Private Bank Art Loans: The Risks of Non-Possessory Security Interests

November 2009Art & Advocacy, Volume 4

Many private banks will make loans to their clients, and receive fine art as collateral. Generally speaking, however, private bankers are reluctant to require these clients to relinquish possession of their art collections. The private banking relationship usually has trust as its cornerstone, and taking a painting off a client’s wall to put it in a bonded warehouse runs very much against the grain.

Although a lender can perfect a security interest by filing a U.C.C. financing statement and be just as protected from other creditors’ claims as it would be had it perfected by taking possession, credit risks resulting from this accommodation by the lender are self-evident (e.g., loss of the collateral due to theft or casualty coupled with lapsed or inadequate insurance). But banks that make this accommodation also face a less obvious risk. For example, what would happen if a client sold art used as collateral without advising the bank? Would the bank’s security interest (perfected by a properly filed U.C.C. financing statement) continue in the artwork after the sale? Is the buyer under a duty to investigate possible encumbrances on the seller’s title, such as the bank’s filed financing statement? The answers to these questions depend on certain additional facts.

Other than the risk a bank faces if it fails to promptly file a U.C.C. financing statement, the one clear risk evident in the foregoing fact patterns is that a sale by a client who the bank believes to be just a collector could turn out to be a sale by (what the law considers to be) an art dealer. The “ordinary course” sale rule is, among other things, intended to facilitate commerce by allowing the public to purchase inventory from a merchant without having to conduct lien searches and other due diligence. The language of the U.C.C. itself and certain cases decided thereunder make it clear that the question of whether a particular transfer is a “sale in the ordinary course” often depends on whether the seller is in the business of selling goods of the kind in question. The business of being an art dealer does not have to be the collector’s primary business for the risk of the involuntary loss of a security interest to arise. A private bank’s concerns are exacerbated by today’s common practice of collectors creating wholly owned limited liability companies or other such entities to buy and sell artwork, often in connection with tax-free exchanges under Section 1031 of the Internal Revenue Code. Such trading vehicles are far more likely to constitute dealers than are collectors who, from time to time, sell a painting or two.

The fact patterns presented are, of course, quite straightforward. In subsequent articles, we will examine consignment sales, auction sales, and other more complex scenarios, sometimes involving the creditors of a consignee or other dealer, all of which can bear upon the credit risk to a private bank that declines to require possession of art used as collateral.