Time to Take the Risk Out of Consignments

May 2014Art & Advocacy, Volume 17

"A picture imperfect" is how Hilary Jay, writing in the Duke Law Journal in 2009, described the application of the consignment rules in Article 9 of the Uniform Commercial Code ("UCC") to artwork. In her paper, Ms. Jay noted that most consignments of artworks to dealers may well fall outside the scope of a "consignment" as defined in revised Article 9 (effective in New York as of July 1, 2001). This means that the protections available to consignors under Article 9 (both the rights of a secured party and the ability to perfect a super-priority purchase money security interest in items they have consigned) are likely unavailable to consignors of art, potentially leaving them vulnerable to claims of an art dealer's/consignee's creditors. In and of itself, that seems to be an unjust result, but there is also a second problem caused by Article 9's apparent exclusion of most art consignments: potential working capital lenders to art dealers are unable to run a simple search of public records that will identify all encumbrances on the title to their borrowers' assets. I am advocating for a change in the UCC that will protect consignors from a risk that most of them do not even realize they are taking, and will enable lenders to easily determine which items of ostensible dealer inventory are, in fact, owned by third-party consignors.

The Problem

Under Section 9-102(a)(20) of the UCC, in effect in New York State, a consignment is defined as follows:

"Consignment" means a transaction, regardless of its form, in which a person delivers goods to a merchant for the purpose of sale and: (A) the merchant: (i) deals in goods of that kind under a name other than the name of the person making delivery; (ii) is not an auctioneer; and (iii) is not generally known by its creditors to be substantially engaged in selling the goods of others; (B) with respect to each delivery, the aggregate value of the goods is $1,000 or more at the time of delivery; (C) the goods are not consumer goods immediately before delivery; and (D) the transaction does not create a security interest that secures an obligation.

The problematic requirements, for our purposes, are (i) that the consigned goods not constitute "consumer goods" immediately prior to their delivery to the consignee, and (ii) that the consignee must not be generally known by its creditors to be substantially engaged in selling the goods of others.

No one knows with certainty if, or under what circumstances, art that is part of a personal collection constitutes consumer goods. Section 9-102(a)(23) of the UCC defines "consumer goods" as goods "used or bought primarily for personal, family or household purposes." Arguably, the ownership of any fine art of substantial value carries an investment dimension, whether or not the owner/consignor has a history of trading art. However, if art worth millions of dollars has been displayed in a family's home for decades, the "personal, family and household purposes" are surely present, as much as with some decorative fireplace tools or a wall sconce. One might say that at a certain price point the investment aspect becomes primary and that goods (art or otherwise) cease to be consumer goods. But the UCC offers no guidance on what that threshold would be, and the only meaningful way to determine if a particular item would meet such a value test, if there were one, would be to conduct an appraisal immediately prior to delivery to the consignee, however impractical that might be.1

If the question of value were all that was involved, there might be a reason to consider a price point test as a solution to the consumer goods problem. However, there are many collectors who buy and sell art with varying degrees of frequency. Determining how much trading is too much for an artwork to constitute a consumer good (as opposed to an investment or even inventory) is a question of fact that would have to be decided on a case-by-case basis. In short, few, if any, collectors/consignors can ever really know if a piece from their collection constitutes a consumer good immediately prior to delivery to a consignee/dealer. For this reason alone, no consignor can be certain whether or not any particular art consignment will fall under Article 9.

Moreover, as noted above, the consumer goods issue is only part of the problem. Aside from being impractical in general, because establishing the facts needed to meet the burden of proof (as a consignor would have to do) would be cumbersome, the requirement that the consignee not be "generally known by its creditors to be substantially engaged in selling the goods of others" plainly excludes most art consignments from the ambit of an Article 9 consignment, as it is widely known that consigned artworks constitute an important part of the inventory of most art dealers. Case law has established that being "generally known by its creditors" means being known by a majority in number (regardless of the amounts owing) of a consignee's creditors. The few reported cases in this area also indicate that the standard for being engaged "substantially" in selling the goods of others means 20% of the consignee's sales volume. It is generally believed that most art dealers in New York easily exceed that 20% threshold.

There can be no doubt that this picture is "imperfect" unless one chooses to say that Article 9 simply does not work for consignments of artworks. But the art business has no less need for a viable legal framework for consignments than other industries do. Indeed, there are few, if any, businesses where consignments are so common and the value of the consigned "goods" so high. And it is not as though insolvencies are unknown in the world of art galleries. In both the Berry-Hill and Salander-O'Reilly bankruptcies, consignors have struggled, often for long periods of time and at considerable expense, to recover the very art they owned.2 In other cases, consignors have actually lost their art to the creditors of a bankrupt dealer.3

If Article 9's consignment rules are inapposite, then the filing of a UCC financing statement by a consignor will be of no legal effect. As a result, in the event of a dealer's insolvency, an art consignor is likely to find himself caught up in a legal imbroglio where the gallery's creditors will argue that Section 2-326 of the UCC should control. This section expressly exposes items delivered to a merchant, on a "sale or return" basis, to claims of the merchant's creditors. Some courts have accepted this argument, to the consignor's detriment, but others have rejected it. When a court finds that no Article 9 consignment was created and also holds that Section 2-326 is inapplicable, the common law of bailments will apply. This would very likely benefit the consignor. We need not come to a conclusion as to whether the Section 2-326 or the bailment analysis is correct (and the specific facts of each case may weigh heavily on the outcome of such an inquiry) to recognize the absurdity of all of this from the consignor's perspective.

Finally, we should note that in the unlikely event that an art consignment were found to be a proper Article 9 consignment, in order to have priority, the consignor must have (i) within five years prior to delivering the consigned art to its consignee, sent a written notice of its purchase money security interest to each creditor holding a security interest in the inventory of the consignor's dealer, and (ii) previously filed its own UCC financing statement. If the consignor did not take these steps, his security interest would come after any properly filed inventory lender to the dealer who had been granted a security interest in "after-appraisal property." This outcome would be at least as bad for the consignor as a court following the Section 2-326 line of reasoning.

The Point

The point is that exposure to claims of a gallery's creditors is not a risk that most art consignors even realize they are taking, and there is no need for the system to continue to work this way. The drafters of revised Article 9 were concerned with protecting working capital lenders from hidden liens against ostensible inventory. They, therefore, wrote consignment rules that effectively reduce or eliminate that risk for, as Hillary Jay noted, "the consignment of screwdrivers to a shop." Two unintended consequences of those rules, however, have been to (i) deny similar protection to consignors of art to dealers, and (ii) deny lenders and dealers alike a system in which prospective lenders to those dealers can search public records and identify which of the works for sale in a gallery belong to third-party consignors.

Possible Solutions

A number of relatively simple solutions are available to fix these problems. For example, since 1995, New York's Arts and Cultural Affairs Law has protected artists from claims by the creditors of art gallery consignees and unscrupulous art dealers by deeming all monies owing from an art dealer to an artist from the sale of an original consigned work to be held in trust for the artist. In 2012, New York State amended that law, and the Estates, Powers and Trusts Law, to strengthen those protections. Massachusetts' law treats all consignments this way, whether the consignor is an artist or a collector. New York could do the same, but a better solution would be to amend the UCC to include a definition for an "art consignment" and to provide for a special kind of financing statement to be filed in the case of such a consignment.

The advantage of this kind of UCC amendment, over expanding the Arts and Cultural Affairs Law provisions to cover consignments from persons who are not artists, is that the public filing of a financing statement creates a record that can be searched by lenders interested in providing financing to art galleries. Herrick has substantial experience in representing commercial banks and niche lenders in making loans to art dealers. These lenders are aware of the possibility that what appears to be the inventory of a gallery may well belong to a third party, whether that third party is the gallery's principal owner or its foreign affiliate, or an independent collector/consignor. Determining the true ownership of art inventory is one of the real challenges on the credit side in lending to art dealers. Earlier this year, a senior credit officer at a prominent New York commercial finance lender told me that keeping track of title to gallery inventory is a "shell game." If New York had a system where consignors simply had to file a UCC financing statement in order to protect themselves from inventory lenders, I submit that, over time, it would become common practice to do so, even in the "handshake culture" of the art world. This, in turn, would encourage more potential inventory lenders to consider making credit facilities available to the galleries, because the lenders would no longer have to rely solely on their borrowers' representations as to which artworks constitute owned inventory eligible to serve as collateral against which money can be lent.

More about UCC Consignments

Article 9 of the UCC does not deal with "title" to goods that are consigned pursuant to its rules. Rather (as noted above), in the case of a consignment meeting the criteria of Section 9-102(a)(20), a consignor is given the opportunity to create a super-priority purchase money security interest in the consigned goods (e.g., screwdrivers) that is superior to that of a holder of a previously filed security interest in the inventory of the consignee (e.g., a hardware store). In order to realize that opportunity, however, the consignor must not only file a UCC financing statement, but must also send written notice to previously filed secured parties having an interest in the consignee's inventory within five years before the delivery of the consigned goods to the consignee.

The amendment to the New York UCC that I am proposing would eliminate the requirement that consignors give notice in order to attain superpriority. It is one thing to ask art collectors to depart from the traditional paperless approach to the business of art by requiring them to file a simple "art consignment" financing statement; it would be unrealistic to also require them to run a lien search, interpret the results of that search, and then send a formal legal notice to pre-existing secured parties who have filed against "after acquired" inventory, merely to establish the consignors' right to something of value that they rightfully believe they own.

Amending the UCC

There is precedent for my proposal. Even though the UCC has been adopted in all 50 states, there are many relatively minor state-to-state variations found in Article 9 and elsewhere within the Code. For example, in 1988 New York amended Article 9 to provide that filing a special form of financing statement was the only way to perfect a security interest in the shares of stock and proprietary lease for a co-op apartment. Until then, there had been some confusion because there was no rule specific to co-ops, and the UCC required a lender to take possession of the certificate evidencing the shares in order to perfect the security interest. That was easy enough, but the question was what to do about the proprietary lease, which represented an interest in real estate, and was therefore outside the scope of Article 9. Under real estate law, a lender could acquire priority in a lease only by recording an assignment of that lease in the land records. Very few lenders actually took that step when lending on a co-op apartment, in part because the boards of New York co-op buildings disapproved of the recording of such assignments because they would be recorded against the title to the building itself (and would have also required the recording of the proprietary lease itself or a memorandum of such lease). This created unnecessary legal uncertainty at a time when the value of these apartments had been rising rapidly as New York City rose from the depths of its financial difficulties of the 1970s. So the law was changed (and a non-uniform provision was added to the New York UCC) to provide a simple and straightforward system for co-op lenders to protect their interests by filing a special form of financing statement. I submit that the time has come for New York, with its relatively large number of art dealers and collectors, to take a similar step to facilitate a better – and fairer – working of the widespread practice of art consignments in the state.

What about Confidentiality?

Some people have expressed concern that requiring consignors to effect a public filing in order to protect their interest in a consigned artwork ignores the traditional – and understandable (to a degree) – desire of collectors to maintain strict confidentiality about their art and their addresses. My own view is that the same people routinely make public the same kind of information, without any particular hesitation, when it comes to co-op apartments and other real estate. In addition, simple devices used in real estate, such as putting record title into the name of a trust or another entity in order to maintain confidentiality, could be employed in the art world as well. The UCC itself provides an additional solution to this problem, in that it does not require great specificity with respect to a collateral description in financing statements. Rather, Article 9 provides for "notice filing," meaning, among other things, that for a financing statement to be legally effective it does not have to contain as much detail as the security agreement. There is some uncertainty as to exactly how much detail is needed for a legally effective collateral description in a financing statement, but the proposed UCC amendment could expressly provide that a description would be sufficient if it referred, for instance, to unspecified artworks set forth in a plainly identified but unfiled consignment agreement.

Time for the Business of Art to Join the Rest of the Commercial World

My bottom-line conclusion is that providing effective and practical legal protection for consignors would ultimately benefit everyone in the art world. As with title insurance, the traditional ways of doing business may have served many people well enough for a long time, but with increasing amounts of money being invested in art and the prevalence of a visual culture that seems more widely interested in art than ever before, it is high time for commercial common sense to supplant tradition and trust. There is, admittedly, something gracious about an environment where a person's word is his bond, and a "handshake culture" sounds refreshing, even to lawyers, in this respect. But those things have been true, at one time or another, in every sector of the commercial world, and people have nonetheless seen fit, over time, to superimpose laws on these systems. In general, there is nothing in particular about the commercial side of art that is different from the world of commerce. It is just a question of changing conventions to bring more reason and order to bear on a largely unregulated and opaque business. Some of the changes I envision, like title insurance,4 cost money and are, in certain ways, complex. But others, like changing Article 9 to accommodate art consignments, should be easy and cost nothing.

Members of Herrick's Art Law Group are presently consulting with a major bar association about legislation to amend Article 9 of the UCC in New York State as proposed in the foregoing article.

1 In In re Morgansen's Ltd., 302 B.R. 784 (2003), the bankruptcy court seems to have assumed that art, jewelry, and other items having a value of $1,000 or more are not"consumer goods." But there is no statutory basis or legal precedent establishing such a bright line.

2 See, e.g., In re Salander-O'Reilly Galleries, 475 B.R. 9 (S.D.N.Y. 2012).

3 In re Morgansen's Ltd., supra; Rayfield Investors Co. v. Kreps, 35 So. 3d 63 (Fla. Dist. Ct. App. 2010).

4 For an in-depth discussion of the potential role of title insurance in the art market, see, The Case for Title Insurance, 15 Art & Advocacy 1 (Spring/Summer 2013).