Merchant Bankruptcies Threaten Gift Card Growth

Stored-value gift cards present greater risks in an economic downturn as the cardholder could lose any money on the card if the retailer declares bankruptcy, according to a new report from TowerGroup.

For example, Linens ‘N Things, a retailer “teetering on the edge of bankruptcy,” has “holdings of $42 million in uncashed gift cards,” according to Senior Analyst Brian Riley.

The retailer Sharper Image kept selling its gift cards until the day it declared bankruptcy, Riley reports in “Charred Card: Private-Label Gift Cards Stumble in a Weak Economy.” In its bankruptcy filing Sharper Image claimed its cards had a total value of $62 million.

The economic downturn and resulting problems for retailers occurs as gift card spend is set to rise from $400 billion this year to $600 billion in 2010, according to TowerGroup. Riley predicts more retailers will enter bankruptcy and that will bring to the forefront the cardholder’s “status as an unsecured creditor,” Riley writes.

The gift cards that present the greater danger to cardholders are called closed-loop cards, and can be used at just one merchant or group of merchants. In contrast, open-loop cards typically carry the brand of a processing network like MasterCard or Visa, and can be used at virtually any merchant.

“Closed-loop programs depend on the success of a retail business and become vulnerable when sales volumes drop,” Riley reports.

The closed-loop gift card issuer has some leeway in its treatment of the unspent funds on a card, though it cannot record revenues from a sale until the cardholder uses it for some exchange of good or service, according to Riley.

The issuer can capture the unused card value by using an accounting technique called breakage, and shifting the card value after a certain time period from a liability account to an income account. The issuer has the authority to set the time period, from 24 months to no cut off date.

The issuer can claim the card won’t be used after this time period, and claim the card value. Riley reports that Home Depot claimed an unused value on its gift cards of $43 million in 2005, and that in 2007 Abercrombie & Fitch claimed $11.7 million and American Eagle claimed $13.1 million.

The bright side to this story is a business opportunity for open-loop card issuers. They should promote the financial strength of their product and build market share, Riley concludes.