By Sophie Chung.
In 2018, investors who put money into art saw an average gain of 10.6% according to the Wall Street Journal based on Art Market Research’s Art 100 Index. While the numbers are attractive, entering the art market that is less volatile and speculative may be infeasible. Buying a blue-chip art that can return economic benefits requires a significant amount of information such as provenance, artist’s background, or potential appreciation. As a result, only limited investors with professional art advice could access that information. Meanwhile, multiple buyers in the 2018 sale of Andy Warhol’s “14 small Electric Chairs” became joint owners of the famous artwork. Maecenas, a UK-based blockchain platform for investing in art, sold a 31.5 percent stake worth $1.7 million in Warhol’s work and the 800 buyers could acquire 100 secured partial ownership of the painting by paying in Ethereum, Bitcoin, or Maecenas’ ART token.
Fractionalized art sales, especially those relying on blockchain technology to divide artwork into digital shares and selling them to investors, have emerged as new art transactions in various countries. Companies such as Artfintech.one (est. 2012) (“creating a holistic ecosystem for digital art”), ArtSquare (introduced in 2018) (a London-based art platform offering “the new art market, for everyone”), Artopolie (introduced in 2019) (“turns art into fractional shares”), Feral Horses (est. 2017) (“Own shares of museum-worthy artworks”), Look Lateral (est. 2018) (“to redefine how art is bought, sold and authenticated worldwide, and to enable more universal participation in the global art market.”), Maecenas (est. 2017) (“Tokenized art on the blockchain. Peace of mind for you.”) or Masterworks (est. 2017) (“Invest in paintings by the best-selling artists of all time.”) launch platforms to sell fractional ownership of artworks under their missions to provide more people with opportunities to invest in fine arts easily.
Most notably, Masterworks, a Delaware-incorporated and NY-based LLC purchased Andy Warhol’s iconic work, “1 Colored Marilyn”, for $1,815,000 in November 2017 at Phillips auction and then sold the joint ownership to more than 1,300 investors in May 2018. Scott Lynn, founder of Masterworks, stated on the company’s announcement: “Artwork made by some of the world’s most significant artists tends to appreciate at the highest rates, but very few people can access them due to the price point. Masterworks aims to make it possible for anyone to invest in this asset class by offering the opportunity to invest in artworks at an affordable entry point.”
From a legal perspective, selling digital shares of artworks amounts to trading securities defined as investment instruments in debt or equity to be actively traded for profit. Therefore, similar to a public company issuing shares, service providers and platforms for fractional artwork ownership need to be accredited to do so. This article will investigate relevant securities laws, consider how they apply to fractionalized art sales and consider whether and how the proliferation of companies selling fractional ownership in art comply with securities laws.
The ultimate goal of the laws that govern securities transactions is to protect investors. Fundamentally, there are three types of regulatory devices to achieve that goal: 1) pre-offer registration of securities, 2) antifraud provisions, and 3) the registration of traders and advisors. The following section introduces the regulations that provide those devices.
The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 (“The 1934 Act”) is a dense legislation that regulates transparency in the securities market. The 1934 Act was enacted to govern securities transactions in the secondary market, ensuring an environment of fairness and investor confidence after issuing securities. Under the 1934 Act, the Securities and Exchange Commission (“SEC”) was established to monitor among other duties all securities transactions in the U.S. For example, the antifraud provision in section 10b prohibits transactions effected by means of any “device, scheme, or artifice to defraud.” Rule 10b-5 also imposes liability for any “misstatement or omission of a material fact” where a material fact may be any information which might influence the investment decision of the reasonable investor. The 1934 Act requires all companies listed on the stock exchange to follow certain requirements including registration, disclosure, proxy solicitations, and audit requirements.
The Securities Act of 1933
The Securities Act of 1933 (“the 1933 Act”) aims at “restor[ing] the confidence of the prospective purchaser in his ability to select sound securities.” What the 1933 Act emphasizes most is full and fair disclosure by the seller. Under the 1933 Act, companies offering securities should provide sufficient information so that potential investors can make an informed investment decision. Once a company files a registration statement and offering documents, the SEC reviews them following a holistic approach of various factors including the scope and method of the offering, a description of the securities offered, financial statements certified by independent accountants, and information about the management of the issuer and key personnel.
While the purpose of registration is to provide investors with full and fair disclosure of material information, Congress recognized that there are certain situations the public benefits to be derived from registration are too remote. Accordingly, the 1933 Act contains a number of exemptions from registration. Section 3 of the 1933 Act identifies the classes of securities that are exempt from the registration. Section 4 of the 1933 Act lists the types of transactions that are exempt from registration.
The Howey Test
The 1933 Act defines a “security” as an “investment contract”. According to this definition, transactions qualified as “investment contracts” are considered securities, which must meet the requirements related to disclosure and registration.
What determines if the transaction falls within “investment contract” is the means and terms of the contract, not the subject matter of the transaction. In 1946, the U.S. Supreme Court in SEC v. W.J. Howey Co. established a standard methodology known as “the Howey Test” to determine that a transaction represents an investment contract if an investor invests money “in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
The Howey Company in SEC v. W.J. Howey Co. was a Floridian corporate who offered real estate contracts in order to “finance an additional development” for citrus groves. The contracts included leaseback agreements, and buyers of the land agreed to lease the land back because they had no “knowledge, skill, and equipment necessary for the care and cultivation of citrus trees.” The SEC sued the company for its failure to register with the SEC. The Court held that “the transactions in this case clearly involve investment contracts… The respondent companies are offering something more than fee simple interests in land… they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise (emphasis added).”
In short, under the Howey test the three essential elements inherent in every investment contract:
- an investment of money
- in a common enterprise,
- with an expectation of profits to be derived solely from the efforts of others.
Fractionalized Art Sales from the Perspective of Securities Law
For fractionalized art sales to be considered as a security transaction, it would have to meet the Howey Test and qualified to be investment contract. The Supreme Court in Howey looked at the substance, not the form, of an investment to determine if it is investment contract. Despite it is not in the form of “stock” or “bond”, fractionalized art sales become securities transactions when the SEC finds there are investment of money in a common enterprise with the expectation of profits.
The “expectation of profits” in art transactions is usually difficult to determine because the purchase of a particular artwork may be motivated by its aesthetic appeal or the collector’s personal preference, more than prospects of economic returns. Note that most fractionalized art sales are for blue-chip artworks, and the platforms of fractionalized art sales advertise them as investable. If the SEC finds that this behavior came from the economic reality that those artworks by prominent artists are sufficiently guaranteed to make potential economic returns, the fractionalized art sale can be securities transaction.
If offering shares of a fine work of art is qualified as trading securities, the platforms providing the fractional ownership of artwork should meet the requirements of the 1933 Act and the 1934 Act. To abide by the 1933 Act and the 1934 Act, the platforms should provide potential investors with sufficient information about the issuer and fractional ownership of the artwork to be sold so that the investors can make an informed investment decision. If not exempted from registration, the companies will have to file with the SEC a registration statement. Generally in the context of an art transaction, material facts could include any information regarding the present market value of the artwork to be sold, provenance of the work, background of the artist who created the work and potential market returns. The SEC will review whether the registration statement includes all the material fact for investment.
In May 2018, Masterworks, for example, filed an offering document with the SEC for the Andy Warhol’s work it obtained. The offering circular named a company for each painting Masterworks bought, and Masterworks incorporated a separate Delaware limited liability company for 99,825 Class A shares of the Warhol painting. The material facts Masterworks disclosed included price per share of the artwork, the total cost to buy the painting, minimum shares that investors can invest in and possible risk factors.
One may be left to wonder about the rights of the “shareholders” who own these fractions of artworks: Who controls the life of the artwork? Who has physical property of the artwork? Do they need the consent of others before selling their shares?
Most of the businesses allow the art owners to stay in control of his or her own digital share of the art. On behalf of the co-owners, the platforms manage the artwork. The artwork is physically displayed in galleries (e.g., Feralhorses) or stored exclusively (e.g., Masterworks). Since the owners have rights as shareholders, they can visit the site for access to the artwork.
After an agreed period, the platform sells the painting and distributes the profits or provides the co-owners with opportunities to trade their own shares. For example, Masterworks explains two ways to make a return on the investment: “Firstly, an investor can sell their shares to another investor on an approved trading platform. Secondly, a collector can make an offer to purchase a painting from investors, and they can vote on whether or not to sell.”
Conclusion: What Happens at Where Art and Securities Law Intersect
Art becomes an investment with more liquidity when it is approved and traded as securities. Securities law strictly requires registration and disclosure of investment contract, thus shares of art qualified as securities under the law must meet the requirements of the Acts. With securities law as a way to protect the investors, fractionalized art sales allow multiple investors co-own artwork and trade their shares easily. This is the opposite of the traditional notion that fine art is a risky investment because the access to material information of the artwork is limited. In the sense that the securities law promotes informed investment decisions of investors, what realizes the mission shared by the platforms providing fractionalized art sales – to provide more people with opportunities to invest in art – can be securities law.
The author would like to thank Mr. Andrew Hudders, partner at Golenbock Eiseman Assor Bell & Peskoe LLP for his valuable advice in the research and writing of this article.
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- S. Rep. No. 47, 73d Cong., 1st Sess. (1933). ↑
- H.R. Rep. No. 73-85, at 5 (1933). ↑
- 15 U.S.C. 77c. ↑
- 15 U.S.C. 77d. ↑
- See note 103 supra. The term has no statutory definition, but it has withstood constitutional challenge on the grounds of vagueness. See, e.g., Securities & Exchange Comm’n v. Brigadoon Scotch Distributing Co., 480 F.2d 1047, 1052 n.6 (2d Cir. 1973), cert. denied, 415 U.S. 915 (1974). ↑
- 328 U.S. 293 (1946). ↑
- Securities and Exchange Commission v. Howey Co. 328 U.S. 293 (1946). ↑
- Id. ↑
- Id. ↑
- Id. ↑
- Id. at 301. ↑
- Retire Before Dad, “Masterworks Review: Marilyn Monroe in Your Investment Portfolio?” Retire Before Dad, in Investing, Personal Finance, Reviews, Unusual, Jul 31, 2019. Available at https://www.retirebeforedad.com/masterworks-review/. ↑
- SEC regulation A offering circular, Available at https://www.streetinsider.com/SEC+Filings/Form+1-A+Masterworks+001%2C+LLC/14455693.html. ↑
- Stewart Rogers, “Masterworks offers fractional ownership of fine art through the blockchain”, VentureBeat, Jul 26, 2018. Available at https://venturebeat.com/2018/07/26/masterworks-offers-fractional-ownership-of-fine-art-through-the-blockchain/. ↑
- Avantika Chilkoti, “The Best Investments of 2018? Art, Wine and Cars”, The Wall Street Journal, Dec 31, 2018. Here.
- Oscar Holland, “How art ‘shares’ could make you a Warhol collector for just $20”, CNN, Aug 21, 2018. Here.
- Eric Jansen, “Tokenized Art: A New Alternative Investment?”, Finivi, Jul 3, 2019. Here.
About the Author: Sophie Chung is a fall 2019 intern at the Center for Art Law and is pursuing her M.A. in Arts Administration at Columbia University. She is a New York admitted attorney and holds her J.D. from the University of Illinois College of Law. Sophie can be reached at email@example.com.