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New gift card risks Store and bank failures can leave you with worthless plastic

Gift cards might seem like the perfect holiday present—they're easy to buy, and many people are happy to get them. Unless, of course, you've been left holding cards from Sharper Image, Bombay Company, Levitz, company-owned Bennigan's restaurants, and other failed or financially ailing businesses.

Though we're not fans of gift cards, in the past we've suggested that if you're going to buy one you should choose a card issued by a retailer, because such cards are generally free of the headaches found with bank-issued gift cards. Bank cards can be redeemed at most stores that accept the major credit-card logo that appears on the card, but they're often saddled with fees, expiration dates, and other gotchas. And retail cards have been improving. For example, Macy's and Bloomingdale's eliminated the two-year expiration date on their cards starting Feb. 3, 2008.

But with worsening economic conditions, consumers should think twice about retailer cards. "Even the store cards aren't as good a deal as you'd think because of the danger of bankruptcy," says Evan Johnson, administrator at Maryland's Montgomery County Office of Consumer Protection.

Hard-to-spend cards

Retailer bankruptcy filings over the past year have left holders of millions of dollars in gift cards with no apparent way to spend that money. Some bankrupt retailers have obtained court approval to continue honoring their cards, certificates, and other customer obligations. But even then, the closing of a chain's poorest-performing stores—as often happens during bankruptcy reorganization—might make it difficult for some consumers to redeem their gift cards, especially if the retailer doesn't accept cards on its Web site.

At the other extreme, some retailers have shut down altogether, advising cardholders to make a claim in bankruptcy court, where they'll have to line up with other creditors for a piece of the defunct company. In the Sharper Image case, an estimated $20 million in gift cards and certificates were unredeemed when the retailer filed for bankruptcy reorganization last February.

No protections for consumers

Sharper Image cardholders got a series of conflicting messages within months of the company's bankruptcy filing. First they were told that the retailer was no longer accepting its cards, then that it would accept the cards if customers spent twice the cards' value, and finally that it was closing its stores altogether.

On Web forums, you can still find messages from frustrated people holding hundreds of dollars in Sharper Image gift cards and certificates. Some cards were issued in connection with merchandise returns, in-store marketing events, or as promotional items by financial institutions or other third parties.

All of this is happening because card issuers typically don't take the measures necessary to protect gift-card proceeds in case of a business failure. Retail companies, for example, could place revenue from the sale of gift cards into special accounts where, protected from bankruptcy proceedings, it could be used to benefit cardholders, says Henry Sommer, a Philadelphia attorney and bankruptcy expert.

Instead, many retailers simply add the money to their general funds, maintaining no reserve to make good on the cards, as home goods retailer Linens 'n Things acknowledged in its bankruptcy filing. As a result, when a company seeks bankruptcy protection, gift-card proceeds become part of its assets, and claims by secured creditors come ahead of those filed by gift-card holders and other so-called unsecured creditors.

Looking for trouble signs

Because of the risk, it's wise to avoid buying cards from financially distressed retailers. But determining which companies are in trouble can be difficult.

For example, Sharper Image was selling gift cards right up to the day it filed for bankruptcy protection, when it stopped accepting its cards, says Brian Riley, director of bank-card research for the Tower Group, a Massachusetts-based research and advisory firm for the financial-services industry. And the Web sites of some bankrupt retailers we recently checked made no mention of the stores' precarious financial position, at least not on their home or gift-card sales pages. Gift cards sold after a bankruptcy filing are generally safer than prebankruptcy sales, but there's no guarantee that those newer cards will be honored, Sommer says.

One example is Linens 'n Things, which continued to sell its gift cards from May, when it filed for bankruptcy reorganization, to Oct. 14, three days before it was scheduled to begin its going-out-of-business sales at its remaining 371 stores. The consortium of companies conducting the liquidation said that it would accept Linens 'n Things gift cards and merchandise certificates throughout the going-out-of-business sales, which were expected to continue for 11 weeks.

Recognizing the risks associated with business failures and gift cards, California and Washington passed laws to protect gift-card holders during bankruptcy proceedings. But California's efforts to enforce its statute in the Sharper Image case were unsuccessful in state and federal courts. It's likely that both states' laws will need to be rewritten before they will provide any protection for consumers.

Bank cards also at risk

With the U.S. economy on shaky footing, retailers are not the only companies at risk of going under. More than 20 federally insured banks and credit unions had failed this year as of early October. As with retailers, banks and credit unions could place their prepaid gift-card revenue into custodial accounts, allowing cardholders to be covered by federal deposit insurance. But we didn't find many that actually do. (The only exceptions were some bank-issued payroll and other reloadable prepaid cards that used special accounting.)

In fact, the terms and conditions on some bank and credit-union Web sites warn consumers that balances on gift cards are not covered by federal insurance. The oddest statement comes from Washington Mutual, which says that its gift cards were not FDIC-insured "unless the FDIC determines otherwise." WaMu was recently taken over by federal banking regulators, and its bank assets were sold to JP Morgan Chase.

ING Direct, which took over NetBank's deposit accounts in September 2007, says it didn't honor that bank's gift cards, some of which were awarded as part of a new-account bonus program. ING says it's unlikely anyone is honoring those cards.

And don't count on MasterCard or Visa to come to the rescue. Their zero-liability policies regarding gift cards don't protect consumers if the card issuer fails. "In general, MasterCard recommends that banks make sure their programs are structured in such a way that they are covered by FDIC insurance," says Tristan Jordan, a MasterCard spokesman.

Adding to the problem is that federal insurance rules for gift cards and other stored-value cards haven't kept up with the times. The FDIC has been trying to correct this for years. Its last proposed rule changes have been languishing on the drawing board since they were first published in the Federal Register in 2005.

The only recourse for holders of a gift card issued by a failed bank or credit union seems to be joining the institution's other creditors in competing for any remaining assets. That group would include uninsured depositors and, paradoxically, the federal insurance agencies themselves.

The weaknesses of retail and bank gift cards could end up ensnaring additional cardholders as the poor economy and bad mortgage-lending practices take their toll. The FDIC said it had 117 banks and thrifts on its "problem list" for the second quarter of 2008, up from 90 the previous quarter.

Safeguards sought

Consumer groups including Consumers Union, the nonprofit publisher of Consumer Reports, have asked the FDIC to ensure that gift-card proceeds held in banks—whether for the bank itself or a retailer—are insured for every cardholder up to the federal limit. They've also asked the Federal Trade Commission to require retailers to set aside gift-card proceeds and have developed model state legislation that would impose the same requirements.

Consumer organizations also want the FTC to develop bankruptcy-reporting requirements for retailers, with the aim of posting a list of bankrupt retailers that gift-card buyers and others could consult. The proposal would also ban supermarkets and other third parties from selling gift cards from bankrupt retailers.

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