In the Winter 2010 issue of Art & Advocacy, we examined the problems a private bank that lends money to an art collector faces due to the likely inapplicability of UCC Article 9’s consignment rules to most art dealers. That deficiency exposes a lender to the danger of losing its priority in collateral securing its loan to a creditor of an art dealer in a situation where artwork collateral is consigned by a collector to the dealer without the lender’s consent. Interestingly, a lender to the dealer may also face problems due to this unfortunate gap in the law. The absence of a straightforward procedure designed to protect consignors (and their lenders) also means that a secured lender to an art dealer cannot simply run a lien search to determine which works on display in the dealer’s gallery are unencumbered inventory belonging to the dealer-borrower and, therefore, available as collateral.
This uncertainty is exacerbated by the “handshake culture” and inadequate paperwork that are almost traditional in the art world. The result is that it can be difficult for anyone to determine exactly which artworks belong to the gallery (and constitute the lender’s inventory collateral), which belong to the gallery owner personally (but are on display in the gallery), which have been consigned, and which are the subject of participation arrangements between the dealer and one or more thirdparty investors. Both the Salander O’Reilly and Berry-Hill bankruptcies were rife with stories of this kind of chaos. In the Salander case, consignors (including John McEnroe and other celebrities) went through months or more of anxiety over their inadequate title documents and the possibility that their often very valuable artworks might somehow be lost to the gallery’s creditors. At the same time, lenders that had advanced money against the inventory of one of these galleries worried that they had been deceived about which works included in their “borrowing base” were subject to the claims of consignors, participants, and other third parties.
A lender that provides working capital loans to a dealer, secured by a “blanket” lien on all of the dealer-borrower’s inventory and accounts receivable, typically provides in its loan documents a formula whereby the lender’s commitment to extend credit will be limited to a percentage (typically around 35%) of what is called “eligible inventory.” For a dealer-borrower, this usually means that: (1) the inventory is located on premises where the lender has easy access to take possession, if necessary; (2) the art has been appraised by a lenderapproved expert; (3) the art is adequately insured and in good physical condition; and, most importantly, (4) no third party has a claim of title or similar rights to the works in question or to the proceeds from their sale. This is well traveled ground for middle-market bankers and presents no particular challenge for the lawyers drafting the documents. But if the bank does not conduct adequate due diligence to determine whether its borrower has the documentation to support its claim of unencumbered title to each item of “eligible inventory,” it may find that its real borrowing base is far smaller than reported in the monthly borrowing base certificates provided, pursuant to the loan documents, by the borrower.
There are, of course, different ways to carry out due diligence. A true asset-based art lender (typically a fund, and not a commercial bank) relies almost entirely on its ability to turn its collateral into cash, and cares only minimally about the borrower’s character and reputation. Such a lender would not usually finance a dealer’s entire inventory. Rather, it would more likely study the provenance of a limited number of artworks, accept those works as collateral, and take physical possession of the works—either directly or through an agent, such as a warehouse that issues a receipt to the lender.
A bank, however, is likely trying to begin or to preserve a long-term relationship with the dealer. A full dominion and control approach would not be well suited in such a case. Instead, a bank would be more likely to monitor its inventory collateral and declare ineligible any item that does not pass muster. Commercial bank lenders also try to be discerning about which dealers to trust and which to avoid. These lenders may rely on the dealer-borrower’s certifications as to its “eligible inventory,” but they understand better than the typical asset-based lender the details of the borrower’s business, competitive position, key relationships, and finances.
Commercial banks in the business of lending to art dealers should strive to improve, not scrap, their basic approach to due diligence on their inventory collateral. Banks making this kind of loan should encourage, among their borrower clientele, improved documentation on all consignments, participations, and similar encumbrances. Taking possession and doing full “asset-based lending style” due diligence on every item of a dealer’s inventory are not practical measures for middle-market bank lenders. However, requiring dealer-borrowers to follow best practices in documenting transactions is the simplest and easiest way for banks to mitigate the impact of the inapplicability of Article 9’s consignment rules and the widespread practice of oral agreements and unwritten promises in the art business.