(March 24, 2020) Written by Nicholas O'Donnell, art law partner at Sullivan & Worcester

Early last week the online auctioneer Paddle 8 filed for Chapter 11 bankruptcy in the Southern District of New York, on the heels of a recent lawsuit demanding payment for works of art sold at a charitable auction last November. While the Paddle 8 bankruptcy seems to have been driven by business conditions long before the complete upheaval of the art and business world due to COVID19, it is all but certain now that the cascading closures of businesses large and small for the foreseeable future will bring a wave of bankruptcies in the months and year to come. As such, taking a closer look at the Paddle 8 situation can be instructive for art market participants of all sorts, particularly with respect to the consignment and sale of art. Put simply, most businesses are going to need to think very soon about their roles as creditors who are owed some good or service, in the hopes of avoiding becoming debtors who need the help of bankruptcy laws to reorganize or stave off liquidation.

Paddle 8 was founded in 2011. In 2016, it merged with Auctionata AG, a Berlin-based online house, before Auctionata itself became insolvent and was spun off in 2017. Earlier this year, Paddle 8 was sued in New York state (Supreme) court by the New American Cinema Group. The lawsuit alleged that Paddle 8 had sold several works of art for New American Cinema, a cinema charity, but had not accounted for the proceeds of that sale. According to ArtNet News, the auction had works donated by John Ahearn, Kiki Smith, Tom Otterness, Jonas Mekas, Jim Jarmusch, and Walter Robinson. New American Cinema accused Paddle 8 and its executives former CEO Valentine Uhovski, financial controller Rameshkumar Ganeshan, and director of operations Michael McClellan not merely of failing to produce the funds, but also of fraudulent inducement and concealment. No specific amount is demanded in the Complaint, and Paddle 8’s page for the auction (still up as of this posting) merely lists each lot as “closed” without results.

Critically, the lawsuit invoked Article 12 of New York’s Arts & Cultural Affairs Law, which provides that whenever an artist consigns his or her work for sale, the consignee (the gallery or auction house) holds that property in trust as a fiduciary. This law was enacted in 2012 (see here for coverage from the Art Law Report at the time). The law was passed in the wake of the Salander O’Reilly collapse after the revelation that the gallery had sold the same works to multiple buyers.

Typically when an owner conveys property to a gallery or auction house in the business of such sales, if the gallery becomes insolvent, the consignor cannot simply exercise its right to retrieve its painting. Rather, the paintings and all other property held by the gallery or auction house become part of the debtor’s estate when the petition is filed to be distributed to allowed claimants in the bankruptcy in accordance with priorities established by the Bankruptcy Code. If the consignor has not taken other action to protect itself, the typical consignor is relegated to the bottom of the food chain in bankruptcy, as a general unsecured creditor. Under these circumstances the owner will not be entitled to the return of his artwork, and may stand to receive little to none of the proceeds in the event that the artwork is ultimately sold by the debtor.

Fortunately, the consignor-owner has the potential to improve its status by filing a U.C.C.-1 financing statement to perfect its purchase money security interest in the consigned property. What’s that? In a general context, the Uniform Commercial Code provides that a consignor of goods (including artwork) holds a purchase money security interest in the consigned goods as inventory, but, in order to “perfect” the security interest so that the consignor will be entitled to priority over other secured parties, including a trustee in bankruptcy, the consignor must file a U.C.C.-1 financing statement. If there are other secured parties of record with interests in the Debtor’s inventory, the consignor is also required to provide separate notice to these competing secured parties before the artwork is delivered. If these actions are taken, the owner of consigned property obtains superior rights in the artwork and its status is elevated to that of a secured creditor in the debtor’s bankruptcy case.

Unfortunately, it is often the case that artist-consignors are not aware that secured creditor status is dependent upon actions taken prior to the bankruptcy filing, and where the artist has failed to take the necessary steps to perfect its security interest, it may find itself in line with other unsecured creditors hoping to receive a small recovery in a gallery-debtor’s bankruptcy case.

N.Y. Arts & Cult. Affairs Law § 12.01 altered that dynamic. For artist-consignors (only), the statute provides that delivery of a work of art creates a fiduciary relationship like a trust. In bankruptcy, “any power exercisable solely for the benefit of another” is not subject to inclusion in the debtor’s bankruptcy estate (11 U.S.C. § 541(b)(1)). So, to cite a simplistic example, if a trustee of an investment account loses a money judgment for a traffic accident, the accident creditor cannot seize the trust assets because it is held for someone else. Or, if the trustee himself becomes bankrupt, the assets in the trust are not part of the array of assets subject to distribution under the Bankruptcy Code.

And lo, now it has come to pass with Paddle 8 (at least as alleged by New American Cinema) and Paddle 8’s filing for bankruptcy protection (Chapter 11 reorganization, not Chapter 7 liquidation). It will get considerably more complicated however, because the argument about what should happen to that money (wherever it is) will take place in the Bankruptcy Court, not the New York Supreme Court where New American Cinema filed its case. The state court case is automatically stayed by operation of the bankruptcy petition filing, and there are very severe penalties for continuing to pursue a lawsuit without leave of court where the automatic stay of 11 U.S.C. § 362(a) is in effect.

A bit of a back and forth has already ensued; Paddle 8’s attorneys quickly advised the state court of their belief that New American Cinema intended to violate the automatic stay. New American Cinema then responded in the Bankruptcy Court case by objecting to the appointment of Paddle 8’s attorneys, directed mostly to the substance of New American Cinema’s claim. New American Cinema did allege that the funds that should have been held in trust were used to pay Paddle 8’s attorneys’ retainer fee. Interestingly, it also identifies a charity affiliated with New American, Penumbra, as the holder of a $14,000 claim, but it is not clear if New American has additional proceeds that it is seeking.

The good news for New American Cinema and/or Penumbra is that if there are in fact any appreciable assets, they will have an argument that their “trust property” should be segregated and not treated as an unsecured claim (where everyone will likely recover, at best, pennies on the dollar) but rather simply something that should be returned to them. Think of it like leaving your car in a friend’s driveway when he files for bankruptcy; it’s still your car. That remains very much to be seen, and will depend on the extent to which assets were commingled or conversely can be traced to specific sources—and whether this was in fact a consignment by the artists (trust property) or an outright donation to New American Cinema which then sold the art (less clear). But New American Cinema will have a good argument to make at the threshold stage simply to take its claimed money out of the equation entirely. Indeed, the automatic stay and bankruptcy proceedings may ironically be to New American Cinema’s advantage in the short term, because the New York State courts are closed to all but emergency applications under the COVID19 emergency; parties may not file motions or requests for relief in the ordinary course at all right now.

What it All Means for the Art World

The art world, from museums, to large auction houses and mega galleries, to small businesses and service providers, is reeling from the sudden inability to gather together with other people. We all know this and feel its absence already. Even before the fallout from the larger economic situation is felt in terms of whatever effect is yet to come on buyers’ willingness to spend money on art, all the events, fairs, and gatherings to which we are accustomed (particularly in New York) are suspended indefinitely.

We don’t make predictions here generally, but it is not telling tales out of school to say that many art businesses are essentially hand to mouth, and will not survive the complete shut off of cash flow already underway. While actual bankruptcy petitions may not tick up for weeks or months, companies are going to start to contract. What to do?

First, account for any works of art that are not in your possession. Even if you are in New York, if you have consigned art to a dealer or gallery, get U.C.C.-1 statements on file, immediately. Remember that the New York law applies only to artist-consignors. State laws will vary and you should consult a local expert. Massachusetts, for example, has a favorable consignment statute too (not limited to artists) that does not require financing statements (G.L. c. 104A, § 2), but which should be covered by a consignment agreement. Such an agreement need not be complicated and a lawyer can help you with even a simple form.

If you are a gallery or auction house, get your records in order. You do not want to be explaining why funds or consigned works (particularly in New York) were not maintained separately.

Lastly, take some time to imagine that your largest customer couldn’t pay you, or you couldn’t pay your largest expense. What drove Paddle 8 to bankruptcy is not known, but its largest creditor listed in the petition appears to be a commercial landlord. What does your lease say about unforeseen events? Acts of God? Force Majeure?

Sadly, I fear that the art world may be looking at a Paper Chase situation: “Look to your left, look to your right, because one of you won’t be here by the end of the year.” It may even be two of you. Now—today—is the time to protect yourself and plan as best you can.

[Opinion is that of the writer.]