Wednesday, January 7, 2015

Appraising in the Age of the Third Party Guarantee

The rise, or rather, the strong reemergence of the auction guarantee in the past few years presents a tricky problem for the art appraiser to solve.  The exact machinations of the practice are not disclosed publicaly and it seems likely that every deal is different, but the idea behind it is straightforward.  Basically, the auction houses offer sellers a guaranteed price at which their property will sell.  If there are no buyers at the auction who make a bid at this minimum price, the auction house buys it from them.  The practice serves to transfer risk away from the seller to the auctioneer and enables the houses to procure desirable property to include in their sales.  In the current booming market, where sellers are firmly in control, it is happening a lot.  A widely quoted study by The Art Newspaper estimated that almost half of the lots at Christie’s and Sotheby’s evening sales in November, 2014 were guaranteed, at a total of about $614 Million. 

Roy Lichtenstein, I Can See the Whole Room….and There’s Nobody In It, 1961, oil and graphite on canvas 
48 x 48 inches; One writer has suggested that if the guarantor and the buyer were the same person, the price paid would have been $40.3 Million, not the $43.2 Million reported by Christie's, who sold it on November 8, 2011.

The assumption of more risk on the part of the auctioneer often comes with a string attached.  Again, it is hard to know exactly how these deals work, but in most cases, the auction house negotiates with the consignor to share in the upside.  I have often heard that it is standard practice is for the auctioneer to keep 30% of the hammer price above the guarantee (in addition to the buyer’s premium).   While making any specific assumption about any given deal is unwise, in general it would make sense.  Offering a guarantee is a huge risk.  Obviously, getting a great painting in for sale enables the auction house to collect a hefty buyer’s premium and creates excitement around the rest of the property on offer, but if the guarantee is high enough, they can also demand a taste of the upside.

It needs to be noted right off the bat that only the most expensive, most salable works of art receive guarantees.  Most appraisals do not involve the sorts of objects that are part of these transactions.  Thus, it would be a very nice problem for an appraiser to have, but it is a problem nonetheless: the auction guarantee has the potential to distort our perception of the sale as it is portrayed in the auction database.

On the face of it, the guarantee is not such a big deal.  If there are no bids at the agreed price, then the auction house buys it; we thus have the standard ‘willing buyer and the willing seller, each with full knowledge of the facts and neither under any compulsion to act’.  If another bidder takes the price beyond the guarantee, then the market has spoken, and we can feel confident that the price they paid was a fair one.  While at least one observer has noted that the auction house might have an incentive to promote a work they have guaranteed over a similar one that they haven’t, it seems unlikely that even if such an unfortunate event happened it would affect the market more noticeably than any of the other myriad conflicts of interest that occur daily in the art business. 

The tricky bit is really the more recent practice of the ‘third-party guarantee’, whereby the auctioneer finds someone else to assume the risk.  Also called an ‘irrevocable bid’, it means that a person or an entity outside of the auction house has agreed to pay the guarantee and acquire the work if it does not attract a bid above the set price.  In many cases, this would seem to be a person who actually wants to own the work at the guaranteed price, but there is at least one hedge fund that specializes in these transactions and it seems likely that there are other individuals, entities or consortiums who see the process as a way to make money and not as part of building a collection.

The third-party guarantee is tricky because the auction house pays the new guarantor a fee to assume the risk as well as the opportunity to share in the upside should the painting exceed the guarantee.  The whispered number for the fee is $50,000 per $1 Million, and the third party will also get half of the auction house’s portion of the upside, should the work exceed the guarantee, as well as half of the buyer’s premium above the set price, but here again, we are flying blind.  At the same time, this third party is allowed to bid on the work themselves (Sotheby’s policy is to not allow this, but Christie’s and Phillip’s specifically do).  In practice what this means is that if a guarantor ends up buying a work above the guaranteed price, they are getting a significant discount on the transaction to what is reported in the database.

A real-world example given by the Prospero blog at The Economist (and which I am following quite closely in this post) illustrates the issue quite well.  In its November evening sale in 2011 in New York, Christie’s sold Roy Lichtenstein’s painting I Can See the Whole Room….and There’s Nobody In It” for a record $43,202,500.  The art advisor Guy Bennett, thought to be bidding on behalf of Qatari collectors, was also thought to have negotiated third party guarantees on top lots prior to the sale.   Further speculation emerged that the Lichtenstein carried a guarantee of $35 Million.  Supposing that his clients had both guaranteed and bought  I Can See the Whole Room…, and further supposing that the arrangement included the above assumptions about how the deal worked, Bennett’s clients would have paid $40,300,000—much less than what is printed in the database.

Again, this is all pure speculation and we cannot know for sure that any of this happened in this instance.  Nonetheless, the fact that these guarantees exist (the auction houses do note in their catalogue when a lot carries one) and the fact that in some cases, guarantors can bid on works indicates that this does, in fact, happen.

The question of how often is where the rubber meets the road.  Christie’s and Phillips expressly permit guarantors to bid on the lots they have an interest in.  Sotheby’s states that irrevocable bidders must pay the full buyer’s premium, although presumably such bidders would still have received compensation that would reduce their total outlay.  The practice of guarantees is common with big ticket items and it seems likely that for a given lot there is a very small number of players with the expertise and knowledge of the market who would be willing to risk such large amounts of money.  And that small pool of people would also be ones who might well have an interest in obtaining the work—indeed, while there are hedge funds and speculators trying to make money in this space, there are also collectors trying to get access to desirable works for whom an irrevocable bid is a great way of getting a jump on rivals and a discount on the announced price.

So what is an appraiser to do?  In the thought-exercise above of the Lichtenstein, the buyer paid over 7% less than the price that is in the database.  And with the lots that sell for closer to $1 Million, the spread might well be larger, maybe even close to 10%  since the buyer’s premiums are higher for lots in that range. 

One solution might be to apply a slight discount to guaranteed lots to take into account the possibility that a guarantor bought the purchase.  One would, of course, need the actual printed catalog to know if a given lot was subject to a guarantee (and in some instances, such guarantees occur after the catalog was printed, so you would need the saleroom notes as well).  But perhaps if we suppose that  at least 20% of the time, the buyer and the guarantor are the same entity, we might then apply a 1.4% discount to all such transactions (.2 x the .07 discount that such a buyer would be receiving from the printed price).  I think this is reasonable, but I would hate to be the appraiser defending such a discount during an IRS audit of an estate appraisal.  In fact, even if you marshaled all of your inside sources and press reports and could state with great authority that the guarantor and the buyer were the same, I very much doubt the IRS would take the applied discount lying down.

Then, on a more meta level, does it really matter?  If the auction house publishes a selling price, that becomes a touchstone for all market participants, observers, researchers and auditors alike.  Like it or not, the public auction is still the most accessible and widely accepted manner for establishing the value for fine art in many categories.  Like most things in the world of human affairs, it can sometimes be misleading.  Potential buyers have colluded to keep prices down; auctioneers have coaxed bids through a variety of shrewd methods unbeknownst to the bidder, reporters have parroted the auction houses’ spin on sales without any objectivity—none of this is news to anyone who has hung around the art market for very long.  The third-party guarantee is a relatively new twist that can serve to distort our perception of the market, but is hardly unique.  In any market in the world, some participants are better informed and have more access than others and it might well be pointless to try and adjust for that. 

My advice, then, is for the appraiser to include the fact that a lot carried a third-party guarantee in their report and to use this fact to strengthen the credibility of their conclusion.  I would imagine that in most cases, the appraiser would use this fact to perhaps guide their valuation downward, but, as always, there will be exceptions.  Like it or not, the auction record is the gold standard in many appraisal situations, warts and all.


Financial machinations at auctions, Prospero Blog at the

Charlotte Burns and Pac Pobric  In auctions, unlike in life, there are guarantees

Cristina del Rivero The Return of the Auction Guarantee… Art Meets Law Blog