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A Game of Gotcha: Delaware’s Audit Estimation Method Ruled Violation of Due Process

While seemingly just another Tuesday, the Federal District Court for Delaware determined that Delaware’s audit estimation method and other practices relating to the Temple-Inland examination violated the due process clause of the Fourteenth amendment of the United States Constitution. 1 The decision rendered is a critical one for the unclaimed property holder community.

Specifically, the court indicated that, “To put it gently, defendants have engaged in a game of “gotcha” that shocks the conscience.” 2

Litigation Background

The lawsuit was initiated on May 21, 2014 when Temple-Inland, Inc., a packaging manufacturer incorporated in Delaware with its principal place of business in Texas, filed a complaint against Delaware state officials alleging violation of several Constitutional provisions including violations of the commerce, full faith and credit, ex post facto and takings clauses plus the substantive due process provision.

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Ultimately, during the early proceedings and after the filing of an amended complaint in December 2015 the issues remaining were the alleged violations of the substantive due process provision and the takings and ex post facto clauses.  Temple-Inland filed a motion for summary judgment related to these constitutional claims.  Delaware filed its own motion for summary judgment.  The court’s June 28th opinion relates to these motions.

Temple-Inland’s allegations stem from an unclaimed property audit initiated by the Delaware State Escheator’s office in 2008 through its contract auditor, Kelmar Associates. The liability assessment at the end of the audit was over $2.1M.  The time scope of the audit spanned the period from January 1986 through December 2007.  Temple-Inland, due to their internal record retention policy, had complete records back to 2003 for accounts payable and to 2004 for payroll.  Further, it produced all of its Delaware unclaimed property reports filed from 1998 to 2008, several Delaware reports filed before 1998, and two audit reports by the state of Texas that covered 1985 to 2005.  For the years that Temple-Inland did not have complete records, Delaware’s contract auditors estimated the unclaimed property liability.

Substantive Due Process

In finding that Delaware violated the substantive due process rights of Temple-Inland, the court noted Delaware’s lack of: 1) a record retention statute; 2) notice to holders that they should maintain records for a period of time longer than a standard retention period; and 3) notice to holders that failure to file a negative report creates a situation where the statute of limitations never begins to run.  Additionally, the decision in favor of Temple-Inland on their substantive due process claim was a result of the follow factors:

  1. Timing: Delaware waited 22 years to audit Temple-Inland.
  2. Statute of Limitations: The court indicated that Delaware, “exploited loopholes in the statute of limitations”. 3
  3. Lack of Notice to Holders: Delaware never notified the holder about the need to maintain records for a prolonged period of time.
  4. Retroactive Application of Estimation Authority: The court specifically stated that Delaware, “failed to articulate any legitimate state interest in retroactively applying Section 1155 except to raise revenue”. 4
  5. Skewed Application Method: The court pointed out that the estimation method ignored factors that would have reduced liability and used inappropriate information to increase liability (like using the property due to other states in the calculation for extrapolating liability for estimating liability for the years when records were incomplete or unavailable).
  6. Multiple Liability: The Delaware estimation method which includes property due to other states in the calculation (base years) may cause a holder to be required to escheat the same property to multiple states. Specifically, the court noted,

“But it seems logical that if two states use the same property in the base years to infer the existence of unclaimed property in the reach back years, then a holder is being compelled to escheat the same estimated property to two states, in violation of the principles articulated in the Texas cases.” 5

Interestingly, no remedy for Delaware’s substantive due process violation was prescribed by the court.  Instead, the court provided that, “It is the defendants who are best able to know which remedy will be the most palatable in its anticipated efforts to normalize the enforcement of its unclaimed property laws. Thus, the court will defer its decision on the subject of an appropriate remedy until another day.”    Considering this statement, the ball is in Delaware’s court to change its practices in a manner that will pass constitutional muster.

Takings Clause

The court denied Temple-Inland’s motion for summary judgment, concluding that there were facts in dispute such that this matter could not be resolved via summary judgment. Specifically, the court noted that Delaware’s estimation techniques could be so inaccurate as to include property that is not abandoned within a final assessment. Those funds would represent a legitimate property interest that the taking clause protects.

However, the court went on to state that the “reasonable estimation of a holders’ unclaimed property liability is not an unconstitutional taking” and that the parties had not presented evidence to the court whether or not the estimation in question was reasonable. With the court’s denial of the motion for summary judgment on this issue, Temple-Inland’s lawsuit moves forward for further consideration of this issue.

Ex Post Facto Clause

The court held that Temple-Inland had not, as a matter of law, stated a viable claim that Delaware’s audit estimation method and corresponding assessment constituted a violation of the ex post facto clause.  In its analysis the court considered whether or not Delaware’s law authorizing the use of estimation and its application are really a criminal punishment in disguise.  Ultimately, they concluded that, “…the fact that Section 1155 may be excessive in relation to its purpose does not provide the clearest proof needed to “transform what has been denominated as a civil penalty into a criminal penalty”.6

Conclusion &  Changes to Audit Estimation Method?

While the court’s decision provides some comfort to holders that Delaware may consider reforming its audit estimation method and possibly add a record retention provision to its statute, it raises many questions as well.  First, it is possible that Delaware will not consider reforms but will appeal the decision.  On the other hand, if Delaware does not appeal the substantive due process determination, will it amend its recently-issued audit manual to reflect an estimation method that is acceptable to the court?   As a result of the court’s decision, will the Delaware legislature enact further audit reforms in 2017, even though they initiated and passed legislation in 2015 reforming audit practices including limiting audit reach back to 22 years?

Keane will keep you informed as the Temple Inland saga and related developments unfold. Sign up for our KeaneUP Blog newsletter or subscribe to Keanotes to be notified when new issues and posts are published.

[1] Temple Inland, Inc. v. Cook, et. al, No. 14-654-GMS (USDC – Dist. of DE) Memorandum Opinion and Order (6/28/2018)

[2] Ibid., at p. 33.

[3] Ibid.

[4] Ibid.

[5] Ibid. at p. 31

[6] Ibid, at p. 38

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