United States: The Legal Canvas - Summer 2009

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Contents

Selling In A Down Market

- Selling At Auction In A Down Market

- Selling Privately In A Down Market

When Museums Collide With A Donor's Creditors

Estate Planning: Is It Time For An Art GRAT?

Antitrust And Authenticity: Warhol Case Survives Motion To Dismiss

Christie's Faces Trial Over "Fraud On The Market" Allegations By A Buyer Who Didn't Buy At Christie's

Deaccessioning Watch: Defeat For O'keeffe Museum Puts Stieglitz Collection One Step Closer To Having A Home In Two States

WELCOME BACK

When times are good, the art market can seem very separate from the world of law. Deals are done, money changes hands, and there are very few legal impediments that cannot be overcome through negotiation. If one deal goes bad, the next transaction is just around the corner.

When the market slows down, underlying legal issues can become more apparent. The ecosystem of a dynamic market falls away, and market players may be left figuring out what they are entitled to under the law. Sometimes, they are surprised and distressed at what they find.

In this edition of The Legal Canvas, we consider a number of the ways that the worldwide economic downturn has legal implications for the way art market transactions are conducted.

• In a two-part article on selling art in this economy, we first look at the sorts of issues a seller – and particularly a seller who is acting as a fiduciary – may want to consider in deciding whether or not to sell at auction. In the second part of the article, we look at issues presented when art is sold privately.
• The downturn has created any number of problems and potential problems for museums. One of them is the difficulty a museum can face when it finds out that art that it has received as a gift – or expects to receive as a promised gift – is subject to the claims of the donor's creditors. This scenario is one that may become more common in today's economy, and we look at the sorts of steps that museums may want to consider in order to protect their collections.
• Finally, with market values low, collectors may want to revisit their estate plans. In this issue we discuss the pros and cons of putting art in a Grantor Retained Annuity Trust (or GRAT). This popular planning technique may help a collector reduce or even eliminate the gift tax on transfers to children, other family members or friends.

In other areas, we provide updates on two pieces of litigation that could expand the liability of, respectively, auction houses and authentication committees, and we discuss the implications of the recent decision in the Fisk University case.

We hope these articles provoke thought and provide useful general guidance. We also hope that we will have the opportunity to work with you on your art-related legal issues.

SELLING IN A DOWN MARKET

The abrupt change in the art market has shaken its collective mindset – but not altogether displaced expectations based on the "old normal." As much as people may talk about a bubble, or celebrate the return of sanity and connoisseurship, many art owners may be inclined to resist the notion that the prices from the market's boom years do not necessarily represent "true value." People with art to sell may want to believe that somehow, somewhere, they can still get the prices they were seeing at auction and in galleries not so very long ago. The market may have hit the brakes suddenly, but expectations have not had time to decelerate.

At the same time, patterns are emerging that seem to undermine old assumptions about how best to sell a piece of art and to underscore the importance of protecting yourself when you do. Failing to rethink old assumptions about the market and neglecting to question traditional ways of doing business can have adverse consequences – legal and financial – for sellers, especially if they are acting as an executor, trustee or in some other fiduciary capacity.

In this article we offer our thoughts on the sorts of things fiduciaries and collectors may want to consider when selling art in the current market. First, we look at current trends at auction and whether the auction-room floor remains a presumptive "safe harbor" for fiduciaries. We then look at private sales and the things that sellers should do to protect themselves – particularly in the wake of recent gallery failures.

SELLING AT AUCTION IN A DOWN MARKET

If you sold art at Christie's or Sotheby's in 2007, used the proceeds to spend two years trekking in the Himalayas oblivious to world events, and returned to New York ready to sell more art, you would be astonished by what you found. The downturn in the economy has brought dramatic change to the way the auction houses are doing business. Those changes raise new questions for potential consignors – particularly for fiduciaries.

How did we get here?

The business model of the major auction houses is based on a fundamental premise: each house needs property to fill an annual schedule of sales and cannot manufacture its own widgets. This leaves them in competition for what is an unpredictable and sometimes very limited supply of available property to sell. Not surprisingly, the competition is most fierce for the most valuable or most high-profile property. That's where the potential for profit lies. Just as importantly, high results and hot publicity attract more consignors for the next sale.

Over the past decade or so, more wealth was attracted into the art market, prices rose, and the major auctions became a kind of high-end spectator sport. The game was judged – and the score was kept – on the basis of market share: at the end of any given season, which auction house had the greater share of sales revenues in any given category. The incentive for each house to get the best consignments increased commensurately, as did the competition for those consignments. The houses responded by moving further and further away from their traditional role as mere middlemen. In the boom market, they offered financial deals (guarantees, advances, and a share of the house's revenue on a sale) that became increasingly generous and increasingly complex.

The music stopped at the fall 2008 auctions, and each major house found itself exposed to financial deals that were signed before the sharp decline in the economy. Having lost tens of millions of dollars, each house announced that it would no longer be giving guarantees. In fact, what that meant was that they would be giving guarantees very selectively. The spring auctions contained far fewer guaranteed lots – but there were some. And though the sales totals were significantly lower than they had been in years, the auctions appear to have been less risky and therefore, at least in relative terms, if not in absolute ones, more profitable for the auctioneers.

One of the notable things about the spring 2009 auctions was how little property was being sold, contrary to some expectations that the market would be flooded by collectors looking to monetize their art in hard times. While some collectors were selling in the private market, others seem to have decided to wait to see where the market would go.

Decisions about whether, when, and how to sell art are key for any collector. Those decisions are legally crucial for someone acting in a fiduciary capacity (such as an executor, a trustee, or the members of a charitable board), because of the risk of legal liability if a decision is later alleged to have been imprudent. Traditionally, selling at auction has been the favored option for fiduciaries, both because of the evident transparency of the auction sales process and the belief that prices at auction may more nearly reflect true "fair market value" – that is, the price where a willing buyer and a willing seller, both having sufficient information about the circumstances and neither being under any compulsion to buy or sell, will enter into a transaction.

A fiduciary, however, may want to re-think traditional assumptions in light of the current market. At the major auctions since the fall of 2008, observers have found that extraordinary objects with good provenance have sold well, while other property has been less successful. For an item to sell well at auction, there have to be at least two people competing to buy it – and ideally, a half dozen or more. The more bidders there are, the higher the price will be. During the boom years, there were plenty of prospective buyers in the market, bidding on a broad range of property at all levels of quality. In the current economy, however, market observers say that fewer people are bidding – and they are bidding with more care. Property that fails to sell at auction may be "burned" – in market terms, shopworn and unmarketable for some period of time. And the auction houses are not providing the sort of financial protection against these risks – or the enhanced rewards to compensate for it – that they did in better economic times.

This is not to say that selling at auction should not remain a favored method for fiduciaries. It is to say that a fiduciary should evaluate his or her options thoroughly – with the objective of maximizing the proceeds of the sale, minimizing transaction costs, and protecting the beneficiaries or charity from unnecessary risk. In deciding whether the auction room is the best place to achieve that goal, there must be a realistic assessment of the property that is being sold, and an understanding of the business imperatives of the auction houses.

• First, a fiduciary should determine whether the property he is selling is likely to provoke real competition among buyers. He should examine its quality, rarity, art historical importance, freshness to the market, condition and provenance. If bidders are unlikely to compete for the work, then he may want to consider whether he could get a better price in a private sale, possibly even a "private treaty sale" negotiated by an auction house. Where an estate is selling a variety of property, the executor may want to make a similar analysis for individual pieces of art, separating them out for private sale where appropriate. To avoid issues of self-dealing or negligence, the fiduciary should keep a record of the information on which he bases his decision, including clear and detailed memoranda on his dealings with buyers or intermediaries.
• If the fiduciary decides to sell at auction, and if the property is of high quality or is being consigned by a high-profile individual or her estate, the fiduciary may want to put the consignment in play between the auction houses as far in advance as possible. Especially in a shaky economy, each auction house will want to announce a major consignment in order to establish an anchor for each major sale and attract other important property. Also, the auction houses' budgets for guarantees and other financial incentives is limited, evidently more so than during the boom years, so it is important to negotiate with the auction houses before the season's worth of financial deals have been spent.
• If the consignment is made late in the season, an auction house that does not yet have a major consignment for a given sale may be more willing to provide financial incentives than a competitor that has already landed a major piece or collection. Each house needs material for a sale – not only for the immediate moment, but to be able to stay in the game.
• In either event, the fiduciary should not be afraid to make the consignment competitive. It is advisable to speak with at least two auction houses and to at least one reputable gallerist who specializes in the area or, in the case of contemporary art, the primary dealer of the artist whose work is being sold. The fiduciary can compare the differing offers, both with respect to the financial terms and marketing commitments. As a practical matter, in a market where many collectors who have a choice are "waiting it out," fiduciaries who control the sale of property that must be sold (such as estate property that must be sold in order to pay estate taxes or bequests) have something that the auction houses need. There is no reason not to exercise that leverage. Moreover, it is a form of due diligence that will help insulate the fiduciary's decision from a successful challenge down the line.

For more information on this topic please contact Jo Laird

SELLING PRIVATELY IN A DOWN MARKET

Observing the spring's thin auction catalogs and reduced results, both The New York Times and The Wall Street Journal have reported a trend towards private sales of art. It is hard to test that premise. After all, the sales are called "private" for a reason, and the dealers and auction houses who are quoted in the articles have good reason to proclaim the health of the art market.

However, sellers may have good reason these days to move property out of the auction rooms and into private galleries (even a private gallery within an auction house). Privacy protects a seller from rumors of financial stress and protects art from the damage of a public failure to sell. A private transaction is more fully within the seller's control. At auction, the seller is protected by the reserve; once it is reached, the property is sold. In a private sale, the seller can negotiate all of the terms of a transaction – price, payment and delivery terms, the provision of title insurance in lieu of a warranty of title, security interests, and protections against default. The timing of a private sale is also, at least theoretically, within the control of the seller. Rather than waiting for an auction that might be months away, a seller can conclude a sale (if there is a buyer) at any time. Moreover, as suggested elsewhere in this issue, certain property may be more suited to private sale when the market is down. Auctions require competition; private sales require only the careful placement of the right piece with the right buyer.

The economic downturn has, however, also underscored the risks of selling through private galleries. A dealer in possession of a work may be able to pass good title to a purchaser, even if the dealer never pays the seller. And, if a dealer goes into bankruptcy, a work of art in his possession may become part of the bankruptcy estate – even if it actually belongs to a consigning seller.

The Uniform Commercial Code

As an initial matter, despite the romance that may swirl around them, purchases and sales of art are commercial transactions. Where they go wrong, stories of trust and betrayal will be less relevant to a court than the rules of law.

In the United States, commercial transactions are generally governed by the Uniform Commercial Code (the "UCC" or the "Code"), a statute that has been adopted, with some variations, in all 50 states. The Code is designed to facilitate commerce by providing universal "rules of the road." Among other things, the Code establishes the rights of buyers, sellers, and creditors when goods are sold or are pledged as collateral for a loan. The Code also provides a mechanism for owners and creditors to protect their interests in property – recording their financial interests by filing a financing statement on a database that is made publicly available by each state and that puts buyers or other potential creditors on notice that someone else has an interest in the property.

Entrustment

Under the UCC, when a collector gives a dealer possession of a work of art, the collector is deemed to have "entrusted" the work to the dealer. This is true whether the dealer is meant to store the work, restore it, exhibit it or sell it. Under the Code, "any entrusting of possession of goods to a merchant who deals in goods of that kind gives him power to transfer all rights of the entruster to a buyer in the ordinary course of business." A "buyer in the ordinary course" is defined as being a "person who in good faith and without knowledge that the sale to him is in violation of the ownership rights or security interest of a third party in the goods buys in the ordinary course from a person in the business of selling goods of that type." In other words, if someone walks into a gallery and buys your work of art, he gets title to the work, whether or not you meant for it to be sold, and whether or not the dealer ever pays you. You are left with a claim for money damages against the dealer; the buyer gets the art.

This makes sense when the art is on consignment to a dealer – in other words, it is there because the seller intends that it be sold. In that case, the sale itself is not in violation of the consignor's rights; the breach is in the dealer's failure to part with the proceeds.

The result may seem astonishing, though, when the work has been placed with a gallery for reasons other than sale – and many shocked collectors have wound up as plaintiffs in litigation against dealers. The Code's rationale is that, as between the seller and an innocent buyer, it is the seller who should bear the risk of a dealer's malfeasance. Indeed, the rules apply even if the dealer obtained possession of the property – or disposed of it – in ways that would be "larcenous under the criminal law." It is the seller who knowingly delivers her property to the dealer, and she assumes the risk of the merchant's acting unscrupulously, because she had the ability to protect herself in ways that the innocent buyer could not.

The result changes if the buyer is not innocent. If he purchases the art knowing that the sale violates someone else's ownership rights or security interest, title will not pass. If a buyer knows, for example, that a painting was left with a dealer solely for purposes of restoration and not for sale, he cannot rely on the UCC to protect his ownership of the picture. With most buyers, courts will look for evidence of actual knowledge. Where the buyer is another art dealer (and therefore considered a merchant under the UCC), courts will consider whether the buyer took reasonable steps to verify the true owner of the work of art. What will be considered reasonable will depend on the circumstances of the transaction. The courts will look to see if there were any "red flags" that should have caused the buying dealer to ask further questions. Was the purchase price too low? Did the negotiations or procedures of the sale differ from previous and uncontroversial agreements between buyer and seller? Did the seller insist on unusual confidentiality provisions or bizarre delivery arrangements? If the selling dealer was unknown to the buying dealer, did the buyer take reasonable steps to verify that the sale was authorized?

Bankruptcy

Artwork consigned to a dealer may be at particular risk if the dealer winds up in bankruptcy. Under the UCC, consigned works are subject to the claims of a gallery's creditors unless (a) the fact that the works are on consignment is posted, (b) the consignor can show that the gallery is generally known by creditors to be "substantially engaged" in selling goods belonging to others, or (c) the consignor has filed a financing statement reflecting his interest in the property. Just as it protects the innocent purchaser who buys entrusted property, the UCC protects the creditor who, unless he is given reason to believe otherwise, should have a right to assume that what he sees in the gallery belongs to the gallery.

What this means is that in a bankruptcy, your dealer's creditors could end up with rights in your property that are superior to your own – regardless of the customs and practices of the art industry. In recent bankruptcy proceedings involving galleries, the bankrupt gallery and its creditors successfully (but perhaps disengenuously) took the position that the creditors did not generally know that the dealer had been "substantially engaged" in selling other people's property. It did not matter to the court that it was not customary in the art market for a consignor to file a financing statement. As a result, the consigned art became assets in the bankruptcy estate, and the consignors were left as unsecured creditors.

Protect Yourself

When a collector is considering consigning artwork to a dealer, she should not abandon her common sense. It is a commercial transaction that should be approached with as much care as any other significant business matter. If things go badly, the collector's rights are going to be judged as a matter of law, and not by the casual and familiar customs of the market.

• Research. First, a collector should conduct due diligence with respect to anybody (including a dealer) with whom she is going to do business. Even something as elementary as a web search of the dealer's name may provide useful information. Has the gallery been involved in any recent litigation? Is there a pattern of litigation brought by other collectors, or by landlords, vendors or creditors?
• Written Agreement. No matter why artwork is being left with a dealer, the arrangement should be reduced to writing. The writing need not be complicated. It should set forth very clearly the basic terms of the particular arrangement: For what purpose is the property being put into the custody of the dealer? What services, if any, will the dealer be performing, and how will he be compensated? What is the time frame in which the services will be completed? If the property is being loaned for an exhibit, when will the exhibit be over? In addition to these sorts of fundamental provisions, the agreement should include (i) an express statement of the consignor's ownership interest in the work, and (ii) an acknowledgement by the gallery that the owner will file a financing statement to protect her ownership interest. If the property is being consigned to the dealer for sale, the collector may want to require that it not be released to a buyer until the collector has received payment in full from the dealer. In most circumstances under the UCC, title to property passes to a buyer when it is delivered, whether or not the buyer has paid for it.
• Physical Tagging. The collector might consider requiring that each work of art be physically tagged or otherwise identified so as to indicate that it is on consignment or on loan to the gallery. In addition, if the gallery publishes a catalog of an exhibition, the collector may want to insist that her works be designated in the catalog as having been consigned or loaned.
• Filing a Financing Statement. Perhaps most importantly, a collector should file a financing statement in the proper state to give public notice of her interest in the work. Filing the form is easy and inexpensive. In most states, it can be done on-line by visiting the website of the Secretary of State (or doing a web search for "UCC Filing" plus the name of the state). In New York, each paper filing costs $40, and each electronic filing costs $20. The filing will protect the collector's art from the claims of the dealer's creditors. It can also provide some protection against the risks of entrustment. If a work is with a dealer for purposes other than sale (e.g., an exhibit), and if the filing discloses that fact, then (i) any buyer (including a non-merchant) who does a UCC search prior to purchasing the work will be on actual notice that the sale will be in violation of the collector's ownership rights and (ii) a buyer who is a merchant who does not do a UCC search may be held not to have performed adequate due diligence to assure himself that the sale was authorized. In either case, good title to the work may have been prevented from passing.

For more information on this topic, contact David Dykhouse, Jo Laird or Paul Hawthorne.

WHEN MUSEUMS COLLIDE WITH A DONOR'S CREDITORS

In April 2009, JPMorgan Chase Bank notified the Rijksmuseum in Amsterdam that a painting that the museum had purchased in 2008, "The Bend on Herengracht" by Gerrit Berckheyde, had been previously pledged as collateral for a debt that was now past due, and JPMorgan said it wanted to take possession of the painting. The Dutch bank ABN Amro chimed in next, claiming that the Berckheyde was also collateral for its loan to the same individual. For about six weeks, the museum and the Dutch press had reason to worry that the picture would be seized. As of the date of this issue of The Legal Canvas, JPMorgan had decided not to pursue the painting, and ABN Amro had accepted alternate collateral from the individual.

In the meantime, the M.H. de Young Memorial Museum in San Francisco was having its own problems defending its right to a major pledged gift. John and Marcia Friede, heirs of the Annenberg family, promised to donate to the museum their famed Jolika Collection of over 4,000 pieces of Oceanic and tribal art. After making the pledge to the museum, Friede granted his brothers a security interest in the collection to collateralize a $30 million debt owed to them in connection with an inheritance dispute. After Friede fell behind in making payments on the debt, one of his brothers attempted to seize some of the artworks. So did Sotheby's, to which Friede had apparently also granted a security interest in certain pieces of the collection to secure a $25 million loan. In October 2008, a New York court gave Sotheby's the right to take possession of 54 works from the collection, and Sotheby's successfully sold all but one of them at an auction on May 15, 2009. On April 22, 2009, the City of San Francisco, which owns the de Young, announced that it had agreed to sell 76 works from the collection to help settle the inheritance dispute and to protect the remainder of the pledged gift. The museum characterized the works that would be sold as redundant, or as less significant than other pieces of the collection.

Sadly, museums may face scenarios like these more frequently in the coming months. The ever-increasing values in the market over the last several years made lenders more amenable to accepting art as collateral. The strength of the market also led some lenders to accept loan-to-collateral ratios that seem to have been based on the assumption that the value of the art would never decline. Some collectors used the opportunity to leverage their collections. With the downturn in the economy, some borrowers may find themselves unable to make their loan payments, and lenders may find themselves holding property that has lost much of its market value, leaving them under-collateralized. Either set of facts can lead to more defaults and foreclosures.

It may not be possible to protect a museum completely. But there are several things a museum can do to protect itself from accepting art that is subject to liens and to prevent donated or promised art from being seized to satisfy preexisting security interests or used as collateral for future secured loans.

• Check to see if the property is subject to any liens or claims.
  First, when a museum is purchasing or accepting a piece of art, it should check the commercial filings in each state in which a lender to the seller or donor would be required to file a Financing Statement under the Uniform Commercial Code in order to perfect a security interest in the property. At a minimum, this due diligence should include every state where the seller or donor is either a resident or conducts business. These filings are generally made with the Secretary of State in the applicable location, and are usually searchable on-line at no cost on the state's website. As a general matter, the rights of any subsequent buyer or donee are subordinate to the rights of the holder of a prior perfected security interest.

• Draft a comprehensive and thoughtful agreement.
  When a museum accepts a gift of property or the promise of a future gift, it should document the arrangement with a formal written agreement. The agreement should include provisions designed to protect the museum's interest in the work, including:
• • A representation and warranty that the donor owns the property free and clear and that no third party has any interest in the property.
  • An agreement by the donor not to grant a security interest to any other party in the work that he has donated or promised to donate.
  • An indemnification provision that protects the museum against costs and damages in the event that the donor has granted or does grant a security interest in the property. In appropriate circumstances, the museum might seek a provision that would require the donor to pay liquidated damages to the museum in the amount of the value of the promised gift, should the donor violate the terms of the agreement in a way that prevents the museum from acquiring or keeping the promised property.
• Consider filing a UCC Financing Statement.
  The museum may wish to consider filing an "informational" UCC Financing Statement. An informational filing will alert subsequent lenders that there is a preexisting, competing interest in the property, even if not an enforceable prior lien. With this notice, potential lenders or buyers may be more likely to make further inquiries about the status of the property before going forward with a contemplated transaction. Note, though, that filed Financing Statements are public and should be considered with caution if there is good reason on the donor's part to keep the donation or promised gift confidential for the time being. Alternatively, in appropriate circumstances a museum may wish to explore asking the donor to grant a security interest in the promised property, so that the property becomes collateral to secure the donor's promised gift to the museum. In that case, unless the museum has possession of the property, a UCC Financing Statement would be filed in order to perfect the security interest.

• Consider acquiring art title insurance.
  Museums may wish to purchase title insurance for donated or promised works from an insurance company with specialized expertise in art title risks. Such policies are designed to provide third-party assurance against the loss of the artwork due to liens or encumbrances (as well as more traditional ownership risks) and against the costs of defending against title claims.
• Check every now and again to be sure there are no problems on the horizon.
  After accepting the pledge of a work – even where the museum has physical possession of the art – a museum should consider periodically checking the status of the work by searching for any UCC Financing Statements related to the donor. This will enable the museum to stay abreast of the status of the property and perhaps pre-empt potential problems.

For more information on this topic, contact Jo Laird or David Dykhouse.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.