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May 27, 2014
SALT Practitioners Stepping In as States Get More Aggressive With Unclaimed Property
by Maria Koklanaris

Full Text Published by Tax Analysts®

Earlier this month, Tracy King, vice president of governmental affairs for the Missouri Chamber of Commerce and Industry, met a goal she has had for several years: She convinced lawmakers in the state that reform of the state's unclaimed property laws was not an arcane matter to be pushed aside, but rather an issue of vital importance to businesses.
"It's a tough issue," King said. Legislators didn't really understand the business side of unclaimed property, she said, adding that "over the last couple of years, [companies] have been more vocal about the impact that the cost of compliance is having on their businesses."

That finally resonated with lawmakers, King said, and the result now sits on the desk of Gov. Jay Nixon (D). HB 1075 calls for the state to allow a business-to-business exemption, establish a maximum three-year lookback period for audits, and allow appeals to a circuit court if a business is unhappy with the state treasurer's treatment of its property. The bill passed both chambers of the General Assembly with veto-proof majorities.

"I just really made it a priority this year," King said.

She's not the only one. In the last five years, according to practitioners and other professionals who deal with unclaimed property, the issue has gone from a "speck" of business to a significant portion of their portfolios that can consume more time than many had anticipated.


A Time-Consuming Business for Practitioners

The reason, practitioners say, is that nearly every state now contracts with third-party auditors operating on a contingent fee basis. These auditors don't get paid unless they find money for the state, and they thus have an incentive to conduct far-reaching, meticulous audits. And they conduct them with vigor, practitioners say.

"This is something I've been handling for 20 years, and it's absolutely increased," said Kendall Houghton, partner at Alston & Bird LLP. "It's more interesting to think about why. The states have pretty much entered en masse into audit contracts. There used to be two or three go-to firms, and now there are nine or 10 firms that do multistate audits."

Houghton said several members of her state and local tax practice spend nearly 100 percent of their time on unclaimed property work. "We're very, very, busy."

Although unclaimed property is not a tax issue per se, compliance and the audit process for it are very similar to corporate income tax compliance and audits and sales tax compliance and audits, said Stephen Kranz, partner at McDermott Will & Emery.

"Administratively unclaimed property is handled the same way that state tax is handled, and in many companies, it's the state tax employees -- the people that are responsible for state tax -- that also are responsible for unclaimed property," Kranz said. "The holders are staffing it with their state tax people, and this goes back to the beginning of time, and that has led to state tax practitioners being the natural ones that the holders go to."

Kranz said the unclaimed property field has grown in importance. He said the time that he and Diann Smith, counsel at McDermott, spend on it has also grown.

"I would say compared to any metric, yes, our unclaimed property practice is growing -- growing significantly," Kranz said. Kranz also pointed to states' increased use of third-party auditors as a reason for the expansion of the business.

But King Woolf, president of Discovery Audit Services, a third-party auditor in Baton Rouge, Louisiana, said third-party auditors play an important role for states. He said the method of payment should not be a factor for the auditor.

"I do not care what method an agency uses to compensate us for an audit. At the end of the day the audit documentation had better support the finding," Woolf said in an e-mail to Tax Analysts. "Contingency suffers the perception of bias. Hourly offers the opportunity to 'churn hours' and increasing interruption to the business [that is being audited]. Both models have strengths and weaknesses."

Woolf added that eventually it all depends on "the integrity of the third-party auditor, transparency in the process, and the supervision and effective control by both the holder and the agency."

Ferdinand Hogroian, tax and legislative counsel at the Council On State Taxation, said the issue naturally calls for businesses to seek more representation. He said in-house tax departments might know how to deal with revenue departments if they need clarification on a tax audit, but unclaimed property is different.

"There's an unreasonable element to the audit that you may want to talk to the administrator about, and they say, 'You're working with Kelmar now -- done,'" Hogroian said, referring to Kelmar Associates LLC, a prominent third-party auditor and the one most often mentioned by practitioners.

Jordan Goodman, partner at Horwood Marcus & Berk Chartered, said his clients need him for damage control. An unclaimed property audit, he said, is never a situation involving one client and one state.

"Initially, you get a notice from either the state or one of the third-party agencies representing the state saying they want to come out and do an audit and do it for a couple of states, and that's when you have to immediately spring into action and try to limit the states that they're representing," Goodman said.

Goodman said that just three active audits can occupy 15 percent of the time he spends working. He said the part of the process spent trying to get the auditor to enter into a nondisclosure agreement (NDA) can drag on for weeks or months because the client's leverage is limited.

"The only leverage you have during that period of time is that you're not going to give up any records until they sign an NDA," Goodman said, adding that even during that process, more states may join the audit. "So you start off with three and all of sudden you're at 12, and your client starts freaking out."

Maeve O'Connor, partner at Debevoise & Plimpton LLP, agreed.

"There is certainly a lot of aggressive negotiation upfront in an attempt to limit and control the process to the extent possible," O'Connor said. "You certainly try that in every instance. It is not always successful."

O'Connor said unclaimed property work was a "speck" of her business five years ago but has since become "fairly significant," especially in the last two years. She represents mainly life insurance clients and said her cases are increasingly going to litigation. "It's been a good chunk of time over the last two years," she said.


Kelmar Responds

Mark McQuillen, president of Kelmar Associates, acknowledged that the audit process has been growing more arduous, but he lays the blame at the feet of holders and their advocates, not from the auditors that he says are unfairly accused of being "hyperaggressive."

"We are not hyper aggressive," McQuillen said. "They are hyperaggressive when they are telling me that they don't have the general ledger, that they can't find last year's bank account, that they can't give me the records the state is demanding because they say I will not protect them."

The resistance to providing records and the accusations of being overly aggressive are actually part of a broader effort to undermine the audit process by misleading the public, he said.

"People will talk to you in great generalities," McQuillen said. "They are not competent enough to add value to their clients, and so they have to sell fear."

To whatever extent states and their auditors may be growing more assertive, holders have themselves to thank, he said.

"For 30 years, the states have been saying to these holders: Would you please comply? And guess what. They haven't," McQuillen said. "Do you think asking them is enough? If you don't have enforcement, the holders simply will not comply."

Nonetheless, he said that Kelmar strives to uphold the integrity of the system by being as transparent as possible.

"We explain all the steps of the audit. We give an entire presentation for how the audit will proceed. We're conducting these things as openly and honestly as we possibly can," he said.

Those presentations shouldn't be a surprise to businesses, McQuillen said. He described his background as an accountant hired by the private sector to audit business' unclaimed property as they were preparing to be acquired by other business. He said that even then, he used the same methods that he uses now.

But now that his audits are being conducted for the benefit of the public rather than for the private sector, he said, business advocates are calling foul.

"People started challenging our math. They started challenging our math because they didn't understand it," he said. "When they figured out they couldn't argue the math, they started arguing the law."

Despite the intensity of the opposition, he's confident in his work.

"I've never been sued. Within a fabulously small margin of error, I think we do a good job," he said.


Unclaimed Property on a National Stage

O'Connor has also been working to raise the issue's profile. In April 2014 the U.S. Chamber of Commerce's Institute for Legal Reform published her report titled "Unclaimed Property: Best Practices for State Administrators and the Use of Private Audit Firms".

Harold Kim, executive vice president of the Institute for Legal Reform, explained his group's interest in the topic.

"It seems like it's open season," he said. "Virtually anybody who holds an asset, or has some type of holding arrangement, is subject to this. This is growing and we don't see an end in sight."

O'Connor's paper suggested best practices for unclaimed property administration, including:

  • transparency in conducting audits and hiring auditors;
  • hiring auditors on an hourly or fixed-fee basis only;
  • ensuring that the state -- not the auditor -- retains control over the process;
  • ensuring that holders can contact state administrators; and
  • instituting voluntary disclosure programs for holders.

"While private auditors, if appropriately incentivized and supervised, can serve a useful role, the existing model of private auditor arrangements based on contingency fees, undisclosed contracts, opaque selection processes, and inadequate oversight creates an intolerable risk of abuse," she wrote.

Woolf agrees that all parties should adhere to a set of best practices, although his ideas do not exactly match O'Connor's. He said he is in the process of completing a document outlining principles and practices for all stakeholders in unclaimed property. He said he has received input from holder advocates, state agencies, and other third-party audit firms, among others.

"I am hopeful that it will be adopted by the various stakeholder groups and that it will be recognized as a reasonable standard of behavior by the majority of all industry stakeholders," Woolf said. "I hope that it will demonstrate that the majority of stakeholders agree on most of what is important. Much attention has been directed to third-party auditors (some deserved), but it is fair to say that all stakeholder groups bear responsibility for supporting a sustainable unclaimed property industry that effectively protects the consumer."

O'Connor said one of the most important reforms a state can make is putting a statute of limitations on audits. COST also rates this issue highly in its unclaimed property scorecard .

"Some of these just really reach back an extensive period of time that is way too long and puts a huge burden on companies," O'Connor said. "The burden from these audits can just be tremendous on businesses. It can require extensive hiring or diversion of internal resources. It can consume years. The burden is huge, and it's huger the further back you reach."

Goodman said that today's technology makes research on a company's records relatively easy but that this advantage fades rapidly as audits are allowed to look further back and demand older records.

"In the 90s, they were on floppy disks," Goodman said. "Who even has the ability to read a floppy disk anymore?" he added. "You can't go back historically and trace the things we can trace now."

The statute of limitations on assessments is one of the issues that have already emerged for a committee assigned to engage in a rewrite of the 1995 Uniform Unclaimed Property Act. During the February meeting of the Uniform Law Commission's drafting committee, Hogroian expressed optimism about finding consensus on that issue but said that finding common ground on several other issues central to holders and practitioners may prove to be a far more difficult proposition.

Among them is the business-to-business exemption, which is addressed in the Missouri legislation and which COST says is a top priority. And then there is the thorniest of all: contingent fee auditors.

"Holders will likely seek to limit or curtail the use of these third-party auditors by states," according to a synopsis of the drafting committee's meeting published by Alston & Bird. "States will likely resist any limitation on their right to use third-party auditors since they view them as vital to the administration of their laws."

The drafting committee is set to meet again in the fall of 2014, according to Alston & Bird. A specific date has not yet been set.


The Mother of Unclaimed Property

Every state has unclaimed property audits. One stands out, however, and it is inevitably mentioned in any conversation concerning the controversy of unclaimed property.

"Just as California is kind of the mother of state taxation, Delaware has become the mother of unclaimed property," Goodman said.

The reasons are numerous, beginning with Delaware's status as the state of incorporation for more than half of publicly traded corporations and Fortune 500 companies. Several state laws are highly attractive to business, but that comes with a price -- companies also often find themselves subject to unclaimed property audits.

Patricia Barganier Thorn, CEO of Barganier and Associates LLC, said her firm is aware of Delaware audits looking back to at least 1981. She said the state's audits have increased in both number and intensity since 2001, when Kelmar Associates was formed.

"I believe that Kelmar had some significant initial success with large assessments," which heightened the interest of Delaware and other states, Barganier Thorn said. She said the use of third-party auditors became a way for Delaware and other states to do a job that they found increasingly difficult to do internally.

Woolf agreed that audit work is difficult for states to do on their own.

"Audits drive voluntary compliance. If you reduce the number of audits, you reduce compliance. State agencies are unable to attract, train, and retain audit talent sufficient to get the job done," Woolf said. "Third-party auditors engaging holders for multiple states is an efficient model, provided the third-party auditors consistently demonstrate they are ethical, efficient, and competent."

Over the years, Delaware has come to rely on the work of third-party auditors for more than just fulfilling a need, and it now relies on them to fill the state's coffers. The money they have brought in has become the third-largest source of general fund revenue for Delaware.

This has always raised the ire of holders and practitioners. But in fiscal 2014, it became a problem for the state as well. Receipts from unclaimed property were down by $30 million, and Delaware now faces a $56 million shortfall over the next two years.

David Gregor, the state's deputy secretary of finance and state escheator, attributed the revenue decline to several factors. The most important, he said, was that about 470 companies participated in the Delaware Department of State's voluntary disclosure agreement, which meant there was no audit revenue from those companies.

"It was very successful, and that was a pleasant surprise," but it also contributed to a lag in revenue, Gregor said.

Gregor's predecessor, Mark Udinski, has also contributed to the controversy surrounding Delaware's unclaimed property practices. In 2013, Udinski left the state and took a position as a principal with Kelmar. This relationship opened Udinski, the state, and Kelmar to a great deal of criticism.

It also sparked legislation. On May 8, Sen. Gregory Lavelle (R) and several colleagues filed SB 215, which would ban contingent fee payments to third-party auditors such as Kelmar, require the state to re-bid contracts once every three years, and reiterate the state's post-employment restriction laws.

Lavelle said plainly that much of the bill was meant to address the state's relationship with Kelmar and the "revolving door" that he said was opened when Udinski left the state and went to work for the auditor. He said the bill reiterates that state employees who have had any relationship with private firms are not to go to work for those firms for at least two years after leaving state employ.

"It's a bit of a stretch of the truth to say you didn't have any contact," Lavelle said, referring to Udinski's role as Delaware's escheator when he would have been overseeing the Kelmar contract.

McQuillen distanced Kelmar from the legislation and brushed off the allegations that came with it.

"I'm not involved in that. We don't lobby, we don't make political contributions, we don't take stands politically," he said. "I feel like we do really good work, and that's why we're the focus of so much energy."

Also recently, Delaware sparked concern among practitioners when the attorney general's office moved to intervene in a qui tam case alleging that several large corporations have engaged in improper schemes to avoid being classified as holders of unclaimed gift card liabilities under unclaimed property laws.

"I anticipate that if this case proceeds, [the escheator and the third-party auditor] will go in and focus on companies who are in the retail and restaurant industries, because clearly those are two of the largest issuers of gift cards," Barganier Thorn said. "I see them using this to go after those companies. It doesn't speak highly for Delaware."


Changing strategies

Gregor said strategies used by holders and practitioners also played a role in the state's decline in unclaimed property revenue. He suggested that their tactics caused audits to "drag on" for longer periods, meaning the state could not be paid in a timely fashion.

"Among the holder advocates, it's a very competitive field," Gregor said. "I think that competition is heating up, and there are different approaches out there, and one approach is a little more prevalent now. It is a little more adversarial now than we've had in the past."

Gregor continued, "You might have had advocates in the past who said, 'my purpose is to serve my client and to get them to pay what we think is a reasonable amount, a fair amount, and to do it in an efficient way so that the examination doesn't drag on.'"

But now, he said, it's becoming more common to exhaust the appeals process and move into litigation.

"They are entitled to that," Gregor said. "We are not passing judgment on that at all."

McQuillen is passing judgment.

"The holder advocates have a scheme to drag the audits out so they can bill their clients, and they make money," he said. "They want to drag the audits out so the state will get tired. The state will either settle or go away. That's been my experience."

Kranz said practitioners and holders are taking more time with audits, but "it doesn't have to do with the personalities of practitioners, or of the state," he said.

He continued: "What I think is happening is an evolution of the legal thinking regarding unclaimed property. The practitioner community is now identifying legal issues and raising them during the course of an audit or an appeal or litigation."

Kranz said that may be why Gregor sees a change in tactics.

As an example, Kranz cited the issue of extrapolating data, which auditors use when holders cannot produce records that go back as far as the auditor demands. The auditor will then use current records to extrapolate an estimate of what the holder should pay.

"I think historically, third-party audit firms working on behalf of Delaware were successful in getting holders to pay money that should not have been paid to Delaware under their extrapolation methodology," Kranz said. "I think it's legally flawed. Holders and practitioners need to stand up to that."

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