Over the Fourth of July holiday, we celebrated our nation’s birthday and independence. The United States of America was formed 240 years ago with a Constitution that guaranteed certain liberties and promised a government that would not be as oppressive as King George’s rule.
Due process is the cornerstone of a government that is not arbitrary and is accountable to its citizens, which is why it was so fitting to kick off the Fourth’s festivities with a major win for the holder in Temple-Inland v. Cook.
In this closely-watched case, the holder challenged Delaware’s methodology in audit, alleging that the extended lookback period without a corresponding record retention requirement violated due process, as did the multi-state exposure. Temple-Inland also asserted that the state’s estimation methodology constituted a taking.
Holders and advocates rejoiced that after nearly eight years of litigation, an objective tribunal had finally reviewed the facts and law relevant to an unclaimed property audit and rendered a decision that resonated. As Judge Sleet observed, “To put the matter gently, defendants have engaged in a game of ‘gotcha’ that shocks the conscience.”
More specifically, Judge Sleet denounced the defendants for: waiting 22 years to audit Temple-Inland; exploiting loopholes in the applicable statute of limitations; failing to notify holders properly regarding the need to maintain unclaimed property records for longer than is standard; employing an unsound method of estimation; failing to articulate any legitimate state interest in the retroactive application of §1155; and ultimately subjecting Temple-Inland to multiple liabilities.
As background, in 2008, Temple-Inland received notice that it would be audited in order to determine its compliance with Delaware’s Unclaimed Property Law (“UPL”). The audit was to cover a 22-year time span (1986 through 2002). The defendants relied on §1158, Delaware’s statute of limitations for state action against holders, to justify this extensive look-back period. That section permits the State Escheator to bring an action “at any time” if a holder fails to file an unclaimed property report in a given year.
Judge Sleet noted, however, that such reliance on §1158 assumes that in the years in which Temple-Inland did not file a report to Delaware, that the company had unclaimed property but failed to file a report. He then proceeded to point out that it is just as possible that Temple-Inland had no unclaimed property due to Delaware in those years, and in accordance with Delaware’s own guidance, did not file a negative report. It is also possible that Temple-Inland did in fact file annual reports that were subsequently lost or destroyed in accordance with Temple-Inland’s 10-year record retention policy.
Because any of these three possibilities provides a rational explanation for the absence of the records sought by Delaware, Judge Sleet found that “it is troubling that [the] defendants’ [assumption] depends on accepting only one explanation for why reports cannot be found (i.e., that [Temple-Inland] had unclaimed property and did not file a report).” Judge Sleet was further concerned that the state’s ability to advance an irrebuttable presumption was benefitted by its own actions, including telling holders that they need not file negative reports, not telling them that they need to retain all their unclaimed property reports, and not keeping copies of all unclaimed property reports actually filed with the state.
Accordingly, Judge Sleet took issue with the fact that Temple-Inland “would be left with few means to defend against overreaching in an unclaimed property audit unless it retained all of its records forever.” After the defendants themselves admitted that corporations do not typically maintain records for longer than seven years, Judge Sleet sardonically noted the defendants’ “surprise” that Temple-Inland “took a ‘calculated risk’ or failing to anticipate an audit covering 22 years.”
Statistical sampling has long been considered a valid audit tool if such sampling is properly performed. Citing numerous cases, Judge Sleet noted, “an estimation is properly performed when it is based on the principle that the unclaimed property in the reach-back years has ‘all the same qualities and characteristics’ as unclaimed property in the base years . . . due process violations arise where the estimation methodology creates misleading results.” Section 1155 of Delaware’s UPL allows the use of reasonable estimation in unclaimed property audits.
Kelmar (Delaware’s contract auditor) calculated Temple-Inland’s net liability for each year between 1986 and 2002 in which Temple-Inland could not provide the records requested by Kelmar. Kelmar employed a ratio estimator which was calculated using the data available for the years in which the company did have records (the base years). The base period liability was determined by adding the sum of all unclaimed property reported to any state, any funds returned to the rightful owner not in the ordinary course of business, and any amounts not remediated.
Kelmar’s base period liability calculation thus includes unclaimed property reported to other states and unclaimed property for which the last known address was not Delaware. Judge Sleet was not distracted by the numbers, percentages, dollar amounts, and baseless justifications put forth by the defendants and concluded that Kelmar’s methodology “relies heavily on property escheatable only to other states to increase the amount of unclaimed property owed to Delaware.” Kelmar’s “logic is contrary to the fundamental principles of proper estimation. . . [creating] significantly misleading results.”
Next, in response to the contention that the application of §1155 for a period of 22 years violates substantive due process, the defendants attempted to argue that they were not relying on that provision to justify an estimation of Temple-Inland’s liability. That argument was quickly dismissed by the Judge as he indicated that it was “difficult to comprehend how [the] defendants can argue that they are not relying on Section 1155 when the Audit Manager [for the state of Delaware] specifically told [Temple-Inland] that Section 1155 authorized [the] use of estimation in [the] unclaimed property audit.” He then further chastised the defendants by stating that they “cannot evade the issue of retroactivity by claiming that they did not rely on Section 1155, and the court does not believe it is a productive exercise to delve into the defendants’ subjective intent to determine when they are, or are not, relying on statutes that authorize their actions.” While the length of the retroactive period does not, in and of itself, establish a violation of substantive due process, the defendants offered no credible reason for using estimation as it did in [the] audit other than to raise revenue.”
In emphasizing the underlying goal of unclaimed property laws to reunite owners with their lost or abandoned property and echoing the concerns of all holders, Judge Sleet reiterated that “unclaimed property laws were never intended to be a tax mechanism whereby states can raise revenue as needed for the general welfare. States violate substantive due process if the sole purpose of enacting an unclaimed property law is to raise revenue.”
In addressing whether Delaware was in fact helping to reunite owners with their property, he pointed to some troubling statistics: unclaimed property is a “vital element” in the state’s operating budget and an estimated 90% of the property collected by Delaware is “owner-unknown” property, thus Delaware has no incentive to seek to have holders (or the state) improve record-keeping which would lead to the recovery of property. Further, Delaware has returned very little of the property collected, and did not do a decent job of processing claims until 2014. He also noted that the use of estimation likely decreases the chances of an owner being reunited with her property. Judge Sleet pointed to Delaware’s instructions for filing a claim, which provide that, “if property is not found in the owner’s name . . . a claim cannot be initiated.” The state seemingly confirmed that likelihood with its admission that it was “unable to give an example of when estimated property was returned to an owner.”
Not only does the state’s use of estimation decrease the owners’ chances of being reunited with their property, it also creates the possibility of multiple liability for holders, since other states may also estimate a holder’s liability. Accordingly, the estimation methods employed by Delaware are unreasonable, lead to misleading results and create multiple liabilities for holders. As such, the methodology employed is unconstitutional.
However, a reasonable method of estimation will not in and of itself violate due process. Judge Sleet did not impose any one method of estimation on the parties, deferring remedies to a future date. However, he seemingly invited the state to overhaul its practices, noting that “[the] defendants are best able to know which remedy will be the most palatable in its anticipated efforts to normalize the enforcement of its unclaimed property laws.”
So where do we go from here? Delaware will likely appeal, since its third largest revenue source is about to disappear, or at least diminish significantly. In the meantime, what should happen with the hundreds of audits currently pending? The state will not likely suspend all audits pending the results of an appeal.
However, holders should not accept demands that rely on unreasonable estimation methods. Perhaps Delaware-incorporated holders should insist on an error rate that includes only Delaware-addressed and owner unknown liabilities in the numerator, as hinted at in the Temple-Inland decision.
More interestingly, what about the VDAs, in which holders are ostensibly voluntarily agreeing to the same methodology that the federal court has just held should not be imposed in an audit? Does the voluntary nature of the VDA remove the specter of a due process violation? Arguably not, since the single largest justification for entering into a VDA is the desire to avoid the methodology debunked in Temple-Inland. If the whole premise for entering into the VDA has been invalidated, can continued participation in the VDA still be deemed to be voluntary? It would be unusual for the state to seek to enforce contracts which are not consistent with federal law. Clearly, Temple-Inland changes the landscape significantly for both audits and VDAs.
Finally, hundreds of millions of dollars have been escheated to the state of Delaware under this flawed methodology. Are refunds in order? That may be the most critical question moving forward.
 Since 2008 many holders have attempted to litigate the same issues that are present in Temple-Inland. For a variety of reasons, most of which have nothing to do with unclaimed property, all other plaintiffs have settled their matters with Delaware without significant rulings or analysis from any state or federal court.
 The court found that when Temple-Inland received its audit notice in 2008, Delaware was one of only four states that had not adopted a statutory retention provision for unclaimed property records.
 Judge Sleet also discredited Kelmar’s exclusion of ACH payments from the denominator in order to increase the ratio estimator. He noted that the exclusion resulted in a million-dollar increase in the amount demanded, as well as the fact that upon administrative appeal, even the Secretary of Finance adopted the opinion of the state’s independent reviewer that the ACH exclusion was not appropriate. Interestingly, Kelmar continues to attempt to exclude ACH payments in its liability calculations in on-going audits, notwithstanding its client’s decision in the Temple-Inland administrative action.