With consumers feeling pressure from the housing crisis and a tightening economy, retailers are facing a rough year. Lillian Vernon and The Sharper Image filed for bankruptcy protection in February, and Linens 'n Things Inc. filed May 2 for Chapter 11. Industry observers such as Dan Horne, associate professor of marketing at Providence College, expect the uptick in retail bankruptcies to continue.

 "The economy continues to suffer, and people are spending all their money on food and gas," Horne tells Prepaid Trends. "This isn't the last. You're going to see some [other retailers] go under."

 So where does that leave shoppers who are holding gift cards from big retailers that have filed for bankruptcy? Until recently, no one really cared.

 "Gift cards [and bankruptcy] have never been a big issue before because the volume wasn't there–unredeemed certificates would have been a small, insignificant number 10 years ago," Horne explains. "But now gift cards can be 2, 3, 4, even 10% of sales. Once the dollars get big enough, people start fighting over it, and it becomes newsworthy."

 Indeed, The Sharper Image found itself the subject of negative publicity when the retailer initially told the bankruptcy court it did not intend to honor outstanding gift cards and certificates valued at $42.6 million, according to Consumer Reports. The Sharper Image did not return messages seeking comment.

 Brookstone Inc., a savvy competitor specializing in high-end gifts and based in Merrimack, N.H., sensed an opportunity and quickly announced in late February that it would honor Sharper Image gift cards by offering a one-time, 25% discount to shoppers who surrendered the cards at any Brookstone store. On March 28, Brookstone stated in a press release that it would continue accepting the Sharper Image cards.

 Smarting from the bad PR and potential loss of market share, The Sharper Image changed course and asked the bankruptcy judge to allow the company to redeem outstanding gift cards, with the condition that cardholders redeem the entire amount of their cards and buy merchandise costing double the amount of the gift card balance, the company said in a press release in early March.

 "We have worked very hard to address the concerns of our customers, and to dispel rumors in the media that Sharper Image's gift cards are worthless," announced CEO Robert Conway in a March 7 press release, just 10 days after Brookstone made its offer.

 In contrast, Linens 'n Things, which is based in Clifton, N.J., declared from the start it would honor all gift cards, according to a May 5 press release.

 Linens 'n Things' policy did not result from lessons learned from Sharper Image's faux pas but instead arose from the different financial problems the companies face, says Brian Riley, senior analyst for the TowerGroup Inc.'s bankcards practice. TowerGroup, a MasterCard Worldwide research arm, is based in Needham, Mass.

 "Sharper Image was a company that fell to floundering retail sales; Linens 'n Things was strapped with debt from a buyout," Riley says in an e-mail message to Prepaid Trends. "It's not particularly true that one company did more than another. One had the capacity to do something, and another did not."

 Retail chains that file under Chapter 11 reorganization intend to re-emerge from bankruptcy or to sell their operations to the highest bidder, says Claudia Springer, managing partner at Reed Smith LLP's Philadelphia law office and an expert in bankruptcy law. Because companies that file for Chapter 11 protection plan to stay in business, the public usually takes it for granted the company will continue to redeem gift cards to maintain customer loyalty and to protect the image of the brand, Springer says.

 The Sharper Image case is the first she can remember where there has been a question as to whether the company would honor the cards during reorganization. "It's not necessarily a decision being made by the company," she tells Prepaid Trends.

 Once bankruptcy proceedings have begun, the decision of whether to honor the cards rests with creditors more than with company management, Springer says. Tightening credit markets may cause some lenders to put pressure on retailers who otherwise would not think twice about honoring outstanding cards, she says. Nothing  is in place to stop the company from using funds in gift card accounts to pay creditors, Springer and Horne both note.

 "We are getting a bit of a change here," Springer says. "It depends on how optimistic the lender is that the organization can get out of Chapter 11."

 "Gift cards are essentially IOUs, so somebody has to pay for the inventory going out," she says. "If they're not willing to lend you the money sufficient to purchase enough inventory to honor your gift cards and replenish inventory levels once the cards are redeemed, then how can you conduct your business? That's probably what happened with Sharper Image."

 Gift card buyers have few protections if a bankrupt retailer cannot honor the card, Springer says. The California attorney general's office tried to prevent Sharper Image from requiring customers to spend extra to redeem the cards, but the Alameda County Superior Court stayed the action until the outcome of bankruptcy proceedings.

Consumers who recently bought gift cards with a credit card could dispute the charge with their credit card company and try to recover the value that way, Springer says.

 Because gift cards have emerged so recently as a major source of income, legal precedent regarding what to do with the cards when a retail chain files for bankruptcy is taking shape on a case-by-case basis.  

 The biggest concern to the gift card industry and consumers alike is what would happen if a big retail chain files for Chapter 7 liquidation and shuts its doors for good. In such circumstances, the company would have no incentive to honor gift cards. That could reduce consumer confidence in the prepaid card industry, observers agree.

 "It would reflect very poorly on everybody else," Horne tells Prepaid Trends. "It could have a ripple effect throughout the industry."

 TowerGroup's Riley says many consumers do not differentiate between competing cards.

 "When people see plastic, they believe a card-is-a-card-is-a-card," he tells Prepaid Trends in an e-mail message. "These were never intended to be savings products, and they lack the protections one assumes they have with their debit or credit card."

 How should gift cardholders avoid the perils of bankrupt retailers? Horne, Springer, and Riley agree: Spend that card as fast as you can!

By Adam Saytanides

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