The proposed reforms are a welcome change, specifically as they relate to lookback periods, electronic filing and limited compliance reviews.
As a result of what some might view as a scathing decision by the U.S. District Court for the District of Delaware in Temple-Inland, Inc. v. Cook, 192 F. Supp. 3d 527 (D. Del. 2016), Delaware has proposed comprehensive unclaimed property legislative reform. This reform could impact any corporation formed in Delaware, without regard to state of activity. Delaware still retains its status as one of the most favorable jurisdictions within which to incorporate, and the unclaimed property priority rules require escheat of property to the state of incorporation when the last-known address of the rightful owner is unknown. As a result, changes to the Delaware unclaimed property laws have nationwide implications for Delaware-incorporated businesses. This article reviews the Temple-Inland decision as well as the proposals on the table in Delaware SB 13, which was introduced in the general assembly on January 12, 2017.
Temple-Inland is a Delaware corporation that manufactures corrugated packaging, with its principal places of business in Texas and Indiana. In 2008, the Delaware state escheator notified the company of an impending audit. The audit was completed by a third-party auditor retained by the state to conduct its escheat audits. As a result of the audit, Temple-Inland was assessed more than $2 million, attributable to escheatable but dormant accounts payable and payroll. Once Temple-Inland exhausted its administrative remedies, it filed suit challenging the constitutionality of the assessment in U.S. district court, rather than litigating the assessment in the Delaware Court of Chancery.
The district court granted Temple-Inland’s motion for summary judgment in part on substantive due process grounds. These substantive due process claims are reviewed below, followed by the proposed changes in the law in light of the decision.
The district court noted that Delaware’s actions during the audit “shocked the conscience,” so as to constitute a due process violation. The court found that Delaware’s attempts to audit a full 22-year lookback period violated the explicit terms of the statute, which provided for a six-year statute of limitations, and that the state could only go back through the entire lookback period if Temple-Inland had not filed escheat returns. Delaware made an impermissible assumption that the reports had not been filed when, in fact, they might have been filed and subsequently destroyed under standard record-retention policies. Additionally, Delaware’s policy on “negative reports” — those reports that show zero escheatable property — was that no filing was necessary, which also would have explained the lack of documentation for certain years. Additionally, unlike many states, the Delaware statutory scheme did not mandate a certain period for record retention, a failure of due process in that it did not put Temple-Inland on notice that it had to retain its records for a certain period of time.
The court also took issue with Delaware’s attempt to apply a 2010 amendment to the escheat statutes retroactively to allow estimation of liability to years prior to the amendment. In viewing and using this technique as a revenue raiser, the court said it violated substantive due process and was inherently inconsistent with the escheat statute’s stated goal of reuniting property with its rightful owner. Additionally, the estimation methodology chosen used a sample that was based on all escheatable property, rather than limiting the sample in such a way to arrive at an estimation of Delaware escheatable property, which violated substantive due process. Finally, the estimation methodology used by Delaware presented a real risk that the same property could be escheatable to multiple states based on the estimation rule being applied to the primary rule (that property is escheatable to the state of the last-known address of the owner), rather than strictly to the secondary rule (that property should be escheated to the state of incorporation of the holder if the last-known address of the owner could not be ascertained).
In response to the Temple-Inland decision, Delaware has proposed legislative reforms that include the below seven key components.
Shortened Lookback Period
When the law is enacted, the audit lookback period will be limited to 10 years plus the period of dormancy — i.e., how long a piece of property must go unclaimed before it is escheatable; it is five years for most property — from the date of the audit letter. This lookback period will apply to pending but uncompleted audits at the time of enactment as well.
One-Time Voluntary Disclosure Agreement Election
After the enactment, those entities under audit may make a one-time election to enter into the unclaimed property voluntary disclosure agreement (VDA) program. The election must be made by July 1, 2017. Any unclaimed property liability would be settled through the secretary of state’s VDA program, rather than with the third-party contract auditors working with the Delaware Department of Finance. To the extent that the audit is a part of a larger, multistate audit, the election would only apply to the Delaware portion. Any holder that makes this election and resolves the VDA in accordance with the secretary of state’s time limits would avoid interest and penalties.
Option to Expedite Audit
This election, also to be made prior to July 1, 2017, allows a holder to elect an expedited resolution of its audit. Like the VDA program, a holder resolving an expedited audit within the time period set forth under the terms of its expedited audit would avoid interest and penalties.
Meant as a kinder, gentler audit, the compliance review would be less intrusive than a full-blown audit and would be limited to the contents of the filed report and its supporting documents. The state would nonetheless retain its ability to conduct a full-blown audit of a holder, but it presents a possibility of an easier resolution.
Historically, only securities-related property subject to escheat required statutory due diligence to identify the owner. The proposed bill extends the diligence requirements to any property held by a holder prior to the holder escheating the property to Delaware.
Increased Interest and Penalties
Current law limits interest on unclaimed property to 0.5 percent per month to a cap of 25 percent of the amount of the unclaimed property. The proposed reform would increase the cap to 50 percent, and it would also reestablish the failure-to-pay penalty, at a rate of 0.5 percent per month up to 25 percent of the total liability. Fraud penalties (up to 75 percent of the underlying liability) and purposeful evasion and willfulness penalties of up to 25 percent of the underlying liability are also proposed. While penalties historically were negotiated as the result of state settlements, the early indication is that Delaware will automatically impose and attempt to collect those penalties.
After March 1, 2018, all Delaware annual unclaimed property reports will be required to be filed electronically. Delaware will develop and implement a web-based portal to accomplish this new requirement.
As a preferred state of formation for entities as a result of its favorable corporate law provisions, Delaware long enjoyed the benefit of the second priority rule for escheatable property. Holders would have to remit to Delaware, as the state of incorporation, any property for which they could not identify the owner’s last-known address. Delaware used this as a source of revenue; as a result, the unclaimed audit process could be difficult and lead to arbitrary results, as it did for Temple-Inland. The proposed reforms are a welcome change, specifically as they relate to the lookback periods, electronic filing and the limited compliance reviews, but also as they relate to the one-time only options, which give entities currently under audit an opportunity to close the audit amicably. The increased penalties and interest should drive compliance higher as a detriment to holders avoiding their responsibilities. Implementation of the spirit of the proposed reforms by the Department of Finance upon passage will be critical to avoid the sometimes difficult and contentious audit process.