The recent expansion of oil and natural gas exploration and production activities in previously unprofitable areas has brought increased attention to issues surrounding compliance with state unclaimed property laws.  Producers should be mindful of the powerful incentives that exist for states and third-party auditors to aggressively pursue those who are out of compliance with the often unknown duties arising in the area of unclaimed property, and owners of royalty interests should be aware that states may be holding funds in their names.

State laws generally require a person holding the property of another to attempt to locate the owner of that property after a specified period of time has passed without contact.  If the owner cannot be located, then most states require the holder of the property to treat the property as unclaimed or abandoned, to prepare and file a report with the state of all the unclaimed property held, and to turn the property over to the state.  The U.S. Supreme Court ruled in Texas v. New Jersey that the state of the owner’s last known address has the first right to receive this property, and if there is no last known address, or if there is no owner’s name associated with the property, then the state of the holder’s domicile or incorporation will have the second right to lay claim to the property.  The state then holds the property as trustee, until the true owner comes forward to claim the property, if ever.  In addition to tangible items, such as the contents of safe deposit boxes, common examples of unclaimed property include intangible items like bank account balances, unclaimed life insurance proceeds, un-cashed checks and accounts receivable credit balances.  In the oil and natural gas arena, unclaimed royalty payments typically are posted in a producer’s suspense account for the required number of years before reporting to a state, and are a consistent compliance burden.

If a true owner never comes forward, or if one comes forward but is unable to prove ownership, then many states can hold the property indefinitely.  For states facing budget shortfalls that are reluctant to raise taxes, unclaimed property has become a welcome source of revenue.  States can audit holders for unclaimed property outstanding on their books and records, and many states hire third-party auditors that are paid a portion of the property found.  These auditors often are contracted to audit a single holder on behalf of many states simultaneously.  And unlike taxes, unclaimed property laws often have extended statutes of limitations going back ten, twenty or thirty years, with some states claiming the right to audit as far back as the 1960s.  Where holders do not have records to prove that they followed the law, auditors can often estimate the amount of unclaimed property on the holder’s books.  One state in particular – Delaware – has garnered attention for its aggressive audits and its dependency on unclaimed property revenues.  The Delaware Department of Finance, which administers the state’s unclaimed property law and offers a voluntary disclosure program, was apparently viewed as so aggressive that the state legislature allowed the Secretary of State to offer its own voluntary disclosure program, which continues through June 30, 2014.

In states such as Texas and Oklahoma, where hydraulic fracturing and horizontal drilling have made previously depleted or low-producing wells viable again, producers are now finding themselves obligated to pay significant royalties to persons with whom they have had little or no contact for years, and who cannot be found.  Often royalty interests have been split among many successive generations of the original royalty owner’s heirs, and the heirs may live in places far from the site of the well.  Sometimes heirs do not even know they have an interest in the royalties.  In addition, unclaimed property compliance likely will become an issue in states just beginning shale exploration such as Ohio, Illinois, and Michigan, and is likely to present unique challenges for both new producers unfamiliar with unclaimed property and experienced producers who will need to familiarize themselves with state rules which often were not designed to address problems arising in this context.   The BakerHostetler North America Shale Blog will watch for developments in state unclaimed property administration and policy as they relate to the oil and natural gas industry, and will report here accordingly.