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.