Gift Card Alert: Third Circuit Confirms States Can Audit Gift Card Subsidiaries, but Emphasizes Limits
Dear Retail Clients and Friends,
Many retailers with gift card programs have faced or may someday face a lengthy and onerous unclaimed property audit by a state government, even if the gift card balances are not escheatable to that state. A recent decision by the US Court of Appeals for the Third Circuit confirmed that there are limits to states’ ability to audit retailers’ gift card programs. This edition of Morgan Lewis Retail Did You Know? examines the recent Third Circuit ruling in Marathon Oil v. State of Delaware, including some of the ways it can be used to help limit the scope of these audits and how it may impact retailers with gift card programs more broadly.
Various state unclaimed property laws, including most notably the law in Delaware, where many companies are incorporated, require companies to annually report and pay to states unclaimed property that includes some portion of the unused balances on gift certificates or gift cards. Under these laws, states such as Delaware can audit companies’ books and records for compliance with unclaimed property law. Such audits often drag on for years and result in demands for millions of dollars in back payments for unclaimed property allegedly owed to the state. States frequently hire third parties to conduct these audits, with those third parties being compensated on a contingency fee basis relative to the dollar amounts they recover.
Marathon Oil and Speedway are Delaware corporations with stored-value gift card programs issued by their subsidiaries or “giftcos” based in Ohio, a state that has chosen not to escheat the unused balances on gift cards as unclaimed property. After an eight-year audit by third-party auditor Kelmar, Delaware expanded the audit to include Marathon’s and Speedway’s stored-value gift cards held by the Ohio-based subsidiaries. In response to Kelmar’s request for “extensive detailed information” about the Ohio subsidiaries, Marathon and Speedway agreed to produce information showing that their Ohio entities were properly formed, but objected to more detailed requests regarding their gift card programs. The companies argued that the requests exceeded the state’s authority because the federal common law priority rules outlined in a series of US Supreme Court decisions require that where there is no last-known address associated with property, the property must be escheated to the state of incorporation. Here, Marathon and Speedway had no last-known addresses for the gift card purchasers and the state of incorporation of the holder, Ohio, does not escheat abandoned property. Thus, Marathon and Speedway asserted that Delaware had no right to escheat gift card balances and that Delaware’s aggressive audit related to the gift cards was improper.
Marathon and Speedway took the further step of filing a lawsuit in federal court asking the court to confirm that the expansion of the audit was improper. After the district court dismissed the claim, holding that the federal priority rules only applied to disputes between states and not to disputes between a private party and a state, the companies appealed to the Third Circuit—which recently issued its decision reversing the district court decision in part and remanding for further proceedings.
Takeaways from Marathon Oil
Private companies can sue states to enforce the federal common law priority rules to halt a state’s unclaimed property audit.
The Third Circuit reaffirmed its prior decision in New Jersey Retail Merchants Ass’n v. State of New Jersey that the federal priority rules do apply to disputes between a private company and a single state, not just to disputes between states. The Third Circuit emphasized that the priority rules also protect states, like Ohio and others, that want to incentivize corporations to incorporate there by choosing to not escheat property. Thus, retailers and other companies can rely on federal courts to protect them from overlapping and invasive audit examinations and demands for escheat payment.
Federal priority rules do not prevent a state from conducting an audit of gift card subsidiaries—including into the specific facts regarding how such entities operate.
Although finding that the priority rules do protect private entities, the Third Circuit also held that a company cannot invoke the priority rules to prevent a state from conducting any audit or examination to verify that the property at issue is actually held by an out-of-state subsidiary and, therefore, is not escheatable. Responding to Marathon’s and Speedway’s argument that Delaware cannot escheat the property because the subsidiaries were formed in Ohio, the court rejected the further conclusion that Delaware was barred from auditing the subsidiaries, holding that this was based on the “speculative assumption” that the state would ultimately try to escheat the property. Delaware was not limited to simply examining the companies’ corporate records and four corners of their contracts and doing nothing further. Instead, the Third Circuit recognized that a fact-intensive inquiry into whether corporate formalities have been observed in practice, and whether doctrines like piercing the corporate veil—which allows courts to disregard corporate forms in the face of fraud—may apply and be appropriate.
Federal priority rules can limit the scope and duration of a state audit.
While a state may conduct an audit into the legitimacy of the giftco structure, the Third Circuit acknowledged that there are limits to the scope and duration of that investigation when the priority rules preclude the auditing state from escheating the property. The court noted that a state’s demand for information “can become so obviously pretextual or insatiable” that the process drags beyond a legitimate inquiry into the parent-subsidiary relationship and becomes an abusive process designed to force a monetary settlement. In those cases, the audit must be preempted and halted by the priority rules. From a practical perspective, however, the court did not decide or provide any guidance with respect to how far an audit must be allowed to progress before the priority rules are triggered to stop the audit. For example, it is unclear how much information a company is required to provide, for how long the company must allow the audit to proceed, how many requests must be complied with, or what actions the state must take to enforce compliance with the audit before the company can ask a federal court to step in and enforce the priority rules.
The court appeared sympathetic to Marathon’s and Speedway’s concerns with Delaware’s escheat audit practices and submitting to an expansion of its eight-year audit. The court pointed to the flaws in Delaware’s escheat audit process and observed that, given Marathon’s and Speedway’s “troubling allegations about Delaware’s escheat auditing process and the State’s third-party auditor, Kelmar,” the companies had “good reason to be concerned” that Delaware may try to escheat property that it has no right to escheat. The court further observed that Delaware’s use of a third-party auditor with a financial incentive to claim as much escheatable property as possible “taints the entire process with an appearance of self-interested overreaching.”