It’s the thought that counts, right?
Despite the fact that gift cards have become the gift of choice for an ever growing number of consumers, such cards often go unused. Whether it is the well meaning but forgetful co-worker who gives a gift card for a butcher shop to a vegan colleague or merely Grandpa Joe who forgets about your thoughtful gift of a mall gift card, the simple truth is that many gift cards will never be redeemed.
Recent estimates suggest that anywhere from 6-10% of all gift card sales never result in redemption. The Chicago Daily Herald recently quoted data and estimates from research company CEB TowerGroup that an astonishing $1.7 billion of the $110 billion gift cards purchased in 2012 will go unused. NPR even reported in late 2011 (citing TowerGroup data) that $41 billion in gift cards have gone unredeemed since 2005.
Although the use of gift cards has become commonplace, most consumers (and likely many franchisors and franchisees as well) misunderstand what actually happens to the unused funds on those cards. Most assume the unused funds automatically become a windfall profit (the industry term is “breakage”) to the issuer of the cards. But that is not necessarily true. Instead, contrary to public perception, absent careful planning, neither the issuing franchisor nor the retailer/franchisee is likely to receive any breakage at all.
Gift cards would, at first blush, seem a perfect fit for large retail franchise systems. Ideally, gift cards can strengthen the franchised brand and identity, and encourage consumers to patronize units across the system. Further, the franchisor/issuer may use the gift card breakage to fund the program, or to otherwise support the brand and system. Unless properly designed, however, a gift card program may cause more grief than it is worth.
The Treasury Department’s regulations governing gift cards and loyalty programs (called Regulation E, 12 C.F.R. Part 205) became effective in August 2010. Under Regulation E, gift cards cannot expire for at least five years (with few exceptions). In addition, states have since passed similar gift card laws, some of which entirely prohibit expiration dates. Because gift cards cannot expire for at least five years, there should be, in theory, some reduction in breakage simply because consumers have more time to use the cards. Most clients tell me, however, that so far, the trend continues that if a gift card has not been redeemed after two or three years, there is almost no chance it will ever be redeemed, regardless of when the card expires.
More importantly, most states have unclaimed property laws (also known as escheat laws) that require issuers to transfer the funds on unredeemed cards to the state rather than to their own bottom line. Theoretically, the state holds the unclaimed funds with the intent of reuniting them with the rightful owner, but some states actually use escheated funds to ease budget deficits. (See e.g., Michael Smerconish, The Pulse: Don’t let those gift cards be a gift to retailers or the state, Philly.com, Jan. 6, 2012, http://articles.philly.com/2012-01-06/news/30598028_1_gift-cards-certificates-credit-card-accountability.) Either way, these escheat laws can potentially eliminate breakage entirely.
Because gift card expiration and escheat laws can reduce or even eliminate breakage, it has become increasingly difficult for gift card issuers (such as franchisors) to distribute breakage. Worse yet, significant liability looms for issuers who do so in violation of law. Thus, it is critically important for issuers, including franchisors, to design their gift card programs to ensure that, to the extent breakage exists, the issuer can retain and distribute it as desired. The following guidelines provide a roadmap for a franchisor’s consideration of gift card breakage.
Step 1- Establishing an Expiration Date Policy
At the outset, the issuer should consider whether to allow its gift cards to expire. This is an important decision, because if an issuer “breaks” a gift card that has not expired, there at least some possibility, however remote, that consumers will attempt to redeem the gift card at a later point. Note, this can happen in states that require escheat of unredeemed gift cards as well, as there are several states that classify gift cards as unredeemed property prior to expiration or before five years have passed. It is possible – though not yet clear – that Regulation E would consider breakage prior to expiration as a violation and/or would preempt such state escheat laws.
In deciding whether to establish an expiration policy, the issuer should consider a number of issues. First, the expiration policy must comply with Regulation E, which generally provides that no gift card may expire for at least five years from the date a consumer loads funds to the card, and that the card must properly disclose any expiration date. The penalties for violating these expiration or disclosure provisions can be severe, and the possibility of a class action challenging an issuer’s premature gift card expiration further warrants strict compliance with these basic rules.
Second, the expiration policy must comply with state gift card laws, which may vary substantially from state to state. For franchise systems with units in multiple states, this consideration may be particularly complex, because Regulation E expressly provides that it does not preempt any state law that is more protective of consumers. Thus, the franchisor must determine and then comply with the requirements of each state where it or its franchisees sell or accept gift cards for redemption. As a result, there may be situations where a gift card could expire in one state but not in the neighboring state. If there are franchised retailers on both sides of the state line, establishing an expiration date in either state could at least theoretically result in a violation and the possibility of legal challenge. Because of the complicated interaction between Regulation E and state gift card laws, determining whether and how to allow gift cards to expire can be a complex proposition for many franchisors.
Third, the franchisor issuer must determine whether there are other practical considerations that caution against expiration. For example, if the franchise agreement does not detail how breakage will be distributed, expiring gift cards may lead to disputes with the franchisees. Or, a franchisee may wish to alert consumers about impending expiration of branded gift cards or to run an “expired gift card forgiveness” promotion, in the hopes that consumers may remember their unused gift cards and make a return trip to redeem them, which may cause friction with the issuing franchisor. Or, if a franchisor has issued a number of outstanding gift cards prior to Regulation E’s enactment, and those gift cards do not contain an expiration date, there may be further questions about whether to expire the cards. Although unilaterally declaring these pre-existing cards as expired would not violate Regulation E, the gift card owners arguably could assert claims for breach of contract. And of course, for purposes of marketing and consumer goodwill, some franchise systems may simply decide to sell gift cards that never expire.
Step 2- Analyzing State Escheat Laws
Under generally accepted accounting principles, revenue from a gift card sale is not actually income until a consumer has redeemed the card or the seller declares the card as “unused.” Although the SEC permits a seller to declare a gift card as unused once it is reasonably likely no one will redeem the card, many states specifically legislate when a card constitutes abandoned property for the purposes of escheat laws and what the issuer must do with the unused funds. Thus, once a franchisor issuer has determined its expiration policy, it must next analyze whether there are state escheat laws that will affect the distribution of the unredeemed funds.
For smaller or localized franchise systems, the analysis of escheat laws often may be relatively simple. With few exceptions, where a franchise sells and accepts gift cards for redemption all within only one state, that state’s escheat law will be the only one it needs to consider.
For franchise systems with franchised retail outlets in multiple states, however, the determination of which state law (or laws) is applicable to its gift card program can be more difficult. Not only are there dozens of states with their own escheat laws that expressly apply to gift cards, but the very nature of gift card sales (initially sold to a customer who will likely give the card as a gift to a third party) will often render it impossible for the franchise to know where a gift card owner lives or where any particular unredeemed gift card is at any given time. In such circumstances, the escheat laws of at least two different states may apply.
Where at least two states have a claim to unredeemed gift cards, federal common law controls the priority of the states’ claims. In Texas v. New Jersey, 379 U.S. 674, 680-82 (1965), the Supreme Court established two “priority rules” to resolve any conflict regarding which state is entitled to intangible abandoned property such as unredeemed gift card funds. The first priority – called the “primary rule” – belongs to “the State of the last known address of the creditor, as shown by the debtor’s books and records.” Id. at 682. If the primary rule fails to resolve the conflict because there is no known address for the gift card owner (as is usually the case) or because the gift card owner’s address is in a state that does not escheat abandoned gift cards, then the “secondary rule” provides that the state where the debtor is incorporated triumphs unless another state proves it has superior rights. Id. Consequently, a franchise that (a) does not keep records reflecting the residence of the person/entity purchasing the gift card purchaser or owner, and (b) is incorporated in a state that does not escheat unredeemed gift cards will be able to convert the unused funds into breakage.
These priority rules essentially allow a savvy franchisor issuer to “game” the system and keep some of its gift card breakage. For example, many larger companies incorporated in states that escheat gift cards will incorporate a separate entity for issuing its gift cards in a state that does not escheat gift cards. The issuing entity then purposely fails to keep records reflecting the gift card purchaser/owner’s address, and once the gift card expires, the issuer may retain the breakage, creating pure profit on its balance sheet.
Of course, states will likely attempt to limit the ability to avoid escheat. For example, in 2010, New Jersey amended its unclaimed property laws to include a “place of purchase” presumption and required all retailers selling gift cards in New Jersey to maintain records of the purchaser’s last known address. In response, a number of gift card issuers challenged the law. The Third Circuit found that Texas v. New Jersey preempted the attempted alteration of the priority rules, but it upheld the record keeping requirements. New Jersey Retail Merchants Ass’n v. Sidamon-Eristoff, 669 F.3d 374, 392-98 (3rd Cir. 2012). In response, American Express went so far as to stop selling gift cards in New Jersey entirely to avoid the record-keeping requirements. For the time being, however, with careful planning, some franchises will continue to be able to avoid escheating unredeemed gift cards.
Step 3- Distribution of Breakage
Once an issuer determines it does not have to escheat the unused funds to the state, it can retain or distribute the breakage. If planned carefully, a franchisor may elect to use the program’s breakage to pay for the gift card program or to support the brand and system generally, such as through the purchase of advertising. Alternatively, the franchisor may elect to simply retain the breakage for its own account, or to distribute breakage directly to its franchisees.
Somewhat surprisingly, industry trends suggest that most franchisors have not expressly provided in their standard franchise agreement how they will distribute gift card breakage. Instead, most franchise agreements are either silent about breakage, or they contain only a general provision stating that the franchisee agrees to participate in the franchisor’s gift card program and the franchisor retains the right to account for and distribute all funds. In such cases, the franchisor’s operations manuals may address the issue, or there may be no controlling provision at all. On the other hand, some franchisors have separate gift card agreements with franchisees that specifically govern the terms of the gift card program, often in connection with the franchisor’s operation of a consumer loyalty program that incorporates the issuance of gift cards.
Best practices are far from established. However the breakage is ultimately divided, it is vital that the franchisor closely examine its breakage goals and applicable law before issuing gift cards. Not only could a mistake regarding its expiration policy or escheat laws result in significant legal liabilities, but it could also eliminate the possibility of ever receiving any breakage at all.