Most everyone has now heard that art has been dubbed “the new asset
class.” Huge returns on art investments in recent years have driven art
prices to record highs across nearly every collecting medium. Art
investment funds have returned to the market in new sectors such as the
Middle East, Asia and Russia, and major U.S. and international banks
have increased their focus on art collectors by lending more against
art (subprime mortgage crisis notwithstanding). Today’s collector
increasingly views art as an investment rather than a purely cultural
pursuit, and also looks at it with renewed interest as part of
tax-favored strategies such as IRC Section 1031 “like-kind” exchanges
of art.
A
hand-me-down painting once thought to be inconsequential is now
recognized as a multimillion-dollar asset, which thrusts both the
client and advisor into a world that neither of them may be familiar
with. Clients who have gradually amassed a number of items seldom think
of themselves as collectors and thus do not apply to their art the same
best practices that they apply to their traditional assets.
Advice
practitioners and art-active clients should understand the legal and
financial risks that pervade this new asset class-whether the client is
building a collection or engaging in estate planning or philanthropy.
This article will review these increasingly important and complex
issues.
How The Art Market Works
To
the uninitiated, there is nothing quite like the art world. Now
exceeding $50 billion in annual transactions globally, it is the
largest essentially unregulated industry in the world.
This
lack of regulation becomes vitally important to consider when one
starts to think about art as an asset, managing it just as one manages
other valuable assets. Clients routinely buy, sell and lend art for
exhibition, borrow against it and donate it, but they give little
thought to fundamental risks such as a work’s questionable ownership,
otherwise known as defective legal title. Steven Spielberg was
confronted with this unpleasant lesson in March 2007, when years after
he innocently purchased Norman Rockwell’s “Russian Schoolroom,” the FBI
came knocking on his door to reclaim the painting, which had been
stolen decades earlier.
Defective title is the most insidious
risk in today’s art world, a hazard inherent in an unregulated industry
that lacks transparency in its transactions. The lack of transparency
stems from the long-standing practice in the industry of withholding
seller and buyer identities in order to protect their privacy, as well
as to conceal the dealer’s source and pricing.
As a
result, clients don’t know the ownership risks of the art they buy,
because they don’t have access to details about the seller’s legal
title to art. They also don’t know whether the dealer owns the art or
is acting as an agent for the actual owner (which means it’s unclear
who has the authority to sell and the ability to transfer the title
free and clear). The involvement of intermediate dealers reconsigning
works may keep the actual owner several steps removed from the current
transaction. What makes the issue worse is that there is no single
repository of public or private industry records that would enable a
buyer to thoroughly investigate the legal title to a work of art. There
is varying anecdotal information, some of which is publicly available,
and there is often provenance information (the records of ownership for
a work of art or the records of its whereabouts after leaving an
artist’s studio up to the present day) but such records are often
incorrect.
Where, then, does this leave the very wealthy
acquirer of art? Sales by dealers and galleries, which rarely own the
inventory they sell, make up 75% of all market transactions globally.
Short of shifting the title risk to a third-party insurer, the
art-buying client’s ability to protect himself from defective title
rests entirely on his ability to negotiate indemnification from the
seller. But even a savvy buyer can still face problems. When a title
problem arises, as it did in Steven Spielberg’s case, it can be costly
and time-consuming to locate, serve, sue and obtain and enforce a
judgment against the seller at some unknown future date. This seller
may be an individual who is no longer alive or it may be a dealer that
is outside the U.S. or no longer in business.
The other 25% of
transactions come via the intermediary auction houses, where there is
even less ability to manage the title risk because these transactions
are subject to the auction house’s right to rescind the sale at any
time without limitation and because the auction house faces no
liability if questions arise later about the legal title to a work that
has been sold.
The following scenarios highlight the effect
this uncertainty surrounding art transactions can have on clients (and,
perhaps, the professional liability of advisors).
Charitable Gifts
If
a charitable gift of art is unwound because it is later determined that
the client did not have clear title to the work, the client faces
adverse tax consequences and the qualified 501(c)(3) institution faces
financial loss. The donor (or the decedent’s estate, depending on when
the title defect is discovered) faces a loss of the charitable tax
deduction plus accrued interest and likely penalties. If a museum is
involved, it will likely suffer economic loss because museums build
their permanent collections around important gifted works, relying on
the assumption that they are acquiring valid legal title. There are
complex statute of limitation issues one must consider when assessing
the penalty on charitable gifts that were void from the beginning.
These issues, as well as the interface of fraud and discovery rules
under the IRC, are topics for a separate discussion.
Also, the
donor and recipient can find themselves at odds when gifts of art turn
out to have a defective title. If a donor gives a museum a piece of
art, and then a third party claims ownership, the institution has two
unattractive choices. On one hand, it can fight the claim, (which it
can rarely afford to do). On the other hand, it can acquiesce to the
third-party, but that means the donor will likely claim a monetary loss
because his tax deduction has been invalidated. Thus, in an unfortunate
twist, the client becomes an adversary of the very institution he or
she sought to support. And the advisor, meanwhile, could become the
target of the client, who will undoubtedly ask the logical question,
“Why was this title risk not managed when the philanthropy was
planned?”
Estate Plans
Similar
problems lurk in estate plans when art (or other tangible personal
property) is sold to pay estate taxes or supplement life insurance
purchased for paying those taxes. Heirs often do not want to keep their
parents’ art because they have different taste or because they prefer
to preserve the more traditional assets, such as real property
holdings, in the family’s estate.
Fiduciaries, such as
personal representatives and banks and trust company officers acting as
independent estate settlement agents, may universally sell the art in
an estate at public auctions in order to assure market neutrality and
thus meet their fiduciary duties. But if the auction sale is later
rescinded because of defective title-and the art returned and the sale
proceeds refunded to the auction house under the auction contract
terms-the heirs must be told why it was necessary to liquidate other
estate assets and suffer significant tax consequences.
Identical
challenges exist for estate transfers of art to tax-beneficial entities
such as private operating foundations. The only difference is that the
defective title issue is delayed. The fiduciaries (which may include an
independent trust company officer, who is now posing challenging trust
administration questions) will be charged with managing the
foundation’s art assets. When the foundation sells, lends for
exhibition or buys works of art to fulfill its mission, the fiduciaries
will face the same title risk.
An Alternative To Self-Insuring
The
proactive risk management of your clients’ art has never been more
important now that the values and complexities of art transactions are
increasing. Clients can continue to self-insure against this risk, as
long as their decision is based on a complete understanding of the
risk’s nature and severity. But few clients are likely to have enough
knowledge to make that decision.
The alternative is title
insurance, which has evolved as a means of managing art ownership
risks. For one to buy, sell, gift or otherwise use property
efficiently, one needs the linchpin of certainty that he or she has
legal ownership. This point is just as true for a client’s art as it is
for his real estate. The key features of art title insurance are
similar to those for real property title insurance: (i) a one-time
premium for coverage for the life of ownership of the work (and the
life of ownership of the heirs at law); (ii) no deductible; (iii) full
indemnity for the value of the art based on the purchase price or a
fair-market value appraisal of the art for owner-in-possession
policies; and (iv) defense costs outside the limits, that is, in
addition to the indemnity for the insured work. Policy endorsements can
give clients charitable gift protection, give them public relations
expense coverage if they are highly public parties and can give them
increases in limits for works that appreciated in value after the
policy inception.
Thinking More Broadly
This
article barely scratches the surface of the risks that clients and
their advisors face when art is a significant element of the overall
asset base. Art should be viewed broadly to include similar
collectibles that have identical title risks, such as limited edition
books and manuscripts, vintage automobiles and rare musical
instruments. If a client does not actually own his or her valuables
free and clear, then their ability to engage in any transaction-buying,
selling, gifting, borrowing against, lending or engaging in a tax
strategy-is at risk and they, together with their advisors, should give
new focus to what is indeed a new asset class.
Lawrence M. Shindell, J.D., is
chairman & CEO of ARIS Corporation. ARIS is the world leader in art
title insurance and serves the art market and the fiduciary banking,
legal, museum and broader non-profit communities.
