Decision clarifies standards for priority treatment under section 507(a)(7); important implications in retail bankruptcy cases for debtors, creditors - and consumers

Overview

In October 2015, City Sports, Inc. (and numerous affiliates) filed for chapter 11 protection in the United States Bankruptcy Court for the District of Delaware.[1] The Commonwealth of Massachusetts sought priority status under section 507(a)(7) of the Bankruptcy Code[2] for unredeemed, unexpired gift cards issued before the cases by the Debtors.[3] The Attorney General of the Commonwealth filed the claims on behalf of Massachusetts consumers, noting that under Massachusetts law, gift certificates are valid for a minimum of seven years and, if not marked with an expiration date, then are “redeemable in perpetuity”.[4] The Debtors opposed the Commonwealth’s claim, arguing that gift cards are not entitled to priority status under the Bankruptcy Code.

The Bankruptcy Court held that gift cards are not eligible for priority status and, instead, should properly be classified as general unsecured claims. This ruling should be noted by retailers operating under bankruptcy protection and creditors holding claims in retail bankruptcies, as well as consumers who purchased or received gift cards from stores presently in bankruptcy protection or otherwise in financial distress.[5]

Proving Priority Status

The Bankruptcy Court discussed the “shifting” burden of proving a claim in a bankruptcy case, noting that ultimately the burden is on the Commonwealth, as claimant. It explained the categories of claims entitled to priority in a bankruptcy case, emphasizing that the “burden is on the party seeking to claim priority status to prove that the claim qualifies for priority status.”

The Bankruptcy Court next discussed the plain language of section 507(a)(7), highlighting that the statute requires the basis of such a claim to be a “deposit” of “money” for good or services “that were not delivered or provided” in order to qualify for priority treatment. It found that the use of the term “deposit” indicates a “temporal relationship” must exist between when the consideration for the goods is paid and when the underlying “right to use or possess” such goods “is vested” in the person paying the consideration.

The Bankruptcy Court did not follow an earlier decision that gift cards qualify as a deposit[6], ruling instead that the purchase of a gift card does not encompass the requisite temporal component. In other words, because a customer pays for and receives a gift card simultaneously, no time passes between when the consideration is paid and when the property is delivered. Thus, payment for a gift card is not a deposit on property to be delivered in the future, but, rather, it is payment for the gift card itself. Whether the purchaser then chooses to use the gift card to buy goods or services (or to stuff it in a stocking for someone else) is a separate decision and a new transaction.

The Bankruptcy Court found previous cases denying priority to money orders and store credits[7] to support its conclusion that payment for gift cards does not meet the definition of a “deposit”, and therefore gift card claimants cannot be afforded priority status under section 507(a)(7).

Legislative History

Before concluding its analysis, the Bankruptcy Court examined the legislative history of section 507(a)(7) to support its decision to break from the holding in WW Warehouse. It found that “Congress likely did not intend to protect gift card consumers with section 507(a)(7).” Why Congress made such a decision is not clear, but the Bankruptcy Court noted that the legislative record seems to indicate that one intent of Section 507(a)(7) was to protect lower-income consumers who often need to purchase goods or services using a deposit (e.g., on an installment or “lay-away” basis). Therefore, the Bankruptcy Court posited that Congress may have simply decided that the “plight of gift card holders” did not merit priority treatment under the Bankruptcy Code.

Conclusion

The Bankruptcy Court sustained the Debtors’ objection to the Commonwealth’s claim, ruling that gift cards were misclassified as priority unsecured claims, and instead should be treated as general unsecured claims.[8] The Bankruptcy Court noted that this does not mean that holders of gift cards would be precluded from any recoveries, but simply that such claimants would have to wait in line with other general unsecured claimants.[9] This decision breaks from previously established Delaware law regarding the treatment of gift cards in the context of a bankruptcy, and therefore should be carefully considered by retailers operating under bankruptcy protection, creditors holding claims against retail companies, and everyday customers who own gift cards from stores in bankruptcy protection or otherwise in financial distress.