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While the duty of corporations and other business entities to report and remit unclaimed property to the states has long been established, there has been an increased focus on unclaimed property in recent years as states seek to escheat unclaimed property as a way of generating revenue without increasing taxes. A variety of techniques have been employed by the states to do this, including new laws, shortened dormancy periods, the offering of formal and informal voluntary disclosure programs, and the more contentious use of third-party auditors conducting multi-state examinations. State enforcement activities and audit targeting with respect to unclaimed property compliance take into account many different variables, not the least important of which is a company’s M&A activities spanning as far back as the 1980s.
Unclaimed Property: A Brief Primer
While the exact parameters of what constitutes unclaimed property vary from state to state, unclaimed property generally consists of a wide range of both tangible and intangible property held by a business. Once the business has held the property for a statutorily mandated holding period (the dormancy period) without communication from the true owner, it becomes subject to escheat. Examples of unclaimed property may include uncashed rebate checks and other customer credits, unused gift certificates and gift cards, uncashed employee payroll checks, uncashed vendor checks, and uncashed dividend checks and the underlying stock or other evidence of an ownership interest in the business.
Companies are required to report unclaimed property in accordance with a set of priority rules established long ago by the Supreme Court. The first-priority rule provides that unclaimed property escheats to the state of the apparent owner’s last known address, as shown on the company’s books and records. The second-priority rule provides that the unclaimed property escheats to the state of the company’s incorporation if: (1) the apparent owner’s address is unknown, (2) the last known address is in a foreign country, or (3) the last known address is in a state that does not provide for escheat of the property in question. States have the ability to audit companies to determine their compliance with unclaimed property reporting obligations and can assess penalties and interest, in addition to requiring payment of unreported amounts, for failure to comply.
M&A Transactions: A Company’s Time in the Spotlight
M&A transactions are often well-publicized due to the transaction size, stock market activity following announcement of the transaction, and impacts on affected communities and levels of employment. Such transactions do not, in and of themselves, create unclaimed property reporting obligations that do not already exist prior to the business combination. However, a company’s time in the public eye can bring greater scrutiny from state unclaimed property administrators and third-party auditors, thus making it more likely that an acquirer will be selected for an unclaimed property audit following the closing of the transaction. These administrators and auditors generally focus on items such as whether the predecessor company properly reported unclaimed property, whether it wrote off credit balances and other obligations, and whether shares or other equity interests were exchanged as part of the transaction consideration.
Unclaimed Property Audits
In addition to being at increased risk for an audit, acquirers are often in a difficult position to respond to an audit notice. M&A transactions can significantly impact recordkeeping functions, the availability of aged documentation, and records retention policies, all while staffing reductions and system conversions are occurring. Depending on how a transaction is structured, M&A transactions can shift the burden of administering unresolved unclaimed property issues onto (potentially unsuspecting) successor entities. These successor entities can become accountable for identifying and tracking sources of unclaimed property, implementing internal controls over unclaimed property items until reported and remitted to the relevant jurisdiction, performing due diligence, and filing reports and remitting funds—all pertaining to obligations that arose pre-acquisition. To add to the difficulty, these liabilities are often maintained on or buried in unfamiliar accounting systems and were frequently written off years before the acquisition.
Unclaimed Property Due Diligence OR Unclaimed Property Compliance History
Because of the increased audit risk arising from a M&A transaction, it is important for an acquirer to conduct adequate due diligence with respect to a target’s unclaimed property compliance history. This includes quantifying past due unclaimed property obligations owed by the target and determining whether a pricing adjustment is required as a result of such obligations.
While most due diligence teams today understand that a target’s unclaimed property attributes can be transferred to the acquirer in an acquisition, typical due diligence continues to focus on the tax and financial attributes of target entities, either ignoring or performing only a cursory review of a target’s potential unclaimed property liabilities. One reason may be a lack of knowledge regarding all the areas where potential unclaimed property liabilities can be generated. In addition to the more well-known areas like payroll and accounts payable, there may be potential unclaimed property liabilities related to benefits payments, royalties, promotional programs and more. Unclaimed property may also be overlooked because individual increments seem small and the amount of unclaimed property that most companies generate annually appears immaterial, especially in the context of most M&A transactions. However, because there are typically no statutes of limitations with respect to unclaimed property, these nominal amounts can compound over time leading to audit assessments covering decades of liabilities at significant cost to the holder.
In voluntary compliance arrangements, states will typically require a company to report a minimum of between five and ten years of past-due unclaimed property, while a company that has been selected for audit may be required to report fifteen to thirty years of past-due unclaimed property. States, including Delaware, New York, New Jersey, Illinois, Texas, and California have the authority to calculate the company’s unclaimed property exposure using available records and estimating the potential liability for all property types and years where records are not available. Therefore, the acquirer should review and obtain all available historical financial information from a target as incomplete records mean that the acquirer will not have documentation necessary to prove whether an audit assessment is unreasonable. In addition to being liable for the target’s unclaimed property liabilities, the acquirer may also be responsible for any unclaimed property liabilities that the target may have acquired over the course its own acquisition history (i.e., the acquirer could be responsible for the unclaimed property liabilities that target acquired from its targets over time).
In some cases, the potential unclaimed property liabilities associated with a target can be so large that they significantly reduce the value of the target company, especially when the target is small or the bulk of its revenue comes from a single source (e.g., gift cards). In one example, the target was profitable, had a strong business record, and even had an unclaimed property compliance history. However, the company had also erroneously taken millions of dollars of reportable unclaimed property into income. When these unreserved liabilities were accounted for, the overall value of the company was cut in half. In another case, an apparently sound target misinterpreted an unclaimed property reporting exemption. A thorough review revealed that the only reason that the target was profitable was that it was incorrectly taking unclaimed property into income. Failure to correctly identify, track, report, and remit an acquired entity’s unclaimed property liabilities can also result in financial reporting issues including potential material misstatements under ASC 450 and the acquirer being unable to make the required Sarbanes-Oxley §302 and §404 certifications and attestations regarding its new acquisition. Several ways to mitigate these effects are discussed below.
The Structure of the Transaction: Important Considerations
The structure of a merger or acquisition can significantly impact the unclaimed property exposure that an acquirer may inherit from the target or a merger “survivor” from its transaction partner. In a stock purchase or a typical merger, the acquirer or surviving entity acquires all of the liabilities of the target, including any unclaimed property liabilities. As discussed above, if the target historically has failed to report or has underreported its unclaimed property, this liability could be significant. In an asset purchase, on the other hand, the acquirer only acquires those liabilities the acquirer agrees to assume in the transaction documents. Typical examples of unclaimed property liabilities often acquired in asset purchases are certain gift card balances, accounts receivable net credit balances, and customer overpayments. If it is likely that unclaimed property liabilities may be acquired in a transaction, it is extremely important to conduct adequate due diligence, as discussed above, to quantify the potential exposure.
Depending on the circumstances, potential acquirers may consider an asset purchase transaction to minimize the acquired unclaimed property liabilities. While this is particularly useful if due diligence reveals large, unreserved unclaimed property liabilities of the target, it may not always be feasible. A stock purchase may be necessary to preserve desirable tax attributes of a target or to prevent the need to obtain a significant number of third-party consents. Aside from requiring the target to clean up its unclaimed property liabilities prior to the consummation of the transaction, there are other ways to mitigate an acquirer’s exposure, even in a stock purchase or a merger transaction, such as the inclusion of appropriate representations and warranties and indemnification provisions, as discussed below.
Delaware Unclaimed Property Settlement
Unclaimed property can arise in the context of a merger involving a share exchange, where the former stockholders (who now cannot be located) fail to receive the shares issuable to them in the merger. At least one SEC reporting company recently entered into a settlement with the State of Delaware as a result of more than four million shares that were reserved for issuance in the merger, but were not claimed by former stockholders. The settlement resulted in the SEC reporting company making a $20,000,000 cash payment to the State of Delaware. Unclaimed property audits, including those with respect to equity interests specifically, conducted by third-party contingency auditors on behalf of multiple jurisdictions are on the rise, so it may no longer be possible for acquirers to ignore potential unclaimed property liabilities.
Unclaimed Property Representations and Indemnification: Sometimes it’s Better to Give than to Receive
Unclaimed property is not a tax and, thus, generally will not be covered by the tax representations and warranties contained in a purchase agreement. Instead, an acquirer should request specific representations and warranties covering unclaimed property liabilities. An example of such a representation and warranty is as follows:
Without limitation of any other representation or warranty set forth herein, the Target has timely filed with the appropriate Governmental Authority all abandoned or unclaimed property reports required to be filed by or with respect to it, either separately or as part of an affiliated group of entities, pursuant to the laws of any Governmental Authority with authority over the Target or its assets or businesses, on or prior to the Closing Date, and such reports were correct and complete in all material respects when filed. The Target has properly paid over (or escheated) to such Governmental Authority all sums constituting [Abandoned Property] as of the Closing Date. With respect to property for which the dormancy period may be running as of the Closing Date, Target warrants that it has reserved sufficient sums to pay over (or escheat) to the appropriate Governmental Authority all amounts that may become due in the future. Target has policies and procedures in place to facilitate such compliance as described in Section ___ of the Disclosure Schedule.
Even if the results of an acquirer’s due diligence indicates that a target is currently in compliance for past-due exposure, a provision should be made for property still in its dormancy period (i.e., property that may be abandoned, but is not yet subject to escheat based upon the reporting dates), as is done in the sample representation and warranty above. Such representations and warranties should be backed by an indemnity obligation and a hold-back or an escrow, if possible.
Most indemnification obligations in purchase documents only survive for a specified period of time following closing. Given that there are generally no statutes of limitations applicable to unclaimed property compliance, if possible the indemnification obligations with respect to unclaimed property liabilities should be excluded from any limited survival timeframe. In addition, the target’s indemnification obligations should be excluded from any basket and cap exceptions applicable to indemnities.
Prospective acquirers need to be sensitive to the unclaimed property liabilities housed in its potential target. Due diligence should be conducted to quantify any potential liabilities, as acquirers may find themselves subject to an unclaimed property audit post-closing. If any potential liabilities are uncovered, these should be addressed through the structure of the transaction, appropriate representation and warranties, indemnities and escrows, as well as a reduction in the purchase price, if warranted. Investing resources to address unclaimed property liabilities prior to closing can save significant time and money in the future.
 A questionable and potentially unenforceable “transactional” priority rule has been more recently claimed by some states as a third-priority rule since the Court’s decision in Texas v. New Jersey, whereby property is escheatable to a state if the transaction out of which the property arose occurred in the state and the property is not otherwise escheatable under the first- or second-priority rules. .
 This term can be defined with reference to the unclaimed property laws specifically applicable to the target or with respect to the uniform unclaimed property act.