The Art of Perfection: Avoiding Pitfalls in Gallery Bankruptcies

With the current economic downturn pushing many art galleries to the brink of insolvency, there is no better time than now to assess the rights that collectors and artists have if a gallery with which they have consigned valuable artwork files for bankruptcy while in possession of their artwork. Should collectors in this situation fear that they may lose their artwork in a battle with the gallery’s other creditors? Should artists have similar concerns? The answers to these questions may be quite different, and will depend upon the facts and circumstances of the particular case. However, both collectors and artists have cause for concern unless they have taken the necessary steps to protect themselves.

The bankruptcies of once-prominent galleries, such as the Andrew Crispo Gallery, Salander O’Reilly, and Berry-Hill, illustrate the competing interests of agency law, which serves largely to protect the principal’s property rights while that property is in the possession of his agent, and bankruptcy law, which seeks to equitably distribute the debtor’s property for the benefit of all creditors. The art world rarely observes the formalities that are part of the fabric of ordinary commercial dealings. The executive who ensures that his company perfects and protects its security interests in routine business transactions is usually less careful in his personal art dealings, even though he could face severe consequences for not perfecting or protecting his interests in his art. Applying business discipline to art dealings requires a change in the mindset of galleries, collectors, and artists alike; failure to do so could cause collectors and artists to lose their entire investment if the gallery with which they have consigned artwork files for bankruptcy. To protect themselves, collectors and artists need to be diligent in entering into tightly drawn contracts, perfecting their liens on their artwork, complying with applicable lien notification requirements, and keeping close tabs on the whereabouts and status of their artwork.

Treatment of Consignments Under the UCC and Bankruptcy Code

The starting place in assessing rights of consignors is the Uniform Commercial Code (“UCC”). A threshold question with respect to any particular consignment is whether it falls under the umbrella of Article 9 of the UCC, which governs most consignments. If Article 9 applies, the consignor with an unperfected interest in his artwork faces an uphill battle in prevailing against a gallery’s bankruptcy estate because the UCC treats the consignee similar to an owner of the consigned property.

In order to take a consignment out of the ambit of Article 9 of the UCC, the consignor must establish the existence of one of the statutory exceptions, including that: (i) the consignee is “generally known by its creditors to be substantially engaged in selling the goods of others,” or (ii) the goods are consumer goods immediately before delivery. In a gallery’s bankruptcy case, a consignor with an unperfected interest in his artwork may be forced to litigate one or both of these issues before a bankruptcy court. UCC § 9-102(a)(20).

Under the “generally known” exception, the consignor has the burden of proving that most of the gallery’s creditors were aware that the gallery was substantially in the business of selling artwork on consignment. This burden will be difficult for consignors to satisfy, particularly where the gallery obtains artwork under a variety of different arrangements. Under the “consumer goods” exception, the consignor has the burden of proving that the artwork was “used or bought for use primarily for personal, family or household purposes.” Establishing the purpose of acquisition or use is not as easy as it sounds, however, because the answer to the question of whether the consignor bought or used the artwork principally for investment purposes or personal enjoyment is highly subjective. The analysis is further complicated by the fact that investment and personal enjoyment motives are not necessarily mutually exclusive. Given the lack of clearly defined case law in this area, the consignor cannot take comfort in how courts will rule on these issues. Moreover, regardless of whether the consignor ultimately prevails, the litigation likely will be hard fought, costly, and time consuming.

If Article 9 applies, the consignor may be found to have a lien on the consigned artwork. The UCC grants consignors an automatic purchase-money security interest in inventory. Thus, if the artwork qualifies as inventory, the consignor would have a lien. To perfect such a lien, the consignor must provide statutorily prescribed notice to holders of competing security interests who have filed a financing statement covering the same types of inventory before giving the consignee possession of the property. UCC § 9-324(b)&(c). This necessitates the performance of a lien search to ascertain the gallery’s secured creditors prior to delivering the artwork. If the security interest is perfected, the consignor is entitled to first priority in the artwork and stands in front of all other creditors. If the security interest is unperfected, the consignor may face a much less favorable outcome.

If the consignor’s security interest is unperfected, then, “for purposes of determining the rights of creditors of . . . a consignee, while the goods are in the possession of the consignee, the consignee is deemed to have rights and title to the goods identical to those the consignor had or had power to transfer.” UCC § 9-319. Consistent with the UCC’s policy of guarding against hidden liens, the consignee is treated as owner of the property unless the consignor has perfected its security interest.¹ If the consignor’s security interest is unperfected, the gallery’s other creditors may share in the value of the consigned artwork. In other words, the consignor may be stripped of all ownership rights and relegated to the position of a general unsecured creditor.

Since Section 541(a)(1) of the Bankruptcy Code deems “all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case” to be part of the bankruptcy estate, and since a gallery’s bankruptcy estate is entitled to set aside any unperfected liens under the “strong arm” provisions of Section 544(a) of the Bankruptcy Code, the bankruptcy estate will be able to sell the artwork free and clear of liens, claims, and encumbrances and treat the consignor who has an unperfected interest as a general unsecured creditor. 11 U.S.C. § 363(b), (f). The consignor who owned the artwork is left without meaningful recourse, a result that may seem counterintuitive and unfair. This potentially harsh consequence shows why it is critical for consignors to perfect their security interests.

Even if Article 9 does not apply, the inquiry does not necessarily end. The consignee’s creditors may also attempt to defeat the consignor by contending that the transaction is governed by Article 2 of the UCC.² Section 2-326 differentiates between “sale on approval” goods (i.e., goods delivered primarily for use) and “sale or return” goods (i.e., goods delivered primarily for resale). Goods found to be “sale or return” goods are deemed to be subject to the claims of the buyer’s creditors as long as such goods are in the buyer’s possession. Thus, as the bankruptcy court held in In re Morgansen’s, Ltd., if artwork is consigned to a merchant on a “sale or return” basis, the merchant’s other creditors will be able to look to the artwork to satisfy their claims.³ Therefore, the manner in which the contract is structured is important.

Special Protection for Artists

Most states have enacted legislation to protect artists who consign their artwork to galleries from the claims of the galleries’ creditors. For example, New York has enacted a statute that deems the gallery to be holding fine art as trust property for the benefit of the consignor-artist.⁴ The statute makes clear that the trust property cannot be made “subject or subordinate to any claims, liens or security interest of any kind or nature whatsoever.” Thus, under the New York statute and similar laws in other states, artists who consign their artwork to galleries are better protected than collectors who do so. The protective statutes, however, do not always afford full protection to artists. Unless the legislation expressly repeals the various UCC provisions, as the New York statute arguably does, those provisions can still be deemed to control.

When Consigned Property Is Moved

With many galleries operating in the international arena, it is common for artwork to be moved to countries other than the one in which they were originally consigned. If a consigned artwork in which a security interest has been properly perfected is moved by a New York gallery to its London branch, for example, and the London branch files for bankruptcy protection, the artwork may not be shielded from claims of the London branch's creditors. Thus, consignors would be well advised to build into their consignment contracts restrictive covenants that prohibit the consignee from moving the artwork without permission, along with notice requirements, to minimize this risk.

Conclusion

The best way to safeguard a consignor’s interest in artwork is by: (i) entering into a tightly drawn contract that structures the transaction properly and imposes restrictions on the movement of the artwork, and (ii) perfecting the consignor’s lien by complying with UCC notification requirements and filing UCC-1 financing statements. While similar measures are routinely effectuated in the business world, they are much less commonly taken in the art world. Given the high stakes involved and the unkind treatment of unperfected consignment liens in bankruptcy cases, prudence requires that they be taken.

---

¹ The concern about hidden liens appears to be less valid in the art world, where consignments are a common occurrence. See Note, “A Picture Imperfect: The Rights of Art Consignor-Collectors When Their Art Dealer Files for Bankruptcy,” 58 Duke L.J

² Although the 2001 amendments to the UCC removed true consignments from Article 2, and. 1859, 1863 (2009). caused them to be treated under Article 9, courts continue to review transactions under Article 2 if they fit the “sale on approval” or “sale or return” criteria. If neither Article 9 nor Article 2 applies, the court will look to the common law on bailments.

³ 302 B.R. 784 (Bankr. E.D.N.Y. 2003).

⁴ N.Y. Arts & Cult. Aff. Law § 12.01(a).