Auction house and third party guarantees are a hot topic. At the 2015 Autumn sales in New York, Bloomberg reported that $1 billion - approximately half - of the $2 billion total value of lots were already sold before the "paddles are even raised". At the same time, Sotheby's confirmed that they had entered into an arrangement with the Estate of A. Alfred Taubman, its former chairman, to sell art from his collection, which was estimated to be worth in excess of $500 million. The arrangement provided that "Sotheby’s agreed to provide an auction guarantee for the collection at approximately that level".

An auction house guarantee is an agreement by which the seller agrees to consign their work or collection to an auction house. The auction house agrees to guarantee to the seller that, whatever the outcome of the auction, the seller will receive a minimum sale price for the work or collection.

How do they work in practice?

The exact way in which a guarantee will operate will depend on the terms and conditions that have been negotiated between the auction house and the seller in advance of the sale. However, the usual potential outcomes of an auction house guarantee are as follows:

  • The lot fails to sell at all: the auction house becomes the owner of the lot and pays the seller the full guarantee amount.
  • The lot sells for less than the guarantee amount: the winning bidder becomes the owner of the lot, and the auction house pays the seller the hammer price plus the difference between the hammer price and the guarantee amount.
  • The lot sells for more than the guarantee amount: the winning bidder becomes the owner of the lot and the auction house receives a proportion of the excess of the guarantee amount from the seller.

Does the auction house take on all of this risk itself?

In giving guarantees auction houses are taking a financial risk. This risk could be substantial, especially if the auction house is guaranteeing a number of high value works in the same period. In the autumn of 2008 Sotheby's reportedly lost $52 million in one season, all from guarantees. It has been reported that the Taubman guarantee resulted in a loss for Sotheby's and the auction house had to take possession of $33m of unsold artworks last year.

Whilst auction houses can take on the entire risk themselves, they can also choose to share the risk with a third party and that is where matters become more complicated. Typically, this works by the third party agreeing, for a fee, to place an irrevocable written bid for an undisclosed amount on the lot before the auction (known as a third party guarantee). The amount of the bid can be up to or exceeding the guarantee amount. As a result, the third party guarantor takes on all or part of the risk of the lot not being sold. For example, if an auction house gave a minimum price guarantee to the seller of £100 million for an artwork, but a third party guarantor places an irrevocable written bid for, say, £80 million, the auction house's risk is reduced by that sum. Third party guarantors may then also participate in the auction themselves and choose to bid on the lot over and above their irrevocable written bid.

Why do auction houses offer guarantees?

There are three primary reasons: profits, certainty and securing works for auction. If a lot sells for more than the guarantee amount, this can provide a good source of profits for the auction house. The guarantee provides certainty that the item will "sell" and therefore commission will be received. If an auction house offers a seller a guarantee as an incentive, they may secure the consignment of works that would otherwise have gone to their rival.

If you are a buyer, how do you know if an item is subject to a guarantee?

Lots which are subject to a guarantee are marked in the catalogue with a symbol and the symbol key in the auction house's conditions of sale provides an explanation. The auctioneer may also disclose at the start of a sale that some works will be sold with guarantees. However, the amount of the guarantee is not disclosed.

Seller advantages

  • Certainty: One of the biggest risks at auction is that an item will fail to sell. This can have a significant impact on the reputation of the item, as some would then consider it "burnt" in respect of the market. A seller may have to wait years before feeling confident enough to offer the item to the market again. A guarantee eliminates this risk, as a seller will have the certainty that their item will be sold.
  • Using the auction process to obtain a minimum price: Normally in an auction if a work fails to reach its reserve price, the work goes unsold, and the seller receives no money. A guarantee eliminates this outcome for works that risk not hitting a reserve.
  • Getting the best of both worlds: In the above circumstance, not only has a seller used the auction process to guarantee a minimum price, but they also have the benefit of the chance the item will exceed expectations and sell for an amount in excess of that at auction.
  • Better promotion of the work?: According to a New York Times article (7 January 2015) critics suggest that an auction house may put more effort into marketing an item in which it has an increased financial interest. However, this should not be the case, as legally the arrangement should not change the duty that the auction house owes to their client, the seller.

Seller Disadvantages

  • It could reduce your profits: Art Market Monitor (29 October 2015) suggests that in the current market sellers are "too smart" to sign up to guarantees. They raise the valid question: "If you know you have something really good … why take the auction house’s insurance policy at the cost of your own profits?".
  • It could reduce the price made at auction: Guarantee prices are not disclosed but they are often close to the pre-sale low estimate. Naturally the guarantor will always want to set the guarantee price as low as possible to reduce their risk. As a consequence, the auction estimate may also be set lower. The fact an auction house has estimated an item's value at a lower amount could have the knock-on effect of reducing the amount that buyers are willing to bid to auction.
  • It could deter bidding: a potential buyer will be aware that another buyer has already put his hat in the ring in respect of an item and will have done so at a potentially discounted price. This may dissuade a potential buyer from bidding as they know this is an item that has already been spotted and therefore there is less chance of obtaining the item at a 'bargain' price.
  • It could sell for less than would be received in the private market: The most important question for a seller to ask is 'if it is necessary for me to sign up to an auction house guarantee, should I really be selling at auction?' The very fact that such guarantees exist is an indicator of the risk of selling at auction.

Are guarantees ethical?

Auction house guarantees are legal but they remain a controversial topic as some consider that they serve to distort the market and inflate prices.

It is noted in the auction house catalogue that a lot is subject to a minimum price guarantee, but the guarantee amount is not made public and the guarantor knows the amount. Therefore, arguably they have information that puts them in a better position than their rival bidders. Normally, the reserve price is not disclosed to anyone else. This arguably threatens the idea that those participating in the auction process are doing so on a level playing field.

There have also been concerns raised over the fact that due to the existence of guarantees and risk-sharing the published price of an item sold at auction may not be the actual price paid.

It has been suggested, that collectors, agents and dealers may attempt to maintain high market values for an artist that they have a financial interest in, by acting as a guarantor and putting in a guaranteed bid. If the winning bid is higher than the guaranteed price, then the guarantor receives their fee and a share of the profits above the guarantee amount. Of course there is a risk that the guarantor may end up with the work if they place the highest bid. However, assuming they can afford it, they have both added to their collection of the artist's work, supported the market of the artist in whose value they hold a stake, and paid a 'discount' price as their fee has been deducted.

The terms of the guarantee are negotiable and in light of the effect it can have on the sums that a seller may end up receiving as a result of the guarantee, legal advice should be sought.

This article first appeared in the RICS Journal January 2017.