A federal judge this week blasted Delaware’s practice of collecting abandoned property, issuing a ruling that could have dire budget consequences for the state.

U.S. District Court Judge Gregory Sleet said Delaware’s abandoned property, or escheat, practices violate due process and amount to a game of “gotcha” that “shocks the conscience.”

The ruling came in a lawsuit in which packaging company Temple-Inland Inc., a subsidiary of Memphis-based International Paper, challenged Delaware’s claim to almost $1.4 million in purported uncashed accounts payable and payroll checks.

Abandoned property is a critical source of funding for Delaware, amounting to about half a billion dollars annually and representing the state’s third-largest revenue category.

State Finance Secretary Tom Cook said his agency was reviewing the decision with attorneys and had no immediate comment.

Gov. Jack Markell said he had not reviewed the decision and referred to questions to his chief of staff, Michael Barlow, who declined to comment on the potential impact of the ruling.

“There hasn’t been an opportunity to review the decision,” said Barlow, who is an attorney.

Diane Green-Kelly, an attorney for Temple-Inland, said the company was pleased.

“We are still in the process of digesting the opinion,” she said.

Estimates of Unclaimed Property

Temple-Inland argued among other things that Delaware’s practice of estimating unclaimed property liability for years in which actual records are not available amounted to an unlawful taking of property and violated constitutional provisions regarding due process.

State officials began an unclaimed property audit of Temple-Inland in 2008, telling the company that the audit period would begin in 1981. But because the company was unable to produce records before 2003, officials used an estimation method to extrapolate that the state was owed $2.1 million. The figure was subsequently reduced to the amount that nevertheless remained in dispute.

Tension with Business

The Temple-Inland lawsuit is one of several challenging Delaware’s abandoned property system, which has become a source of tension between the business world and a state that is the legal or corporate home to more than 1 million business entities, including more than 60 percent of Fortune 500 companies. It also has led other states to challenge Delaware in court over abandoned property.

Abandoned property can include unclaimed stocks and bonds, insurance policies, uncashed checks, unclaimed wages, dividends, even unredeemed rebates and gift certificates. Under federal law, a state can take such property if it remains unclaimed for a certain number of years and the true owner can’t be found.

Under U.S. Supreme Court rulings, states follow a two-tier scheme for reporting and claiming abandoned property. Under the primary priority rule, unclaimed property is reported to the state of the owner’s last known address appearing on a company’s records. But if the owner’s address is unknown or incomplete, the unclaimed property is reported to the company’s state of incorporation.

Because so many corporations are formed in Delaware, the state benefits significantly from the second-priority rule.

Delaware has been criticized, however, for the way it aggressively targets abandoned property, reaching back several years into companies’ records to search for it and using estimates to calculate what it is owed when documentation is lacking.

In his ruling Tuesday, Sleet said he found several aspects of the state’s abandoned property practices troubling. He noted that the state waited more than 20 years to audit Temple-Inland, exploited loopholes in the statute of limitations, never properly notified companies about the need to maintain unclaimed property records longer than is standard, and failed to articulate any legitimate interest in retroactively applying state law except to raise revenue.

He also said Delaware officials employed a method of estimation where characteristics favoring liability were replicated, but characteristics that reduced liability were ignored.

“To put the matter gently, defendants have engaged in a game of “gotcha” that shocks the conscience,” said Sleet, who said he would defer a decision on an appropriate remedy until later.

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