Holders of Unredeemed Gift Cards Denied Bankpruptcy Priority

City Sports was a Boston-based athletic apparel and equipment retailer that ­operated primarily in urban areas, including Philadelphia. Before the company filed for bankruptcy on Oct. 5, 2015, it sold gift cards, which, critical to the court's analysis, did not expire. At the time of the filing, City Sports listed $1.4 million in unredeemed gift cards as general unsecured debt. After the company's going-out-of-business sale ended on Dec. 29, 2015, that amount ­decreased to $1.18 million.

On March 23, 2016, the Commonwealth of Massachusetts asked the court to assign the $1.18 million in unredeemed gift cards priority ­status — i.e., to repay card holders before City Sport's general unsecured creditors. Massachusetts sought priority status for the entire $1.18 million because the debtor could not determine which gift cards were purchased in the state or were otherwise held by state residents. Massachusetts specifically focused its argument under the provision within Section 507 that ­applies to “unsecured claims of ­individuals … arising from the deposit … of money in connection with the purchase, lease, or rental of property.” City Sports objected, arguing that the unredeemed gift cards should simply be treated as general ­unsecured debt.

At the outset of his analysis, Judge Kevin Gross highlighted a central tenet of the Bankruptcy Code — that similarly situated creditors should be treated the same. Exceptions do exist to this rule, however. For example, Section 507 of the Code grants certain designated classes of unsecured creditors priority status, ­meaning that they are repaid ahead of general unsecured claims. Because of this tension, Judge Gross observed that Section 507 must be construed “strictly and narrowly.”

To address Section 507's applicability, the court first focused on the statutory term “deposit,” which is not defined in the Code. Judge Gross therefore looked to case law and ­dictionary definitions and concluded that the term contemplates a “temporal relationship” ­between the payment of money and the occurrence of a future event such as payment of the entire purchase price. In this respect, Section 507's consumer-deposit provision “expressly applies to transactions requiring additional steps to reach completion.” Judge Gross held that the purchase of a City Sports gift card was “complete” at the time it is purchased — i.e., the purchaser gave City Sports money, and the company issued a gift card. Accordingly, in the court's opinion, “whether the consumer uses the gift card in a future transaction, or gives the card to another party and that party uses it in a future transaction, is beyond the scope of the inquiry.”

WW Warehouse

This conclusion departed from the Delaware Bankruptcy Court's 2004 decision in WW Warehouse. In that case, the court held that a gift card was a “deposit” under Section 507 because there was an additional step in the transaction after the initial purchase of the gift card — the holder's “ultimate purchase” of goods from the seller. The City Sports court was not persuaded. It observed that because City Sports gift cards did not expire, there could be a potentially unlimited period between the purchase of the gift card and the “ultimate purchase” of goods. In the absence of a “temporal relationship” ­between those events, Judge Gross determined that a City Sports gift card “transaction extends to receipt of the card and no further.” The City Sports court supported its position by analogy to cases denying priority status for products such as money orders and store credit.

Section 507

The judge also engaged in a searching analysis of Section 507's legislative history and determined that for two reasons, Congress did not intend for gift card holders to be covered by Section 507's consumer deposit provision. First, Congress discussed ­during Senate and House of Representatives hearings whether Section 507 should apply to gift card holders, but the final House report did not identify gift card holders as consumer groups to whom the statute would apply. Exclusion from the House report, according to the City Sports court, meant that Congress did not intend for Section 507 to apply to unredeemed gift cards. Second, Judge Gross distinguished the retail-bankruptcy case that prompted the enactment of Section 507's consumer ­deposit provision. In the bankruptcy case involving retailer W.T. Grant, consumers who purchased “Grant Scrips” — coupons for future store purchases — lost the money they used to purchase the scrips.

Judge Gross stated that although Grant Scrips appeared to be similar to gift cards, the legislative history highlighted that, unlike traditional gift cards, Grant Scrips were intended for “low-income” individuals and “contained a layaway component.” According to the court, the latter feature provided for a “temporal relationship” between ­purchasing the scrip and the future ­payment in full of the entire layaway amount.

Conclusion

The City Sports decision has arguably created a division of authority in the bankruptcy court for the District of Delaware, where many corporate bankruptcies are filed. Unless the U.S. Court of Appeals for the Third Circuit resolves this issue, debtors and holders of unredeemed gift cards (or, more likely, governmental entities pursuing claims on their behalf) will be able to point to supporting case law, but will also have to distinguish contradictory authority.

One unanswered question is the scope of City Sports decision. Given the court's focus on the required “temporal relationship” between the placement of a deposit and a future event needed to ­“complete” the transaction, would the purchase of a gift card that expired in one year be considered a “deposit”? Based on the state of the retail industry, it is all but certain other courts will be called upon to choose between the competing decisions in City Sports or WW Warehouse or find a way to harmonize what appears to be inconsistent results.

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Francis J. Lawall is a partner in the Philadelphia office of Pepper Hamilton. Francis A. Weber is an associate in the same office. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.

For some time now, the brick and mortar side of the retail industry has been in financial distress. In 2015 and 2016 alone, brand-name ­companies such as Sports Authority, RadioShack, Aéropostale, American Apparel, Eastern Mountain Sports and City Sports sought bankruptcy protection. A common question in these cases is how to treat holders of unredeemed gift cards. Are they near the back of the line with other general unsecured creditors, or are they entitled to “priority” payment status under the Bankruptcy Code? The Delaware Bankruptcy Court recently revisited this issue in In re City Sports, No. 15-12054, 2016 U.S. Dist. LEXIS 2884 (Bankr. D. Del. Aug. 4), and concluded that holders of unredeemed gift cards from now-defunct retailer City Sports were nothing more than general unsecured creditors.

The City Sports decision is significant not only because of its potential applicability to the wave of retail companies in or on the verge of bankruptcy, but also because it reaches a conclusion different from one issued in a 2004 decision from the same court, In re WW Warehouse, 313 B.R. 588, 592 (Bankr. D. Del. 2004).

Background

City Sports was a Boston-based athletic apparel and equipment retailer that ­operated primarily in urban areas, including Philadelphia. Before the company filed for bankruptcy on Oct. 5, 2015, it sold gift cards, which, critical to the court's analysis, did not expire. At the time of the filing, City Sports listed $1.4 million in unredeemed gift cards as general unsecured debt. After the company's going-out-of-business sale ended on Dec. 29, 2015, that amount ­decreased to $1.18 million.

On March 23, 2016, the Commonwealth of Massachusetts asked the court to assign the $1.18 million in unredeemed gift cards priority ­status — i.e., to repay card holders before City Sport's general unsecured creditors. Massachusetts sought priority status for the entire $1.18 million because the debtor could not determine which gift cards were purchased in the state or were otherwise held by state residents. Massachusetts specifically focused its argument under the provision within Section 507 that ­applies to “unsecured claims of ­individuals … arising from the deposit … of money in connection with the purchase, lease, or rental of property.” City Sports objected, arguing that the unredeemed gift cards should simply be treated as general ­unsecured debt.

At the outset of his analysis, Judge Kevin Gross highlighted a central tenet of the Bankruptcy Code — that similarly situated creditors should be treated the same. Exceptions do exist to this rule, however. For example, Section 507 of the Code grants certain designated classes of unsecured creditors priority status, ­meaning that they are repaid ahead of general unsecured claims. Because of this tension, Judge Gross observed that Section 507 must be construed “strictly and narrowly.”

To address Section 507's applicability, the court first focused on the statutory term “deposit,” which is not defined in the Code. Judge Gross therefore looked to case law and ­dictionary definitions and concluded that the term contemplates a “temporal relationship” ­between the payment of money and the occurrence of a future event such as payment of the entire purchase price. In this respect, Section 507's consumer-deposit provision “expressly applies to transactions requiring additional steps to reach completion.” Judge Gross held that the purchase of a City Sports gift card was “complete” at the time it is purchased — i.e., the purchaser gave City Sports money, and the company issued a gift card. Accordingly, in the court's opinion, “whether the consumer uses the gift card in a future transaction, or gives the card to another party and that party uses it in a future transaction, is beyond the scope of the inquiry.”

WW Warehouse

This conclusion departed from the Delaware Bankruptcy Court's 2004 decision in WW Warehouse. In that case, the court held that a gift card was a “deposit” under Section 507 because there was an additional step in the transaction after the initial purchase of the gift card — the holder's “ultimate purchase” of goods from the seller. The City Sports court was not persuaded. It observed that because City Sports gift cards did not expire, there could be a potentially unlimited period between the purchase of the gift card and the “ultimate purchase” of goods. In the absence of a “temporal relationship” ­between those events, Judge Gross determined that a City Sports gift card “transaction extends to receipt of the card and no further.” The City Sports court supported its position by analogy to cases denying priority status for products such as money orders and store credit.

Section 507

The judge also engaged in a searching analysis of Section 507's legislative history and determined that for two reasons, Congress did not intend for gift card holders to be covered by Section 507's consumer deposit provision. First, Congress discussed ­during Senate and House of Representatives hearings whether Section 507 should apply to gift card holders, but the final House report did not identify gift card holders as consumer groups to whom the statute would apply. Exclusion from the House report, according to the City Sports court, meant that Congress did not intend for Section 507 to apply to unredeemed gift cards. Second, Judge Gross distinguished the retail-bankruptcy case that prompted the enactment of Section 507's consumer ­deposit provision. In the bankruptcy case involving retailer W.T. Grant, consumers who purchased “Grant Scrips” — coupons for future store purchases — lost the money they used to purchase the scrips.

Judge Gross stated that although Grant Scrips appeared to be similar to gift cards, the legislative history highlighted that, unlike traditional gift cards, Grant Scrips were intended for “low-income” individuals and “contained a layaway component.” According to the court, the latter feature provided for a “temporal relationship” between ­purchasing the scrip and the future ­payment in full of the entire layaway amount.

Conclusion

The City Sports decision has arguably created a division of authority in the bankruptcy court for the District of Delaware, where many corporate bankruptcies are filed. Unless the U.S. Court of Appeals for the Third Circuit resolves this issue, debtors and holders of unredeemed gift cards (or, more likely, governmental entities pursuing claims on their behalf) will be able to point to supporting case law, but will also have to distinguish contradictory authority.

One unanswered question is the scope of City Sports decision. Given the court's focus on the required “temporal relationship” between the placement of a deposit and a future event needed to ­“complete” the transaction, would the purchase of a gift card that expired in one year be considered a “deposit”? Based on the state of the retail industry, it is all but certain other courts will be called upon to choose between the competing decisions in City Sports or WW Warehouse or find a way to harmonize what appears to be inconsistent results.

*****
Francis J. Lawall is a partner in the Philadelphia office of Pepper Hamilton. Francis A. Weber is an associate in the same office. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.