Gavel and cash on a wood desk

Delaware’s Estimation Method Shocks the Conscience

Gavel and cash on a wood desk

This unclaimed property case from Delaware is notable for an opinion in which the district court judge held that the state’s actions in auditing the holder amounted to a “game of gotcha” that “shocked the conscience.”

Temple-Inland Inc. is a corporation organized under Delaware laws with its principal place of business in Tennessee (initially, later moving to Texas). Temple-Inland is a manufacturer and supplier of packaging materials and the plaintiff in this case.

The Temple-Inland Audit

In late 2008, Temple-Inland received notice of an impending unclaimed property (UP) audit to be conducted on behalf of the state of Delaware by Kelmar, as the third-party contingent fee auditor.

The audit notice included the statement “I’m sure all records are being retained under standard retention policies” from the Audit Manager, Michelle Whitaker. The defendants in this case later admitted during the litigation that “standard retention policies” typically required maintenance of documents for seven to ten years.

However, the audit went well beyond that. It actually looked back a full 22 years — from 1986 to 2007. While the holder produced complete records beginning from 2003 for accounts payable and 2004 for payroll, the company had disposed of older records pursuant to its “standard retention policy.”

Temple-Inland also submitted all of the UP reports it had filed with Delaware from 1998 to the time of the audit, a few reports before 1998, and two reports by Texas (covering specific years between 1985 and 2005).

For all years prior to Temple-Inland’s complete records, looking back to 1986, the state of Delaware thus turned to estimation to determine the amount of UP for which the holder was responsible.

The Litigation Between Temple-Inland and Delaware

On May 21, 2014, Temple-Inland filed suit against Delaware. That complaint alleged the violation of both federal common law and the company’s rights under various provisions of the U.S Constitution.

A few months after filing suit, on July 22, 2014, Temple-Inland filed a motion for summary judgment on two claims—violation of its rights under federal common law and violation of the prohibition against ex post facto laws under the Constitution. Simultaneously, Delaware filed a motion to dismiss the company’s complaint in its entirety on the basis that it failed to state a claim upon which relief could be granted.

In 2015, the District Court granted the state defendants’ motion to dismiss the federal common law claim stating that the Texas trilogy of cases does not apply to disputes between private parties and a state. Practice Note: the Texas trilogy has now been applied to private party-state disputes in Card Compliant and Marathon and Office Depot.

The court also denied Temple-Inland’s motion for summary judgment and refused to dismiss the remainder of the company’s claims.

Later in 2015, Temple-Inland amended its complaint to drop claims based on the Commerce Clause and the Full Faith and Credit Clause of the U.S. Constitution. Subsequently, both parties filed cross-motions for summary judgment.

Delaware’s “Shocking” Estimation Methodology

The Delaware General Assembly provided in 2010 that the state UP officials can use “reasonable” estimation methods in UP audits, meaning that state escheat officials have wide discretion in how and when to use estimation in audits.

However, the legislature didn’t adopt a statute requiring the retention of records for any specific period of time, nor did the state’s Finance department issue any guidelines or rules, except calling for “standard retention policies.” This set up a conflict that resulted in the situation where the holder didn’t have records for a long stretch of years that were the subject of an audit, thus forcing the auditors to estimate the holder’s UP obligations.

So how did the state’s auditors estimate Temple-Inland’s UP obligations for the years outside its retained records? Here’s the short answer: it multiplied Temple-Inland’s “adjusted calendar sales” by a specific “ratio estimator” for each year in the “reach-back” period for which it did not have records (so, 1986-2002 for AP and 1986-2003 for payroll). The State credited Temple-Inland for any amounts provably reported and paid for each calendar year in question (aka “prior filings”).

The ratio estimator is a fraction or percentage that’s extrapolated from information contained in “base years” (the years for which Temple-Inland had records–2003-2007 for accounts payable and 2004-2009 for payroll).

With apologies to those suffering from math phobia, it’s important to understand a little bit about the math behind Kelmar’s estimation methodology in this case. Specifically, we need to look at the ratio estimator fraction. If you’ll recall from third-grade math, any ratio is basically a representation of two numbers, or a numerator divided by a denominator.

The Numerator of the Ratio Estimator Fraction

In this case, the numerator is the estimated “base period liability.” This BPL is the sum of:

  • All unclaimed property the holder reported to any state
  • Any funds returned to Owner other than in the ordinary course of business (reissued and cashed after the audit began, where Kelmar presumed those checks would not have been replaced if they hadn’t audited Temple-Inland)
  • And any amounts not otherwise remediated.

Whether an amount was deemed “remediated” was based on Kelmar’s sampling of aged checks, separated into “stratum” by the amount of the check and randomly selected into samples, with one key exception: Kelmar selected all of the highest value checks.

If Temple-Inland could prove the check was not unclaimed property, it was remediated, but otherwise included in the estimation methodology.

Kelmar used all unremediated checks in its sampled set to form the basis of its estimation for all aged checks.

The Denominator of the Ratio Estimator Fraction

The denominator amounted to Temple-Inland’s adjusted calendar sales during the base period, reduced by Kelmar to account for increased use of ACH electronic payments. The state and Kelmar believed that ACH payments were less likely to be unclaimed property. That reduction of the denominator meant the resulting ratio estimator would be larger than it otherwise would be, and thus resulted in a greater amount of UP assessed for the reach-back years.

Kelmar’s estimation technique rested to a significant extent on property that was legally escheatable only to other states. Unclaimed property that was reported to other states, as well as unremediated checks to owners with a known address located outside of Delaware, were both included in the calculation.

As a result, the base period liability was increased beyond what it otherwise would have been. A larger base period liability in turn means a bigger ratio estimator, which results ultimately in a much larger amount of UP from reach-back years that the audit estimated Temple-Inland owed to Delaware.

The impact was substantial. Had Kelmar’s calculation removed the amounts previously filed to other states from its base period liability calculation, the ratio estimator would be 0.00114124%, as opposed to 0.00365273%.

What does that mean in dollars and cents? Quite a lot. Looking solely at the liability based on unclaimed accounts payable, the audit estimated Temple-Inland’s liability at $1,176,767.77.

Without those amounts file to other states? It would have been $330,252.89.

Delaware’s Actions are Arbitrary (and Shocking!)

As the court notes, the fundamental principle behind due process is the prohibition against arbitrary government acts that work a deprivation on an individual (or corporate entity). What constitutes an arbitrary act will vary depending on whether there’s a statute or some executive action at the heart of the government act.

In this case, because Temple-Inland isn’t so much challenging the statute as it is the way the defendants implemented that statute, the dispute centers on an executive action. As such, the court can only find a violation of substantive due process if it also finds that the defendants’ conduct “shocks the conscience.”

In most reported cases, the conduct alleged to “shock the conscience” involves physical violence or excessive force. However, the lack of clear precedent isn’t fatal to Temple-Inland’s claims. In fact, the court crystallized the shocking nature of the state’s conduct by reducing it to a point-by-point narrative:

  • The state “waited 22 years to conduct an audit”;
  • It “avoided the otherwise applicable 6-year statute of limitations under dubious circumstances”;
  • It “gave holders no notice that they would need to retain unclaimed property records to defend against unmeritorious audits”;
  • It “applied Section 1155 for a prolonged retroactive period for no obvious purpose other than to raise revenue”; and
  • It “failed to follow the fundamental principle of estimation where the characteristics of the sample set are extrapolated across the whole” resulting in Temple-Inland facing the risk of multiple liability.

Taken together, this is a problematic series of actions. In fact, the Court says:

To put the matter gently, defendants have engaged in a game of “gotcha” that shocks the conscience.

How Long Can You Wait to Audit?

Especially troublesome to the court is the statute of limitations issue. Delaware assessed a significant liability against Temple-Inland for actions that took place 22 years prior.

Yet, as the court notes, state action against holders is limited to three years from the date a report is filed to sue for enforcement of the payment obligation. (This period is increased to six years if the deficiency is over 25% of the amount of abandoned property disclosed in the report. Additionally, there is no statutory period to bar enforcement when the holder doesn’t file a report, or if it files a false and fraudulent report intending to evade its obligation to pay. In those situations, enforcement can be instituted at any time.)

Delaware relied on section 1202 of the Escheat Act to argue against the applicability of the statute of limitations. Yet this section doesn’t “undo” the statute of limitations. It only provides that even if an owner’s claim against a holder is time-barred, the holder is still obligated to turn over the property to the state. That statute says nothing about state enforcement of a deficiency payment against the holder. Its purpose is to prevent holders from asserting rights of their own in abandoned property, nothing more.

The state assumed that the company didn’t file a report for the earlier years for which it could not produce records, not that it filed a false report. But as the court points out, it’s equally possible that Temple-Inland didn’t have any unclaimed property for the year in question and that’s why it didn’t file a report, or that it did file a report but copies were lost or destroyed.

While the state put the burden on the holder to prove reports were filed, it ignored the fact that the state itself didn’t keep copies of all UP reports filed with it. The result is that only holders bear negative consequences from a failure to maintain all reports, not the state.

Why Didn’t Delaware Require Records to be Maintained?

At the time of the notice of audit in this case, Delaware was one of only four states without a records retention statute.

Put another way, 46 states had set a firm and clear number of years for which records had to be retained. Of those, 42 statutes established the retention period somewhere between 5 and 10 years.

Yet the state defendants asserted it was surprising that Temple-Inland didn’t anticipate an audit that covered a 22-year period, where corporations don’t normally retain any records for more than seven to ten years, unless there’s a specific, identifiable need to do so.

While the court agrees that the state officials bear the burden of proving the property is actually unclaimed, it doesn’t agree that estimation can never meet this burden. This holding relies on precedent from the Seventh Circuit and other federal appellate courts that governments can use sampling, extrapolation or estimation as long as the plaintiff is given an opportunity to rebut that estimation. That requires clear notice of record retention obligations, which was never present in this case.

Why Such A Long Look-Back Period?

The court holds that the sheer length of the retroactive period isn’t by itself enough to constitute a substantive due process violation. Instead, it must consider the appropriateness of the period given the motivation for it.

Here, the court concludes that the state defendants’ asserted reasons for the 22-year period simply don’t stand up to scrutiny. Sure, the defendants might collect a greater amount of money but that doesn’t flow through to the owners. The amount an actual owner of UP can claim from the state remains unchanged—they only get what they abandoned. Nor does the lengthy look-back period serve the viability of the UP program in general. And the estimation methods used won’t make it any easier for the owners to regain their property. In fact, it might make it harder.

The state defendants also argue that if the owner can’t claim the abandoned property due to the use of estimation, then it’s better that the estimated property benefit and serve the public, as opposed to a corporate holder.

The only credible reason offered by Delaware for using estimation the way the auditor did in Temple-Inland’s case was to raise revenue. The Court points out the obvious: UP laws were never intended as a revenue-raising mechanism for whatever funds a state might need for general public purposes. If that’s the sole purpose of a UP program, then the state creating that program violates its holders’ substantive due process rights.

Estimation Must Be Based on Reality

Sampling and estimation have long been approved by courts, as long as it maintains and adheres to the same characteristics as other UP in base years. The defendants here failed to apply that principle correctly.

The defendants acknowledge they have no rights in property from base years if the payees are located outside Delaware, yet their estimation extrapolated that out-of-state property into the reach-back years to calculate Temple-Inland’s total obligation to Delaware. The results were deeply misleading and unfair.

This Estimation Subjects the Holder to Multiple Liabilities

The United States Supreme Court held in the Texas cases that “the same property cannot constitutionally be escheated by more than one State.” Otherwise, the holder is subjected to multiple liability.

If two states rely on the same base-year property to extrapolate to reach-back years, then a holder is essentially being obligated to escheat the same property to two states, which is a clear violation of the Texas cases. Since the state of Texas also audited Temple-Inland for the same time period as Delaware, the company estimated it was wrongfully subjected to at least $299,085.86 in multiple liability.

The state defendants argued that there was no risk of multiple liability in this case, because Delaware is the state of incorporation and was only searching for UP where the owner address is unknown (i.e., secondary priority under the Texas rules of priority). Thus, it claims it’s the only state that can properly use estimation to calculate Temple-Inland’s liability.

The court points out that this isn’t actually true. No state that statutorily permits estimation has limited its use only to secondary-priority-rule cases. The Texas audit is clear proof that this isn’t a customary practice nationwide.

Temple-Inland Leads to New Unclaimed Property Statute Amendments

The District Court granted Temple-Inland’s motion for summary judgment as to the substantive due process claim, but denied as to the takings and ex post facto claims, granting the state’s motion for summary judgment on those two claims.

While the Court granted Temple-Inland’s motion for summary judgment and even said the estimation was shocked the conscience, the Court did not conclude what the appropriate methodology would be. It left this open for discussion between corporate holders and the state, as well as for input from the state legislature.

After Temple-Inland, Delaware went through another major wave of legislative amendments with S.B. 13 to address some of the concerns that the court had.

Unfortunately, Delaware re-adopted most of the same estimation methodologies that shocked the court’s conscience. So we are sure to see another holder file a new lawsuit as some point.

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