Bloomberg Law: Managing Unclaimed Property Risks in Bankruptcy
This article was originally published in Bloomberg Law (password required)
Authors: Donna Culver, Morris, Nichols, Arsht & Tunnell, and Matthew Chenowth and Jim Weigand, True Partners Consulting
The extended shuttering of business operations due to the Covid-19 pandemic is expected to contribute to a sharp increase in corporate bankruptcy cases in 2021. As beleaguered companies seek to reorganize or sell themselves through the Chapter 11 bankruptcy process, prospective acquirers of bankrupt entities should understand the impact that a target’s bankruptcy history can have on its unclaimed property profile, which may affect its desirability as a target. Many prospective acquirers believe that if a target has filed for bankruptcy in the past, its historical unclaimed property liabilities have been discharged through the bankruptcy process. However, that is not always the case.
Compounding that concern, companies involved in significant merger and acquisition transactions and high-profile bankruptcy cases are frequently in the news and may make attractive unclaimed property audit targets for states facing declining revenues and budget shortfalls as the result of the pandemic. Therefore, it is critical for acquirers to understand how a bankruptcy filing can impact a target’s potential unclaimed property reporting responsibilities, and to dispel the myth that once a company files for bankruptcy, no potential unclaimed property liability remains.
This article discusses the bankruptcy discharge process and how prospective acquirors of bankrupt companies can identify and potentially avoid liability for legacy unclaimed property liabilities that may remain following confirmation of a plan of reorganization.
Unclaimed Property 101
Unclaimed property is generally defined as any tangible or intangible property that is held, issued, or owed by a company, known as the “holder,” in the course of its business that has remained unclaimed by the owner of the property for a specific period of time (the dormancy period). All U.S. states, several U.S. territories, and certain Canadian provinces have established unclaimed property reporting requirements that allow the state to take custody of dormant property.
Typical examples include accounts receivable net credit balances, unused gift cards and stored value cards, and uncashed payroll, vendor, and dividend checks. In addition, a company’s unclaimed property liability is not limited to amounts reflected on its current books and records, but may include items incorrectly taken into income—e.g., uncashed checks or small dollar credit balances.
Once the dormancy period has passed without the company receiving any contact from the owner, the company may have an obligation to report the property to the appropriate jurisdiction as established by the priority rules laid down in a series of U.S. Supreme Court cases. The first priority rule provides that unclaimed property should be reported to the state of the owner’s last known address, as shown on the holder’s books and records. If the apparent owner’s address is unknown, the last known address is in a foreign country, or if the last known address is in a state that does not provide for escheat of the type of property in question, the second priority rule provides that the property should be reported to the holder’s state of domicile—typically the state of incorporation or formation.
Unclaimed Property Audits on the Rise
Enforcement activity by the states to ensure a holder’s compliance with its unclaimed property reporting responsibilities has long been a part of the unclaimed property landscape. Historically, most unclaimed property audits were led by Delaware and its principal third-party contingent fee auditor, with other states joining as participating states. However, as states struggle to fill budgetary shortfalls created by the pandemic, more states have shown a willingness to select and pursue companies formed in their states, enabling them to lay claim to any owner-unknown property the holder may have, as well as companies with significant business operations within their borders.
At the same time, the number of third-party unclaimed property audit firms working for the states has increased, with some audit firms focusing on specific industries—e.g., energy, healthcare and insurance—and/or narrow geographic locations—e.g., oil-producing states. Many of these firms work on contingent fee basis, creating financial incentives for them to maximize the property that they attempt to identify and scope into the audit, resulting in costly and time-consuming audits for companies typically lasting three to five years or longer.