Category: audits

An Offer You Might Not Want to Refuse

Delaware Secretary of State Issues VDA “Invitation” Notices

The Delaware Secretary of State’s Office recently sent letters to over 100 companies identified as “likely” out of compliance with Delaware’s unclaimed property laws. The letters “invite” those companies to enroll in Delaware’s Voluntary Disclosure Agreement (VDA) program. Delaware’s VDA is program pursuant to which a company performs a thorough self-review of its unclaimed property reporting history and remits any overdue unclaimed property to the state. That self-review is, in turn, thoroughly reviewed by unclaimed property professionals on behalf of the Secretary of State’s office who may identify additional property, if any, to be reported and remitted. In exchange for performing this self-review, the VDA program provides companies with a waiver of all penalties and interest that the state might otherwise assess on late-reported unclaimed property. In addition, the company and the Secretary of State will generally agree in advance on a methodology for certain contested issues that come up during the review: How far back does the review go? What entities have to be reviewed? What is the process for dealing with periods for which the company does not have researchable records?

The waiver of penalties and interest is the VDA’s “carrot;” now for the “stick”: companies who do not accept the invitation to enroll in the VDA program may be selected for audit by the State. That audit is not a company-controlled, state-checked review, but is conducted by a private auditing firm retained by the state. Those audits tend to be much (much, much) lengthier than a VDA and carry the threat of interest and penalties. In addition, the auditors generally employ more aggressive and controversial audit methodologies, seeking to shift the burden upon the company to prove that items are not unclaimed property, rather than the auditors demonstrating that items are unclaimed property. Indeed, there have been several lawsuits filed in just the past few years challenging the practices used by Delaware’s selected auditing firms. See Univar v. Geisenberger, Case No. 18-cv-01909 (U.S. District Court, D. Del.); AT&T Capital Services v. Geisenberger, Case No. 19-cv-2238 (U.S. District Court, D. Del.); Eaton Corp. v. Geisenberger, Case No. 19-cv-2269 (U.S. District Court, D. Del).

Given the potential audit risk, companies that are incorporated in Delaware should be on the lookout for these notices.  Unfortunately, the letters often do not go to the individual responsible for reporting and remitting unclaimed property at the organization, but rather are generally addressed to a senior executive such as the Chief Financial Officer.  Time to accept the invitation is limited; companies receiving the notice have 60 days from the date the request was made to enroll in the VDA program.  After that, an audit notice may issue.

Delaware Adopts New Unclaimed Property Audit Regulations, Starting 60 Day Audit Conversion Clock for Some Holders

On October 1, 2017, the Delaware Department of Finance issued long-awaited unclaimed property regulations, effective October 11.   The new regulations continue the overhaul of the State’s unclaimed property program and provide numerous and detailed instructions to both holders and auditors relating to unclaimed property audits.  The regulations specify, among other things, the State’s process for initiating and audit, the process of information requests and inquiries by the auditors, and specific guidelines on the use of estimation.  The guidelines also address a number of substantive issues of interest in the normal reporting process, such as:

  • a specification of records to be maintained by the holder in the ordinary course of business;
  • details on calculating the “maximum cost to the issuer” associated with gift-card or stored value instrument that must be escheated to the state;
  • specifications concerning what activities do, or do not, constitute “owner activity” sufficient to void the presumption that property has become abandoned;
  • what information is sufficient to establish the state of the owner’s last-known address; and
  • standards for requesting an extension of the annual reporting deadline.

In coming posts, we will review the details of some of the new regulations.  In the meantime, however, holders should be aware that the promulgation of these new regulations starts a 60 day period during which certain companies under audit by the State of Delaware will have the option of converting the audit to a Voluntary Disclosure Agreement with the Secretary of State.

Pursuant to legislation adopted earlier this year, for audits commenced on or before July 22, 2015, (except for securities examinations in which estimation is not required) the holder “may notify the State Escheator and the Secretary of State of the person’s intent to convert the pending examination into a review under the Secretary of State’s voluntary disclosure program.”  Holders are required to make that election “within 60 days of the adoption of regulations under § 1176(b) of this title.”  Thus, the new regulations kick-off that election period.  Holders that are currently under audit by Delaware should take this opportunity to assess whether the VDA program is more favorable.

Notice of the conversion period, as well as forms for implementing the conversion process, can be found at the Secretary of State’s VDA website.

The DMF Is Not Infallible

Since the widespread audits of life insurance companies’ unclaimed property compliance became public knowledge in 2011, there has been copious ink spilled on discussion regarding the Social Security Death Master File.  The macabre-sounding index is not the central plot point of a horror movie, it is a database file maintained by the Social Security Administration that tracks deaths reported to the SSA.  That information, in turn, is used for a number of purposes by government agencies and private industry.

In more recent years, the DMF has also become a new (if controversial) tool of unclaimed property auditors and states seeking to recover property that does not otherwise meet the black-letter presumption of abandonment set forth in state unclaimed property laws.  (The propriety of such a practice is a topic for another day).  At a minimum, however, Fox has an article that proves that resort to the DMF is not panacea for the states or holders. According to Fox, a 94 year old Ohio man is being stopped from filing his taxes because the IRS thinks he’s dead.  The culprit?  According to the article, the reason that the IRS refused to accept the return “was because the filer was dead according to the Social Security Administration.”

While similar errors can likewise happen with holder records, the article is a reminder that no test or tool is infallible, and generalizations made by auditors and states during the audit process are just that — generalizations that must always be subject to rebuttal.

Another Delaware Audit Related Lawsuit

Earlier this summer Temple-Inland commenced a lawsuit against the State of Delaware, challenging the findings of a Kelmar-initiated unclaimed property audit, especially as to how estimated liabilities are calculated.  In particular, Temple-Inland alleges that Delaware made an audit demand in excess of $1 million for estimated historical unclaimed property liabilities after having identified only about $150 in actual liability.  Delaware promptly moved to dismiss that litigation, and that motion is still pending in a Delaware federal court.

Now, it looks like Delaware has another lawsuit on its hands.  Late last week, Osram Sylvania, filed suit against Delaware in the same federal court arising out of another Kelmar audit.  This time, according to the allegations of the complaint, Delaware seeks in excess of $2.2 million on an actual liability of less than $22,000.  As in the Temple-Inland case, Osram alleges that Delaware’s audit and liability estimation methods violate holders’ due process rights and the Supreme Court’s holding in Texas v. New Jersey as to both the mechanics and the retroactive nature of that process.

One notable item in the filing is an allegation as to the fees Kelmar earns from auditing holders.  According to the complaint, Delaware earned in excess of $53 million from Delaware from unclaimed property.  Since most audits are conducted on a “contingent fee” basis – that is, the auditor’s fee is a portion of property collected.  That’s a lot of (presumably, other peoples’) money.

Delaware to Consider Banning Contingent Fee Auditors?

Corporations and financial institutions that are subjected to an unclaimed property audit often come away from the process with a number of complaints.  The process is usually (very) lengthy, disruptive to ongoing operations, and more often than not, bears precious little resemblance to a process designed to uncover property that will actually go to a rightful owner.  Of all holder complaints about audits, however, the most pervasive and significant is skepticism regarding the states’ use of contingent fee auditing firms to carry out the process.  In most instances, instead of conducting an audit through its own unclaimed property department, bank examiner, or other regulator, most states use private auditing firms that collect a percentage of the unclaimed property that they “find.”

Many holders question whether an auditor who is given a direct financial stake in the outcome of the audit has the objectivity and independence necessary to conduct a fair examination.  Notwithstanding these objections, the vast majority of states have ignored this critique, claiming that they don’t have the resources to enforce compliance any other way.

Now, a recent announcement from the Delaware State Senate suggests that at least some legislators have noticed.  The Republican Caucus has announced its plan “introduce legislation intended to disallow commission-based contracting for escheat.”  The attached press release goes into more detail, and contains some startling (or not, depending on your view) statistics.  According to Senate Republicans, during Fiscal Year 2013 “the state paid Kelmar Associates, a firm that provides government auditing services, $53.4 million, according to the State of Delaware Online Checkbook.”

That’s a lot of money, and whether the auditing firms are overly-aggressive or not, it suggests a potential misalignment of state priorities.  If, on the one hand, this huge amount is a product of overly-aggressive auditing (a question upon which this blog takes no position for purposes of this article) this represents a significant amount that companies have paid, but potentially should not have been required to pay, to settle these audits.  If, on the other hand, these amounts are all truly unclaimed property belonging to owners (or failing that, the state) then this seems like a tremendous amount of money that is being diverted from the state and its citizens.

Only time will tell whether this press release represents a huge shift in the way unclaimed property law enforcement is handled or just a PR move to be announced and just as quickly forgotten.  Remember, until the legislative process is complete, this is Just A Bill.

New Michigan Law Will Apply “Generally Accepted Auditing Standards” to Unclaimed Property Audits

Last week, the Governor of Michigan signed House Bill 4289 into law.  The new law revises the “Examination of Records” provision of the Michigan Unclaimed Property Act to provide certain specific standards relating to audit techniques, memorializes the holder’s right to receive a copy of the audit report, and guidelines for the use of estimates in connection with unclaimed property audits.  For example the new law requires that audits conducted by the state (or by private firms on behalf of the state) “be performed in accordance with generally accepted auditing standards to the extent applicable to unclaimed property audits.”  Those Generally Accepted Auditing Standards require, among other things, that an auditor maintain “independence in mental attitude in all matters related to the audit,” which may provide a holder with some protection from unreasonable, overzealous, and/or legally incorrect positions taken by private auditing firms in connection with unclaimed property audits.  The new law also requires the Administrator to propose rules for “auditing standards” within six months.

The law also contains a number of provisions concerning the use of estimates in connection with audits.  First of all, the law expressly provides statutory authority for the use of those estimates (as did prior law), but now further provides that such estimation shall only be used when the holder does not have “substantially complete records,” now defined as “at least 90% of the records necessary for unclaimed property examination as defined under the principles of internal controls.”  The ambiguity of that provision (e.g., how do you determine what records are “necessary”?  Who gets to decide?  What are the “principles of internal controls” referred to?) is compounded by the clarification that the calculation is not made “solely as a percentage of the total overall individual records to be examined, but also on a materiality level of value of the records.”  Other provisions make clear that the determination of “substantially complete records” can be made on a property type by property type basis.  The new law thus appears to provide some helpful protections, but the scope and extent of those protections will have to be fleshed out by regulations, administrative practice, and subsequent lawsuits.

All in all, even somewhat malleable or unclear auditing standards are preferable to the complete lack of standards in most states’ laws.  Congrats to Michigan for taking the first step.

Former Delaware State Escheator Joins Private Auditing Firm

Last week, we passed along the news that Mark Udinski, the Delaware State Escheator, was retiring from that office.  The Delaware State Escheator is, as the name suggests, the public official primarily responsible for the operation of Delaware’s unclaimed property program.  While Delaware has not announced who Mr. Udinski’s successor will be, a press release issued by Kelmar Associates indicates that Mr. Udinski has joined that firm.  For those who don’t know Kelmar is a privately-held unclaimed property auditing firm routinely engaged by states (especially Delaware) to perform unclaimed property audits of companies on the states’ behalf.

No specific word on what Mr. Udinski’s particular responsibilities will be, other than the general statement that he will work in the areas of “Practice Development, Marketing, Businsess Development, and Client Relations.”

Breaking News: Delaware Sued Over VDA/Audit Demand has an article from Randall Chase of the Associated Press with the story of a lawsuit by Select Medical against the State of Delaware arising from a VDA initiated with the Delaware Division of Revenue*.  According to the complaint, which was filed in Delaware federal court on Wednesday, Select Medical entered into a VDA with Delaware in 2006.  As a result of its own review, it attempted to close out the VDA in 2008 with a payment of approximately $20k of Delaware (in addition to some $300k filed in other states).

In response to this payment (again, according to the allegations of the Complaint) Delaware initiated an audit of the company, going back to 1981.  As a result of that audit, Delaware demanded an additional $300k from Select.  The lawsuit raises a number of challenges to the Division of Revenue’s normal audit practices including:

  • the use of estimation prior to the enactment of Delaware’s statute authorizing estimation;
  • the alleged use of “arbitrary and capricious” estimation methods;
  • the inclusion of non-dormant property in Delaware’s estimation procedures; and
  • Delaware’s claimed disregard of the Texas v. New Jersey priority rules.

 The Complaint seeks a preliminary injunction preventing Delaware from demanding the $300k audit assessment, or imposing interest and penalties on that assessment, until such time as the court can review the case.  The case is named Select Medical Corp. v. Cook, et al., Case No. 1:13-cv-00694 in the United States District Court for the District of Delaware.

* Note that the VDA program described in the complaint appears to be the Division of Revenue’s VDA program, not the temporary VDA program currently being offered by the Delware Secretary of State.

North Dakota Gets "Reasonable" About Third-Party Unclaimed Property Audits

North Dakota’s Governor signed Senate Bill 2058 into law on March 15th.  In addition to giving the state tax commissioner authority to share personally-identifying information with the state’s unclaimed property division it also sets forth that a new provision concerning audits. 

While the North Dakota Unclaimed Property Act (like most state laws based on one of the uniform acts) provides that the state may commence an unclaimed property audit regardless of whether the holder believes it has unclaimed property, the new law clarifies that the state many not “contract for an examination” (i.e., with a private auditing firm) unless the state has “reasonable cause to believe” that a person has failed to comply with the act.

This distinction, while minor, is a welcome addition to the precepts of unclaimed property law enforcement.  In the context of a privately-run examination — even where the holder has little or nothing to report — the time, effort, and resources necessary to respond to an audit is tremendous.  Indeed, in some instances, the private auditors may be working on a contingent fee (meaning, they get paid a portion of what they find) and thus have a financial interest in making sure that the audit result is a large amount, regardless of whether that is the right amount.  While the contingent fee nature of the audit should, in theory, protect a compliant holder because the auditor will not want to waste (unpaid) time trying to squeeze blood from a stone, that theory does not hold up to practice.  In reality, some contract auditing firms perform “their” audit by making burdensome information demands upon the holder, selecting items at random to be “tested” from that information, then demanding the holder “prove” that the randomly selected items are not unclaimed property.  Adding insult to injury, should the holder push back on a particularly burdensome, ill-conceived, or irrelevant demand, the auditing firm responds by threatening to inform the contracting states that the holder is being “uncooperative.” 

For a variety of reasons (not the least of which is that state employed auditors do not get a cut of what they find) state-run unclaimed property audits tend to be less disruptive and less adversarial.  Accordingly, North Dakota’s decision to limit the contract auditors to places where there is “reasonable cause” to believe that noncompliance exists is a welcome step for those holders who are in compliance. 

Factors That Trigger Unclaimed Property Audits

One of the topics that most unclaimed property want to know (but are afraid to ask) is:   What factors lead to a state’s decision to commence an audit?  Obviously, there are a multitude of factors that influence this decision, and from time to time, the audit of a particular holder may be completely random, or part of an industry-wide “sweep” of many holders in the same line of business.

While certainly not an exhaustive list, Section 1301:10-3-04(E) of the Ohio Administrative Code has a non-exclusive list of factors that may be used by the Director “in determining whether reasonable cause exists to believe” that a holder should be audited.  Among the factors are:

  • the size of the holder;
  • the “types and amounts” of accounts reported (and, presumably, whether some types of accounts are not being reported);
  • the holder’s past reporting history, “relative to other entities of the same size or industry”;
  • significant merger, acquisition, or disposition activity;
  • owner complaints regarding due diligence (or lack thereof);
  • failure to perform due diligence or provide complete reporting information; and
  • the filing of negative reports in consecutive years.

If many of the items below apply to your company, an unclaimed property audit may be in your future.