, since the 2017 overhaul was fast-tracked through the legislative process with little time for amendment. A new chapter of the dispute over unclaimed property estimation has begun.