The onset of the global COVID-19 pandemic in early 2020 promoted a significant change in the art market, including an abrupt shift to digital-only forms of engagement following the cancellation of in-person art fairs, gallery exhibitions, and auctions. Compared with other sectors, the art market is seen as opaque; art transactions are often conducted privately and/or informally by commercial players, of which some of the largest and most influential are privately-held rather than publicly-traded.

Market uncertainty from pandemic-induced disruptions was exacerbated in March 2020, when news broke that prominent auction platform Paddle8 had sought Chapter 11 bankruptcy protection. This was compounded further in May 2020, when an independent audit of another leading auction house noted "substantial doubt" about the company's ability to continue as a going concern. 

Against this backdrop, sophisticated consignors sought greater clarity on the potential impact of bankruptcy on their artwork consignments. 

This was particularly the case for consignors with fiduciary obligations, such as trustees, executors, family office heads, and private bank art advisors.

In the United States, one of the bankruptcy law's fundamental aims is to protect creditors from interests in a debtor's property that could not reasonably have been known to them: so-called "secret liens." If a consignor has not placed a consignee's creditors on notice of the former's interest in the consigned property and the consignee sees bankruptcy protection, the consigned property may be deemed part of the bankruptcy estate. In this scenario, the consignor effectively loses title thereto and may be relegated to general creditor status, potentially limiting the consignor's recovery to a pro-rata distribution (typically at a pennies-on-the-dollar rate) following the liquidation of the bankruptcy estate assets. 

The risk of this worst-case scenario can be mitigated under certain circumstances. Fiduciary consignors are arguably obligated to explore common-law, statutory, and contractual protections for their consigned property, the availability of which depends on several factors, including the type of consignor, the type of consignee, and the location of the consignment. 

Common-law protections

• US bankruptcy courts apply state law to determine the nature and extent of a debtor's interest in property. Some states have developed relevant common law precedents pertaining specifically to auction consignments.
• For example, New York common law imposes an agent-principal relationship between auctioneers and their consignors, which continues through the property's sale until the auctioneer has remitted the net proceeds due to the consignor. Under this precedent, if an auctioneer does not segregate consignor proceeds, the consignor may benefit from the court's imposition of a constructive trust on these funds. Similarly, an auctioneer's agency may be presumed under New Jersey law, resulting in sale proceeds being held in constructive trust for the consignor's benefit even when the parties' consignment contract is oral.
• However, common-law precedent varies from state to state, and other precedents are less favorable to consignors than in New York and New Jersey. For example, bankruptcy courts applying Nebraska and Oregon law have found that the agent-principal relationship between an auctioneer and a consignor may end when the consigned property is sold if the parties' written agreement does not require segregation of consignor proceeds. In these cases, consignors are not entitled to constructive trusts and instead of recover (if at all) alongside other general creditors. 

Statutory protections

• 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 (the "UCC"). All 50 US states have adopted in some form this model act's provisions that apply to secured transactions involving personal property. 
• When consigning artwork property to a gallery, a consignor should strongly consider filing a UCC-1 financing statement in the state where the gallery is formed. The consignor may seek to ensure the priority of its interest by delivering the requisite notice to other relevant creditors before delivering the artwork into the custody of the gallery or its agents. Although there are relevant filing, notice, and timing requirements, no contractual grant is needed to create such an Article 9 interest. 
• By contrast, when the consignee is an auctioneer, the arrangement is expressly excluded from the relevant definition of "consignments" for which a financing statement is meant to be filed.
• Accordingly, auction consignors should consider the application of art-consignors should consider the application of art-consignment-specific statutes. Over 30 states have enacted such laws, but they vary widely in terms of the type(s) of consignor to which they apply, and whether/how they supplant or modify a consignor's obligation to undertake UCC filings. 
• In New York, the class of regulated "art merchants" expressly includes auctioneers. However, the class of consignors that benefit from the relevant stature is limited to artists consigning their own property. Such artworks and their proceeds are held in trust for the artist's benefit; as a result, the artist's interest is automatically protected from subordination to any claims of the consignee's creditors, and the artist does not need to file a financing statement to notice this interest. 
• However, for most fiduciary consignors, protections that benefit artist-consignors will not apply. States including Massachusetts and Michigan have enacted artwork consignment statutes that apply to a broader class of consignors. Other state laws, such as Florida's and New Jersey's, may require these consignors to notice the consignee's creditors by posting signage. In other states, such as California and Washington, auctioneers have statutory obligations to undertake consignor trust accounting, or otherwise keep consignor trust accounting, or otherwise keep consignor funds separate from their own operational funds.

Contractual protections

• If a consignor is not clearly entitled to file a UCC-1 financing statement under Section 9-102 and/or the consignment is not protected by applicable state statute - or if the consignment is to a foreign consignee is a jurisdiction without a comprehensive system for registering and/or noticing secured interests, such as the United Kingdom and certain European Union countries - the consignor should consider negotiating contractual protections. 
• An auction consignor may consider requiring the auctioneer to acknowledge a precautionary purchase money security interest (PMSI) in the consigned property and the net proceeds due under the consignment agreement, under Section 9-103. Unlike the security interest recognized under Article 9 for consignors to non-auctioneer consignees, a transactional party can contractually grant a PMSI to recognize the other party's first-priority interest, including in non-consumer goods. Despite the lack of robust legal precedent on the treatment of precautionary PMSIs, 2020 and 2021 saw a marked increase in such filings, most undertaken by trust companies and other professional representatives of fiduciary consignors.
• Also, a consignor may seek to include provisions in the governing consignment agreement that confirms the consignee's express duty to hold and remit net proceeds as the consignor's agent, and/or reduces the period during which the consignee is permitted to hold these funds following a purchaser's payment.
• When doing business with gallery partners, a would-be consignor may prefer to structure the transaction as a sales agency rather than a consignment, which permits the gallery to broker sales without taking custody of the property. 
• In addition, for consignments transacted as private sales, using a third-party escrow agent to receive and disburse sale proceeds may provide enhanced security.

Although the long-term impact of COVID-19 on the art market remains to be seen, the radical shifts of 2020 and 2021 do not appear to have triggered a wave of auction house or gallery bankruptcies. Still, it is always prudent for fiduciaries to consider the impact of market conditions on their transactional risks and attempt to mitigate these risks in light of available legal and practical options.

This will likely require fiduciaries to consult with transactional counsel experienced in navigating both the legal nuances that apply to different consignment contexts and the art market's unique business norms and negotiation mechanics. 

Read the full article on page 308 of the Deloitte Art & Finance Report 2021. The report may be accessed through the link below.