Editor’s Note

This is Volume 2, Issue No. 1 of Spencer’s Art Law Journal. This issue contains two essays, which will become available by posting on Artnet, starting June 2011. Volume 2, Issue No. 2 will appear in Fall 2011.

As noted in Volume 1 of this Journal, the legal structure we call art law (an amalgam of personal property law, contract, estate, tax and intellectual property law) supporting the acquisition, retention and disposition of fine art, should (but sometimes doesn’t) mesh comfortably with art market custom and practice.

The essays in this Spring issue continue to deal with ownership of visual art. The first essay looks at the ownership risk involved in consigning art to a dealer for sale. The second essay deals with sale restrictions on dealers and collectors.

Three times a year issues of this Journal will address legal questions of practical significance to collectors, dealers, scholars and the general art-minded public.

A FUNNY THING HAPPENED ON THE WAY TO THE GALLERY: A BANKRUPTCY FABLE (OR NOT)

Aaron R. Cahn

This essay is about a collector consigning art to a dealer for sale and not filing a financing statement. In the event of the dealer bankruptcy, a bankruptcy trustee will likely assert that the collector’s consigned art is now owned by the trustee for the benefit of the gallery’s general unsecured creditors. In order to get the art back the collector/consignor must prove that the gallery was generally known by the gallery’s creditors to be selling art owned by consignors -- a task more difficult than might first appear. -- RDS

Aaron R. Cahn is counsel to Carter Ledyard & Milburn LLP, and a member of the Creditor’s Rights and Bankruptcy Group.

A common scenario in the art world: a collector amasses valuable works over the course of time, and then, from necessity, boredom, or lack of interest on the part of the collector’s heirs, decides to sell all or part of the collection. A dealer is contacted and a consignment agreement signed. The consignment agreement contains restrictions as to price, time, and category of buyer, and also, typically, provides that the collector can terminate the agreement for various reasons or no reason, and compel redelivery of the works not yet sold.

But suppose the dealer files a bankruptcy proceeding -- not an uncommon scenario in today’s world, and one already realized in the recent bankruptcies of such well-known galleries as Berry-Hill and Salander-O’Reilly. The owner then decides there is no point continuing sales efforts with the now-bankrupt dealer, and figures he’ll start over with someone else who’s spending less time hanging around the bankruptcy court.

But the parties may have missed a step here, and that missed step can dramatically alter the legal status of the artwork and the expectations of the owner. That step is the filing of a little piece of paper known as a Uniform Commercial Code Financing Statement, or Form UCC-1.

People in the business world, many of whom may also be involved in the art world, have come to be familiar with financing statements. Any business which borrows money and secures that loan with the assets of the business, be they receivables, inventory, equipment, intellectual property, or other property, knows that its lender will file a financing statement with the appropriate state filing office.

The statement takes roughly ten minutes to complete and a few dollars to file (and there are services well known to corporate lawyers and bankers who can quickly accomplish these filings electronically) and its function is to provide notice to the world, including others who may become creditors of the business, that the assets are already pledged to someone as collateral and therefore may not be available to satisfy the claims of other creditors. These protections are laid out in Article 9 of the Uniform Commercial Code, a model statute first proposed in the 1950s by a group of commercial lawyers and academics, and adopted (sometimes with minor variations) by all 50 states.

As noted, the protection of Article 9 is mainly designed to be used for secured loans. And of course, a consignment is not a secured loan. Consignment, a device dating back to the beginning of commercial history, is nothing more than an arrangement in which one person, usually but not necessarily a merchant, undertakes to sell property for another, in exchange for a share of the proceeds realized on the sale. It is certainly not a loan as we know it.

However, consignments are also subject to the provisions of Article 9.

The reasons need not detain us long: essentially, the Commercial Code is concerned with devising rules that will ease the free flow of goods in commerce, as a matter of social and commercial policy, and preventing, insofar as possible, lengthy disputes over title to goods and priority of liens that could interfere with the buying and selling that is the lifeblood of American business. And so it is deemed to be important that persons who need to determine the financial health of a business enterprise -- lenders, suppliers, service providers, and others -- be able to know whether or not goods on display at a business premises are owned by the merchant or whether there is some other arrangement at work.

Accordingly, Article 9, in order to advance the policy expressed by its creators, declares that just as creditors of a business have a right to know whether or not goods have been pledged as security for a loan, they also have a right to know whether or not the goods are actually owned by the business or by someone else. Thus the Code requires that persons who consign goods for sale to a merchant must file a financing statement in order to protect their ownership interest. This process is known as “perfecting” an interest in the property.

Note here that not all transactions where someone undertakes to sell another persons’ goods are treated as consignments under the Commercial Code. First, the seller must be a merchant, so these rules don’t apply if you’re giving items to your neighbor to include in his garage sale. Second, and more importantly, these rules don’t apply if the consigned goods are “consumer goods.” The Code defines consumer goods as goods “held or acquired primarily for personal, family, or household purposes.”

There is much discussion among academics as to whether goods of intrinsic value -- as opposed to, say, a toaster -- are or should be consumer goods. The currently prevailing view is that they are. So an individual collector who buys a few pieces to display in his home probably does not need to worry about the filing rules when he takes a piece down to his dealer to sell it. But an active collector who buys and sells with some frequency may not be able to rely on the “consumer goods” exception -- a court may determine that the level of activity signifies a business purpose and decide that the consignor should have filed a financing statement after all. So if there is any doubt at all, the consignor should file -- if only for the peace of mind that filing brings.

Failing to take this rather simple step can have dire consequences in the event of a bankruptcy filing by the consignee. The United States Bankruptcy Code gives certain powers to a bankruptcy trustee (or the bankrupt company itself, if no trustee is appointed) to override any interest in property that is not properly perfected under state law. In essence, the bankruptcy trustee becomes the owner of the property, and the owner/consignor can find himself being stripped of title to the work.

A significant number of art owners came face-to-face with this problem in the Salander Gallery bankruptcy case.
Owners who had consigned works to the gallery without having filed the requisite financing statement (or, having originally filed the statement, did not renew it five years later as required) found themselves confronted by a bankruptcy trustee who asserted that the bankrupt estate was now the owner of the art in question and the owner/consignor no longer had any rights to the works. (The owner/consignor then becomes just a general unsecured creditor of the bankrupt gallery.)

Fortunately for consignors, there is another way out of this conundrum, although the alternative is a bit like walking to the top of the Empire State Building instead of taking the elevator. The Commercial Code’s definition of a consignment is somewhat narrower than the commonly accepted one, and one of the elements in that definition is that delivering goods to a merchant is a consignment only if the merchant is “not generally known by its creditors to be substantially engaged in selling the goods of others.” In other words, if those dealing with a merchant know the merchant is selling goods on consignment, there would be no real need to make a UCC filing.

(While relatively few cases have considered the issue of the meaning of “substantially engaged in selling the goods of others,” there appears to be something of a consensus emerging that a merchant whose inventory includes more than 20% consigned goods will usually meet that definition (FN 1). For art dealers, of course, 20% is not a particularly high bar to meet.)

But the higher bar is the meaning of the phrase “not generally known.” Art galleries, like any other business, have many creditors and many types of creditors. They may have owners to whom they owe money for works that they have sold, but they also have utility bills, tax bills, and obligations to all sorts of others who have no reason to know or care whether the works on the gallery floor are owned or consigned.

While there are relatively few judicial decisions on this issue, virtually all the cases on this point have accepted several propositions: first, that the phrase “generally known” equates to a majority of the debtor’s creditors; second that all creditors (not just trade creditors) must be counted; and finally, the size of the creditors’ claims is not taken into account. So the collector who is owed millions for the sale by the gallery of a Picasso is given the same weight as the pizzeria, owed $100 for a late-night delivery!

The difficulty that a consignor will have in carrying the evidentiary burden placed on it was highlighted in a recent decision by an Indiana bankruptcy court (FN 2). The debtor, which bought and sold gemstones and finished jewelry items, had a total of 91 creditors. The court rejected the consignors’ argument that a majority of the creditors knew the debtor was substantially engaged in selling goods of others, finding that while some of those creditors may themselves have been consignors, their knowledge of their own transactions did not enable the court to infer that consignment was the debtor’s general or usual practice. The court also rejected proof as to the standard industry practice of selling consigned goods. In the end, the court accepted only that the principals of the debtor, who were also creditors, together with the company’s attorneys and accountants, could be said to have knowledge that the debtor was substantially engaged in selling the goods of others, and rejected the consignors attempt to regain their consigned goods.

It will thus be seen that a consignor whose only option is to walk up the stairs will face a very long climb. In a case where there are hundreds of creditors (not at all an uncommon scenario), proving the specific knowledge of each of a majority of creditors will be a time-consuming and expensive task. And creditors who are not otherwise familiar with the operation of the debtor’s business are not likely to know in any event whether the debtor is substantially selling consigned goods.

The answer, then, is to not be put in this situation in the first place. It may seem awkward and even a bit unseemly for a collector, particularly an individual, to run out and arrange to file a Form UCC-1 whenever he or she consigns a work of art to a dealer for sale. But when that mild embarrassment and inconvenience is weighed against the potential loss of valuable art if the dealer files bankruptcy, the decision should be a simple one.

New York, New York
May 2011

Aaron R. Cahn, Esq.
Carter Ledyard & Milburn LLP
Two Wall Street
New York, NY 10005
Email: cahn@clm.com
Website: www.clm.com

NOTES
(1) See, e.g. In re Valley Media, Inc., 279 B.R. 105, 125 Bankr. D. Del. 2002).

(2) In re Downey Creations, LLC, reported in 414 B.R. 463 (Bankr. S.D. Ind. 2009).

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