Unclaimed property operations managers at US financial firms need to stay proactive when it comes ensuring correct administrative and reporting procedures, warn compliance experts. The costly alternative: whopping state fines.
A recent lawsuit filed by Illinois-based chemical supplier Univar against the state of Delaware provides ample evidence that Delaware is being even more vigilant in guaranteeing it receives all the money from unclaimed accounts it thinks it is entitled to. Univar has asked a US federal court in Delaware to deny the state through its audit agent Kelmar Associates the right to audit its books searching for unclaimed accounts on multiple constitutional grounds. Delaware, in turn, wants the federal court to dismiss the lawsuit on the grounds that the state filed a separate lawsuit in Delaware’s state chancery court to enforce its subpoena to look through Univar’s records.
Univar doesn’t have legal precedent on its side. In previous lawsuits filed by other firms for similar reasons, audits were already underway and the companies in question ultimately settled with Delaware. Univar is the first firm to do so with an already issued administrative subpoena, making its chances of winning even more difficult.
“{Due to the separately filed subpoena enforcement action], the case involving Univar could come down to a messy matter of jurisdiction,” says Michael Giovannini, a partner with the law firm of Alston & Bird in Charlotte, North Carolina.”Even if the federal court decides in Univar’s favor, it is unclear what impact that would have on the pending state court action which Delaware claims should govern the outcome of the dispute.”
Unclaimed accounts– which include uncashed checks and inactive bank or securities accounts — present a cash cow for state coffers which can use the funds to close budget gaps. Financial firms and other holders of unclaimed accounts must either send the unclaimed accounts to the state of the last known address of the investor or customer. If that’s not known to the state of incorporation of the issuer of securities or other corporate entity involved.
That’s just the tail end of the lengthy workflow unclaimed property operations managers have to contend with. They must first figure out whether to tag and account as unclaimed, then keep it at bay for a three to five year dormancy period. If they can’t find the owner by then send it to a state with the correct documentation.
As a popular state for incorporation, Delaware has developed a reputation for being aggressive in its audits and heavy-handed with its penalties. As one of Delaware’s audit agents, the Wakefield, Massachusetts-headquartered Kelmar earns a contingency fee, or percentage of the value of the assets it tracks down as potentially escheatable.
Univar’s lawsuit marks the climax of a three-year battle over Kelmar’s right to search Univar’s books and records. The two sides simply couldn’t come to an agreement over which records would be searched and the confidentiality of the information retrieved. When Delaware got tired of waiting, it opted to issue a subpoena, prompting Univar to file its suit in Delaware federal court in December 2018.
In its lawsuit, Univar alleges that the unclaimed audit spearheaded by Kelmar in December 2015 violates its right to due process and the right to be free from unreasonable searches and seizures. Kelmar is taking private property without just compensation and is exposing Univar’s confidental and public records to public exposure, despite its claims to the contrary.
Behind all the rhetoric on constitutional rights, Univar has practical operational and financial concerns to worry about. Univar doesn’t have all of the 10-years worth of records that Delaware wants Kelmar to dig through. Therefore, Univar would be subject to Delaware’s complicated estimation methodology for the value of the accounts that were unescheated and the ultimate fine. That methodology, largely based on statistical extrapolation, could subject Univar to multimillions of dollars worth of penalties.
Univar’s defense is that Delware is erroneously applying its unclaimed property law retroactively from 1991 to 2010 and its estimation methods are unclear. Univar says that before the February 2017 overhaul of Delaware’s unclaimed property law, there was no “look back” period. In fact, it wasn’t even until July 2010 that Delaware’s unclaimed property administrator was given the right to use any estimation methodology to calculate the penalty owed.
The change to Delaware’s unclaimed property law, made a year after a Delaware federal judge sharply criticized the state’s estimation methodology, allows for a limited ten year look-back period and for the methodology to be applied to the “extent practical.” However, Delaware’s methodology typically results in firms who can’t find historical records going back far enough end up paying heavier fines than they think are reasonable.
Preventative Check-Ups
Now what? “Unclaimed property operations managers shouldn’t wait for a court decision in the Univar case,” recommends Robert Peters, a managing director for global financial services consultancy Duff & Phelps in Chicago. “Instead, they should consider conducting their own self-audit immediately to determine if they are compliant with Delaware’s unclaimed property laws and assess their potential liability.” Duff & Phelps is one of a handful of consultancies which do that work.
What should the audit include? At the core is an analysis of whether the firm can defend its decision to not mark an account as unclaimed. The burden of proof is on a firm, because state auditors will work under the presumption of the account being unclaimed. “In instances where there is some uncertainty regarding whether an account is escheatable firms face a tough call,” says Giovannini. “They must decide whether to protect an account from escheatment and subsequent liquidation or escheat it and avoid substantial pentalties and interest levied by states.”
A firm’s audit analysis need to start off with an inventory of all forms of potential unclaimed property and establish companywide policies and procedures to document transactions that give rise to unclaimed property and correct any problems immediately. Most errors, says Peters, occur because firms do not thoroughly research unresolved transactions until when they may be categorized as unclaimed years later.
Hopefully, firms will have kept impeccable records on investor payments including dividends, debits and credits, corporate reorganizations requiring investor consent, and customer correspondence. Recordkeeping mistakes can easily tip the scales in Delaware’s favor.
“When a firm is recording transactions on its books and records, it might not be giving ample consideration to the potential unclaimed property implications,” says Peters. Case in point: if a company voids a check either because the original check may have been issued in error or outstanding for an extended period of time as uncashed, a new check would be issued. Absent specific documentation showing the reissued check replaced the original check, the presumption would be that the voided check constitutes unclaimed property, explains Peters. Specific supporting documentation includes evidence of encashment and of a written trail explaining the nature of the voided check.
However, even the best recordkeeping won’t be enough. It is easy for financial firms to make an unintentional error when it comes to tagging an account as unclaimed. “The rules on marking an account as unclaimed vary by each state,” says Christa DeOliveira, chief compliance officer in Salt Lake City for Linking Assets, a New York firm specializing in reuniting owners with their unclaimed accounts. “Financial firms can’t simply depend on the fact that they have received correspondence back from the post office as undeliverable.”
The clock starts ticking as to when an account must be transferred to a state coffer as soon as it is declared unclaimed. It is typically three to five years later. If the account isn’t tagged as unclaimed for whatever reason, the subsequent dormancy period can’t apply. Hence, the account won’t be escheated to a state coffer and the firm holding the account faces state fines.
Delaware law says that the triggers for declaring an account as unclaimed include whether there has been any activity in the account, whether there are any uncashed checks, or even whether the investor has communicated with the financial firm. Surprisingly, even the death of the investor might trigger the account being marked as unclaimed.
Hopefully, firms will have stored shareholder records for a sufficient number of years to prove whether they have made the right decision in marking an account as unclaimed or not doing so. Multiple system changes over the course of several years can often result in lost records. “The common standard of seven years of record retention isn’t sufficient when it comes to unclaimed accounts,” explains DeOliveira. “Financial firms need to think more along the lines of at least ten years, plus the dormancy period of accessible records.” The longer the timetable the higher the shareholder administrative costs, but the less likely Delaware can justify applying its estimation methodology.
Given that financial firms could face hefty fines from Delaware for failing to escheat the right number of accounts, they might consider signing up to Delaware’s separate voluntary program which allows them to disclose any mistakes and reduce potential penalties. “Not enough firms aren’t taking advantage of the voluntary program thinking they are compliant with Delaware’s unclaimed property rules or they don’t have any unclaimed property,” says Peters.
That thinking might be short-sighted. Firms which have a good track record of complying with Delaware’s unclaimed property laws stand a good chance of having a reduced penalty through voluntary disclosure should interest payments be eliminated.
Yet firms shouldn’t count on signing up for Delware’s voluntary disclosure program as the only solution to their audit woes. States won’t want to give up on potential revenue streams from unclaimed accounts and the potential fines. Therefore, lawsuits could continue involving not only Delaware but other states as well.
“The outcome of the case involving Univar could provide a useful roadmap as to how these disputes will play out,” says Giovannini. “It is never too early for holders of unclaimed accounts to start preparing for a potential audit and take steps to proactively defend themselves against future assessments by states.”
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