Bankruptcy and Gift Cards Explained

What happens to gift cards when a company goes bankrupt? Can a company refuse to redeem outstanding gift cards during bankruptcy? Does it matter whether the company declared Chapter 11 or 7 bankruptcy? Is there federal or state law regarding bankruptcy and gift cards? All these questions are the subject of this article. 

Before answering the questions above, it is important to explain the difference between Chapter 11 and Chapter 7 bankruptcy. A company typically files for Chapter 11 bankruptcy protection when it wants to work with creditors to change the terms of its debt obligations and restructure its business in order to emerge from bankruptcy as healthy company. A Chapter 7 bankruptcy involves the liquidation of assets to pay creditors. When a firm files for a Chapter 7 bankruptcy, the company is going out of business and would typically close all stores. 

However, a company planning on liquidating can also file a Chapter 11 bankruptcy protection, as in the case of KB Toys Inc, which filed for Chapter 11 bankruptcy protection in December 2008 even though the company plans to liquidate its entire business and close all stores. A company would typically file a Chapter 11 to liquidate in order to gain more control as it sells off assets. Therefore, for this article, what is important is whether the bankruptcy is to reorganize or liquidate, rather than whether it is a Chapter 7 or 11. 

The decision to honor gift cards during bankruptcy, regardless of whether it’s a reorganization or liquidation is the sole decision of the company, with approval from the judge overseeing the bankruptcy. After the bankruptcy is filed with the court, the company will file what is called “first-day motions”, which seek approval from the judge on issues like how the company plans to pay its workers, including whether it plans to honor gift cards. Gift Card redemption requests are typically approved by the judge, although the judge may deny them for whatever reason. 

Therefore, when a company decides not to honor gift cards during bankruptcy, it is because they either decided not to petition the judge for approval to do so, or the request was denied by the judge. Generally, it is more of the former than the latter. Considering the fact that some companies go into bankruptcy with millions in outstanding gift card obligations, a company should expect consumer backlash and pressure from politicians if it decides not to honor millions in gift cards during bankruptcy. This happened to the Sharper Image when it initially decided not to honor about $20 million in gift card when it filed for bankruptcy liquidation in early 2008. After pressure from both consumers and a number of state Attorney Generals, the company relented and allowed gift card holders to redeem their gift cards if they purchased goods worth twice the value of their gift cards. 

Companies that file for bankruptcy reorganization have several incentives to redeem gift cards during the reorganization. First, the last thing a company planning to stay in business wants to do is upset current customers, and refusing to redeem gift cards is a sure way to do that. Second, gift card holders typically spend more than the gift card value. So redeeming gift cards during a tough time helps the company boast sales. Third, it prevents competitors from stealing customers. When The Sharper Image initially refused to honor gift cards during bankruptcy, competitor Brookstone saw and opportunity to gain more customers by offering Sharper Image gift card holders attractive discounts if they surrendered their gift cards to Brookstone. Finally, honoring gift cards during bankruptcy helps to project a “business as usual” image, which is what a company planning to stay in business should hope to project to its customers.  

Companies that file for bankruptcy liquidation have less of an incentive to redeem gift cards, since they don’t plan to stay in business. However, there are a number of reasons why it is a good idea to honor gift cards during liquidation. First, it is the right thing to do. Consumers purchase gift cards with the hope that they or their recipients will be able to redeem them during a reasonable timeframe. Refusing to honor gift cards breaks this trust and makes the gift card holders victims of unfair business practice. Second, buy honoring gift cards during the get-out-of-business sale, the merchant will be able to move inventory quickly since gift card holders typically spend as much as 20% more than the card value. This then becomes a win-win situation for both parties.