Audit Defense

Introduction:

When the audit letter arrives, companies must not delay. While it is always better to pre-empt the possibility of an audit with an internal review, the unprepared company is not without remedy.

As discussed further in this section:

Often referred to as the burden of proof, the burden of persuasion can be very significant. The party who has this burden must convince the court; otherwise he loses! In the unclaimed property context, the statute has the burden of persuading the court that the property at issue is covered by the state and has met the conditions of presumptive abandonment, i.e. the property is payable or distributable and there has been no owner-initiated activity for the requisite dormancy period. If the state's evidence fails to persuade the court that any of the prerequisites have been met, the state has not carried the burden of persuasion. Consequently, the court would not require the holder to report and remit the property.

States usually meet this burden

This heavy burden has caused the states to fail in some cases: N. Carolina State Treasurer v. City of Asheville, 300 S.E.2d 283 (N.C. App. 1983) (state unable to prove that unpresented "Elvis" tickets were truly unclaimed); Broussard v. Louisiana Public Service Commission, No. 89-CA-0964(La. 1989) (state unable to prove that the remainder of the refund reserve was "payable"); Mason and Dixon Lines v. Eagerton, 555 F. Supp. 434 (M.D. Ala. 1982) (state unable to prove that customer and interline credits were "unqualifiedly due" anyone). However, the states usually are successful in meeting this burden - except in the complex area of checks and drafts issued by property and casualty insurers.

Property & casualty carriers usually prevail

States and property& casualty carriers have litigated the escheatability of uncashed checks nine times; the state has lost eight of those litigations. Why? Each time the state failed to meet its burden of persuasion that the checks and drafts were "payable or distributable." Unlike a bank deposit or an employee's salary check, checks and drafts issued by a property and casualty carrier sometimes represent 1.) offers to settle a disputed claim, 2.) payment issued for services not actually rendered, or 3.) payment for a loss paid by another carrier.

This makes it difficult for a state to prove that the uncashed check is "payable or distributable." As stated by a Pennsylvania court:

The fatal flaw in the Commonwealth's case is its failure to prove that these persons to whom the checks, drafts and credit memoranda were payable, or to whose accounts they were credited were unqualifiedly entitled to same. The findings some of the court below that at least of the items in question were drawn in anticipation of unliquidated claims never made, or liabilities never incurred, leaves the Commonwealth, whose rights in an escheat proceeding are derivative [citations omitted] in the position of attempting to create liquidated claims where none exist.
Kane v. Insurance Company of North America, 392 Ad 325 at 329 (Pa. Commw. 1978).

This poor track record does not mean that the state's burden is insurmountable. The states have been successful when the auditors had been properly advised about this line of insurance as well as the evidence necessary to meet the burden of persuasion.

1995 Uniform Act

The Commissioners on Uniform State Laws recognized this difficulty and responded with a new provision in the 1995 Uniform Unclaimed Property Act. Section 6 of this latest version of the model legislation reads as follows:

Section 6. Burden of Proof as to Property Evidenced by Record of Check or Draft.

A record of the issuance of a check, draft or similar instrument is prima facie evidence of an obligation. In claiming property from a holder who is also the issuer, the administrator's burden of proof as to the existence and amount of the property and its abandonment is satisfied by showing issuance of the instrument and passage of the requisite period of abandonment. Defenses of payment, satisfaction, discharge and want of consideration are affirmative defenses that must be established by the holder.

Obviously Section 6 will greatly assist the eight states who have adopted the 1995 Uniform Act with their audits of property and casualty insurers. This helpful provision is another reason that the remaining states will undoubtedly consider the adoption of the 1995 Act.

Conclusion

The burden of persuasion falls to the state as it must convince the court that the property is in fact presumptively abandoned. Usually the states have met this burden. The highest concentration of state losses have been when (1) federal statutes have pre-empted the state's legislation and (2) the state could not prove that the funds were "payable."

I. STATES' RIGHT TO AUDIT
A. LIMITATIONS

Holders of unclaimed property often ask: is there any limitation upon a state's right to conduct a compliance review of the holder's books and records? Section 23 of the 1954 and 1966 Uniform Disposition of Unclaimed Property Acts provided three limitations:

The [State Treasurer] may at reasonable times and upon reasonable notice examine the records of any person if he has reason to believe that such person has failed to report property that should have been reported pursuant to this act.

The 1981 Act in Section 30 maintained the requirements of reasonable time and notice found in the predecessor Acts, but expressly eliminated the requirement that there was "reason to believe" that the holder was noncompliant. Section 30(b) reads, in pertinent part:

The administrator may conduct the examination even if the person believes it is not in possession of any property reportable or deliverable under this Act.

That language is repeated, almost verbatim, in Section 20(b) of the 1995 Act. That new section also expressly allows the administrator to contract with an independent third-party auditor to conduct an examination.

Where does all this revision leave the state and the holder? Clearly these changes have made the examinations easier for the states which have adopted the examination statute from either the 1981 or 1995 Act. However, a number of states still retain the "reason to believe" requirement of the 1954 and 1966 Acts.

B. JUDICIAL INTERPRETATION

So what constitutes "reason to believe"? Four cases have construed a state's right to conduct an examination. In the first case a retailer attempted to block the examination by claiming that the statute of limitations had expired. The trial court rejected that argument; the retailer appealed. The Massachusetts Court of Appeals upheld the trial court's decision and allowed the audit to proceed.

In the 1980's a trust company attempted to avoid examination by claiming Illinois' exemption of "active express trusts." The trial court accepted that argument. The Illinois Court of Appeals reversed the trial court and rejected the trust company's contention. To do otherwise, the court stated, would "allow the regulated to become the regulator."

The sufficiency of evidence necessary to constitute "reason to believe" was tested by a state banking association. When the bank received the audit notice, it obtained an injunction. At trial, the Oklahoma Tax Commission presented evidence that it had found unreported property at each of its prior bank audits. Furthermore, the Tax Commission proved that it had utilized neutral, non-discriminatory factors in its selection of audit candidates. The Oklahoma Supreme Court allowed the audit.

The final question is: when must the escheat administrator formulate his/her "reason to believe?" A recent decision from Maryland Court of Special Appeals held that the administrator's decision need not be made prior to the audit notice. Although this holder had reported securities-related property, the holder had never reported general ledger items such as payroll and vendor checks. Given the volume of the holder's interstate leasing business, the absence of such general ledger items was very unusual.

The holder argued that the Comptroller's allegations were too vague. The motions judge allowed the Comptroller to amend his pleading. The trial judge, however, viewed the amendment as an admission that the Comptroller had initially lacked a "reason to believe" and therefore dismissed the case. The Comptroller appealed. The Court of Special Appeals found in favor of the Comptroller and stated, "The right to audit comes into being at a discrete and easily identifiable point in time - whenever the Comptroller has 'reason to believe' . . .."

Conclusion

Clearly the states have been able to persuade the courts that there is sufficient "reason to believe" that the holder is non-compliant. Although the holders have the right to raise any defense such as the statute of limitations or claim any statutory exemptions from the broad coverage of the law, it is also clear that such possible defenses or exemptions will not prevent the initiation of the audit. The holder, of course, always retains the right to object to the audit results.

C. FINANCIAL PRIVACY CONCERNS - PROTECTION FOR THE HOLDER

1. The Tension:

Escheat & unclaimed property law requires holders to allow review of their customers' personal (name, address, date of last activity) and financial information; yet federal law mandates confidentiality of account information.

2. The Resolution:

Review is mandated, but information must remain confidential.

II. HOLDERS' RESPONSE TO AUDIT NOTIFICATION

A. Possible Strategies

B. Recommended Tactics

C. Audit the Auditor

Case Study No. 1: Audit the Auditor

The Company had received a series of virtually identical letters from a dozen states, each insisting that "their" contract auditor examine the Company's books and records. The Company had heard that (1) this particular contract auditor was aggressive and (2) the states routinely accepted its findings.

Our first response was to determine whether the contract auditor had the requisite authority to conduct the audit. Did the individual state statute permit a private sector entity to determine compliance with that state's law? If so, was there a contract with the state in place at the commencement of the audit? Surprisingly the contract auditor refused to provide these contracts.

What criteria were used in the selection of the Company as an audit candidate? Some states are required to articulate a "reason to believe" that a company is not in compliance. Were these dozen states even aware that the Company had been regularly reporting property pursuant to the Texas v. New Jersey rules? No, they were not. Or had the auditor merely picked the Company from the Fortune 500 list? Yes, that's exactly what had happened.

Our next series of questions focused upon the audit methodology and the qualifications of the auditors themselves. In a conference call with the lead contract auditor, my client and I discussed these concerns. At the conclusion of the conversation we requested written materials to support the auditor's representations.

Then we addressed the issue of confidentiality. The auditors would have had access to personally identifying data: names, addresses, social security numbers as well as insurance and medical data. While we had no suspicion that anyone would intentionally abuse the patients' privacy, we recognized the possibility that portions of the auditors' work papers could be misplaced. I drafted a confidentiality agreement which (1) limited the disclosure to only those states which had already joined the audit and (2) provided that all work papers be returned to the client at the conclusion of the audit.

While the contract auditor objected strenuously to our requests, I knew that we had grounds for concern. The auditor should be no less forthcoming than he would expect the audit target to be. I recommend that your company be equally inquisitive prior to the commencement of an audit.

Case Study No. 2: Attack the Audit Findings

The Company was presented with a demand for $20,000,000 representing payables due residents of a western state. The audit covered a thirty year period; the demand included a significant amount of interest. The state's auditors had prepared carefully for the audit. The state utilized a statistician to develop a representative sample to estimate the total liability.

The Company employed a three-prong counter-attack: they retained a forensic accountant, a statistician and my firm. The three of us focused on the three major issues:

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