It's Showtime! Companies Under Delaware Audits Have to Make Critical Time Sensitive Decisions

Introduction
On October 2, 2017, the State of Delaware adopted Regulation 104, Department of Finance Abandoned or Unclaimed Property Reporting and Examination Manual (the "Regulations"), and issued them in final form with an effective date of October 11, 2017. Companies that are currently under a Delaware initiated audit have until December 11, 2017 (60-days from the effective date) to elect one of three options that will have a significant impact on the conclusion of each respective audit.

This article addresses the following questions:

• What was the impetus for the Regulations?

• How do the Regulations change the current Delaware audit landscape?

• What impact, if any, do these Regulations have on companies audited by the Delaware’s third-party auditors or those participating in the State’s VDA¹ program? 

• What are the pros and cons of the upcoming elections required to be made by companies currently under Delaware audits?

Background
On June 28, 2016, the U.S. District Court for the District of Delaware in its landmark Temple-Inland, Inc. v. Cook²decision, held that Delaware's audit and specifically its estimation methodology used in the audit of Temple-Inland, not only violated the company's rights to constitutional due process, but that the State's estimation practices were so egregious that Delaware was, "engaged in a game of 'gotcha that shocks the conscience'"³. [Emphasis Added]. Despite these findings, the judge's decision stopped short of establishing the remedy but instead, directed the State to propose what an adequate remedy should be to correct the constitutional violations. Because of this unprecedented decision, there was a heightened state of uncertainty as many unclaimed property practitioners laid bets on exactly how the State would react. However, this uncertainty was short lived as Delaware beat a quick path to Temple-Inland’s doorstep agreeing to settle the audit for zero dollars, in addition to paying all of the company's legal fees and associated costs. By accepting the terms of the settlement, Temple-Inland agreed to withdraw its complaint, thus putting an end to the litigation and keeping the door open for Delaware to continue its aggressive practices, at least for now.

Further, in a direct and immediate response to the Temple-Inland opinion, approximately seven (7) months later, on January 12, 2017, Delaware introduced Senate Bill 13 ("SB 13" or "the Bill"), which was intended to address some of the constitutional violations identified by the District Court in Temple-Inland, but more importantly, was also intended to solidify the State's audit program and its lucrative contribution to the State's budget. SB 13 radically nullified the existing unclaimed property law in its entirety and became the State's new Unclaimed Property Act. This Bill moved with lightning speed through the Delaware legislature and was signed into law less than a month after its introduction, on February 2, 2017. However, while SB 13 addressed some important issues identified by the court, such as the inclusion of a record retention provision, the Bill remains silent on the seminal issue for which the State was chastised by the District Court—its methodology used in extrapolations. The Bill also established three options for which companies under Delaware initiated audits must elect to conclude the existing audits. [A full discussion of the three options is set forth below]. To view a copy of SB 13, click here.

Despite SB 13's failure to directly address the extrapolation issues for which the District Judge chastised Delaware in Temple-Inland, the Holder community held its collective breath hoping—that just maybe—the State would address these issues through the regulations mandated in SB 13. Specifically, Section 1176(b) requires the Secretary of Finance, in consultation with the Secretary of State, to promulgate regulations intended to promote consistency in the audit standards used for both audits and voluntary disclosure agreements. Sadly, the Regulations in final form provide no such relief from the existing aggressive and over-reaching practices of the State's extrapolation methodology.

Key Provisions of the Regulations
While the Regulations did not provide the guidance hoped for with respect to extrapolations, it did clarify and offer some much-needed uniformity pertaining to certain areas of the State's audit practice. 

• Stored Value Cards/Gift Cards:
  • Guidance on the calculations of the Maximum Cost deduction for stored value or gift cards using the company’s Federal 1120s.
• Owner's Address (To Establish Priority):
  • Sufficient description limited to two of the following three options:
    • A city;
    • A state; and
    • A postal code.
• Examination of Holders:
  • The State Escheator has the express authority to resolve an examination via negotiation and settlement with a Holder.
• Auditor Solicitation:
  • An auditor of the State shall not inform other states or jurisdictions that Delaware has authorized an examination of a Holder in order to solicit such states or jurisdictions to join the audit or conduct an audit of the Holder.
• Historical Filings of the Holder:
  • If requested by the Holder, the State shall provide the Holder with all records of prior unclaimed property reports filed previously with the State.
• Abatement of Interest and Penalties for "good cause":
  • In certain circumstances, interest and penalties may be abated for "good cause" at the discretion of the State Escheator. In determining good cause, the State Escheator may consider:
    • Whether the Holder has a significant history of filing unclaimed property reports;
    • The responsiveness of the Holder during the examination; and
    • Whether the Holder used ordinary business care in its compliance efforts.
• Adding New Entities to an Audit:
  • Once an entity scoping has been determined by the State, no additional entities may be included in the examination without the Holder's consent.
  • At the election of the Holder and with the consent of the State, legal entities acquired after the conclusion of the entity scoped may be added to the existing examination.
• Record Retention:
  • Holders who file reports are required to retain records 10 years after the date the report is filed (15 years including the standard 5-year dormancy period for most property types).
• Estimations:
  • Funds returned in the normal course of business will not be included in the population of potential unclaimed items.
  • Checks that remain outstanding less than 90-days will be excluded from the population.
  • Checks voided within 30 days shall be excluded from the population (unless the State Escheator, in his/her sole discretion, determines that a redefined outstanding period is warranted).
  • "To the extent permitted by law" names and addresses identified in the Base Period shall not be used to determine which state has the priority claim to the abandoned property estimated to be due over periods where records of owners’ addresses do not exist.
  • All sampling, projection and estimation techniques used by the Auditor to determine unclaimed property due to the State shall be in a method approved by the State prior to use.
  • The State may permit the Holder to comment on or suggest an alternative technique; however, the ultimate decision to employ a particular technique is at the sole discretion of the State. The Holder may challenge this decision at the close of the examination.

The finalized Regulations do not reveal any major policy shifts on behalf of how Delaware and its auditors will conduct unclaimed property audits in the future.

However, adoption of these regulations does start the clock on the major decision all companies, currently under audit, will have to make within 60 days of the October 11, 2017, or on or before December 11, 2017.

Statutory Required Elections
SB 13 requires all companies that are currently under audit to make certain elections within 60 days of the adoption of the final regulations authorized in Section 1176(b) of the Act. The adoption and issuance of the Regulations, which become effective on October 11, 2017, mandate all companies that are currently under Delaware initiated audits to choose one of the following three elections on or before December 11, 2017:

1. Elect to convert the audit into a VDA managed by the Delaware Secretary of State ("SOS"), and its representatives, who are NOT compensated on a contingent fee basis. While there is a suggested two-year period in which VDAs are to be completed, for cause, this time period can be extended beyond two years. Interest and penalties are waived. To see the Secretary of State's Call to Action, click here.

2. Elect to convert the audit to an "accelerated audit" where the existing Delaware auditor will attempt to complete the audit within two years from the date an election is made. If after the audit is completed in the two-year period, interest and penalties will be waived; however, if after the expiration of the two-years the audit in not complete, interest and penalties will be assessed; or

3. Continue the audit as presently being performed with no commitment to complete the audit within two years. Interest and penalties will be assessed.

Each of the above options represent significantly different consequences for Holders as each Holder's specific facts, circumstances and audit experience is different. For many companies that have faced the aggressive scrutiny of third party auditors, the notion of entering the SOS' VDA program, where the Holder performs a self-review and presents its facts and circumstances before the SOS in order to close the review period, may be quite appealing. While for others, who may be close to a final resolution with the auditors over one or all of the property types under audit, the accelerated audit route may prove to be the most efficient and cost-effective means of concluding the audit.

For a guide summarizing the pros and cons under each of the three scenarios, click here.

Some of the less obvious questions that are not specifically addressed in SB 13 or the Regulations include:

• May Holders that are currently under audit bifurcate the property types and pursue some via the VDA route, some through the accelerated audit route and others through the continuation of the audit?

Yes, based on discussions with representatives of the SOS' office, Holders may bifurcate their election, agreeing to pursue one or more property types through the VDA route while either continuing the audit or consenting to the accelerated audit for the remaining property types.

• Are Holders that elect the VDA option but fail to ultimately reach agreement at the end of the period prevented from exercising their legal appeal rights as authorized by SB 13?

Under the legislation and Regulations, Holders that cannot reach agreement under the VDA route will be turned over to the Secretary of Finance where the audit may continue. All of the appeal rights afforded under an audit would be afforded companies that cannot reach a final settlement with the SOS' office.

• May companies that agree to a settlement under the VDA or accelerated audit options subsequently seek a refund if the estimation methodology applied by Delaware is subsequently overturned by court?

No. Once a formal settlement agreement is entered between a Holder and the State of Delaware via the VDA or audit route, it is generally understood that the parties would not be eligible to seek a refund. As such, Holders should carefully consider the benefits/costs of pursuing each of the various options.

• What happens to the remaining state audits that are being conducted by the third-party auditor if the Holder elects to pursue the VDA route through the Delaware Secretary of State's Office?

Entering into a VDA with Delaware for some or a portion of the Delaware audit does not impact the portion of the audit that is being conducted by the third-party auditor(s) on behalf of other jurisdictions. That portion of the exam would continue, but opportunities may exist to reach similar settlement(s) with one or more states in a more expedient manner now that the Delaware audit (oftentimes the most time intensive portion of the examination) has been removed from the auditor's jurisdiction.

Conclusion
For the hundreds of companies that are currently under Delaware unclaimed property audit, the deadline to select one of the three options is growing near-a mere 60-days away. 

Many companies have already begun to consider their options, while others were awaiting these final Regulations to make a decision. It is important to note that no two entities are alike. An election that is right for one company may be inappropriate for another. For companies that are close to finalizing their audits, it may be advantageous to try and reach a settlement with the Secretary of Finance before the expiration of the 60-day period. However, if the company and the Secretary of Finance fail to agree on a settlement, then the company will have consider the three options on or before December 1, 2017, without the risk of interest or penalties. Similarly, if the audit has not progressed over a prolonged period of time and no immediate resolution is in sight, the VDA route may appear a prudent course of action. And if an ultimate settlement cannot be reached down the road, the Company still would preserve its rights to defend its position in court through the standard appeal procedures. 

Companies should weigh and consider several issues in evaluating their options, including but not limited to the following:

1. What is your reporting history-do you have compelling facts for the application of the State's statute of limitation provision, thus significantly shortening the scope of your audit?

2. What is the state of your records-can you produce records for the years within your audit period, thus eliminating the need for estimations? 

Another factor companies need to consider is that while the VDA route is an option to resolve the Delaware audit, in the event of a multi-state audit, the auditors may proceed in auditing an organization's books and records for compliance with the other jurisdictions. This does set the stage for two distinctly different work streams; those required to complete the Delaware VDA (should that option be elected) and those related to the multi-state audit.

These and several other questions should be evaluated and addressed by you and your advisors before the December 11, 2017 election deadline. Failure to make the right election for your company could result in a significantly increased assessment of interest and penalties under SB 13.

For more information on how the newly issued Delaware Regulations may impact your organization contact one of Duff & Phelps' unclaimed property specialists or visit our website at www.duffandphelps.com.

^1.Voluntary Disclosure Agreement ("VDA").
^2.Temple-Inland v. Cook, No. 14-654-GMS, (D.Del.June 28, 2016).
^3.Id. at 33.