Art

Heightened Consignment Risks

Sellers of fine art—particularly those with fiduciary obligations—must consider the heightened risks of consignment in this climate, including the possibility that a consignee will seek bankruptcy protection and the impact of such an event. A consignor’s avenues for protection depend on a number of questions, including:

• Who created the artwork(s) being consigned? Certain statutes offer increased protections to artists who consign their own property (and in some cases, their successors-in-interest), as compared to non-artist consignors.
• What’s the nature of the consignee’s business? For property consigned to certain art merchants, a consignor may be able to file a protective financing statement under Article 9 of the Uniform Commercial Code (UCC)—but for auction consignments, this path is less clear.
• What’s the location of the consignment? State laws vary widely, including with respect to the type(s) of consignors eligible for special protections, notice requirements vis-à-vis a consignee’s creditors and the obligations of consignees to undertake trust accounting.

Bankruptcy and UCC Basics

A fundamental objective of bankruptcy law is the protection of creditors from so-called “secret” liens—interests in a debtor’s property that couldn’t reasonably have been known to its creditors. In certain cases, a consignor may perfect a security interest in consigned goods by complying with provisions of the UCC for the filing of a financing statement, which puts the consignee’s creditors on notice of such interest.

However, if a consignor fails to do so and the consignee becomes the debtor in a bankruptcy case, the consignee may obtain the “rights and title to the goods identical to those the consignor had" and then transfer those interests to its creditors (this legal process is known as “attachment”).  In such a scenario, the consigned artwork becomes part of the “bankruptcy estate,” meaning that it’s no longer recognized as separate property of the consignor, and the consignor will be relegated to the status of a general creditor.

Moreover, while perfection of a security interest may protect the consignor’s interest in the property itself, it doesn’t necessarily protect the consignor’s interest in the sale proceeds of that property. This risk is exacerbated by the policy preference in bankruptcy of favoring equal treatment of creditors. Typically, this is accomplished through a pro rata distribution of available debtor funds, so that creditors recover on an equal basis from the available pool of assets—often at pennies-on-the-dollar—rather than receiving preferential treatment over other similarly-situated creditors.

Even a diligent consignor may have trouble determining whether a consignment is eligible for the perfection of a security interest, because the interpretation and application of the UCC consignment provisions has a fraught history and continues to result in judicial confusion. Prior to 2001, certain consignments were governed by  Article 9 of the UCC (under which the consignor could be recognized as having a perfected security interest) and others by Article 2 (under which the arrangement might be deemed a “sale or return,” giving rise to no equivalent interest).

In 2001, certain revisions to the UCC took effect in most states, including the articulation of a narrower definition of “consignment” under Article 9 and the removal from Article 2 of rules governing other consignments. The drafters’ intention was to afford protection to more consignors under Article 9, and for non-Article 9 consignments (sometimes called “common law” or “true” consignments) to be governed by the common law of bailments.

However, because the drafters opted not to remove the “sale or return” language from Article 2, some courts erroneously continued to operate on the assumption that consignments must be classified as falling under either Article 9 or Article 2, and have applied the latter (rather than common law) to art consignments not falling squarely under Article 9’s definition. As discussed below, this narrowed definition may be of particular significance in its exclusion of certain consignment types and underscores the importance of giving careful consideration to the contextual specifics of a proposed consignment.

Who’s the Consignor?

When the consignor of an artwork is the artist who created it, special statutory protections may apply, including the automatic status of the merchant as a fiduciary. In New York, artist-consigned property and its proceeds are held in “trust … in the hands of the consignee” for the artist’s benefit. As a result, the artist’s interest in the artwork may not be “subordinate[d] to any claims, liens or security interest[s] of any kind or nature whatsoever of the consignee’s creditors.”

New York’s Arts & Cultural Affairs Law (ACA) was amended to provide its current enhanced benefits to artist-consignors as a result of advocacy following the 2007 bankruptcy of the prominent Salander-O’Reilly gallery, in which it came to light that the gallery had failed to pay artists and their heirs nearly $120 million in sale proceeds. Over 30 other states have enacted similar artist protection statutes.

The ACA provides an artist-consignor with the equivalent of a super-priority with respect to the actual artwork property. But this shield is less bulletproof as applied to the sale proceeds owed to the artist. The statute requires art merchants to establish separate trust accounts and provides that the failure to do so is a breach of duty subject to penalties set forth in the New York Estates, Powers and Trusts Law. Yet, practically speaking, when an art merchant improperly commingles artist-consignor proceeds with its own funds prior to declaring bankruptcy, the artist-consignor may still wind up in a difficult position. As the old saying goes, one can’t “get blood from a stone”—if the merchant has already disbursed the funds that should have been held in trust, the artist-consignor is unlikely to recover the full amount of net proceeds due.

New York’s artist-consignor protections may apply to an artist’s successors-in-interest, but will generally not be applicable when the consignor of artwork is a primary or secondary market purchaser (or the heir or other beneficiary thereof). However, the ACA operates independently from the Article 9 financing statement process, which may still be available to non-artist consignors, depending on the nature of a consignee’s business. Other state consignment statutes may also protect a broader class of consignors than the ACA. Determining what protections are available thus implicates the other two factors mentioned below.

What’s the Consignee’s Business?

When a consignee is a gallery in the business of selling art, is known to sell its own inventory, and the consigned property isn’t reasonably categorized as “consumer goods immediately before delivery”—as is arguably the case for artwork being consigned by a trust or estate, if it was previously personal property of the decedent or grantor—the consignment may qualify under Article 9 for perfection of the consignor’s security interest. Although there are relevant filing, notice, and timing requirements, no contractual grant is required to give rise to such an Article 9 interest.

By contrast, when a consignee is an auctioneer, the arrangement is expressly excluded from Article 9’s definition of “consignments” for which a financing statement is meant to be filed. An auction consignor may consider seeking to bootstrap such a consignment back into Article 9’s ambit by requiring the auctioneer to grant a precautionary purchase money security interest (PMSI) in the consigned property and the net proceeds due under the consignment agreement. While the filing of a precautionary statement noticing the auctioneer’s creditors of such a purported interest is unlikely to be practically detrimental to the consignor, the legal impact of such a filing is unclear in the absence of robust legal precedent on the treatment of precautionary PMSIs in the auction context.

Where's the Congsignee Located?

In the absence of a PMSI (or if a PMSI is found to be ineffective), an auction consignor may seek to rely on a constructive trust theory—asserting that the debtor doesn’t hold equitable title to artwork in its possession because that property is held constructively in trust for the benefit of the consignor. Bankruptcy courts apply state law to determine the nature and extent of a debtor’s interest in property. This factor may thus be summed up as: location, location, location.

Some states have developed common law precedents as to the role of an auctioneer. For example, in In re Martin Fein & Co., the Bankruptcy Court for the Southern District of New York acknowledged that New York common law imposes an agent-principal relationship between auctioneers and their consignors as a matter of law, continuing through the sale of the property until the auctioneer has remitted the net proceeds due to the consignor. As a result, the Fein court held that even when an auctioneer fails to segregate consignor proceeds, the consignor may benefit from the imposition of a constructive trust. Such a finding, however, is maddeningly state-specific: while one bankruptcy court has held that an auctioneer’s agency may be presumed under New Jersey law even when a consignment contract is oral, other courts have applied Nebraska and Oregon law to find that the agency relationship may terminate even under a written consignment agreement if the parties didn’t specifically document the auctioneer’s obligation to segregate funds.

Auctioneers in other states, such as California and Washington, have statutory obligations to undertake consignor trust accounting. Moreover, as noted above, state consignor protection statutes applicable to both gallery and auction consignments vary widely: in addition to potentially protecting a broader class of consignors than just artist-consignors, they may supplant the requirement to file a UCC-1 financing statement or create an alternative to such requirement.

It’s critical, therefore, for a consignor to understand which state’s law will govern a proposed consignment and to bear in mind that even when that law may impose a statutory or constructive trust, the reality is that any pot of commingled funds is still likely to be shared with other similarly situated consignors.

Consignor Best Practices

The intricacies of the UCC consignment provisions are compounded by inconsistent judicial application and by the material differences in state common-law precedent and statutory provisions on agency relationships and consignor protections. Given this complex and confusing landscape, fiduciaries considering the consignment of artwork should be cognizant not only of the importance of conducting available diligence on prospective consignees and taking full advantage of available statutory notice provisions, but also of exploring the use of protective contractual protections.

When consigning property to a gallery, a consignor should strongly consider filing a UCC financing statement in the state where the gallery is formed and ensuring the priority of that interest by delivering the requisite notice to the gallery’s other relevant creditors prior to placing the consignment property in the hands of the gallery or its agents. Alternatively, the would-be consignor may prefer to structure the transaction as an agency rather than a consignment, permitting the gallery to broker sales without taking possession of the property. In addition, the use of a third-party escrow agent for the receipt and disbursement of purchase funds may provide enhanced security.

When consigning artwork for sale by auction, a consignor should inquire about the auctioneer’s financial health and use of segregated accounting. Where the latter isn’t available, the consignor may consider including negotiating to include protective language in the consignment agreement, such as provisions establishing the auctioneer’s express duty to hold and remit net proceeds in its capacity as the consignor’s agent, granting the consignor a precautionary PMSI and/or reducing the time period during which the auctioneer is permitted to hold the consignor’s net proceeds following receipt of purchaser funds.

Although the long-term impact of COVID-19 on the art market remains to be seen, the March 2020 Paddle8 bankruptcy hasn’t yet proved to be the harbinger of additional art world bankruptcy filings that was feared. Still, it’s always prudent for fiduciaries to consider the impact of market conditions on their transactional risks and to attempt to mitigate those risks in light of available legal and practical options.