Private Bank Loans: Consignments Pose Additional Risks

January 2010Art & Advocacy, Volume 5

The Fall 2009 issue of Art & Advocacy presented the first installment in a series examining the potential hazards faced by private banks that accept artwork as collateral for loans but do not take possession of the artwork. That article examined a straightforward sale of art collateral by a private bank client to another collector without the bank’s consent, and concluded that there are commonly occurring scenarios in which a bank that does not take possession of its collateral may find that its security interest in the artwork has been extinguished. In this installment, we examine the private bank’s position when a client places artwork used as collateral on consignment with a third party.

A typical consignment takes place when an owner of goods (the consignor) delivers those goods to a third party (the consignee) so that the third party can sell the goods on behalf of the owner. The consignor retains title until a sale is completed, but the items to be sold are physically turned over to the consignee. Assume that a private bank (PB) has made a loan to a client (C), accepted as collateral a painting owned by C, perfected PB’s security interest by filing a financing statement, obtained a security agreement from C prohibiting the sale of any collateral without PB’s consent, and left the painting in the possession of C. Further assume that C subsequently decides to sell the painting, but instead of arranging a sale directly with a buyer, C consigns it to an art dealer (AD) without advising PB. In addition to placing C (and, therefore, PB) one step away from the ultimate buyer, a consignment introduces AD’s creditors as parties with potentially competing interests in PB’s collateral. Future articles will examine issues that can arise with respect to PB’s security interest when AD sells the painting. This article addresses the rights of PB and AD’s creditors if AD defaults to its own lender or files for bankruptcy while the painting is on its premises.

With consignments, the threshold inquiry is whether the business arrangement meets the special criteria for a consignment under Article 9 of the U.C.C. If it does, Article 9 provides a procedure whereby a consignor can protect its property from the consignee’s creditors. If it doesn’t, the consignment falls into a legal twilight zone, where the conflicting rights of C (and PB) and AD’s creditors will be determined either under Article 2 of the U.C.C. or by common-law rules pertaining to bailments.

In order for a consignment between C and AD to fall within the purview of Article 9, several elements must be satisfied, the most significant of which are as follows:

  1. Immediately before delivery to AD, the artwork must not be “consumer goods,” that is, goods used or bought primarily for personal, family, or household purposes. This means that C must not be a mere private collector of art, but must sell or trade art from time to time. (In this regard, note that there is a legal question as to whether artwork, even if owned by a collector who rarely, if ever, trades, is more of an investment than it is consumer goods.)
  2. AD must be an art dealer who is not an auctioneer.
  3. AD must not be generally known by its creditors to be substantially in the business of selling the goods of others. In other words, for this consignment to qualify as an Article 9 consignment, AD’s creditors must believe that AD’s main business is to sell inventory owned by AD itself.

If C is a collector, his artwork may well be considered “consumer goods.” In addition, many, if not most, art dealers are known to be substantially in the business of selling works on consignment. Thus, there is a strong probability that a court would find that Article 9 does not govern the situation. If that happens, a court might then find that the consignment qualifies as a “sale or return” transaction under Section 2-326 of the U.C.C., which would specifically allow the claims of AD’s creditors to attach to C’s artwork while in AD’s possession. The other possible outcome from a non-Article 9 consignment is that the transaction would be seen as a bailment under common law. In such case, the artwork would be returned to C with title intact, albeit after a long and expensive legal battle for C and PB.

Even if the consignment between C and AD were somehow found to be an Article 9 consignment, PB’s vulnerability to the claims of AD’s creditors would by no means be eliminated. As noted above, Article 9 provides a procedure whereby C can protect itself (and PB) from such claims by filing a U.C.C. financing statement against AD, and by sending notice of the consignment to AD’s existing creditors that have filed financing statements covering AD’s inventory, including after-acquired property such as C’s artwork. Such notices must be received by creditors within five years of delivery of the artwork to AD. It seems clear from the nature of the foregoing requirements, and from the conventions and common practices in the art world, that consignors of art are unlikely to file the U.C.C. financing statement, run the lien searches and send the notices required to fully protect themselves (and their lenders, such as PB) from AD’s creditors. Even where there is a true Article 9 consignment, if these steps are not taken, the artwork could well be treated as AD’s asset and be lost (by C and PB) to AD’s creditors. At a minimum, PB’s challenge to AD’s creditors’ priority would be costly, and its outcome uncertain. Thus, even where the facts surrounding a consignment afford C and PB a viable means of protection from AD’s creditors under Article 9 of the U.C.C., AD’s creditors would not necessarily lose their priority.

All of the foregoing points to the same conclusion: A private bank that lends against art collateral, without taking possession of the artwork, can find its position as a secured lender placed in jeopardy if its clients consign collateral without its approval. Taking possession of art collateral is generally not a realistic option for a private bank. If a private bank’s client is having liquidity problems, however, or is otherwise under a significant financial strain, the risks are sufficient enough that the bank may want to reconsider taking possession. In fact, in any kind of distress situation, the pitfalls seem sufficient to warrant regular, perhaps quarterly, monitoring of art collateral to verify its location.