Why Most Financings for US Art Dealers Look Exactly like Loans to Collectors
Many art gallery businesses in the United State have annual revenues of between $20 million and $100 million. This is a range that is often a “sweet spot” for the middle-market divisions of commercial banks in places like New York. These banks regularly provide revolving credit facilities to mid-sized businesses, which are secured by all of the borrower’s inventory and accounts receivable. But facilities of this kind are rarely made available to art dealers, even though their need for liquidity is no less real than that of other businesses of similar size. This article will explore the reasons why this is true, and propose some ways in which art dealers might adapt to make themselves more attractive to commercial bank lenders.
Lending to US Art Dealers
The foregoing is not intended to suggest that art dealers in this country cannot obtain financing. Private banks in New York and other cities, as well as Athena Art Finance Corp. and Borro Inc. and other asset-based lenders, are active in making loans to art dealers. But these loans are almost identical in structure to the loans provided by the same lenders to art collectors. In the case of the asset-based lenders, credit is extended against the security of a limited number of specific works, which are usually held in a storage facility under the lender’s control. Only a handful of the most successful dealers are able to qualify for the type of middle-market, revolving credit facilities described above, wherein the collateral consists of a gallery’s inventory and accounts receivable, generally, and the inventory is held at locations that are disclosed to the bank but are often controlled by the gallery. In addition, galleries that own real estate and are willing to pledge their inventory and accounts are sometimes able to obtain mortgage financing from banks on more favorable terms than a mortgage of the real estate alone would have permitted. In other words, US lenders are plainly reluctant to extend credit to art dealers as ordinary business borrowers. Even the lenders who are comfortable taking art as collateral (and many are not, for the reasons explained below), are usually unwilling to make loans to art dealers where a key component of the credit support is the performance of the gallery, as a business, in and of itself, i.e., the ability to reliably generate the cash flow needed to service the debt. This is what is sometimes referred to as “cash flow lending.”
Cash Flow Lending v. Asset-Based Lending
Cash flow lending is what enables successful middle-market businesses to maximize their access to working capital financing. These are very often secured loans, but they are not “asset-based.” The difference is that in the case of an asset-based facility, the lender relies on its collateral as the primary source of repayment; whereas a cash flow lender will also derive important credit support from the proven, strong performance of a borrower’s business in selling its goods or services. Cash flow lenders can often tolerate “air balls,” i.e., shortfalls in the value of the collateral supporting the available credit. Asset-based lenders will never allow that; they adhere strictly to ‘borrowing base” requirements, which limit the lender’s commitment to extend credit to a percentage (called an “advance rate”) of the value of the borrower’s “eligible” collateral. Eligibility criteria for inventory include clean title, suitable location, absence of liens and other claims, good physical condition and similar common sense considerations for a creditor whose approach to making such a loan is that it almost doesn’t care if the loan goes into default, because the lender is confident that it has sufficient, readily marketable, collateral that can be liquidated to satisfy the debt.
There are, of course, hybrid structures, which incorporate some of the features of both types of lending. These are sometimes called “ABL-lite” facilities. In these situations, banks will lend against the security of a borrowing base but will not require “full dominion” over the cash coming into the borrower’s bank accounts, and will test the outstanding indebtedness against the borrowing base on a monthly or even quarterly basis, rather than every day, as would be done with a full-dominion, asset-based loan.
Bank Loans to Top US Dealers
Importantly, there is a handful of top US art dealers who have been able to obtain these “ABL lite” credit facilities that are commonly found in the middle-market commercial world. The reason for this is that these dealers have adopted many of the “best practices” of the contemporary commercial world, and operate in a financially sophisticated manner that permits them to transcend some of the inherent risks to a lender in relying on fine art as its collateral. These practices include audited financial statements from reputable and independent accounting firms, chief financial officers who are far more than mere bookkeepers or controllers, as well as internal controls and systems managed by more than just the principal of the gallery. Many of these things have become common even in the low end of the middle-market today, but they are notably lacking among all but the top US art galleries, according to commercial bankers who are active in this space.
These best practices are important to banks because an inherent weakness in the commercial banking business is that, as a practical matter, they are critically dependent upon what their clients tell them about how a borrower’s business is performing. This makes transparency and the reliability of financial reporting essential to the middle-market lender. Thus, if an art dealer or any other business is deficient in this regard, meaningful credit support can usually only be found in the value of its inventory and accounts receivable collateral.
Art as Collateral; Risk
Most art dealers have some accounts receivable to offer as collateral, but these ordinarily constitute a small portion of their assets. Moreover, the credit-worthiness of the dealer’s account debtors (a critical consideration for a lender advancing monies on the basis of accounts receivable) would often be quite difficult to assess. Thus, it is an art dealer’s inventory could serve as the primary basis for a working capital financing. As indicated above in the explanation of borrowing base eligibility criteria, the best inventory collateral consists of goods that can be reliably and easily sold, preferably on a regulated and well-established market. For example, it would be relatively easy for a lender to liquidate consumer products with major brand names (e.g., Colgate or Crest toothpaste), if a drugstore borrower went into default. If we contrast that scenario with having to sell off the fine art inventory of a New York gallery, the difficulty faced by a lender to the gallery becomes clear. Rather than needing to sell something tangible, of easily determined value and nearly universal utility, art lenders forced to sell their collateral would be seeking to dispose of unique “goods” that are rarely traded, with little or no practical value. This is almost the polar opposite of needing to liquidate some name-brand toothpaste.
Unfortunately, the challenges of using art as collateral do not stop there. In fact, here are some risks for a lender that are unique to fine art. No other high-value asset carries the same potential for being faked or attributed to the wrong source. People in the art world are all well-familiar with these issues, but they are all but unheard of in the wider world of secured lending.
The other special risk attendant to taking art as collateral is title. This is a less well-understood problem than authenticity or misattribution. When the subject is raised, most people think only in terms of World War II restitution claims. But the fact is that there is a multitude of title issues of an everyday nature that can (and sometimes do) impair good title, some of which do not manifest themselves for many years (e.g., questions as to whether the grant of an artwork was a loan or a gift, rights of first refusal which appear only in sparse bilateral documentation and, perhaps above all, ordinary theft, unrelated to major historical events). In considering the difficulty posed by this risk for a lender, first remember that if the collateral grantor does not have good title, the lender probably has no security interest in anything. Then consider that parties to art transactions have traditionally (i) been obsessed with secrecy (or confidentiality), and (ii) accepted, as a matter of course, remarkably thin legal documentation when compared with transactions involving other valuable assets. Similarly, the buying and selling of fine art has, more often than not, involved the use of agents for undisclosed principals (often a dealer acting on behalf of the real buyer or seller, or on behalf of another dealer also acting as an agent), to such an extent that in the famous “Red Elvis Case” decided in Connecticut state court in 2005 and affirmed on appeal by the Supreme Court of Connecticut in 2007, the court found that industry norms dictated that only when “circumstances surrounding the sale cast severe doubt on the ownership of an artwork are merchants and buyers required to obtain documentary assurances that the seller had good title.” Lindholm v. Brant, No. X05CV020189393, 2005 WL 2364884 (Conn. Super. Ct. Aug. 29, 2005), aff’d, 283 Conn. 65 (2007). Although there are indications that such practices are slowly evolving to where the true identities of a buyer and a seller are often disclosed, at least to each other, for those who are accustomed to consumer goods or other things that are commonly used as collateral, title to art remains, at best, a troublesome subject.
Art Lending to Collectors
As indicated above, major US private banks often make loans secured by specific works from an ultra-high net worth client’s art collection. Usually, these banks are relying primarily on the overall financial strength of their borrowers, rather than the quality of the art collateral itself. However, that collateral does allow the bank to increase the size of its loan, to reduce the interest rate or otherwise sweeten the terms of the deal for its client. Moreover, with the collateral pool consisting of a limited number of works, as opposed to a gallery’s ever-changing and larger inventory, private banks lenders can perform some reasonable due diligence to mitigate the risks attendant to the art collateral, and often find some meaningful credit support therefrom, as a result.
While true asset-based lending is all but non-existent as against the full inventories of art dealers, there are non-bank lenders that will often make loans to gallerists secured by a pool of specific dealer-owned pieces that can be released and replaced with other specific works as sales occur. This is the main financing option that has evolved to fill dealers’ need for working capital, because all but the most prominent art dealers in the United States cannot qualify for the kinds of larger revolving credit facilities described above, which are commonly made available by banks to businesses in other industries in the middle-market commercial world. In other words, most dealers who obtain debt financing do so in exactly the way that an individual art collector might, without deriving any benefit from the fact that the dealer has a going-concern business, ready to stand behind its obligations to its lender.
A Way Forward
The example set by the few US dealers who have succeeded in obtaining bank financing based upon the value of their full inventory is significant. It demonstrates that with the adoption of better business practices which, among other things, evince a healthy respect for the legitimate needs of an institutional lender for transparency and reliable financial information, the prospects for an art dealer to obtain enhanced working capital financing from US banks are real, notwithstanding the obvious weakness of having to rely upon fine art inventory as collateral.
In addition to the audited statements, better accountants and other upgrades in reporting and in the administration of a gallery’s finances, there are certain other steps that would surely serve US art dealers well. For example, New York and certain other states have laws that deem the commissions owed by dealers to artists to be trust funds (i.e., monies belonging to the artists are held, in trust, by the gallerist, as “trustee,” until they are paid over to the artists). Among other things, this means that such funds are not supposed to be commingled with the gallery’s own money. Some people say that these laws are “more honored in the breach than in the observance.” That may be an exaggeration; however, commingling of this sort is not uncommon and is plainly a bad business practice with which US banks are familiar. And it makes the banks skeptical about whether the account balances and cash in hand shown on the books of some dealers really belongs to the dealer, or to artists whom the dealer represents.
Another common form of commingling can perhaps be more easily remedied. Article 9 of the Uniform Commercial Code provides for the filing of a UCC financing statement by a consignor (as the secured party) against its consignee (as debtor). This is intended to protect a consignor from the claims of the secured inventory lenders of a consignee in the event of the consignee’s insolvency. Leaving aside the question of whether or not a consignment to an art gallery in a place (like New York) where it is widely known that galleries deal substantially in the sale of consigned art, gives rise to a bona-fide Article 9 consignment for legal purposes, the filing nonetheless creates a public record of what is not dealer-owned inventory. This kind of independent, corroborating information would be of real value to a bank when asked to accept a borrower’s representation that its “eligible” borrowing base inventory collateral was, in fact, dealer-owned and not merely the subject of a consignment. But the filing of UCC consignment financing statements is not a practice that galleries seem to require, or even encourage.
Finally, there would be another, less obvious, benefit to adopting these best practices: An art dealer’s inventory would very likely become more acceptable as collateral, to both cash flow lenders and even, to some extent, to asset-based lenders, like Athena and Borro. Credit officers at banks and other lenders are keenly aware of all the inherent risks of art as collateral, and their concerns are exacerbated by what they see as a culture in the art business that is lacking in respect for the norms of transparency and standards of due diligence that are found in the rest of the commercial world Fairly or unfairly, one inference that lenders inevitably draw is that what passes muster for many art dealers under the “connoisseurship-based” due diligence, concerning issues of title, authenticity and attribution, could be improved. Thus, if the culture abroad in the art business seemed more mature and disciplined, lenders’ confidence in a gallery’s due diligence concerning its fine art inventory would likely be enhanced. In this regard, it is worth nothing that while there is no insurance (and there probably can never be insurance) available for authenticity and attribution risk, there is title insurance available for art. Aris Title Insurance Corporation is under new leadership and has expressed interest in developing programs for dealers that would allow a gallery’s buyers to title insure their purchases at commercial rates. This would, of course, require dealers to maintain certain standards and best practices in performing due diligence on the sales that they originate, but title insurance would also be a huge step forward in removing “eligibility” clouds from the borrowing base of a dealer’s inventory.
The point of all of this is not that art dealers should change their ways to please banks. Rather, the availability of greater and more reliable sources of credit for gallerists could benefit the entire industry. More working capital would mean that more emerging artists could be promoted effectively, additional opportunities could be realized to purchase works that are perceived to be under-valued, exhibiting at some additional, perhaps overseas, art fairs could become feasible. The full list could go on for pages. The real point of upgrading these business practices was made perfectly by Andrea Danese, CEO of Athena Art Finance Corp., who, in talking about doing business with art dealers, said, “Debt financing has a natural place in the capital structure of many galleries and dealers. There is significant financial upside for the art trade to embrace a well-structured debt financing option and, by extension, to standardize certain business practices.” Note that this is the perspective of an asset-based lender. No commercial banker could disagree or say it any better.
There are undoubtedly some good reasons why the art trade has traditionally been conducted the way that it has, but some dealers have seen the wisdom in stepping up and into the middle-market commercial world of the 21st century. These dealers have been rewarded with greater access to debt capital, and the same could certainly happen for others who make the leap. Changes to time-honored ways of doing business are slow to occur and difficult to implement in any field. The art world is no different, and may even be more challenged in this regard, because it is so opaque. Nonetheless, the availability of additional and more flexible sources of capital is quite visible, and there is, after all, such a thing as an idea whose time has come.
“Why Most Financings for US Art Dealers Look Exactly like Loans to Collectors,” by Stephen D. Brodie was published in the TEFAF Art Market Report: Art Dealer Finance 2018 (May 2018). To read the article online, please click here.
Mr. Brodie also served as a panel and presentation speaker at The European Fine Art Fair (“TEFAF”) Special Featured Event, TEFAF Art Market Report: Art Dealer Finance 2018 Presentation and Panel Discussion, on Friday, May 4, 2018, in New York City.