The Gift That Never Starts Giving - Buchalter Nemer

The Gift That Never Starts Giving

The Gift That Never Starts Giving
Anthony J. Napolitano
March 5, 2009

Los Angeles Daily Journal

The current uncertainty of the financial markets made one thing certain: Retailers are in significant trouble. And if you are a consumer holding a gift card to a financially distressed retailer, restaurant or service provider, now is the time to redeem those cards before they become worthless. Over the past few years, gift cards have become a significant source of revenue for retailers. Consumers spent an estimated $26.3 billion in gift cards at retailers alone during the 2007 holiday season, compared with $24.8 billion in 2006 and $18.48 billion in 2005, according to the National Retail Federation. But today's financial climate highlights the risk that consumers take by purchasing and holding gift cards from financially distressed companies.

The current economic meltdown has driven some well-known national and regional companies to file for bankruptcy protection, including: Circuit City, Linens 'N Things, Levitz Furniture, Wickes Furniture, Mervyn's, Gottschalks, Goody's, The Shaper Image, Shoe Pavilion, The Bombay Company, BabyStyle, KB Toys, Bennigan's and Mrs. Field's Cookies, to name a few. Some were able to successfully reorganize and continue to do business, while others quickly shut down stores and liquidated their inventory. As retail sales continue to plummet, it can only be expected that many more retailers will seek bankruptcy protection in 2009.

When a company files for bankruptcy protection, it can choose to file a bankruptcy petition under either Chapter 7 or Chapter 11 of the Bankruptcy Code. Under Chapter 11, the debtor company is seeking to reorganize its business, restructure its debt and hopes to emerge from bankruptcy protection as a more efficient, competitive and profitable company. Under Chapter 7, the debtor company has determined that it cannot continue to conduct business as a going concern, and is attempting to liquidate its businesses in order to maximize value for its creditors and equity holders.

The date that the bankruptcy petition is filed is significant, as it defines the relative priority and treatment of the company's creditors. Debt incurred prior to the petition date is considered pre-petition debt and receives different treatment then debt incurred after the filing of the bankruptcy petition. Generally, creditors of the bankruptcy estate receive payment in the following priority: secured debt (either pre-petition secured debt or post-petition debtor-in-possession financing), administrative claims (which generally consist of unsecured post-petition debt and the costs incurred in administering the bankruptcy estate), unsecured priority debt (which typically consists of employee wage claims and taxes), unsecured non-priority debt (which typically consists of trade creditors) and then equity interests.

The holder of a gift card purchased pre-petition falls into the second-to-last category of unsecured non-priority debt. Essentially, a gift card purchaser makes an unsecured loan to the gift card issuer. That loan is "repaid" when the consumer redeems the gift card for merchandise, food or services. There are two primary reasons that the redemption of gift cards post-petition are disfavored. First, it allows a pre-petition unsecured creditor to receive "property" of the bankruptcy estate in contravention of the priority scheme set forth in the Bankruptcy Code. Second, the redemption of the gift card depletes value from the bankruptcy estate. For example, a gift card redeemed for merchandise does not provide the estate with any net benefit. In fact, it essentially takes merchandise that could have been sold for cash.

Fortunately, many debtors and bankruptcy courts have realized that there is value to the bankruptcy estate in continuing the debtor's gift card program post-petition. Particularly, in a Chapter 11 case, the debtor will need customer goodwill to continue to conduct business as a going concern. Refusing to honor consumers' gift cards is a surefire way of destroying any remaining goodwill. For example, when The Sharper Image filed its bankruptcy petition, it indicated in its first-day bankruptcy motions that it did not intend to honor its outstanding gift cards. It wasn't until after significant public outcry that the embattled retailer decided to seek bankruptcy court approval of a modified gift card redemption program. The modified program, which was approved by the bankruptcy court, allowed the consumer to redeem the entire amount of their gift card only if they spent twice that amount on Sharper Image merchandise.

Similarly, high-end baby and maternity clothing retailer Babystyle sought and obtained bankruptcy court approval allowing it to honor gift cards only at the stores that were not being closed down. This meant that gift card holders in California could still redeem their gift cards, whereas consumers in Texas, where the company liquidated its stores, could not. Specialty goods retailer The Bombay Company initially sought and obtained bankruptcy court approval to honor its pre-petition gift card obligations, but less than three months after commencing its bankruptcy case, the company obtained a bankruptcy court order disallowing use of gift cards as a form of payment.

On the other hand, Circuit City immediately sought bankruptcy court approval to continue honoring its gift card obligations from the outset of the bankruptcy case. As of March 3, Circuit City was still accepting gift cards even in the midst of liquidating and shuttering all of its stores. KB Toys also sought and the bankruptcy court authorized the debtor to honor its gift card program, but the order did not obligate KB Toys to do so and provided that the company could discontinue the gift card program in its sole discretion. Similarly, Gottschalks, a West Coast department store chain obtained bankruptcy court approval permitting it to honor its gift card obligations and customer programs in its discretion and in an amount not to exceed $10 million.

Whether a particular retailer will honor its gift cards is essentially a guessing game. Clearly, the prospects for reorganization and the amount of unredeemed gift cards outstanding will be the main factors that dictate if, and for how long, the retailer will continue to accept its pre-petition gift cards. So, as the economy worsens and more retailers file for bankruptcy, what's a consumer to do?

The most obvious protection is to spend those gift cards before the retailer files for bankruptcy. Savvy consumers will generally know when a retailer is in financial distress. Slow-moving merchandise, store closings and layoffs are clear signs that the retailer is in significant trouble. In such cases, use your gift card immediately and refrain from purchasing new cards.

If your retailer has already filed for bankruptcy, call the nearest store and find out if they are still accepting gift cards. It usually takes a few days to a week for the bankruptcy court to enter the initial orders authorizing the debtor to either continue or terminate their gift card programs. Fortunately, the recent trend seems to indicate that debtors are seeking, and the courts are granting, orders permitting retailers to continue their gift card programs, but giving the retailers the discretion to terminate the programs as they sees fit. Thus, the quicker a gift card holder can get into that store, the better his or her chances for redeeming that card for full value.

If the bankrupt retailer is no longer accepting gift cards, there may be a few other options available. Check out the retailer's competition. When Sharper Image initially refused to honor its gift card obligations, its largest competitor, Brookstone, offered Sharper Image customers an instant 25 percent off Brookstone merchandise in exchange for their worthless Sharper Image gift cards. Similarly, when restaurant chain Bennigan's went out of business, its competitor Texas Roadhouse exchanged Bennigan's gift cards for a free entree certificate for any item on Texas Roadhouse's menu.

Another option is to file a proof of claim against the retailer's bankruptcy estate. But remember that since gift card holders hold non-priority unsecured debt, the likelihood that the holder will receive any meaningful portion of his or her claim is remote. Gift card holders can also contact their state's attorney general's office or consumer protection agencies to see if they are pursuing any relief on behalf of consumers. Recently, a local spa in St. Louis, Missouri, ceased doing business and left several hundred gift card holders with worthless gift cards. More than 300 consumers filed complaints with the Missouri attorney general's office. The attorney general was able to get the former owners of the spa to pay up to $103,000 to redeem the unused gift cards and certificates.

Lastly, LeverageCard.com, an online gift card exchange, offers a limited type of insurance on gift cards purchased through its Web site. The terms and conditions on that Web site provide that if a consumer purchases a retailer's gift card from Leverage and within the 60-day period preceding the occurrence of that retailer filing for bankruptcy and subsequently refusing to accept its own gift cards, Leverage will exchange the remaining verifiable balance on that retailer's gift cards that the consumer holds for any other retailer's gift card that Leverage has in its current inventory. This bankruptcy "insurance" is a great protection, but the chances that both conditions being met are slim, particularly where most retailers are honoring their gift cards for a period greater than 60 days following its bankruptcy petition.

In this worsening economy, we can expect to see many more retail bankruptcies in the coming year. For consumers holding gift cards, the message is clear: Spend them now, and buy new ones only from the most stable of retailers.

Anthony J. Napolitano is an associate in the insolvency and financial solutions practice group of Buchalter Nemer.

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