Art as CollateralJune 2009 – Art & Advocacy, Volume 2
Recent articles in The New York Times have noted that fine art, prime photographs, and other collectibles can serve as a source of cash for people or businesses under financial strain. One article discussed two loans made to an artist where the rights to her works were made part of the collateral package. The story focused on a firm called Art Capital Group and other “pawnshop” type lenders, as the Times referred to them, that bring these transactions an “asset-based lending” (or “ABL”) perspective more commonly found with debtor-creditor relationships in rough-and-tumble businesses. The other article noted how The Metropolitan Opera had elected to grant JPMorgan Chase a security interest in its Chagall murals as substitute collateral — replacing cash held by the bank — for a loan. Anyone considering using art to relieve pressure from creditors needs to know the differences between the niche asset-based art lenders and the bankers that will lend against this type of collateral.
Niche Asset-Based Lenders
True asset-based lenders typically do not care if a borrower defaults. They collect relatively large fees and charge higher interest rates than conventional bank lenders charge. These lenders are usually willing to take their chances with the value of the security and the enforceability of their legal position. This approach, of course, may cause collectors in need of money to worry that they might fall victim to a “loan to own” lender, which will effectively be buying their art for half (or less) of its real value.
Fortunately for many collectors, the private banking side of several large U.S. commercial banks will also lend against art collateral, often at better pricing than that of the niche asset-based art lenders. To qualify for such loans, borrowers generally must be “high net worth” individuals and either have, or be willing to establish, a significant banking relationship. All private bankers will look at art collateral as a “second way out of the loan.” A key difference between a private bank and an asset-based art lender: The bank must be convinced that the borrower will be able to service the debt and repay the loan at maturity without having to sell the collateral. A concomitant of requiring financial confidence in the borrower is that private bankers care about the character and reputation of their clients. Niche asset-based art lenders are less likely to be concerned with these things. They will always take possession of the collateral, whereas private bankers may not.
Despite their differences, niche asset-based art lenders and private bankers that make art loans have some common ground. Both will use a maximum 40% to 50% advance rate, meaning that the amount of the loan may not exceed 40% to 50% of the then-current appraised value of the collateral. In addition, both will want the appraiser to be of their choosing, and will likely require that there be an international market for the art in question.
Although individual collectors generally have to go to either a niche asset-based art lender or a private banker, many reputable businesses, such as The Metropolitan Opera, and many respected galleries and dealers will use art collateral to obtain credit from “middle market” commercial bankers1 (i.e., business bankers that make loans to middle-sized companies using the bank’s own funds, without reliance upon capital markets). These loans bear some resemblance to private bank financings in that a significant banking relationship, good character, and the ability to repay without resorting to the collateral are necessary. However, these are fundamentally conventional business loans where the bank’s credit policy will dictate such things as profitability over a meaningful period of time, strength of management, barriers to entry in the industry by competitors, and many other considerations.
Though both types of loans are secured, this kind of lending is, in some respects, the polar opposite of asset-based loans. In a typical middle-market business loan, the credit policy considerations referred to above will predominate; the artwork will simply be inventory, which can be converted to accounts receivable, and its current value will be of secondary importance.
The current recession has impaired the quality of almost everyone’s credit, making it difficult for businesses and individuals to borrow from banks. The impact of the economic downturn has had less of an impact on asset-based art lenders because they are almost exclusively concerned with the value of the works and their marketability. Although the most prominent and rarest works appear to be holding their value well, the art market is clearly not as hot as it was a year ago. The global economic downturn is cause for concern that the trend will continue downward for some time. This inevitably leads to greater uncertainty as to the reliability of appraisals, even those made by an expert chosen by the lender. These factors will diminish the credit available even from the niche art lenders.
Today, as in prior recessions, banks and other lenders engaged in workout negotiations with a borrower or guarantor, on a real estate or other kind of commercial loan, will often consider taking a direct pledge of artwork as additional credit support. Thus, where the original property or business assets are deemed “under water,” or insufficient to support an extension of maturity or to obtain approval for a waiver of a financial covenant breach or other default, art can sometimes fill the gap enough to solve the immediate problem. In many of these situations, creditors worry about throwing “good money after bad.” One benefit of this kind of collateral is that, although it is not an income-producing asset, art provides the creditor with the comfort of knowing that it will not have to reach far into its own pocket to maintain the assets, as it would have to with other kinds of collateral offered in problem loan negotiations, such as certain kinds of real estate, boats, and planes, which typically require the lender to incur more expenses on top of what it already has lost or put at risk just to preserve the value of its new security.
At Herrick, Feinstein, we have considerable experience in representing a variety of lenders, as well as art collectors and dealers, in transactions where artwork serves as the key to a new loan or as part of a collateral package shoring up a problem financing.
1 To clarify, commercial banks usually have asset-based lending groups of their own that do not accept art and collectibles as collateral, as do the independent art lenders referred to in the Times article. These bankers are looking for something that can easily and reliably be converted to cash. The art market requires too much special knowledge and is subject to too much uncertainty to work well for lenders that are only comfortable advancing money against accounts receivable and inventory in, for example, the jewelry and the apparel business.