Consumer prepayments and insolvency: Is it fair to treat customers as “unsecured creditors”?

What happens when you buy something at a retailer? For most transactions, the answer is simple and straightforward — the retailer provides you with goods, and in exchange, you pay them with money. 

There might be the occasional issue with e-commerce deliveries being sent to wrong addresses or some other hiccup; but by and large, the understanding of what it means to buy something is widely shared. 

Yet in recent times, this relationship between businesses and their customers has come into the spotlight. 

In June 2022, crypto lender Celsius collapsed and during bankruptcy proceedings, customers were referred to as unsecured creditors. 

Crypto lending is not the only industry that has such a relationship with their customers, with investment platforms like StashAway and Syfe also classifying their customers as unsecured creditors. 

Closer to home, there was an outrage when local fitness studio X Fitness shut down without any warning last September. Customers who had prepaid for classes but were now unable to book such classes were furious, and a police investigation was launched. 

Apparently, it seems to be quite common for businesses to treat their customers as unsecured creditors. Since 2019, The Consumers Association of Singapore has received more than 20 complaints due to the sudden closure of gyms and fitness centres, involving more than S$16,000 in contract value.

So why do so many companies refer to customers as unsecured creditors, and is this business model a healthy one?

Why do businesses treat customers as unsecured creditors?

One reason why some businesses may refer to customers as unsecured creditors is that they may require the money to run their day-to-day operations. 

Gyms and fitness studios, for example, may sell packages in order to get some cash upfront to pay for their day-to-day operations. Essentially, prepayments may serve as a valuable tool at times to prop up revenue for businesses such as gyms.

Admittedly, the usage of these prepayments by businesses sometimes makes sense. After all, customers are paying for services, and are expected to make use of the services. Someone who pays for a package of say, 10 fitness classes is expected to attend these 10 classes, while the gym receives payment for these 10 classes.

Barring special circumstances, the customer will not see the money again, since it has been exchanged for the 10 classes. If this is the case, what businesses owe to their customers is not money, but services.

So when the prepayment occurs, the business is treating the customer as an unsecured creditor, to whom they owe an obligation of service, and which the customer is expected to claim in the future.

Lawyers have warned that if prepayments are protected by law and that these companies are unable to use these funds, some may not be able to continue operating, or may need to charge higher prices in order to deal with the inflexibility. 

What are the implications for us as consumers?

Consumers would be correct in assuming that being an unsecured creditor comes with plenty of downsides. 

For one, it means that you are one of the last to get paid last during a liquidation. Secured and preferential creditors get paid first, while unsecured creditors get paid last, before any remaining assets are distributed among business owners.

In other words, customers are at the high risk of not being able to receive compensation during a liquidation, if they receive any money at all. 

Liquidations can also become complicated when it comes to large companies. Companies like FTX have plenty of subsidiaries, located all over the world. With many now questioning Binance’s health, this may well be something to look out for. 

A former liquidator at an accounting firm told Vulcan Post that such liquidations can be extremely complicated. 

There is the UNCITRAL Model Law, which is intended to help guide countries in reforming their laws in international commercial arbitration, but each jurisdiction also has domestic laws that liquidators have to account for.

Most of the time, each subsidiary in a foreign jurisdiction is a separate legal entity in a group structure, and the company in Singapore may not necessarily be the controlling shareholder of overseas subsidiaries. 

Even if the local company was the majority shareholder, it does not necessarily mean that subsidiaries have to be liquidated as well — if a buyer can be found to take over the company’s shareholding, then some money can be recovered.

Needless to say, these procedures can take months, and consumers — as unsecured creditors — will have to wait out the lengthy processes only to be paid at the very end, if at all.

Such a process puts consumers at a significant disadvantage, especially since many are not warned that they are put in such a position in the first place. 

Why should consumers foot the bill?

But why should consumers even be considered unsecured creditors in the first place?

Businesses may have a need for cash and thus turn to customer’s prepayments or deposits, but is this really fair for customers, especially in the cases when businesses fail and customers get paid last?

Customers pay first and expect services later, but they are customers nonetheless. They do not expect to make profit from their purchases. Instead, prepayments and deposits are made with the guarantee of their return, or fair exchange.

On the other hand, investors are not customers, and invest with a profit motive in mind. What they put into the business is expected to bring returns in the future, through profits that the business generates.

The distinction is a key one — investors invest with the knowledge that they may not always get their money back, so why should they be first in line to receive their payouts when a company fails? 

How a company normally functions is that salaries and other expenses and liabilities are paid before any revenue can be considered profit that can be paid out to business owners as part of the business’ equity.

Prepaid services are liabilities on the part of businesses, so why should customers be paid last and foot the bill when a business fails and is liquidated?

Why ringfencing payments is the way to go

Of course, there is the argument that without the flexibility to use prepaid funds and deposits, some businesses may not be able to cover the day-to-day operating costs, and be forced to raise prices in order to cope. Consumers would in turn suffer from this 

But if that were the case, should a business really be operating and promising customers that it will be around for the future if it cannot even guarantee that it can keep the lights on without customers prepaying for months in advance? And how would customers be confident in new businesses if they have such short runways?

In the long run, this would mean that only large businesses with long cash runways and large cash reserves will be able to expand and remain in business. Once small business owners have been run out of the market, those who remain will be free to raise prices, knowing that customers have few alternatives. 

So what can be done to address the needs of business owners while providing assurance to consumers that prepayments will not ultimately be a bad decision?

First off, the idea of prepayments itself is not a problem — the problem is that prepayments by customers themselves are not protected. One method could be to allow for prepayments to be accounted for in cashflow only once the company has fulfilled some portion of its obligations. 

Gyms, for example, will not be able to use prepayments for fitness packages until a certain percentage of the customers’ sessions have been claimed and used.

Alternatively, prepayments could be limited in length, to prevent scenarios where businesses overpromise customers. If the company only has sufficient cash runway to last them half a year, for example, they may not offer a package to customers that would take a year to fully redeem. 

Ringfencing payments may not be ideal, since they mean that there is some inflexibility with regards to how businesses can deal with cash that is effectively theirs. But they may be ultimately necessary to inspire confidence in customers who will eventually provide a consistent source of income for the business, especially since customers now know that they are just unsecured creditors to companies.

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