One small mistake with prepaid services can cost businesses millions

In the new “on demand” economy, subscription-based revenue models, or subscription plans, have grown in popularity. Think of Netflix, Dollar Shave Club, Blue Apron, and what feels like hundreds of monthly “boxes” delivering everything from clothing, to vinyl records, to wine. But not all subscription plans are created equally under the law. Businesses also are increasingly offering their customers the option to buy packages—for instance, a pack of 5 classes at your local gym.

Sounds innocent enough, right? Maybe not. Entrepreneurs should consult with a business attorney before proceeding down this path.

Warning for subscription businesses

Potential risks lies in the “Credit Card Accountability Responsibility and Disclosure Act,” i.e., the “CARD” Act. This  was passed in 2009 to limit abuse of consumers by credit card companies and banks. The CARD Act sets new laws on things like credit cards, but also gift certificates.

Congress took action on a bi-partisan basis (almost hard to believe) to stop merchants from selling gift cards that quickly expired, viewable only in  fine print. People expect that they will be able to redeem the full value of gift cards—not that they will expire in short order or be subject to “management” fees. The law prohibits offering any “gift certificate, store gift card, or general-use prepaid card” with an expiration date of less than five years.

Lessons for selling with an expiration date

The CARD Act provides a compelling case study into the need for every small business owner to hire a good business law attorney. Compare two recent cases of fitness companies who sold class packs to customers and faced lawsuits over alleged violations of the CARD Act: SoulCycle, a nationwide operation of indoor “spin” cycling studios, and CorePower Yoga, a yoga studio chain.

SoulCycle sold passes for spin classes that expired between one to 12 months after purchase. Last year, SoulCycle paid out as much as $9.2 million in a class-action lawsuit due to the expiration date.

By comparison, CorePower Yoga sold prepaid yoga classes in packs of five, ten, and 20 that expired within six months. CorePower Yoga successfully defended an attempted class action—and the case was dismissed early in the litigation.

The court decisions are not necessarily inconsistent. The differences in outcomes turned on a minor difference in how the two merchants structured their class passes.

The class passes offered by both companies lie somewhat in a legal gray area. On the one hand, the CARD Act clearly would apply to a gift certificate for $100 to your local gym. On the other, the law clearly would not apply to a $100 monthly gym membership (after all, how could it? The monthly nature of the membership naturally expires before 5 years). But what about the sale of a $100 card good for 5 workouts to the gym? That is, prepaid passes that can be redeemed for a specific number of exercise sessions.

By way of background, and for the legal geeks out there, the CARD Act defines “gift certificate” as  “an electronic promise that is: (i) redeemable at a single merchant or an affiliated group of merchants that share the same name, mark, or logo; (ii) issue in a specified amount that may not be increased or reloaded; (iii) purchased on a prepaid basis in exchange for payment; and (iv) honored upon presentation by such single merchant or affiliated group of merchants for goods or services.” Both cases turned on the interpretation of “a specified amount.”

Subscription plans gone bad

Here’s the rub: SoulCycle made a $9.2 million mistake. The fatal flaw was that the passes for the spin classes too closely tracked a cash value. The plaintiff in the case successfully argued that the certificates were issued in a specified amount—that is, the “series certificates” (the Plaintiff’s term of art for the prepaid spin cards) could be used to purchase classes up to the amount specified on the certificate.

SoulCycle classes differed in prices depending on the geographic market. So, for example, SoulCycle spin class in San Francisco cost $30, while the price increased to $34 in New York and up to (a whopping) $40 for the Hamptons. If a customer purchased a series certificate that can be used to purchase classes value at $30, the series certificate issued by SoulCycle displayed as “SOUL30.” (For a $34 pass, the series certificate was “SOUL34”.) While a “SOUL30” pass could be used to reserve a bike for a spin class in San Francisco, it could not be used to reserve a bike in not New York. But a “SOUL34” pass could be used in both locations.

The court found that the “SOUL30” pass looked less like a prepaid spin class (not covered by the CARD Act) and more like a $30 gift card that could be applied toward the purchase of a spin class (covered by the CARD Act). The cash equivalent value of the class passes was clearly displayed when purchased by the consumer—that is, if a customer purchased a “series certificate” that can be used to purchase classes valued at $30, the series certificate was displayed as “SOUL30.”

The small change that can lead to millions in liability

The federal guidance accompanying the CARD Act provides two helpful illustrations. First, not covered by the law were gift cards that could be redeemed “for a specific good or service, or ‘experience,’ such as a spa treatment, hotel stay, or airline flight.” By comparison, the law does cover gift certificates  that “can be applied toward the purchase of a specific good or service, such as a certificate or card redeemable for a spa treatment up to $50.”

As the court wrote, SoulCycle’s “sale of classes are tethered to a specific monetary value of the class being purchased” and in this way the “SOUL30” and “SOUL34” passes more closely resemble a “certificate redeemable for a spa treatment up to $50” rather than merely a “spa treatment.” This was enough for the court to deny SoulCycle’s motion to dismiss.

CorePower Yoga structured their gift certificates slightly differently—i.e., the passes to yoga classes were not tied to any specified dollar amount. Theoretically, after the sale of the passes, the yoga studio could increase the price of individual yoga sessions, and the class passes would still permit entry to the number of yoga classes purchased.

The judge in the CorePower Yoga case, in rejecting plaintiff’s claims, noted the “absurd result” that would follow from plaintiff’s proposed interpretation of the law, as a violation of the CARD Act could result from any “time limits on admission passes, codes, vouches, or tickets, including time restrictions on monthly passes to a parking garage, admission passes to theme parks, physical training packages, music lessons, and bus passes good for a certain number of rides.” The court found, “It would be absurd to determine that these prepaid, time-limited goods and services are unlawful because they contain expiration dates or temporal restrictions.”

The key takeaway was that the federal CARD Act applies to gift cards and other certificates that are linked closely to a specified cash dollar amount. North Carolina law also includes additional restrictions on gift certificates not covered here.

The case study of these two cases show the pitfalls of not carefully planning your company’s operations in close consultation with a business attorney. Spengler & Agans can advise your business to help ensure your startup doesn’t become victim to the next $9.2 million class action suit. Spengler & Agans offers a flat-rate legal checkup for startups and business needing a broad, overall legal review of their business and business practices.

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