Why Unclaimed Property Risk Management Is on the Menu in 2022
For certain states, unclaimed property represents a significant revenue source 

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Every state has adopted an unclaimed property (or escheat) law, which generally provides that a holder of unclaimed property must escheat the property to the state after it has remained unclaimed by its owner for a certain period (usually three or five years). The unclaimed property is the legal obligation or debt that is owed to the owner of the property, and the holder is the party that is obligated to pay or deliver the property to the owner. Common examples of unclaimed property include uncashed vendor and payroll checks, failed ACH or direct deposits, dormant bank and shareholder or investment accounts, unredeemed prepaid cards, aged customer credit balances, and, more recently, virtual currency.

Companies do not need physical presence in or material revenue sourced to a given state to be subject to its unclaimed property laws. Because the property owner’s state has first claim to the property (rather than the state where it was found or where the holder is based),1 a company could have annual reporting and remittance obligations in up to fifty states, the District of Columbia, and US territories.

The importance of knowing and understanding unclaimed property laws has grown in recent years, because unclaimed property is now a significant revenue source for certain states, even though unclaimed property is not a tax.2 The New York Times recently estimated that state government agencies have tens of billions of dollars’ worth of unclaimed property.3 It is the fifth-largest general fund revenue source for California4 and was Delaware’s third-largest source of revenue during the 2019 fiscal year.5 As a result, states now actively enforce these laws to capture unclaimed property in audits, voluntary disclosure programs, and litigation or through legislation (for example, through shortened dormancy periods, enumeration of “new” property types, etc.).

As a panel discussed during the recent TEI Annual Conference,6 tax personnel are often called upon to advise the C-suite on unclaimed property risk management and to defend audits. Among other things, the correct application of unclaimed property laws is critical to maintaining accurate balance sheets. For example, financial statements and company reserves can be materially impacted if a company incorrectly determines that certain assets are (or are not) unclaimed property. The overreporting of property that is exempted by certain unclaimed property statutes (for example, property that is outside the statute of limitations, property exchanged between two businesses, de minimis property, and so forth) can depress a company’s annual profits. By the same token, the underreporting of unclaimed property can have potentially adverse implications beyond the liabilities assessed—for example, in a worst-case scenario, a company might be required to re-report earnings. Inaccurate unclaimed property records may also affect mergers and acquisitions. In a stock deal, the purchaser of a company assumes any preexisting successor liability, including unreported unclaimed property in the target’s possession or on its books, so it is critical that these records are correct and clearly maintained. But unclaimed property statutes are notoriously tricky and may not always clarify whether a company’s business model produces, or its accounting practices memorialize, unclaimed property.

Tax executives should familiarize themselves with these statutes and understand their nuances to maintain the accuracy of balance sheets. Millions of dollars may quite literally depend on the tax executive’s understanding of unclaimed property compliance regimes and the tailoring of the company’s reporting practices and positions. Holder companies, and their tax executives, should also proactively monitor proposed and enacted changes in state unclaimed property laws as well as administrative guidance to ensure operational resilience in meeting compliance obligations, including pandemic and remote-working disruptions such as changing filing deadlines.7

Compliance Continuum Audits: VDAs, Private Enforcement 

So, what happens if your company receives an audit notice—which could pertain to a single state or, more frequently, to multiple states that jointly employ a contract audit firm? Or state “self-audit” directives? Or “invitations” to voluntarily disclose liability? Or questionnaires and reminders to file reports? Or all of the above? 

Audits. Every state today employs audits as a principal enforcement tool, and most states have contracts with numerous third-party audit firms. Although a handful of states have published formal audit manuals or guidelines, most provide scant guidance to companies on how a compliance examination will be conducted and what standards pertain. What’s more, unclaimed property administrators are not often directly accessible if a holder has questions or concerns with the audit process or with the theories of liability propounded by a contract auditor. 

Compounding the risk associated with audits is the fact that most audit firms treat companies differently if they have retained advocates to represent themselves during an exam. The tax executive’s staff will likely be assigned audit management tasks. Ensuring that your company’s CEO, CFO, and controller know the enforcement landscape and that a voluntary disclosure agreement (VDA) program “invitation,” if not responded to promptly, may initiate an audit is critical to securing the opportunity to control the process and, to some degree at least, the outcomes of one or more states’ outreach. The impacts of noncompliance with state unclaimed property laws are potentially materially adverse. State unclaimed property audits carry potentially significant dollar assessments, and mandatory interest (California and other states impose a twelve percent annual rate8) and penalties could equal the assessed liability if a company failed to report high-value property for many years—the holder company pays such fines out of pocket. States now issue interest assessments more regularly than in the past, since they are direct sources of revenue for the states.

VDAs as an Alternative. Performing a compliance self-review (potentially under attorney-client and attorney work product privilege) and self-disclosing any identified liability pursuant to a state’s formal or informal VDA program is a potentially attractive alternative to sitting on your hands and risking audit(s), because the vast majority of states will waive otherwise applicable interest and penalties. Given that imposed interest could equal or exceed the amount of unclaimed property that a company failed to report and remit on time, a VDA may represent a very effective risk management tool for a noncompliant holder. That said, the company’s tax executives should understand that VDA programs also carry certain risks that require close attention to manage against downsides, which may include:

  • a requirement that the holder estimate its liability for years in the VDA lookback period using the state’s mandated estimation methodology (see the discussion below on Delaware’s constitutionally flawed approach);
  • a requirement that the entire self-review and reporting process be completed within relatively brief periods (ranging from six months to two years);
  • the requirement that a holder secure agreement from state-appointed administrators or audit firms with the holder’s self-review process and determinations of liability—cynics view certain states’ programs as constituting “audit-by-VDA”;
  • the risk of being kicked out of the VDA program and referred to audit, if the holder’s handling of its VDA self-review is deemed deficient or if legal disputes prevent the settlement of liability; and
  • the risk that information shared by the holder with the VDA state or its “administrators” (typically the same audit firms that conduct audits for these states) may not be adequately safeguarded, even if a nondisclosure agreement is executed.

New Forms of Compliance-Focused Outreach. The states, at the request or with the encouragement of the same third-party firms that conduct audits and oversee some VDA programs, have begun to send a variety of new notices to holders, with titles like “self-audit directives,” “compliance questionnaires,” and similar. The major takeaway from these initiatives is that the states are now trying to identify new sources of unclaimed property revenue. Tax executives should understand that there is an annual reporting obligation in fifty-four separate jurisdictions, with some requiring negative ($0) reports. A holder ignores such notices at its peril; at a minimum, tax executives should understand the degree of risk their company assumes when it elects not to file reports annually on a multistate basis.

Alternative Enforcement Mechanisms—AG Investigations and False Claims Act Suits. Many holders have learned to their chagrin that being audited by one state agency does not eliminate the risk of being investigated by another. We have assisted several companies in defending their escheatment of funds to a state pursuant to audit assessments, where that state’s attorney general’s office later investigates the company based on property owner complaints that their property was “improperly” escheated. We have also seen the increased use of state False Claims Acts by whistleblowers to assert that a holder’s alleged failure to report unclaimed property—or even to self-assess interest in cases where a holder has reported unclaimed property to a state, albeit some of which was past due9—effectuated a fraud on the state that is subject to treble damages if the court finds the holder in violation.

When Litigation Is Required

If an audit or VDA undertaking fails to resolve a holder’s issues, litigation may ensue. Tim Cook, the current chief executive officer of Apple Inc., famously said, “I’ve always hated litigation, and I continue to hate it.” But even Cook would undoubtedly agree that litigation may be the means through which a company resolves a specific legal issue; and litigation also helps define the climate under which the lawsuit was brought and under which other, similar lawsuits will follow.

This trend is clear in unclaimed property litigation, which until recently occurred infrequently. Although unclaimed property laws are not new,10 through the twentieth century, litigation served as a last resort for states and holders of unclaimed property that were unable to resolve a dispute during an audit or through an administrative appeals process. It was rare to see a holder litigate an unclaimed property issue against the auditing state, much less challenge a state’s use of enforcement tools, including records subpoenas or even the delegation of audits to third-party contract audit firms. This started to change in the second half of the 2010s, when states—often at the urging of their contract auditors and perhaps taking advantage of holders’ reluctance to litigate—argued aggressive administrative positions and legal interpretations that were simply unsupported by state unclaimed property laws. In response, holders started to litigate issues that they would not have before, and their courtroom successes all around the country have emboldened them to continue doing so.

For example, in Temple-Inland, Inc. v. Cook,11 Judge Gregory M. Sleet of the United States District Court for the District of Delaware granted Temple-Inland’s motion for summary judgment on its substantive due process claim, holding in a particularly pointed opinion that Delaware’s audit practices, including its unclaimed property estimation methodology, “shocked the conscience” in violation of substantive due process. Judge Sleet denounced Delaware’s estimation methodology as “contrary to the fundamental principle of estimation” and stated that it created significantly misleading results by using unclaimed property owed to residents of other states to extrapolate unclaimed property owed to Delaware.12

The courtroom assault on Delaware’s aggressive auditing practices continued in Marathon Petroleum Corp. v. Sec’y of Fin. for Del., where the United States Court of Appeals for the Third Circuit held that plaintiffs had “good reason to be concerned that Delaware may claim property that it is not entitled to escheat.”13 It also took a suspicious view of Delaware’s use of contingency-fee third-party auditors: “Kelmar’s financial incentive to claim as much escheatable property as possible taints the entire process with an appearance of self-interested overreaching.”14

The rise in unclaimed property litigation generally and holders’ successes specifically have changed the legal landscape of unclaimed property. Based on our recent interactions with state administrators, they presently approach unclaimed property disputes, whether arising in the context of an audit or a VDA, and not just those involving millions of dollars of escheatable property, with the understanding that litigation may be in the offing. Indeed, so should holders and their representatives. In fact, litigation has been embraced by some holders to achieve strategic ends, including as a shortcut to more favorable settlements of unclaimed property liability, whereas other holders may be litigating a question of legal substance on which the dispute turns. Tax executives should be aware of recent unclaimed property lawsuits that illustrate both these approaches.

First, holders have recourse to challenge how states conduct audits. This typically occurs when a state (at the behest of its contract audit firm) issues sweeping subpoenas for documents as part of a fishing expedition that requires companies to expend undue resources just to comply. Courts are mindful of these improper tactics and may refuse to enforce such subpoenas. For example, on June 1, 2021, the Delaware Supreme Court in State v. AT&T Inc. affirmed the Court of Chancery’s decision to quash a Delaware administrative subpoena seeking extensive unclaimed property records in an audit of AT&T led by Kelmar Associates LLC.15 The Supreme Court held that sanctioning Kelmar’s requests for records related to disbursement checks issued by AT&T going back more than twenty years and checks written to payees in every state, not just to payees in Delaware, would constitute “an abuse of the court’s process.”16 While it acknowledged that a state is normally entitled to “great deference” in the scope of its unclaimed property investigations and that judicial review of a complaint for enforcement is “strictly limited,” where a court has “serious questions” regarding the breadth and scope of the subpoena that the state is not able to answer, the Court asserted its authority to quash the subpoena.17 Holders should consider whether requested documents are plainly irrelevant to the determination of the company’s compliance with state law, and/or if the breadth of the audit is extreme enough to constitute an abuse of process.

Second, holders can challenge who conducts the audit. Given the limited resources of state agencies, states now commonly retain third-party auditors to lead audits. As the Third Circuit noted in Marathon, “[t]he Escheator is permitted to rely on third party auditors to conduct an audit, and the vast majority of Delaware’s audits are in fact farmed out to an entity called Kelmar Associates, LLC.”18 Although these third-party auditors should not have carte blanche to conduct audits, we have seen many—perhaps most—states simply defer to them to conduct audits on behalf of their represented states any way they see fit. This is troubling, because these auditors are compensated on a contingency-fee basis, that is, their compensation is directly tied to the amount of unclaimed property they identify. Such a financial structure incentivizes aggressive interpretations of unclaimed property statutes, sweeping subpoenas, and inflated unclaimed property estimations. Knowing this, the state agency, not the third-party auditor, must serve as the ultimate decision maker, particularly if the third-party auditor identified or proposed the holder as an audit target. At the extreme end of the outsourcing spectrum, audits led by third-party auditors who target holders, decide the audit’s scope, conduct the audit, propose the liability, and advise client states on all responses to holder outreach, while the state agency merely “rubber stamp[s]” what the third-party auditor did, invite invalidation by the courts. Yet, third-party-performed audits comprise the bulk of all audits, and many—perhaps most—of these audits are undoubtedly controlled by contract auditors. Holders should carefully examine the respective roles of the state agency and third-party auditors. If it is clear that a third-party auditor dominates the audit, a holder has recourse—particularly if the audit is brought by a state whose authority to even retain third-party auditors is ambiguous.

Third, holders can challenge regulations that a state agency promulgates without complying with the necessary requirements. State laws require state agencies to meet certain procedural hurdles before promulgating regulations. These laws are designed to give the public an opportunity to comment on and shape the proposed regulations before they take effect. States frequently fail to heed these requirements because of the costs associated with conducting a public hearing and the delay that it necessarily causes. Or they simply do not think about whether the guidance that they publish falls within the scope of these laws. Regulations that do not comply with these procedural requirements are called “underground regulations,” and they are void and invalid. For example, in Thrivent Fin. for Lutherans v. Yee, a California superior court judge overruled the California State Controller’s Office’s demurrer to Thrivent’s complaint, which alleged that two provisions of the Controller’s Holder’s Handbook are unenforceable underground regulations and inconsistent with the Unclaimed Property Law.19

Likewise, a holder should not assume that a state agency was exempted from following these procedural requirements because a state agency promotes a “policy,” “plan,” “procedure,” or “guideline” rather than a “regulation.” The term used is immaterial because “anything regulatory is a regulation whether or not so labeled by the agency.”20 This was precisely the issue in Yee v. ClubCorp, where ClubCorp recently challenged California’s third-party auditor policies and procedures as being an underground regulation.21 The California Superior Court overruled the state controller’s demurrer, holding that ClubCorp stated a cause of action because the California State controller’s office failed to initiate a formal rulemaking process, provide an opportunity for public notice and comment, and file the required rulemaking action with the Office of Administrative Law prior to promulgating the third-party auditor policies and procedures, which allowed California to hire a third-party contingency-fee audit firm.22 Actions such as these provide powerful leverage for holders because underground regulations are void, and eliminating objectionable or unfair agency guidance from the mix may enable the resolution of an otherwise intractable or “principles”-based dispute.

Finally, holders can challenge what is at issue during an audit. For example, a holder can bring a declaratory judgment action that unclaimed property falls outside the statute of limitations or is exempted by the business-to-business exemption. Other substantive issues can be broader and more complicated. For example, in Bed Bath & Beyond, Inc. v. John Chiang, a California superior court held that unredeemed merchandise return certificates issued by Bed Bath & Beyond (BB&B) to its California customers are exempt “gift certificates” under the California Unclaimed Property Law rather than “intangible personal property” under the California catchall provision, because BB&B’s certificates may be redeemed only for merchandise at BB&B or one of its affiliates and cannot be redeemed for cash.23 Under the derivative rights doctrine, a state has only a derivative or custodial claim to unclaimed property, meaning that a state does not have more rights to property than the owner of such property. In the case of BB&B’s certificates, because the certificates provided only for the redemption of merchandise and not cash, a state had no right to require the escheat of cash corresponding to the value of these certificates. More commonly, holders can bring actions to clarify the meaning of ambiguous unclaimed property statutes if the state agency adopts an incorrect interpretation, or whether certain items constitute unclaimed property.24

Many people understandably share Tim Cook’s sentiments on litigation. It can be difficult, time consuming, and costly. But it may also be the most effective way to obtain a good result—whether by way of a favorable settlement or judgment, particularly now that courts have become more skeptical of state agency tactics and erroneous statutory interpretations. 

Conclusion

Understanding unclaimed property laws, how states enforce them, and the options you have to respond is becoming more necessary than ever for tax executives. We hope this discussion highlights the need for awareness and study of these state laws, while also showcasing the numerous tools available to tax executives to manage the risks associated with the increasingly aggressive range of public and private enforcement initiatives.


Kendall L. Houghton chairs Alston & Bird LLP’s tax practice; she is based in the firm’s Washington, D.C., office, where her practice focuses on multistate unclaimed property and tax matters. Daniel Dubin, an associate in the firm’s state and local tax/unclaimed property practice group, is based in the firm’s Los Angeles office.


Endnotes

  1. The US Supreme Court has established two federal common law rules to determine which state has the jurisdiction to escheat unclaimed intangible property. The “primary rule” provides that, if the holder of the property has a record of the owner’s address, then the state in which such address is located has the right to escheat. See Texas v. New Jersey, 379 US 674 (1965); Pennsylvania v. New York, 407 US 206 (1972); Delaware v. New York, 507 US 490 (1993). The “secondary rule” provides that if the holder does not have a record of the owner’s address or if the address is in a state that does not provide for escheat, then the state of “domicile” of the holder has the right to escheat the property. Id. The domicile of a corporation is the state in which it is incorporated.
  2. Or is it? See Chris Hopkins and Matthew Hedstrom, “Unclaimed Property Laws: Custodial Safekeeping or Disguised Tax?,” Journal of Multistate Taxation and Incentives 21, no. 2 (January 2012), https://silo.tips/download/unclaimed-property-laws-custodial-safekeeping-or-disguised-tax. 
  3. Mark A. Stein, “There Are Billions in Unclaimed Assets Out There. Some Could Be Yours,” New York Times, November 6, 2019, www.nytimes.com/2019/11/06/your-money/unclaimed-assets.html.
  4. Ryan Miller, “Unclaimed Property Is 5th Largest General Fund Revenue Source,” [California] Legislative Analyst’s Office, February 10, 2015, https://lao.ca.gov/LAOEconTax/Article/Detail/58.
  5. Chris Hopkins and Maggie L. Young, “Unclaimed Property Audit Fallacies and Myths,” Tax Adviser, September 1, 2019, www.thetaxadviser.com/issues/2019/sep/unclaimed-property-audit-myths.html.
  6. “Unclaimed Property: What the Tax Department Needs to Know,” presented by Kendall Houghton, Cathleen Bucholtz, and Sara Lima. The panelists’ presentation provided links to various resources for tax professionals who are becoming familiar with unclaimed property, as follows. For information about best practices, check out this half-hour 2021 podcast: Cathleen Bucholtz, Michelle Moloian, and Kristin Mauer, “Ten Best Practices for Unclaimed Property Compliance,” True Partners Consulting, accessed November 19, 2021, www.tpctax.com/insights/podcast/ten-best-practices-for-unclaimed-property-compliance/. True Partners Consulting also provides this 2020 article on the same subject, although the text is not identical to that of the podcast: Cathleen Bucholtz and Michelle Moloian, “Ten Best Practices for Unclaimed Property Compliance,” True Partners Consulting, accessed November 19, 2021, www.tpctax.com/insights/ten-best-practices-for-unclaimed-property-compliance/. The information is also available at TEI.org in an “Ask the Expert” interview with Michelle Moloian dated July 16, 2019, http://taxexecutive.org/10-best-practices-for-unclaimed-property-compliance/. For more information about managing unclaimed property risk, see Kendall L. Houghton, “Unclaimed Property Risk Management Challenges,” Risk Management, August 2, 2021, www.rmmagazine.com/articles/article/2021/08/02/unclaimed-property-risk-management-challenges. Last, to request a “cheat sheet” about managing unclaimed property, contact Alston & Bird at UP@alston.com.
  7. Similarly, holders were well served in 2020–2021 to monitor federal agency changes that impact the performance of compliance duties, for example, recent US Postal Service mailing suspensions to foreign addresses. 
  8. See, for example, Cal. Code Civ. Proc. Section 1577.
  9. See New York ex rel. Raw Data Analytics LLC v. JP Morgan Chase & Co., 65. Misc. 3d 705 (N.Y. Cnty, August 30, 2019). 
  10. Colonial America adopted the English common law doctrines of escheat and bona vacantia under which property—typically, real property or tangible personal property—reverted to the King as the sovereign lord if the owner died without heirs.
  11. 82 F. Supp. 3d 539 (D. Del. 2015).
  12. Id. at 550.
  13. 876 F.3d 481, 497 (3d Cir. 2017).
  14. Id.
  15. 253 A.3d 537 (Del. 2021).
  16. See id. at 553.
  17. Id. at 547, 552.
  18. 876 F.3d at 486.
  19. No. CGC-15-548384, 2016 Cal. Super. LEXIS 5650 (S.F. Sup. Ct. April 8, 2016).
  20. State Water Res. Control Bd. v. Office of Admin. Law, 12 Cal. App. 4th 697, 703 (1993).
  21. No. CGC-19-576314 (S.F. Sup. Ct. April 27, 2021).
  22. See id. at pp. 4–13.
  23. No. 37-2014-00012491-CU-MC-CTL (S.D. Sup. Ct. March 4, 2016).
  24. See, for example, State v. Pac. Far East Line, Inc., 261 Cal. App. 2d 609 (1968) (deciding whether seamen’s unclaimed wages constitute abandoned property).

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