Spotlight: art transactions in USA

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Art transactions

i Private sales and auctions

As a result of the covid-19 pandemic, which began at the start of 2020, the art market, like almost all other commercial activity, was disrupted. As a result, several cases have been brought by businesses against their insurance companies to recover for resulting business losses. The issue of whether a brick-and-mortar gallery could recover expenses under its business property insurance policy for pandemic-related disruption was addressed in 10012 Holdings, Inc v. Sentinel Insurance Co.44 The plaintiff brick-and-mortar art gallery located in New York sought coverage under its property policy for business income losses and expenses arising out of the March 2020 state-mandated closure of non-essential businesses due to the pandemic. The insurer denied coverage on the grounds that the art gallery had not suffered ‘direct physical loss’ within the meaning of the policy. The Second Circuit affirmed the decision of the district court and held that ‘physical loss’ did not include mere loss of use of the premises where there was no physical damage to the gallery’s property, and thus the gallery could not recover under its policy.

Although the covid-19 pandemic initially caused a dip in art sales generally, the art market made more than a full recovery in 2021, with the US market retaining its leading position. Online sales in 2021 continued to grow and generated a record high of US$13.3 billion, compared to US$12.4 billion in 2020. The auction sector rebounded with estimated sales of US$26.3 billion, an increase of 47 per cent compared to 2020.45 In-person auctions, art fairs and other modes of traditional sale returned, but have not returned to their 2019 levels of activity. With this resurgence, however, the share of online business declined in 2021 as a result.46

Digital art and non-fungible tokens (NFTs) have also continued to take the market by storm. In March 2021, a digital art collage, Everydays: The First 5000 Days, by Beeple sold at Christie’s auction house for a whopping US$69.3 million. The digital file was linked to an NFT, a unique asset (contrary to fungible tokens such as bitcoin or ethereum, which are interchangeable). Using blockchain technology, an NFT serves as a certificate of authenticity and ownership. Sales of art and collectible NFTs saw substantial growth in 2021 on NFT platforms to a total of US$11.1 billion in sales.47 The market for NFTs is constantly growing and evolving as are its legal implications (as further discussed below).

New York City, in what was considered a stealthy act, eliminated long-standing regulations48 governing the auction industry on 15 June 2022. Auctioneers will no longer have to obtain a licence to operate. Moreover, auctioneers will no longer be required to make disclosures in their written consignment contracts, such as the amount of the auctioneers’ commissions and charges. Nor in their auction catalogues are they required to disclose that a lot being sold is subject to a reserve price (which previously could not be above the low estimate) or that the auction house had a financial interest in the sale. The provisions designed to oversee ‘chandelier bidding’, whereby auctioneers invent fictitious bids to stir interest, were also repealed, and auctioneers are no longer prohibited from taking chandelier bids above the reserve price. As the large auction houses have not given any indication that they intend to change their practices as a result of the repeal,49 its effect on the industry is currently unclear.

ii Art loans

There are many reasons a private collector would want to loan a work of art to a museum. Museum loans present a philanthropic opportunity for lenders to share their work with the general public in a controlled and safe environment. Additionally, the borrowing museum may provide new scholarly information about the works of art. Inclusion in a museum exhibition could also bolster an artwork’s provenance, potentially increasing its monetary value through public exposure. Many museums, however, frown upon the sale of a loaned work shortly after an exhibition. These museums often include a provision in their loan agreements that prohibits a sale within a specified period after the close of the exhibition. These periods can range from as short as three months to as long as two years after the conclusion of the loan. Before loaning a work of art, a potential lender must first consider whether it is appropriate to lend a particular work, taking into account safety and damage concerns. Once these issues are addressed, the potential lender must then determine what should be included in the loan agreement once a work is approved for exhibition.

Lenders should also consider if the loan creates a use tax liability. This tax applies on account of a property’s use within a taxing jurisdiction (in contrast to sales tax, which applies on account of a property’s sale within a taxing jurisdiction). For example, if a painting is purchased in state A, and five years later is loaned to a museum in state B, the use of that painting in state B (i.e., its exhibition at a state B museum) may subject it to a use tax. Generally, sales tax paid on a property will be credited against the owner’s use tax liabilities, if any. The challenge, therefore, is mainly for items that were protected from sales tax, whether on account of happenstance or creative tax planning. The circumstances that create a sales tax exemption or discount tend to vary from state to state, and a work that has not been subject to sales tax might become subject to use tax on account of a loan to a museum situated in an inhospitable taxing jurisdiction. In those circumstances, a lender may face a use tax that is prohibitively expensive.

Another preliminary issue for the lender to consider is whether there are any provenance questions regarding the artwork. If there are competing claims to a work, these may open the artwork to the risk of judicial seizure. In the United States, the Immunity from Judicial Seizure Statute50 protects certain objects from seizure by the US government. Pursuant to the federal statute, any not-for-profit museum, cultural or educational institution may apply to the US Department of State for a determination that art to be loaned from abroad for exhibition is culturally significant and that the exhibition is in the national interest. If the application is granted, the art is immunised from judicial seizure by the federal government.

Unlike with individual collectors, where the lender is a cultural institution owned by a foreign state, there are added issues to consider. Under the FSIA, a foreign state and its agencies and instrumentalities are immune from suit in US courts unless certain exceptions apply.51 One of these exceptions is where rights in property taken in violation of international law are in issue. The Foreign Cultural Exchange Jurisdictional Immunity Clarification Act of 2016 added Section 1605(h) to the FSIA, which made clear that activities of a foreign state associated with the temporary exhibition or display of art determined to be immune from seizure shall not be considered ‘commercial activity’ within the meaning of the FSIA’s expropriation exception,52 which deals with cases in which rights in property taken in violation of international law are in issue.

Collectors lending to museums should also carefully consider the loan agreement with the museum. Although art loans raise legal concerns that touch on a variety of issues, the forms provided by the borrowing museum are often quite short and inadequate for the purposes of the lender. To maximise protection, lenders should not hesitate to negotiate and add any terms reasonably necessary to protect their interests to the loan agreement.

A few key areas to focus on include the following.

  1. Title: the loan agreement should make clear that the borrower does not have a right to sell or transfer title of the artwork.
  2. Insurance: the loan agreement should describe the insurance coverage for the artwork, including the work’s insurance value. International loan agreements should also take into account whether any government insurance will be provided. In the US, if the exhibition is insured through the Arts and Artifacts Indemnity Act of 1975, the US government will pay insurance claims in addition to the insurance coverage provided by the borrowing museum. This insurance applies to artwork loaned to US exhibitions, where the artwork is of educational, cultural or scientific value, and is certified by the Secretary of State as being in the national interest.
  3. Taxes: for international loans, the loan agreement should take into account any tax considerations that are specific to the host country. For example, in the US, the Internal Revenue Code, Section 2105(c), provides that artwork loaned to a public gallery or museum in the US will not be subject to estate taxes if the work remains on loan at the time of the owner’s death, as long as the owner is a non-resident who is not a US citizen.
  4. Copyright: the loan agreement may need to include copyright provisions. If the borrowing institution plans to photograph the artwork for publicity materials or commercial purposes, and the artwork is under an existing copyright, the borrower will have to obtain permission from both the owner and the copyright holder.
  5. Force majeure: the loan agreement should address the lender’s concerns about circumstances beyond the parties’ control, including war, natural disaster and political unrest. Many loan agreements excuse performance of certain provisions where events of this kind make performance of the contract dangerous.
  6. Term: the agreement should specify a term; this may help to avoid problems that would arise if the lender relocates or loses contact with the museum.

For every loan, there is a cost-benefit analysis that must be made. It is up to the lenders and borrowers to assess the risk and, if they decide to go forward with the loan, to ensure that steps are taken to maximise the safety and security of the artwork.

iii Cross-border transactions

Countries whose borders encompass the rich culture of ancient lands have struggled for decades to prevent the unauthorised excavation and smuggling of their cultural artefacts, and to attempt to reclaim them after they are discovered in the possession of museums, auction houses, galleries and collectors. The United States is the top importer of art in the world and thus, although they may arguably be insufficient, it has laws in place to combat this issue.

When US law is applicable, a true owner always has the right to reclaim stolen property, unless barred by the statute of limitations or other technical defences. To exercise this right, a plaintiff must first establish that it owns the property in question.

First, the foreign government claimant must prove that the object in the defendant’s hands is, in fact, the stolen item. A foreign government plaintiff must also demonstrate that at the time the objects were discovered in and removed from its territory, there were laws in place that clearly vested the government with ownership rights, or some other proprietary interest, in the objects. Virtually all ‘art-rich’ countries have enacted laws, mostly in the early twentieth century, declaring that anything found in or under the ground, even if not yet discovered, is owned by the government. These laws, called ‘patrimony laws’, are usually the key to establishing the foreign government’s ownership. Export laws are considered part of a country’s internal policing regulations, and generally are not enforced by the courts of other countries. Only foreign laws clearly establishing that the government owns everything found in or under the ground will be applied in US courts.

To avoid this distinction, however, several countries have entered into special bilateral agreements with the US government, pursuant to the Cultural Property Implementation Act of 1983 (CPIA),53 which implements the international Convention on the Means of Prohibiting and Preventing the Illicit Import, Export and Transfer of Ownership of Cultural Property.54 Pursuant to these agreements, the US agrees to enforce the export laws of these countries, and will therefore seize and return items brought into the US from these countries without an export permit, even without requiring proof that the government owns those items pursuant to patrimony laws. Several countries currently have these agreements with the United States, including Albania, Algeria, Belize, Bolivia, Bulgaria, Cambodia, Chile, China, Colombia, Costa Rica, Cyprus, Ecuador, Egypt, El Salvador, Greece, Guatemala, Honduras, Italy, Jordan, Libya, Mali, Morocco, Nigeria, Peru and Turkey. The CPIA also provides for emergency implementation of import restrictions without the negotiation of a bilateral agreement for objects that are shown to be in particular jeopardy. The United States currently imposes emergency restrictions on archaeological and ethnological materials from Iraq, Syria and Yemen.55

US import laws also give US Immigration and Customs Enforcement and US Customs and Border Protection authority to seize cultural property and art that are stolen or otherwise brought into the United States illegally, and the persons involved in these violations may be subject to civil and criminal penalties.

iv Art finance

US private banks will make loans to their clients and receive fine art as collateral. In general, banks are reluctant to require these clients to relinquish possession of their art collections. Lenders will only finance a percentage of the appraised fair market value of the artwork, typically 40 per cent to 60 per cent. They will also typically require proof of ownership from potential borrowers. There are also specialist art lenders, boutique lenders and auction houses that provide this service. A lender can perfect a security interest by filing a UCC financing statement that puts others on notice that there is a lien on the artwork and be just as protected from other creditors’ claims as it would be had it perfected by taking possession.

An art fund, which is generally a privately offered investment fund that is managed by a professional investment manager, may be organised either in the United States or as an offshore vehicle, depending on where the fund’s prospective investors reside. In the United States, art funds are typically structured as ‘closed-end funds’, more commonly known as private equity funds. Some art funds pursue a focused investment strategy (e.g., Old Masters or Chinese Imperial porcelain), while others seek a more diversified portfolio of artwork. While the individual strategies of art funds differ widely, at a basic level all art funds seek to generate financial gains through the acquisition and disposition of artwork.

An art fund seeks to wield its size to acquire a diversified portfolio of works of art at prices generally unattainable by individual investors. But, unlike other tangible assets held by many other types of private investment funds, art has no inherent value and its valuation is highly subjective. Further, the art market can be extremely volatile with no certainty of liquidity. Thus, art funds rely on professional investment managers and art advisers to implement their strategies and realise investment returns. In light of the risks involved, it is important that investors consult with a professional adviser before investing in an art fund.

Recent start-ups now enable investors to purchase fractional shares of artwork, including blue-chip work. In some cases, these companies work directly with the SEC, the government agency tasked with regulating the securities market, to register each artwork. Likewise, decentralised autonomous organisations, which mainly use blockchain technology to manage the rules of each organisation, have also grown in popularity as a means to collectively acquire digital or physical artwork.

NFTs as an asset class also present new challenges for identifying and preventing money laundering. Digital artwork, unlike other physical work, does not have the historical price information to value a piece of work and thus provides an excellent cover in an industry where elements of the transaction are often kept private.

There are currently no specific government regulations in place specifically addressing NFTs, and whether the SEC will officially deem NFTs to be securities subject to its rules is yet to be determined. While it is likely that a single work of digital art or collectible will not be considered a security, an NFT sold in groups or fractionalised (i.e., sold in shares) may have the characteristics of an investment contract, making compliance with the applicable SEC rules necessary.56 According to a Bloomberg report, the SEC has started to look into whether certain NFTS are being used as a means to raise traditional securities revenue and has served subpoenas demanding information about token offerings in connection with its investigations.57

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