When gift-card promises go unfulfilled

As the holiday gift-giving season nears, sensitive types claim nothing says, "I made no effort" like the ubiquitous gift card.

It's an assertion most Americans ignore: 79 percent of us have given a gift card for Christmas within the past five years, says Britt Beemer, chairman of America's Research Group, a consumer-behavior research company.

But this holiday season, industry experts say gift cards should be very thoughtfully selected. With more companies shuttering their doors, consumers holding gift cards issued by a retailer that has filed for bankruptcy could find their balances suddenly reduced to zero.

And they'll have little recourse to fight the drain. When Sharper Image filed for bankruptcy in February, some $20 million in unredeemed funds remained from patron's prepaid gift cards.

But that's no reason to stop purchasing gift cards, these same experts say. With a little savvy, consumers can give the cards and spare loved ones the shock of finally finding the perfect gift, only to be rejected at the counter with an empty gift card.

Most Americans are unaware how little oversight regulates gift cards, Mr. Beemer says. According to a survey he conducted around the time of Sharper Image's bankruptcy filing, 14 percent of consumers said they never thought gift cards could lose value.

But gift cards can lose value, either through monthly maintenance fees, expiration dates, or when a company files for bankruptcy.

A lot of money is at stake, says Brian Riley, director of bank-card research for TowerGroup, a global financial services research firm in Needham, Mass. Mr. Riley estimates the 2008 prepaid gift card market is about $94 billion. And since 10 percent of gift cards are never redeemed in their entirety, some $9 billion in unused funds remain in retailers' coffers, TowerGroup reports.

The current economic crisis should also spur buyers to be more conscientious, says Jennifer Mathe, cofounder of Leverage, an online company which sells and trades gift cards.

"If the holiday season doesn't pan out [for retailers] … you're likely to see a higher increase in bankruptcy in the New Year," she says. "And I'm not familiar with any retailers who stopped gift-card sales before filing for bankruptcy."

Retailers face little regulation about what they must do with money they receive from selling gift cards. "When funds go in, they're booked to the general funds of the store," Riley says.

"Rapid consumer acceptance of the product during good economic times has created a fallback for merchants to use when their cash flow begins to dry up," Riley wrote in a May 2008 TowerGroup report. In an interview, Riley adds that this practice, called breakage, is legal and based on the assumption the funds on some cards will never be redeemed.

But shifting funds can leave coffers empty and gift card holders out of luck when a retailer files for bankruptcy.

The only legal recourse open to card holders in that situation is to file as an "unsecured creditor" with the bankruptcy court.

But analysts say it's usually not worth the effort. For many, the return would be pennies on the dollar.

"At the end of the day you are a little consumer, still in line with thousands of other consumers," and unsecured creditors often get repaid last – if funds are available, Riley says.

Rather than scramble to get money returned, it's better to purchase cards from a strong company, analysts say. But who has the time to research an organization's financial statements?

"I've bought them before and [even] I don't go to Moody's [a credit-rating service]," Mathe says.

Thankfully, prudent practices don't require an MBA. One clear option, Beemer says, is to buy cards from very stable retailers.

"You may be forced to pick companies like Wal-Mart or Target," he says. "But you know they aren't going anywhere, versus a store you may not know as well."

Another option is "open loop" gift cards that are tied to a bank rather than a store. In this case, it won't matter if your favorite retailer goes bankrupt. But open-loop cards often come with monthly maintenance fees, warns Beemer. "A bank card may be safer, but fees may make it the worst to buy" for those consumers who will let the cards languish, he says.

Mathe advocates a simple formula: "Giver: Purchase [the card] as close to the event as possible. Recipient: Go ahead and spend that gift card, and take advantage of post-holiday sales to get more bang for your buck."

Or, she says, purchase a gift card from Leverage, which provides consumers with gift-card insurance. Leverage sells gift cards for more than 200 retailers, one of which was Sharper Image, whose bankruptcy prompted their insurance policy.

"We asked ourselves, are they [card holders] holding on to a dead piece of plastic? This doesn't feel right. We've benefited from consumers giving money to us in exchange for a gift card. It seems intrinsically fair for us to absorb some of the risk," she says.

If a customer owns a Leverage gift card from a retailer that has declared bankruptcy, Leverage will transfer the balance to another store whose gift cards they sell.