Secrecies, Guarantees, and Securities in the World of Auction Houses

July 22, 2020

By Amber Lee.

After a 31-year run as a public company, Sotheby’s, which was founded in 1744, announced in June 2019 that it was being acquired by a French billionaire, Patrick Drahi, thus joining its arch-rival auction house Christie’s in conducting business as a privately held company.^[1] The privatization of Sotheby’s raised concerns over the loss of transparency in a world that has very little. As a privately held company, the auction house is essentially free of the strict financial reporting mandates imposed by the SEC, which requires public companies to file annual and quarterly reports containing the company’s financial statements.^[2]

Further, taking Sotheby’s private means it can now avoid the type of public scrutiny on certain auction house practices, such as the use of guarantees (the subject of this article), which could potentially draw unwanted attention to the auction house’s financial health.^[3] While spectators were only too happy to have access to annual financial reports (still available here),^[4] the financial markets would reflect company performance in spikes and dips of the stock prices. For example, in a statement published in conjunction with the release of its 2018 second quarterly financial report, Sotheby’s attributed the decline in its auction commission margin to the “auction guarantee shortfalls” and “the sale of two guaranteed paintings,” which reduced its auction commission margin by 1.4% and 1.1%.^[5] The announcement caused a dip in Sotheby’s stock prices from $52.90 to $49.93 per share. The “sale of two guaranteed paintings” in Sotheby’s statement referred to the sale of a Modigliani and a Picasso, both of which were reported to have been sold to third-party guarantors after sparse bidding.^[6] But what exactly is a guarantee, and how does keeping it from public scrutiny help shield an auction house from financial backlash?

BID Sotheby’s stock chart between May 2018 and Oct. 2018, showing a significant dip in the auction house’s stock price following the sale of two guaranteed paintings. Source: ADVFN.

Setting the Stage

Before diving into the discussion on guarantees, it is important to mention some auction house practices that provide a deeper understanding of the role played by guarantees in the auction world.

For example, a “reserve price” is a price below which the auction house will not sell a particular consigned property, and the price is agreed upon in advance of the sale between the seller or consignor of a work and the auction house.^[7] Although the exact amount of the reserve is customarily kept secret,^[8] laws governing the disclosure of its existence differ from jurisdiction to jurisdiction. In New York City, for example, the existence (but not the price) of a reserve must be disclosed prior to the auction.^[9] Generally, if no bid comes above the reserve price, the consigned property fails to sell and, as a result, reverts to its owner, unless the auction house is able to broker a post-auction sale. In New York City, a work that fails to sell above the reserve price is listed as “bought in,”^[10] which could have the effect of “burning” a work and impact its marketability for some time.^[11] This has not always been the case––as auction houses have not always been legally obligated to disclose the existence of a reserve, owners could manipulate the market valuation of their works by setting high reserve prices since a repurchase by the owner was treated the same way as if the work had been purchased by a third party.^[12] In the 1970s, Sotheby’s has since changed its policy by disclosing the existence of a reserve system in its auction catalogs,^[13] and the New York City ordinance similarly alleviates concerns associated with the use of a reserve system.

Despite attempts to pass legislations in the state of New York to increase transparency in auction house practices, the rules in New York City allow auctioneers to engage mock-bidding by starting auctions below the reserve price and submitting bids on behalf of the seller up to the secret reserve price.^[14] With all its theatrics, this practice of “chandelier bidding” is perfectly legal. Michael Duffy, currently a director of and wealth strategist at Merrill Lynch points out that the Securities Act of 1933 and 1934 make up a comprehensive set of rules to ensure that buyers of public securities receive accurate information before investing and to prevent occurrences of insider trading.^[15] However, Duffy notes that no comparable regulation exists to govern art and collectibles.^[16] Chandelier bids, which are essentially fake bids used to create the appearance of interest to warm up the auction room, would be illegal if transacted in the U.S. securities markets.^[17]

Guarantees: The Mechanics

Guarantees are closely related to the reserve system. Generally, guarantees are financial instruments that have been widely recognized as a “consequence of the principle of freedom of contract.”^[18] In the context of a bank-guarantee, it usually involves a guarantor (i.e., the financial institution that issues the guarantee) promising the beneficiary to pay in case a specific event does not occur.^[19]

Amedeo Modigliani, “Nu Couché (Sur Le Coté Gauche)” (1917), sold for $152.2 million at Sotheby’s New York during the Impressionist & Modern Art Evening Sale in May 2018 with a notice that the work was a “guaranteed property”. Source: Sotheby’s.

When an auction house provides a guarantee on a specific work, it enters into a contract promising the consignor that their work will sell for minimum a pre-specified amount, and if the piece fails to sell at auction, the auction house itself will purchase the work.^[20] If the piece sells for above the reserve price but less than the guaranteed amount at auction, the winning bidder takes the lot home and the auction house absorbs the difference between the hammer price and the guaranteed amount to the consignor.^[21]

Successful guarantee deals can present themselves as win-win solutions for both sellers and auction houses. Guarantees are used to secure consignments: if one auction house is offering a guarantee and the other does not, a consignor might be swayed to consign with the auction house that offers a guarantee. The seller can take comfort in knowing that the work will sell no matter the outcome of the auction, and if the work sells for more than the guarantee, the seller might enjoy an additional percentage from the upside (which is the amount of the hammer price minus the guaranteed price stipulated in the consignment agreement).^[22] The auction house, on the other hand, gets to entice collectors to consign works with them in order to remain competitive, and if the work sells for more than the guarantee, the auction house similarly enjoys a percentage from the upside.^[23]

Third-Party Guarantees: What are they?

The most glaring risk associated with providing guarantees is that guarantors who overestimate demand for an artist might end up with an asset that is difficult to liquidate quickly.^[24] For example, when the 2008 recession hit, Sotheby’s and Christie’s were holding $63 million worth of art that they had guaranteed with house money.^[25] Hence, in the wake of the financial crisis, auction houses have begun to shift their guarantees to third parties in order to minimize in-house financial risks.^[26]

Depending on how the third-party guarantee deal is structured, an auction house might offer a couple of incentives to entice potential outside guarantors, such as a percentage of the upside and buyer’s premium (also known as “financing fees”) from a successful bid.^[27] In return, the third-party guarantor agrees to take on part of or all of the risk by placing an irrevocable written bid on the lot.^[28] The basic structure of third-party guarantees are generally similar, but the form they take differ depending on the policies of the individual auction house. For example, third-party guarantors at Christie’s are allowed to receive their portion of financing fees if they are the successful bidders, whereas third-party guarantors at Sotheby’s are not allowed any compensation if they bid on a winning lot.^[29] Consider the following scenarios if an artwork carrying a house guarantee of $1 million is partially or wholly guaranteed by a third party who does not bid at auction:

• Scenario 1: The artwork sells for $1.5 million hammer price at auction. There is an upside of $500,000 ($1.5 million less $1 million), but now the auction house has to share its portion of that upside and perhaps even the financing fees with the third-party guarantor.
• Scenario 2: The highest bid for the artwork is $800,000, which is $200,000 less than the guaranteed amount. Prior to the auction, the third-party guarantor places an irrevocable bid at $900,000. Because no bids above the irrevocable bid are placed during the auction, the third party obtains the artwork (and at a discount if the third-party guarantor receives financing fees from the auction house).

Criticisms on Guarantees & Third-Party Guarantees

Auction houses, acting in their capacity as agents of their consignors, owe a fiduciary duty to their principals.^[30] In The Art Law Podcast episode entitled “Art of the Chase: Inside Art Auctions–Revisited,” attorney Katie Wilson-Milne noted that the practice of involving third-party guarantors potentially conflicts with these traditional fiduciary obligations because the auction house is essentially negotiating deals with two different parties—the consignor and the third-party guarantor—all of whom have financial interests in the outcome of a sale.^[31] UK attorney Rebecca Foden also notes that guarantors often come from a pool made up of the auction house’s top clients.^[32] By allowing these guarantors to participate in placing irrevocable bids prior to the auction, Foden writes, the auction house is essentially “pitching two clients’ interests against one another.”^[33]

Further, the Rules of City of New York require the existence of a guarantee to be disclosed, but the actual amount of the guaranteed price need not be.^[34] Thus, it has been suggested that third-party guarantors are consequently bestowed with greater information that is not available to the general public, which puts them in a far better position than other bidders in the room.^[35] For example, a third-party guarantor, equipped with information on the guaranteed price of a work, might bid on the work themselves, push the price above the guaranteed price, and pocket a percentage of the upside when someone else “outbids” the guarantor.^[36] It has also been noted that the existence of a guarantee might signal that a work has been “pre-sold,” thereby causing potential buyers to refrain from bidding.^[37] All these seem to suggest that the use of guarantees might create an illusion of equal participation when they in fact artificially distort the art market. ^[38]

On the other hand, a 2015 empirical study by economists Kathryn Graddy and Jonathan Hamilton analyzes data from Christie’s and Sotheby’s Contemporary and Impressionist Evening Sales between January 2010 to February 2012 and suggests the existence of a guarantee “has no effect on the final price achieved.”^[39] According to the study, there is also inadequate support to suggest that third-party guarantees dampen bidding and lower prices at auction at both auction houses.^[40] The economic theories explored by Graddy and Hamilton are beyond the scope of this article, but interested readers may read the working paper here.

Moving Forward?

The practice of setting reserves and offering guarantees and third-party guarantees are not necessarily harmful or even undesirable, but they do highlight some of the regulatory gaps in the art market. Auction houses have only recently begun to exclude financing fees when disclosing the price of any sales to third-party guarantors in order to better reflect the true price.^[41] Critics of guarantees and third-party guarantees might also take comfort in the fact that guarantees seem to have fallen out of favor in the art world in recent years.^[42] Reporting on this occurrence, Artnet editor Eileen Kinsella speculates the downward trend is likely to continue as “guarantees have a lower payoff than they used to.”^[43] And because guarantees are basically a form of insurance that sellers purchase to ensure their work get sold regardless of the outcome of an auction, whatever profit the sellers might enjoy from a successful sale is also reduced by the cost of such insurance,^[44] which might make guarantees unattractive to sellers.

Lastly, as a result of Covid-19, some auctions and fairs that have transitioned online have chosen to reveal the prices of works offered–a welcome informative change and a step towards a more transparent art transaction.

Endnotes:

1. Kelly Crow et al., Sotheby’s to Be Sold, Jolting the Art World, Wall St. J. (June 18, 2019), https://www.wsj.com/articles/sotheby-s-to-be-acquired-for-57-a-share-11560777058. ↑
2. Eileen Kinsella & Tim Schneider, What the Sotheby’s Sale Means for the Future of the Art Industry—and How It Reflects a Broader Shift in Global Economics, Artnet News (June 19, 2019), https://news.artnet.com/market/sothebys-drahi-private-sale-1577782; Securities Exchange Act (SEA) of 1934 § 13, 15 U.S.C. § 78m(a) (2018). ↑
3. Id. ↑
4. Sotheby’s rival, Christie’s, still publishes its annual reports. See Christie’s Annual Report, Christie’s, https://www.christies.com/about-us/welcome-to-christies/annual-report/ (last visited July 13, 2020). However, as a privately-held company, it is not required to comply with the financial reporting mandates of the SEC. See 15 U.S.C. § 78m(a) (2018). ↑
5. Press Release, Sotheby’s, Sotheby’s Reports 2018 Second Quarter Financial Results (August 6, 2018), https://sothebys.gcs-web.com/news-releases/news-release-details/sothebys-reports-2018-second-quarter-financial-results. ↑
6. Isaac Kaplan, $157 Million Modigliani Breaks Sotheby’s Record at Otherwise Underwhelming Impressionist and Modern Sale, Artsy (May 15, 2018), https://www.artsy.net/article/artsy-editorial-157-million-modigliani-breaks-sothebys-record-underwhelming-impressionist-modern-sale. ↑
7. See Patty Gerstenblith, Picture Imperfect: Attempted Regulation of the Art Market, 29 Wm. & Mary L. Rev. 501, 529 (1988); see also Art of the Chase: Inside Art Auctions – Revisited, Art L. Podcast (Dec. 2, 2019) [hereinafter The Art Law Podcast], http://artlawpodcast.com/2019/12/02/art-of-the-chase-inside-art-auctions-revisited/. ↑
8. Daniel Grant, How Low Can You Go?: Should Auction Reserve Prices Be More Transparent?, Observer (Nov. 27, 2013), https://observer.com/2013/11/how-low-can-you-go-should-auction-reserve-prices-be-more-transparent/2/. ↑
9. 6 Rules of the City of New York § 2-122(f). ↑
10. Id. § 2-123(a). ↑
11. See The Art Law Podcast, supra note 7. ↑
12. See Gerstenblith, supra note 7, at 529. ↑
13. Id. at 530. ↑
14. 6 Rules of the City of New York § 2-123(c)(1). ↑
15. See Michael Duffy, Painting a Not-So-Pretty Picture, 28-Dec Prob. & Prop. 10, 12 (2014). ↑
16. Id. ↑
17. Id. ↑
18. Jens Nielsen & Nicolai Neilsen, The German Bank Guarantee: Lessons to be Drawn for China, 5 Geo. Mason J. Int’l Commercial L., 171, 172 (2014). ↑
19. Id. at 171-172. ↑
20. See Gerstenblith, supra note 7, at 530. ↑
21. Rebecca Foden, Auction house guarantees: friend or foe?, Boodle Hatfield, https://www.boodlehatfield.com/the-firm/articles/auction-house-guarantees-friend-or-foe/ (last visited July 3, 2020). ↑
22. Doug Woodham, Why Guarantees are Actually Good for the Art Market, Artsy (June 28, 2018), https://www.artsy.net/article/artsy-editorial-guarantees-good-art-market#:~:text=To%20entice%20third%2Dparties%20to,house%20negotiates%20with%20the%20consignor. ↑
23. Id. ↑
24. See Kelly Crow, Art Speculators Bid to Lose, Wall St. J. (May 13, 2019), https://www.wsj.com/articles/investor-speculation-grows-in-art-auctions-11557780259. ↑
25. Id. ↑
26. Id. ↑
27. Id. ↑
28. Foden, supra note 21. ↑
29. See Conditions of Sale for Christie’s Inc., Christie’s, https://www.christies.com/pdf/onlineonly/ECOMMERCE_CONDITIONS_OF_SALE_CINC_Jan_2018.pdf (last visited July 16, 2020) (“Where the third party is the successful bidder, the third party’s remuneration is based on a fixed financing fee.”); see also Key to Sotheby’s Lot Symbols, Invaluable, https://www.invaluable.com/catalog/symbolKey.cfm (last visited July 16, 2020) (“If the irrevocable bidder is the successful bidder, they will be required to pay the full Buyer’s Premium and will not be otherwise compensated.”). ↑
30. See Cristallina v. Christie, 117 A.D.2d 284, 292 (1986) (citing City of New York v. Union News Co., 169 A.D. 278, 281 (1915)). ↑
31. See The Art Law Podcast, supra note 7; see also Anna Brady, Guarantees: the next big art market scandal?, Art Newspaper (Nov. 12, 2018), https://www.theartnewspaper.com/news/guarantees-the-next-big-art-market-scandal#:~:text=%E2%80%9CGuarantees%20have%20the%20potential%20to,we’re%20due%20for%20another.. ↑
32. See Foden, supra note 21. ↑
33. Id. ↑
34. 6 Rules of City of New York § 2-122(d) (“If an auctioneer or public salesroom has any interest, direct or indirect, in an article, including a guaranteed minimum, other than the selling commission, the fact such interest exists must be disclosed in connection with any description of the article or articles in the catalogue or any other printed material published or distributed in relation to the sale.”). ↑
35. See Foden, supra note 21. ↑
36. Isaac Kaplan, The Auction House Buzzwords New Collectors Need to Know, Artsy (Mar. 15, 2017), https://www.artsy.net/article/artsy-editorial-auction-house-buzzwords-new-collectors. ↑
37. See Foden, supra note 21. ↑
38. Reporting the 2018 Modigliani sale at Sotheby’s, The New York Times quoted Parisian dealer Christian Ogier: “Everyone knew what was expected. The high guarantees break the dynamics of an auction, somehow.” See Pogrebin & Reyburn, $157 Million for a Modigliani Raises Hardly Any Eyebrows, N.Y. Times (May 14, 2018), https://www.nytimes.com/2018/05/14/arts/design/modigliani-sothebys-auction-picasso.html. ↑
39. Kathryn Graddy & Jonathan Hamilton, Auction Guarantees for Works of Art 1, 13 (July 29, 2015) (unpublished manuscript), https://people.clas.ufl.edu/hamilton/files/guarantee-WP-2015.pdf. ↑
40. Id. ↑
41. In 2016, Bloomberg reported that Christie’s, in response to New York City’s Department of Consumer Affairs’ interpretation of the applicable regulations on reporting auction prices, vowed to change its reporting policy to exclude financing fees from final sales prices. Katya Kazakina, Auction Houses Told to Improve Transparency in Reporting Prices, Bloomberg (Oct. 17, 2016), https://www.bloomberg.com/news/articles/2016-10-17/auction-houses-told-to-improve-transparency-in-reporting-prices. ↑
42. Eileen Kinsella, Auction Guarantees Lifted the Art Market to Record-breaking Heights. The Only Problem? The Golden Age of Guarantees is Over, Artnet News (Nov. 11, 2019), https://news.artnet.com/market/auction-guarantees-bubble-pop-1698762. ↑
43. Id. ↑
44. Foden, supra note 21. ↑

About the Author: Amber Lee is a Summer 2020 Intern at the Center for Art Law. She is in the Class of 2021 at the University of Florida Levin College of Law and received her undergraduate degree in visual arts and emerging media management from the University of Central Florida. She can be reached at lee.amber@ufl.edu.

Acknowledgments: The Author wholeheartedly thanks Véronique Chagnon-Burke, Academic Director for Christie’s Education in New York, for her guidance in writing this article.