The Erosion of the Derivative Rights Doctrine and the Business to Business Exemption
As we review recent developments and consider the obvious reality of the states’ financial situations, we can draw only one conclusion: the states will continue to increase amounts collected, will attempt to accelerate collections, and will strive to make ever greater amounts that are escheated the permanent and nonrefundable property of the state.
One key indicator of this potential trend is the erosion of the “Derivative Rights Doctrine.” The Derivative Rights Doctrine is the bedrock of unclaimed property law and dictates that when a state takes possession of property, it is doing so as a custodian only and has identical, but no greater, rights than the owner. The taking is not permanent.
RUUPA failed to codify the Derivative Rights Doctrine when passed in 2016. Not surprisingly, legislators in three states – Hawaii, Arizona and Louisiana – proposed bills in 2018 to extinguish an owner’s rights after a time period or below certain dollar thresholds, allowing those states to become the owners of the property. We expect more state legislatures to follow suit. The National Association of Unclaimed Property Administrators (NAUPA) has stated that they are opposed to permanent taking by the states, setting up a potential future conflict with lawmakers. Their interest in RUUPA’s omission of the Derivate Rights Doctrine appears to be focused on preventing corporations from using contractual arrangements between parties to extinguish property rights, and thus by extension extinguishing a state’s rights, a concept they refer to as private escheat.
A cornerstone concept of unclaimed property is consumer protection. Many states recognize that corporations have sophisticated accounting systems and don’t need the same protection as individuals, and thus exempt transactions between businesses. Twelve key states have statutes or regulations allowing Business to Business (B2B) exemptions, which have been utilized extensively by corporations to prevent dollars from escheating that should be reconciled with other businesses.
RUUPA failed to address B2B. Right on cue, Illinois enacted a new unclaimed property statute in 2018 based on RUUPA that eliminated their long standing B2B exemption and appears to make the application retroactive. We believe that B2B exemptions will become extinct soon, a victim of the states’ desires to increase collections.
Chipping Away at “Buy and Hold”
The erosion of the B2B exemption is a clear indicator that states collectively intend to extract more unclaimed property from owners that are corporations. Will they do the same of owners who are individuals? Assets in retirement accounts are one of the most tempting sources for states to tap for unclaimed property collections. Most states ignore IRAs until the owner reaches the required minimum distribution (RMD) age of 70.5 years old, and then impose a three-year dormancy period if distributions have not been taken.
In 2016, Pennsylvania enacted HB 1605 that allowed for the escheatment of IRA accounts before the RMD if two pieces of mail from the investment company have been returned to the post office (RPO) as undeliverable. This action seemed to be an attack on the “buy and hold” investment philosophy upon which the investment industry has been based. This law may expose owners to potentially severe tax consequences.
Pennsylvania’s action is especially troubling considering IRS Revenue Rule 2018-17 published in May. The IRS declared that escheated proceeds from an IRA constitute a designated distribution and must be recorded on a form 1099-R. While troubling for owners in all states, IRA owners in Pennsylvania may face additional taxes for early withdrawal. Collectively, these actions appear to be a trial balloon to push the limits of increasing unclaimed property collections onto the backs of individual investors.
The reaction to this law has been universally negative, with Pennsylvania legislators feeling pressure to take corrective action. Thus, HB 2167 and SB 1058 were introduced in 2018 to ease the burden a bit for private investors, proposing to adopt standards that IRA accounts should have been coded as RPO and have had no activity for a three-year period before being subject to escheat. While better than an RPO standard only, such a corrective action will not return the standard of protection previously enjoyed by Pennsylvania citizens – that their account should not he considered for escheatment until they have reached the age of RMD.
In our view, states will further test the boundaries of their ability to escheat the assets of individual investors in the future.
Virtual Wallets, the Cloud and Cryptocurrency: New Frontiers for the States
Advancements in payment systems technology and the rise of digital currencies has been noticed by the states and their legislatures as potential sources of unclaimed property collection. Financial Technology, or “FinTech,” companies have proliferated to offer new types of financial services. Many online transactions now take place with the use of virtual wallets. In lieu of a traditional payments, online retailers and marketplaces routinely place funds as a credit in a virtual wallet for individuals. These credits are often available to purchase goods or to be withdrawn by consumers in a variety of methods. The states noticed that funds available in virtual wallets are often small dollar amounts that frequently go unused by the owner. We believe as more and more companies, and the marketplace in general, migrate from paper checks to electronic payments, companies using virtual wallets will face continued and expanded scrutiny in the very near term.
Complicating matters is record retention. Any organization that has undergone an unclaimed property examination understands that access to detailed historical vendor, customer and employee payroll records is critical to overcoming the “presumption of abandonment” by the states and their contingent fee auditors. As organizations increasingly “offshore” or “outsource” their accounting functions to third parties or park such records in the Cloud, the likelihood of retaining the necessary records diminishes over time. It is not a matter that the records cannot be retained, but rather that financial pressures and perpetual system upgrades make doing so cost-prohibitive. As such, we anticipate the use of estimation techniques, not only by the state of incorporation, but imposed as a penalty for failure to comply by the states, will increase in frequency. This is one of the components included in RUUPA. To date, Kentucky, Utah, Tennessee and Illinois have enacted legislation based on RUUPA, with several more states expected to follow suit in 2019.
We also anticipate continued focus by the states on loyalty, rewards and promotion programs. While currently exempt under RUUPA, few states have yet to embrace the RUUPA definition and we expect continued narrowing of those programs which will remain exempt from the definition of unclaimed property. Holders need to be especially careful in crafting such programs so as to avoid inadvertently causing their reward programs to give rise to unclaimed property.
The rise of crypto or virtual currency has been dramatic and covered extensively in the press. RUUPA included virtual currency and several states have adopted RUUPA-based laws calling for the escheat of virtual currency. One major problem is: no one can truly define who is the holder, is it the exchange? If a bank or financial institution offers virtual wallets for virtual currency, is it the holder? One of the most vexing questions is: who can transmit the virtual currency to the states and what would they do with it once they receive it? Virtual currency relies on a “crypto-key” for transmission. How can a holder transmit escheat when the owner holds the key? If the owner holds the key, can the owner truly be considered to have abandoned the property?
Finally, will states liquidate virtual currency if they receive it? And, if they do, will they expose themselves to jeopardy based on the wild valuation swings in that marketplace? We’ve seen lawsuits over the states’ ill-timed liquidation of escheated securities. We are certain that the states will be looking for ways to escheat virtual currency in the very near future.