What retailers should know about gift cards

Gift cards continue to grow in popularity – a fact especially noticeable now, during the holiday season. Retailers and consumers should be aware of problems gift cards can create – notably regarding money left unredeemed by card holders and what happens when an issuing company goes into bankruptcy.

Unredeemed gift card money is commonly called “breakage,” and the Securities and Exchange Commission says retailers can recognize that money as income when it’s unlikely that cardholders will spend it -- typically after two years. Otherwise, retailers can recognize an unused percentage as breakage income based on historical patterns.

That said, not all companies recognize gift card sales the same way. A recent trend is to treat gift cards as accounts receivable, so companies use historical experience to determine when cards likely won’t be redeemed. If a card goes unredeemed for two or three years, or if it has a very small balance, retailers typically feel safe removing the cards from unearned revenue accounts.

States sometimes get involved, too, as about half have escheat laws, which send unused gift card funds to state control after a mandated period, with the stated hope that unused money will return to consumers. But even states with escheat laws handle things differently – creating jurisdictional issues.

Federal law says that the funds from unused gift cards belong to the state of the last known address of the consumer, as shown in the retailer’s books and records. If there is no known address, or if the card owner’s address is in a state that does not take control of abandoned gift cards, then the state where the debtor is incorporated wins -- unless another state can prove it has superior rights.

When can retailers claim revenue from unredeemed gift cards not covered by escheat rules? In accounting terms, the funds received from customers are unearned revenues – balance-sheet liabilities. That means revenue from a gift card sale is not income until a consumer redeems the card or the seller declares the card “unused.” A company also can recognize revenue when the likelihood of the card being redeemed is remote based on an inactivity for an unusually long period.

But what happens to consumers and their gift cards if a retailer that issued the card goes bankrupt – as quite a few retailers have done in the past few years. Some huge names have filed for Chapter 11, including Borders, Sharper Image and Radio Shack.

The amount on each card may not be large, but the aggregate amount on all gift cards issued by a retailer can be huge. Sharper Image had about $19 million in unused gift cards when it filed for bankruptcy. At one point in Radio Shack’s bankruptcy case, there were $46 million in of unexpired outstanding gift cards.

Holders of gift cards either become priority status creditors (who get paid ahead of other unsecured creditors) or they become general unsecured creditors, not entitled to priority treatment. States’ attorneys general have become more aggressive in protecting the interests of gift card holders and now regularly appear in bankruptcy courts.

Retailers in bankruptcy often seek to limit the time in which gift card holders can redeem their cards. They may require the holders to make additional purchases in amounts exceeding the value of the gift card, or they may require the gift card to be fully redeemed at one time.

The treatment of gift cards is driven by the needs of the bankruptcy case – whether the debtor deems preservation of its brand reputation as critical to continuation of the business, whether the debtor believes that preservation of its brand reputation is critical to selling its intellectual property or whether the debtor just wants to achieve the best recovery for creditors without enabling too many dollars to “come off the top.”

A National Retail Federation study earlier this year found gift cards to be the most requested gift in America, a position they’ve held for eight years. Even if gift cards pose challenges regarding federal rules, varying state laws and bankruptcy proceedings, retailers need to be careful to avoid mistakes. Otherwise, an audit or government inquiry could be around the corner.

Kenneth A. Rosen is chair of Lowenstein Sandler's Bankruptcy, Financial Reorganization & Creditors' Rights Department. He focuses on Chapter 11 reorganization, out-of-court workouts, financial reorganization, and litigation.