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Punctual Leadership Blog

18 Jun
Uncategorized

Art Heist: Security Agreement Fails to Encumber Consigned Goods

by Punctual Abstract

Would you use boilerplate language from the UCC in your security agreement? As it turns out, it may be inadequate to truly encumber all intended assets. That was the lesson in a recent case out of New York involving a lender, a bankrupt art gallery and a famous Botticelli painting called Madonna and Child.

Case Study

First Republic Bank loaned $29 million to the New York art gallery Salander-O’Reilly Galleries, LLC. In the security agreement, the gallery granted the bank a security interest in “assets and rights of the Borrower wherever located, whether now owned or hereafter acquired” and “all personal and fixture property of every kind and nature including without limitation all goods (including inventory).”

Seems like a pretty all-inclusive collateral description, right?

Well, shortly after receiving the $29 million loan, the gallery began accepting world-class art on consignment, including a famous piece by Early Renaissance Italian painter Sandro Botticelli called Madonna and Child. In a consignment relationship, you have:

– A consignor: the one who owns the asset but allows the consignee to sell it. In this instance, an art dealer.

– A consignee: the one who agrees to sell the asset, usually for a percentage of the final sale price. In this instance, the art gallery.

When the art didn’t sell, the gallery entered bankruptcy. The consignor (art dealer) sought the painting back, but the bankruptcy trustee, who had received an assignment of the bank’s rights, claimed the painting was part of the collateral described in the security agreement.

The bankruptcy court ruled in the trustee’s favor, likely thanks to the trustee’s argument: the gallery did not own the consigned goods, but Article 9 of the UCC gives a consignee “rights and title to the goods identical to those the consignor had,” including the right to transfer or encumber them. In other words, the gallery could encumber the painting even though it did not truly own it. This ruling would obviously be a huge break for the bank, which was struggling to recoup whatever it could on its $29 million loan.

Yay! But not so fast.

On appeal, the district court reversed the decision. The bank’s security agreement limited the collateral only to goods “ now owned or hereafter acquired” and the court argued that the gallery never “owned” or “acquired” the painting — a fact that the trustee admitted to — even though it had the right to transfer it.

The lesson?

A typical security agreement for inventory financing will likely describe the collateral as “all of the debtor’s currently owned and after-acquired Inventory” and then include the UCC definition of inventory from § 9-102(a)(48). The problem is that terms like “owns or hereafter acquires” do not always encumber assets that the debtor previously sold to a buyer who failed to perfect their security interest. Lenders and transactional lawyers would be wise to use a phrase like “currently or hereafter consigned to” in their security agreement, especially if the business sells things on consignment!

The Salander-O’Reilly Galleries, LLC case has since been used as a precedent in other cases involving inventory, including in the court wrangling after Sports Authority declared bankruptcy.

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