Regulations purporting to authorize unclaimed property examinations performed by third-party auditors put on ice. Our Unclaimed Property Team examines an Office of Administrative Law (OAL) ruling that shuts down regulations from the State Controller’s Office (SCO), at least for now.

• The third-party auditor regulations were born of a court decision that voided guidelines that sidestepped the Administrative Procedure Act (APA)
• The OAL ruled that the SCO regulations also did not properly follow the state’s APA
• Third-party audits may be on hold until the end of the year

On August 12, 2024, the California Office of Administrative Law (OAL) rejected the State Controller’s Office’s (SCO) first attempt to promulgate regulations governing the activities of third-party auditors, concluding that the proposal failed to comply with the “clarity and necessity” standards of the state’s Administrative Procedure Act (APA) along with other procedural requirements of the APA.

California Code of Civil Procedure Section 1571 sets forth the SCO’s right to examine the records of any person if there is “reason to believe” that the person is a holder of unclaimed property that should have been reported to the SCO. Although the Code of Civil Procedure does not itself allow third-party auditors to examine a person’s records, it notes that the SCO “shall adopt guidelines as to the policies and procedures governing the activity of third-party auditors who are hired by the [SCO].”

The SCO initially sidestepped the APA requirements and in September 2003 published “Policies and Procedures Applicable to State-Authorized Unclaimed Property Examinations Conducted by Third-Party Auditors,” updated in January 2022. Despite contending that these guidelines were “adopted pursuant to California’s Code of Civil Procedure (CCP), Section 1571(c),” the SCO did not comply with the strict procedures of the APA for enacting regulations, broadly defined by the California Government Code as “every rule, regulation, order, or standard of general application or the amendment, supplement, or revision of any rule, regulation, order, or standard adopted by any state agency to implement, interpret, or make specific the law enforced or administered by it, or to govern its procedure.”

Represented by Alston & Bird, ClubCorp Holdings Inc. argued in a 2020 petition for writ of mandate and cross-complaint against the SCO in the California Superior Court, County of San Francisco that the guidelines violated the APA and did not provide adequate authority for the SCO’s use of a third-party audit firm to conduct an unclaimed property examination. ClubCorp argued that all actions taken by the SCO in those third-party-auditor-run examinations, including authorizing any and all unclaimed property examinations utilizing third-party audit firms, were void and invalid.

The SCO filed a demurrer (California’s motion to dismiss) arguing that the third-party auditor guidelines did not constitute regulations under the APA. The court overruled the demurrer, holding that ClubCorp “adequately pled a claim for writ relief predicated on its request for a writ directing the [SCO] to set aside the [guidelines].” The court explained that the guidelines were void underground regulations because they implemented how examinations will be conducted under CCP Section 1571. As a result, the court found that ClubCorp sufficiently alleged the invalidity of the guidelines and its request that they be set aside and replaced. A copy of the decision can be found here.

Following the superior court’s order, the SCO abandoned its use of a third-party auditor in its examination of ClubCorp and sought to formally adopt its third-party auditor regulations under the APA. Although the SCO’s initial regulations may have failed, it is not prohibited from amending its proposal and trying again. The SCO will likely enhance the proposed regulations by adding further details, particularly about a third-party auditor’s responsibilities in examinations, and resubmitting to the OAL within the next 120 days, which the SCO may do in response to the OAL’s action.

Nevertheless, as a practical matter, the OAL’s decision may stall third-party-auditor-run examinations (at least the California component, if the exam is a multistate exam), until at least the end of this year, to stave off arguments that actions conducted by third-party auditors before the adoption of the regulations are invalid. However, although it is technically true that examinations performed by third-party auditors are invalid right now under the APA, the passing of a formal regulation that the OAL signs off on would have the practical effect of curing the issue.

Several superior court cases within California have held that the subsequent passage of a formal regulation moots any argument that actions conducted before the formal adoption of regulations are invalid. Villarreal v. Allison, for example, said, “In light of Respondent’s passing of a formal regulation, the court indicated its intent to vacate its prior order granting the writ in part as moot, and to dismiss Petitioner’s claims pertaining to the underground regulation as moot.” Even if that were not the case, the holder’s likely remedy would merely be for the examination to restart or continue without a third-party auditor.

If California audits conducted by third-party auditors are currently “on hold” until the end of the year, one additional consideration is whether the holder could be considered to no longer be “under audit” and potentially eligible for California’s voluntary compliance program (VCP). While there is room for argument, the holder would likely still be considered to be under audit by the state, even if the third-party auditor cannot perform the exam during that time, and therefore the holder is not eligible for the VCP.¹

¹ Alston & Bird wrote two advisories evaluating California’s voluntary compliance program and its potential impact on holders: “Insights into California’s New Voluntary Compliance Program: Some Answers, More Questions” (July 13, 2023); “Volunteers First Need to Be Volun-told: What’s in California’s Voluntary Compliance Program?” (March 20, 2023).

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