Just in Time for The Holidays

After many wonderful family dinners and football games across America have come to an end, consumers begin to turn their attention to what really has become the number one sport in the country; shopping.

A survey conducted by the National Retail Federation predicted that over 138 million consumers planned to shop over the Thanksgiving Holiday weekend and in fact, the actual number of shoppers who hit the stores exceeded the prediction reaching 247 million, this represents a 9 percent increase over last year. Online sales on Black Friday were up 26 percent and for the first time exceeded $1 billion.¹ It begs the question - what are most folks primarily focused on purchasing?  Retailers across the country have placed huge bets on wooing customers to their storefronts or websites, but one item that is a certain purchase, for over 68 percent of all shoppers, is at least one gift card. Gift Card sales this year are expected to peak at $130 billion, a 6 percent increase over the prior year and, except for the 2008-09 recession period, this increase is in line with the growth experienced in gift card sales over the past 20 years.²Consequently, for almost a decade, gift cards have remained the number one requested holiday gift.

For retailers, gift card sales provide multiple advantages over traditional merchandise sales. The obvious advantage is the increased revenue and the immediate cash flow. Less obvious is the increased brand awareness, customer loyalty and limitless website access regardless of storefront hours. Less publicized is the profitability that results from the breakage, or the unredeemed portion of gift card sales, which if properly structured, can be retained by the retailer. This is the very issue that is at the center of a landmark whistleblower case brought by the State of Delaware against 30 major retailers together with the National Retail Federation. The complaint alleges that the defendants violated Delaware’s False Claims and Reporting Act (“DFCRA”) by failing to report unredeemed gift card balances to the State pursuant to its escheat law. However, the real issue in this case is Breakage and who gets to keep it, the retailer or the State of Delaware.

Court’s Decision and Findings
Just before the Thanksgiving holiday, the Delaware Superior Court issued a major decision on motions by the defendants (retailers) to dismiss the case.³ The judge denied the motions to dismiss for most of the defendants and granted the motions of four defendants, continuing the case on the merits against the majority of defendants named in the original suit.

The Delaware Court held that except in four specific instances, the Delaware defendants did not meet their burden of proof to have the case dismissed before a full hearing on the merits. Specifically, the four Defendants excused from the action include:

• Three defendants that were able to prove the entities, which entered into agreements with Card Compliant, were not incorporated in Delaware (hence, Delaware lacked jurisdiction over these defendants).

• One defendant was previously audited by Delaware and hence raising the issue again in this forum would be tantamount to re-litigating what was already the subject of the audit; and

• A fourth defendant, the National Restaurant Association, which may have endorsed the Card Compliant arrangement to its restaurant members, but was not a direct participant in any issuance of gift cards. 

The motions to dismiss were denied for all remaining defendants.

It is important to note that the Court’s decision to not dismiss the case as to the majority of the defendants is not in of itself surprising, as the burden of proof required to sustain such motions is generally quite high. However, what is surprising is the strong tone the judge took in finding that various documents referenced in the complaint, coupled with the defendants alleged failure to file escheat reports and the State’s detailed allegations of a specific scheme, create a “strong inference that false reports (including not filing reports) were submitted to the state” (emphasis added). The judge also concluded that the “Delaware retailers were the relevant debtors for escheat purposes”, foreshadowing that the court did not accept the defendant’s argument that the obligation to satisfy the gift card liability and hence the underlying liability for the unredeemed gift cards, was transferred from the retailers to their customers. This preliminary finding, though disappointing to the retailers, is not dispositive of the Court’s ultimate ruling on the merits.

The Court further found that with respect to corporations that are not C corporations, the second priority rule discussed below in the background section of this document, is to be interpreted based on the state of formation of the corporation and not the principal place of business criterion. This is yet another setback in the arguments fostered by the defendants to erode Delaware’s jurisdictional claims in this complaint.

Take-Aways
Regardless of the ultimate decision in this case, the thousands of retailers that issue gift cards, whether they are among the hundreds that entered into an arrangement with a third party such as Card Compliant or alternatively formed a similar internal captive structure to accomplish a similar purpose, should carefully review their gift card program to ensure that they meet the requirements to negate any presumption of abandonment under states’ escheat laws. It is quite clear that such arrangements will continue to be closely scrutinized by Delaware, as well as other jurisdictions and their multi-state auditors.

On a positive note, retailers that issue gift cards should not be dissuaded from continuing to plan and utilizing means, such as captive gift card companies, to minimize their escheat liability. What companies should be cognizant of, as this Qui-Tam case and prior audits of internally formed entities has revealed, is that the details matter and ensuring that proper care is exercised to demonstrate that economic substance and proper form is addressed in both the formation and operation of any gift card planning initiative is of critical importance to prevent any unused gift card balances (breakage) from falling within the various state escheat provisions.

In particular, gift card issuers that fall within any of the following situations should pay close attention to this case:

1. Card issuers that are not part of the Qui-Tam case, but entered into similar arrangements with Card Compliant or other similar third party providers should closely scrutinize their agreements and existing arrangements. The case provides some important insight on how NOT to structure such agreements;

2. Card issuers that have already formed captive gift card entities similarly can benefit from a comprehensive review of the structure, form and operation of their gift card activities in order to refute any challenge by Delaware or other states. This may include, possibly entering into Voluntary Disclosure Agreements with one or more states to secure favorable treatment in the form of limiting any “lookback period”, and avoid any risk of interest or penalties being imposed if examined; and

3. Those retailers that have not entered into any gift card planning should give thought to whether or not opportunities do exist to reduce or minimize future liabilities; and

4. All retailers that issue gift cards and either have or are considering offering a loyalty or rewards program, should review their current practices, as the combination a gift card and rewards or loyalty program can significantly alter the unclaimed property implications to one or both programs.

Background
At issue is application of Delaware’s unclaimed property laws to  a series of major retailers that entered into an arrangement with a third party provider (Card Compliant) with the intention of avoiding remittance of any unused balances that may remain on the gift cards as unclaimed property pursuant to Delaware’s unclaimed property provisions. Delaware is among one of over 30 states whose escheat provisions require the remittance of unused (unredeemed) balances remaining on gift cards if the card balance is not utilized within a specified dormancy period (three to five year period4). For over two decades, Delaware has been considered the most aggressive state in its efforts to secure unclaimed property collections as a major source of revenue. The reason stems from the application of a triage of Supreme Court decisions dating back over 50 years governing which state has jurisdiction over unclaimed property that is deemed held by corporations or other legal entities (“holders”).⁵

Under these decisions, the state of the property owner’s last known address has a first priority claim (first priority right) over any intangible property that goes unclaimed after a statutory period time set forth in each jurisdiction’s unclaimed property rules.⁶ If, however, the address of the property owner is unknown, as is typically the case for retailers who sell millions of gift cards either through the internet or in brick and mortar store locations, the state of corporate domicile (“state of incorporation”) of the entity holding the unclaimed property is the jurisdiction which is deemed to have a secondary priority claim (second priority right) over any unclaimed property. 

Despite being the second smallest state in the country, Delaware is the legal home to over 800,000 public and private entities, providing a significant base over which Delaware can assert its jurisdiction with respect to unclaimed property collections. In addition, the State has been quite successful, as over one-third of its annual budget is realized through aggressive (some would say unconstitutional) audit policies and practices. Many of these practices are now being challenged in the Federal court system and a ruling in one such major case is expected within the next several months.⁷

On a different, but parallel track, the rationale for Delaware’s initiating this case pursuant to the DFCRA is to secure not only the revenue the unused portion of gift cards, but also to collect treble damages of the amount deemed owned in interest and penalties for the defendants alleged failure to remit unredeemed gift card balances accrued over an approximate 15 year period. If successful, the treble damage portion under the False Claims Act would likely be more than the amount of any underlying liability deemed due by the retailers for any unreported gift card balance deemed to be unclaimed property.

In the lawsuit, Delaware claims that the retailers entered into a scheme with Card Compliant (“Delaware Defendants”) to fraudulently withhold revenue owed to the State in the form of unredeemed gift card balances. Specifically, the State argues that the Delaware Defendants entered into a “phony relationship” with Card Compliant whereby the gift cards redeemable for products and services and sold by the Delaware Defendants were represented as “issued” by Ohio and Florida corporations, two states, which coincidentally exempt the value of unredeemed gift cards from being remitted as unclaimed property.

Earlier, the Delaware Defendants were rebuffed in an initial attempt to have the Qui-Tam case heard in Federal versus the Delaware court and in this most recent decision, were similarly shot down by the Delaware Superior Court on their request to have the case dismissed. Among the arguments raised for dismissal by the defendants was that:

1. Under the various Card Services Agreements (“CSA”) entered into with Card Compliant the retailers are not the relevant debtors;

2. The Complaint fails to rise to the level of creating a “false record or statement;” and

3. The Delaware Defendants did not “knowingly” violate Delaware’s False Claims Act.

Regardless of the outcome of this case, Delaware and other states will likely continue to scrutinize not only arrangements with third party providers, but also any gift card issuer that may have formed a captive gift card entity to accomplish a similar result of not having to remit as unclaimed property the unused portion of gift cards. 

We encourage all gift card issuers as well as those who are contemplating either entering into a gift card, rewards or loyalty program to review carefully the possible alternatives and options in structuring their arrangements. Doing so could make a substantial difference not only in helping to drive customer loyalty, revenue and bottom line growth, but also will secure these savings in event of a future challenge from Delaware, other states and their third party auditors.

For more information or questions we encourage you to reach out to either Sonia Walwyn at (312) 697-4664 email [email protected] or Robert Peters at (312) 697-4924, email [email protected]. 

^1.Survey conducted by NRF at https://nrf.com/resources/holiday-headquarters
^2.Bain & Company, First Data, National Retail Federation, Tower Group, Venture Beat
^3.6 Del. C. § 1201 (2009), 12 Del. C. §§ 1199, 1201.
^4.The rules vary considerably among states regarding the inclusion of unredeemed gift cards in the definition of unclaimed or abandoned property. A large majority of states include unredeemed gift cards in the definition of unclaimed property if certain conditions are not satisfied including absence of an expiration date as well as no fees being imposed if the card goes unused for an extended period. Some states include certain forms of cards in the definition of unclaimed property including “open loop” cards (cards usable at multiple retailers), while others only treat closed loop cards (usable at a single retailer’s location(s)) in the definition of unclaimed property. Colorado exempts gift certificates, but not gift cards from its definition of reportable property.
^5.See Texas v. New Jersey, 379 674; Pennsylvania v. New York, 407 U.S. 206; Delaware v. New York, 507 U.S.  490.
^6.Unredeemed gift card/certificates, if included in the definition of unclaimed property, typically are reportable after the expiration of either 3 or 5 years of inactivity.
^7.See related article on Temple Inland v. Thomas J. Cook as Sec. of Finance State of Delaware at http://www.duffandphelps.com/expertise/publications/Pages/BlogEntryDetail.aspx?itemid=22&list=blogs