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.