State Unclaimed Property Laws: A Look At Broad Trends

Tuesday, March 1, 2005 - 01:00

Unclaimed Property

[ Editor's Note: The payment obligations under a 10-year compact among the states governing the distribution of unclaimed property expired last year. In this article, former Delaware Bank Commissioner Timothy R. McTaggart discusses possible state and industry responses to the expiration of the payment obligations under the compact, along with the possible emergence of a new, "third rule" to govern the disposition of abandoned property.]

Introduction: 1993 Compact

During the past 10 years, the basic methods for analyzing escheat law claims remain intact. Under the primary rule established by Texas v. New Jersey,1 property (tangible or intangible) is escheated to the state where it is located. Under the secondary rule, established by Pennsylvania v. New York,2 if there is no known last address with respect to the property, then the property is escheated to the state where the holder of the property is incorporated.

The decision in Delaware v. New York3 reinforced the primary and secondary rule methodology with respect to unclaimed distributions of securities held by banks and other securities brokers. In brief, the unclaimed funds would escheat to the state where the debtors - those financial institutions holding the securities - were incorporated if the last known addresses of the creditors - the registered shareholders of the company issuing the securities - were unknown.

Ultimately, the states entered into a compact in response to the Delaware v. New York decision. Delaware, New York, and Massachusetts entered into an agreement with the 47 other states not to challenge the ruling in Delaware v. New York by seeking federal legislation or other means to undo the result. In exchange for this commitment, Delaware, New York, and Massachusetts purportedly agreed to share a portion of such escheat proceeds for 10 years - through early 2004 - with the other 47 states. (This agreement among the states is referred to as the "1993 compact" in this article.)

Expiration Of Compact

Since the 1993 compact is not a public document, it is unclear what may happen next now that the commitment by Delaware, Massachusetts, and New York to share escheat funds - or more directly, to make payments to the other 47 states - apparently has ceased. It would appear that the 1993 compact remains in effect even though its 10-year payment obligation to the other 47 states has expired. Thus, although there may be renewed pressure for federal legislation, similar to what happened a decade ago, which ultimately led to the creation of the 1993 compact, now the states might not be free to act. Unlike as in 1993, the other 47 states may still be bound by the commitment not to challenge the Delaware v. New York result by seeking federal legislation.

Of course, there no longer remains a financial incentive for the other states to forego such a challenge, but they do run the risk of proceeding to Congress "with unclean hands" on the issue if they are bound by the 1993 compact. The 47 states also might seek the reauthorization of the payment stream for an additional time period, although a period of another 10 years may not now be acceptable to the "paying" states and their current governors. Moreover, since the establishment of the 1993 compact, there have been other broad trends emerging that might cause substantive objections to the principles accepted by the 1993 compact.

For example, Congress previously overturned the secondary rule in some specific instances. In particular, in reaction to the Pennsylvania v. New York decision, Congress enacted legislation addressing the escheat of traveler's checks or money orders. Under 12 U.S.C. §§2501-03, the state where the traveler's checks or money orders were purchased, not the debtor's state of incorporation, is granted the escheat right, if the creditor's last address is unknown. However, if the place of purchase is unknown or if the state of purchase does not have an escheat provision addressing traveler's checks or money orders, then the debtor's state of incorporation, as required under the secondary rule, would receive the escheatable funds.

Is A Third Rule Developing?

This is a very interesting approach because the federal law for traveler's checks or money orders relies on a "gap filler" rationale. That is, the secondary rule does not apply to these types of instruments except when the state of purchase of these products is unknown, and, more importantly for purposes of developing a gap filler rationale, if the state of purchase is known but its law is silent with respect to escheatment of travelers' checks or money orders. Under this approach, it is more likely that some state will be identified for the property to be sent to as escheatable funds.

This raises the question of whether other types of instruments, such as gift certificates, which are not subject to a federal law in the same way as money orders or traveler's checks, might be pursued by a state likewise seeking to assert an escheat claim to fill a gap with regard to that type of instrument. For example, a state that is entitled to unexpired gift certificates under the secondary rule would not receive the funds if its escheat law were silent about, or affirmatively disclaimed, instruments such as gift certificates. A state with no escheat claim basis under the primary or secondary rule could force the issue of whether the escheatable balance could be reached by it if the primary and secondary rules have not settled the question of where the escheatable funds should be directed. This third state might seek the escheatable funds to ensure that the funds were collected in the public domain by a state, rather than retained by a private sector creditor.

This is not the logic of the federal statute pertaining to traveler's checks or money orders where the secondary rule yields to an identifiable state of purchase unless that state's law is silent with regard to such instruments and then the gap is filled again by the operation of the secondary rule. Instead, the sequence followed in the hypothetical gift certificate is that if, after applying the primary and secondary rules, escheatable funds remain, then that gap should be filled by a third state (the state where the certificates were purchased) asserting a claim to those funds to keep them from being released to the private sector. In the absence of federal or state4 legislation accepting this approach, states seeking to pursue such gap filler escheat claims do so at their peril.

Companies also now face the risk that a strategy crafted to create a situs of their operations (incorporating in a state where gift certificates are excluded from that state's escheat law) could be challenged by another state using a gap filler logic under a possible third-rule approach so that the escheatable funds do not "escape" from the public domain.

Defensive vs. Offensive Strategy

Under the secondary rule, a state of incorporation of a property holder benefits from escheatable funds not claimed under the primary rule. However, private industry has a choice of where to incorporate various corporate subsidiaries and affiliates, and if a particular jurisdiction is viewed as being unnecessarily aggressive in its enforcement of escheat laws, that can be a factor in selecting another state. So, for example, if a type of nontraditional property (such as gift certificates, frequent flyer miles, or other electronic commerce-enabled payment devices) is developed, a company may choose to locate that activity in an entity incorporated in a state that excludes that type of property from its escheat requirements. Applying the secondary rule to that type of product in such a state would not result in escheat liability. The company thus is structuring its activities to eliminate escheat liability in its "traditional" state of incorporation when such property would be covered as escheatable property under the secondary rule, although there is also risk of the emerging "third rule" to consider.

Anecdotal evidence indicates that companies are changing their behavior to incorporate in more favorable "escheat" states when a specific product line is at issue. There also is a general sense that this type of offensive strategy by industry has been on the rise during the past 10 years as escheat law obligations and state enforcement gained greater attention.

Risk To Some States

Of equal concern to states that are the traditional preferred states of incorporation are the defensive strategies considered or engaged in by private companies. In particular, such states run the risk of escheatable funds declining due to improvements in technology and recordkeeping by private industry when companies for independent business reasons do not wish to change their state of incorporation because of escheat law issues but do desire to better manage their escheat obligation.

Up to now, the cost of creating appropriate systems to prove that, for example, a dividend was properly paid, received, and cashed in all instances may have exceeded the cost of a company entering into a voluntary agreement with its state of incorporation or it may have exceeded the cost of the escheatment payments to its state of incorporation - essentially "double paying" the dividend. In other words, sometimes states collect escheatable funds that are not truly abandoned property, but are treated that way because a company's records are inadequate to demonstrate payment or redemption.

Anecdotal accounts suggest that incurring the cost of the technology to address the recordkeeping deficiencies now may well be preferable to entering into a voluntary agreement with a company's state of incorporation or for it to continue to double-pay on certain instruments by annually escheating the comparable amount to the company's state of incorporation.

However, state behavior influences industry practices in this area in many ways apart from direct changes in state law. Anecdotal evidence suggests that companies have reacted to certain state behavior by incorporating certain business lines in more advantageous jurisdictions and bypassed their traditional states of incorporation that have less advantageous laws as well as less reasonable audit modeling assumptions.

States also may mistakenly become emboldened by industry acquiescence when companies decide to pay "whatever it takes" to settle any escheat liability because that task is undertaken in connection with due diligence or other "cleanup" stemming from merger activity or from an asset sale. A private company in those circumstances will desire to reduce its potential escheat liability to a known number, and price and negotiate its merger/asset sale with knowledge of that escheat cost. However, it does not follow that for escheat law estimates in future years the new owners of the business will consider themselves bound by the escheat estimates agreed to by the prior owners when they wished to "clean up" the company books for a marketplace sale.

Conclusion: What To ExpectIn Years Ahead

Escheat laws have become more prominently considered in recent years as states have enforced their audit rights more aggressively, but always with an eye towards the probability of a recovery in a specific instance as balanced against the specific cost to examining and auditing in such instance, rather than merely to ensure general compliance with escheat laws. Additionally, the proliferation of e-commerce products and other new instruments has created new theories and interpretations of what constitutes abandoned property, and e-commerce innovators and their advisers know that escheat law is one element that needs to be managed as part of planning their business models. Escheat law also is now on the "deal points" list for companies when mergers and asset sales are considered, which was largely unheard of as recently as 15 years ago.

Additionally, it seems that the emphasis among advisers and industry has shifted from offensive escheat law strategy to defensive escheat law strategy. What likely will happen next is greater focus on data collection and accurate recordkeeping to mitigate escheat law liability. The availability and cost of the technology to perform those tasks thus becomes the key item to watch in the next five years.

Ultimately, better recordkeeping may lead to property being identified under the primary rule, and it may lead to the elimination of possible "double payments" - once to the property owner and then again under the secondary rule to a company's state of incorporation - due to poor recordkeeping. It is not known what might forestall efforts by states to develop a "third rule" that arises on a transactional basis when the primary and secondary rules are inoperative, but case law will be critical with respect to the outcome of that approach when an appropriate test case challenging the validity of a third rule is identified.

1 378 U.S. 674 (1965).
2 407 U.S. 206 (1972).
3 507 U.S. 490 (1993).
4 Interestingly, under the 1995 Uniform Unclaimed Property Act, there is a presumption that if a gift certificate is redeemable in merchandise only, then 60 percent of the amount of abandoned gift certificates is deemed to be escheatable, and the private sector holder of the property would retain 40 percent of the escheatable balances. This essentially splits the amount of escheatable gift certificate funds between the state and the private sector company. Arizona, Arkansas, Indiana, Kansas, Louisiana, Maine, Montana, New Mexico, North Carolina, and West Virginia have adopted the 1995 Uniform Unclaimed Property Act, and only Indiana, Kansas, Montana, New Mexico, North Carolina, and West Virginia have adopted the gift certificate presumption, while Arizona, Louisiana, and Maine adopted the provision with significant changes.

Timothy R. McTaggart is a Partner in the Corporate and Financial Services Department of Willkie Farr & Gallagher LLP's Washington, DC office. Formerly he was bank commissioner for Delaware, responsible for administering the state's escheat laws with respect to banks, trust companies, and credit unions in Delaware. This article was originally published in the BNA Tax Management Weekly State Tax Report and BNA Tax Management Tax Library. The article is reprinted with permission from Tax Management, Inc., a subsidiary of The Bureau of National Affairs, Inc., 1250 23rd Street, N.W., Washington, D.C. 20037 (www.bnatax.com).

Please email the author at tmctaggart@willkie.com with questions about this article.