United States: The Legal Canvas - Winter 2010–2011 - Part 2

Litigation as performance art.

Setting aside the legal issues for a moment, the lawsuit itself can be seen as an acting out of the very theme of the MOCA show.

It is a rare thing for a museum to have a functioning boutique as part of an exhibition. Museums often have gift shops, but they are not usually located in the middle of the exhibition floor. The inclusion of the shop was not, however, as controversial as one might have expected. Why? Because the boutique was there as a concrete expression of a central theme of Murakami's work – an acceptance of (and enthusiasm for) the blending of art and commerce. Indeed, the theme is proclaimed in the title of the show – "©MURAKAMI."

The canvases that Arthur purchased in that boutique consisted of the same patterns that were on the handbags in the shop. Arthur says that he didn't know at the time of the purchase that the canvases were made from the same material as the handbags – and alleges that this means that they are not original works of art. As a legal matter, the court was right to conclude that Vuitton's failure to identify the source of the material did not constitute a basis for a claim of fraud. The information seems clearly to have been available to Arthur. It also seems that the answer to the more conceptual question – "is it art?" – was also clearly on display. In fact, it was the whole point. One can buy into Murakami's concept or not, but the show, the shop and the canvases all reflected the conflation of commerce and art that is central to the artist's work.

As of this writing, a jury trial is set for February 22, 2011. In the meantime, canvases from the exhibition have sold at auction at Sotheby's and Phillips at prices that range from $10,000 – $13,745.

THE CHANGING FACE OF ARTIST'S RESALE ROYALTIES

In February 2009, a bill was introduced in the New York State Assembly that would require the seller to pay 5% of the sale price to the artist every time a work of art by a living artist is sold in New York for $1,000 or more. The bill was referred to committee, where it remains as of the date of this issue.

The formal justification for the bill was to provide "basic protection of the rights of artists who fall at the very bottom of the economic spectrum. Very few artists are able to support themselves and their families by the income derived from the sale of their works.

This will permit artists to benefit fractionally from the appreciation of the value of their works." This rationale has informed the concept of the resale royalty ever since it was first introduced as the droit de suite in France in the 1920's. On first blush, it seems like a simple – and even compelling – concept. The artist who creates the work should not live (and die) in poverty while others benefit from the appreciation of his work's value. In an article published in 1972 in The Art Journal, Monroe and Aimée Price described the "theology" of the droit de suite:

The use of the word "theology" in the article is apt; it connotes an article of faith that persists in the face of contrary evidence or argument. The resale royalty is an idea that has never really worked, but will not go away.

The Fundamental Flaws

The central feature of a resale royalty is that it requires a resale of a work of art. In other words, it only applies to secondary market transactions – and only a tiny fraction of artists ever make it to the secondary market. Moreover, even where an artist's work does sell on the secondary market, the overwhelming bulk of resale royalties are paid to the estates of the wealthiest and best known artists – such as Picasso and Matisse. This has to do not only with the significantly higher prices that are achieved for the works, but also with the difficulty and expense of enforcement. It costs money to enforce private legal rights – and the risk/reward analysis that any artist or estate must make before bringing lawsuit will be to compare the royalty to be received to the cost of litigation, as well as the cost of angering a collector who has no interest in adding the royalty to his bill.

Resale royalty schemes have also proven to be a questionable use of government resources. As an example, in California, the only state that imposes a resale royalty, if the seller of a work is unable after 90 days to locate the artist to whom a royalty is owed, the money is payable to the California Arts Council, which then has 7 years to locate and pay the artist before the funds are kept by the state to support a public arts program. An article in the Wall Street Journal in March 2009 outlined the Council's difficulties in disbursing the funds, describing one (presumably extreme) situation in which a state employee spent five months attempting to deliver an $80 check to an artist. A similar structure is proposed for New York.

As a result, the enforcement of the resale royalty laws is sporadic at best. Add to that the difficulty of even tracking sales in the private market – sales by dealers and by private collectors – and you get legislation that is likely to be more honored in the breach than in the observance.

The Australians take a turn.

Legislation became effective in June in Australia that aims to address these enforcement issues. Under the Australian scheme, every commercial sale of an original work of art (i.e., every sale in which an art market professional is involved) is required to be reported to Copyright Agency Ltd. (or CAL), a private organization designated by the Australian government to implement the legislation. The report must contain the sale date; the price; a description of the work; the title of the work; the name of the artist who created it; the artist's nationality, and whether the artist is living or dead. Where CAL deems it necessary in order to enforce payment of the royalty, it can also require the names of the parties to the transaction. Using that information, CAL determines as to each transaction whether the payment of the royalty – 5% of the sale price – is required by the statute. If it is, the seller, buyer and art market professional all bear joint responsibility for its payment.

The Australian royalty is payable with respect to (i) sales of artwork for $1000 or more, (ii) by artists who are living or have been dead less than 70 years, and (iii) who are (or were) Australian or citizens of other countries that have resale royalty legislation. In order to be paid a resale royalty, artists or their estates must be registered with CAL. Once CAL has made a determination that the royalty is payable with respect to any reported sale, it is required by the legislation to publish on its website all of the information that it has about the transaction other than the names of the parties and the sale price of the artwork. The information stays on the website for 21 days, during which time artists or their estates who have not yet registered with CAL may register and seek payment of the royalty, and artists who are already registered may decline to receive the payment. The legislation requires that artists who decline to receive the payment do so with respect to each individual transaction; CAL is not permitted to honor blanket waivers.

Where an artist declines to receive the royalty, CAL does not collect it. In all other circumstances, CAL is required to collect the royalty and to pay it to the entitled recipient. Where, after six years, CAL is unable to locate any entitled right-holders, it will attempt to repay the party who paid it. Failing that, it will retain the money to finance the administration of the scheme.

An unintended consequence?

CAL is authorized to take steps to ensure that it is receiving the mandatory reports of every commercial art transaction and to impose penalties where parties fail to make those reports. The legislation will therefore create a comprehensive record of every sale of art that goes through Australian dealers, galleries, advisors, and auction houses. In its publications about the new rules, CAL says that "as far as it is aware" it is not required to share any of the information with any part of the Australian government, including the tax authorities. Nor is it aware of any obligation on its part to disclose information pursuant to a private inquiry under Australia's freedom of information laws. But the law is new, and the possibility remains that the information may one day be used for other purposes.

Will it work?

It remains to be seen whether the Australian experiment will work and how its success or failure will be defined.

A particular focus of the Australian legislation is the population of indigenous artists – artists whose work has recently found a broader international audience. Special efforts have been made to reach these artists, including outreach to the indigenous art centers that promote their work. This particular focus may be the closest modern equivalent of the nineteenth century starving artist in a garret, in need of protection from a sophisticated market always eager for the "next new thing."

More generally, though, the underlying fairness and usefulness of a resale royalty regime has been widely questioned.

First, as noted above, resale royalties largely benefit artists for whom the market has already amply provided. That may be an acceptable result. Some recent proponents have begun to justify the need for a resale royalty by arguing that authors and musicians receive royalties when their works are published, purchased, and performed. Shouldn't painters and sculptors get equivalent treatment? Whether or not the analogy works, it is a far cry from promoting the support of unpaid and unappreciated artists.

Second, when a collector purchases a work of art, it is a statement of confidence in the particular work. Where the purchase takes place early in the artist's career, it is a statement of confidence in the artist's future – and the purchase itself may help the artist achieve that future. There is no guarantee at the time of the purchase that the value of the art will increase. If it does, it is often related to the later work of the artist himself. If his career is strong, not only will the value of his earlier work increase, but his later work will also command higher prices. If his reputation fades as he gets older – i.e., if he and his work do not stand the test of time – the prices of his earlier works will likely decline. If the artist is to be entitled to a portion of the upside, should he also share in the collector's loss if the price declines?

Finally, as a practical matter, galleries who work with emerging artists often use the proceeds of secondary market sales to subsidize their sales efforts on behalf of new and emerging artists. By diverting the funds that dealers would otherwise use to support as–yet unsuccessful artists, or that collectors might otherwise use to purchase work by those artists, the royalty may actually be counterproductive.

Each of these arguments would be less persuasive if a resale royalties scheme could be shown to accomplish its proffered goal – that is, to assist the artists "at the very bottom of the economic spectrum." Perhaps the enforcement mechanism now in effect in Australia will make a step in that direction. It will be interesting to assess its effectiveness over the next five or ten years.

IN FISK LITIGATION, COURT'S SOLOMONIC DECISION PROVES CONTROVERSIAL

In the Summer 2009 issue of The Legal Canvas we covered a case involving the proposed sale by Fisk University of a partial interest in its Alfred Stieglitz collection. In order to improve its desperate financial condition, Fisk had sought leave of a Tennessee court to lift a donor restriction on sale of the collection so that the university could sell an undivided half-interest in the collection to the Crystal Bridges museum in Arkansas. We noted that this case would be one to watch, as it enters the debate on art deaccessioning and grapples with how an institution can honor donor intent when financial needs are pulling in a different direction. After a series of filings and interim decisions this summer and fall, the court recently issued a decision that authorizes the sale to go forward – but with unexpected limitations that have dismayed both parties and will almost certainly be appealed.

This summer the court held a trial on the question of whether Fisk had met the legal standard warranting release of the donor's restriction – in this case, primarily the prohibition on sale of the collection imposed by Stieglitz's widow, Georgia O'Keeffe, when she gave the collection to Fisk. Under the equitable doctrine of cy pres (an abbreviated version of the old Anglo-French phrase "cy pres comme possible," which means "as nearly as possible"), a charity seeking to modify the restricted purpose of a charitable gift must demonstrate, among other things, that the donor's original purpose has become "impossible or impracticable" to achieve and that the proposed modification will cure the impossibility or impracticability and "most effectively accomplish" the donor's intent.

In an opinion dated August 20, the court found that while literal compliance with the donor's specifications was "impracticable," because Fisk could no longer care adequately for the collection, Fisk's proposed modification would not most effectively accomplish O'Keeffe's intent. Instead, the court said, the proposed relief would dilute her intent to "enable the public – in Nashville and the South – to have the opportunity to study the Collection in order to promote the general study of art." The court sent the parties back to the drawing board.

The party opposing Fisk is the Attorney General of Tennessee. As the agency charged with protecting the public's interest in the proper application of charitable assets, the Attorney General has taken the position that the proposed sale departed from O'Keeffe's articulated intent to benefit the people of Tennessee. Throughout the fall the Attorney General and Fisk presented dueling proposals and critiques of each other's proposals.

On November 3, 2010, after the last round of submissions, the court issued its decision, permitting the sale to go forward, but with significant restrictions. First, the sale agreement will have to contain a number of provisions developed by the court in order to preserve donor intent andmaintain the court's continuing jurisdiction over any future sale or transfer of the collection. Second, and even more significantly, $20 million of the $30 million sale proceeds will have to be placed in an endowment fund administered by a separate foundation exclusively for the benefit of the collection, with only the "income" of the fund to be paid over to Fisk for maintenance of the collection. The court directed the endowment fund to be set up in such a way that if Fisk goes out of business, the endowment may not be used for winding up costs or be reached by Fisk's creditors.

The court's decision derives from its view that it must ensure that any modification of donor restrictions adheres as closely as possible to the donor's "full dispositional design." The court made it clear that its decision was meant to honor the various elements of O'Keeffe's charitable design, which included not only benefiting the people of Nashville and the South but also benefiting Fisk specifically. The court also appears to have been concerned that Fisk might fail, even after receiving the $30 million infusion of cash contemplated by the original proposed agreement, in which event none of O'Keeffe's purposes would be served.

Fisk has objected to the decision on grounds that not nearly enough cash will be freed up to meet its current financial needs. Furthermore, Fisk has pointed out that the collection only requires about $131,000 annually in upkeep and has estimated that $20 million could generate nearly ten times that. Meanwhile, looking at the outcome of the case as representing a major deaccession by Fisk, the American Association of Museum Directors would have wanted precisely the opposite result and has issued a statement disapproving of the decision for letting any of the proceeds be used by Fisk for its general operating needs.

If $10 million is not enough to enable Fisk to survive and a $20 million endowment fund is more than Fisk needs for the collection, the court hasmerely postponed till another day a determination of what will ultimately happen to this endowment fund and to Fisk's share of the collection. Both sides are presently studying the decision and considering their options.

QUICK UPDATES

JOE SIMON-WHELAN DROPS ANTITRUST SUIT AGAINST WARHOL FOUNDATION

In our Summer 2009 issue, we reported on an antitrust case brought against the Andy Warhol Foundation, the Andy Warhol Authentication Board, and the artist's estate and its executors. The suit was brought by collector Joe Simon-Whelan, who owns a work that the Authentication Board twice declared to be inauthentic. Simon-Whelan alleged that the Foundation and the Authentication Board restrained trade by conspiring to reduce artificially the number of authenticatedWarhols on themarket, and engaged in anticompetitive conduct in order to monopolize the market for the re-sale of works by Warhol. In May, 2009, a federal district court permitted the case to go forward.

In late October, Simon-Whelan announced that he was walking away from the case. He said he still believed that the work he owns is authentic, and during the course of discovery he presented supportive testimony from respected Warhol experts. He said, though, that he simply could not afford to continue the litigation against the vigorous defense of the Warhol entities.

The Warhol Foundation, however, declared that it would continue to pursue its counterclaims. At a hearing on November 10, the parties reached a tentative settlement whereby each side would drop its claims, Simon-Whelan would state that he had found no evidence of any wrongdoing on the part of the Foundation, and he would agree not to make any profit from his claims (such as from book or movie deals).

Simon-Whelan's decision to drop the case underscores the truism that litigation is expensive. And, because you can't predict what your adversary will do, you can't predict or control what the cost will be.

The decision to drop the suit also underscores how difficult it is to obtain any meaningful legal remedy against authentication committees and authors of catalogues raisonné. In our Spring 2010 edition, we discussed the case brought by Joel Thome against the Calder Foundation, established not only that authors of catalogues raisonné have no legal obligation to render any opinion on a work of art, but also that a court will not itself engage in the authentication process. That case left open the possibility that a successful cause of action could be raised against an authentication board if the plaintiff could show that the board was engaging in unlawful activity.

That, of course, is exactly what Simon-Whelan was trying to do. We will never know whether he was right or wrong, because the cost of proving his allegations came to be too high.

We will also never know what would have happened had Simon-Whelan won the lawsuit. Even if he had succeeded in proving that the actions of the Foundation and the Board were unlawful and that the denial of the authenticity of his picture was a part of that unlawful activity, it is not at all certain that the market would have accepted the picture as authentic.

NYPMIFA – NEW YORK'S NEW RULES FOR INVESTMENT MANAGEMENT AND ENDOWMENT SPENDING

In our Spring 2009 issue, we addressed the question of "underwater" endowments and noted that the Uniform Prudent Management of Institutional Funds Act, if adopted in New York, would work significant changes by (among other things) providing greater flexibility to nonprofits in making appropriations from endowment funds.

UPMIFA is a model act promulgated by the Uniform Law Commission, applicable primarily to not-for-profit corporations. By mid-2010 it had been adopted in 46 states and the District of Columbia. On September 17, 2010, UPMIFA finally came to New York, but with unique features that present significant challenges and burdens for the state's nonprofit organizations. New York did not depart dramatically from the uniform statute in the area of investment management, where the statute updates existing law to provide a more detailed standard of care in the management and investment of institutional funds. However, the New York version of UPMIFA – known as "NYPMIFA" – does contain unique provisions concerning diversification of funds and conflicts of interest possessed by agents to whom the investment management function is delegated.

In the endowment law area, New York substantially modified the uniform statute. While UPMIFA was intended to give greater flexibility to charities by eliminating the rule that an organization could not spend below the "historic dollar value" of an endowment fund and instituting a more detailed prudence standard governing appropriations from endowment funds in its place, NYPMIFA has several features that reduce UPMIFA's flexibility or impose hurdles before an institution may avail itself of the new regime. Where the donor of an endowment fund is not available (i.e., is no longer alive or cannot be located), the organization must consider a list of eight factors before deciding to appropriate or accumulate funds and must make a contemporaneous record describing the consideration given to each factor. Where the donor of a fund is available, the organization must send a prescribed notice to the donor at least 90 days before availing itself of the new appropriation regime, essentially seeking the donor's consent to do so. For endowment funds set up after the September 17, 2010 effective date of the Act, New York adopted a presumption that an appropriation in excess of 7% of the fund in any one year (calculated as a quarterly average over a 5-year period) is imprudent. Most of the states that have adopted UPMIFA have declined to include a presumption of imprudence for new endowment funds, and none of them has included NYPMIFA's notice provision for existing funds with available donors.

NEW YORK SALES TAX: RISKS FOR LIMITED PARTNERS AND MEMBERS OF LLC'S

Introduction

New York art galleries generally are required to collect and pay over to New York State any New York sales tax that arises from the sale of a work of art. Galleries that do not properly collect and remit sales tax from purchasers are directly liable for the tax, in addition to any interest and penalties.

The New York art community is no stranger to the dangers of failing to comply with New York sales tax rules. After the 2002 indictment of Tyco International's former chief executive, L. Dennis Kozlowski, for evading New York sales tax on $14 million worth of artwork, many buyers and art galleries were investigated and held liable for unpaid sales taxes.

As dealers discovered in 2002, it was not just the gallery as a corporate entity that could face liability for unpaid sales tax; the owner of the gallery and the persons responsible for the payment of taxes on behalf of the gallery could be held personally liable. A recent decision of the New York Tax Appeals Tribunal makes clear that if the gallery is organized as a limited liability company ("LLC") or a partnership, these aren't the only individuals at risk. Under the December 2009 ruling In the Matter of Santo, any member of an LLC or partnership can be held liable for the entire amount of the entity's unpaid sales tax (including penalties and interest), regardless of the member's day-to-day involvement in the company's business and regardless of the size of the member's interest in the LLC or, in the case of partners, the partner's status as a general or a limited partner.

Background

The Santo ruling is less a change in the law than a shift in the state's enforcement policy. The New York statute at issue could not be more clear. Any person "required to collect any [sales] tax" is personally liable for the business' unpaid sales tax. New York Tax Law Section 1131(1) defines a person "required to collect any tax" to include "any member of a partnership or limited liability company."

The statutory language imposing strict liability on "any member of a partnership" has been part of Section 1131 since its enactment in 1965. In 1994, the New York State Legislature expanded the provision to include "any member of a limited liability company." As discussed more fully below, the sales tax rule is inconsistent with the basic rules governing partnerships and LLCs. Indeed, when the rule was initially extended to LLCs, some observers though that it was so inconsistent with the purpose of an LLC as to have been a simple legislative mistake. Perhaps as a result, the New York State Department of Finance and Taxation evidently chose for a number of years not to enforce the sales tax provisions against limited partners of limited partnerships and members of LLCs. To the extent that the more lenient enforcement policy was a deliberate one, the Department has clearly changed its mind.

The Santo Decision

In 2004, Joseph P. Santo and two other individuals formed a New York LLC to operate a restaurant. Mr. Santo, who primarily oversaw the management of the restaurant staff, contributed nothing to the LLC in exchange for his interest in it (which ranged over time from one third of the LLC to less than one quarter), was not in charge of the company's financial operations and was not responsible for filing any LLC tax returns. The restaurant eventually failed and bankruptcy proceedings for the LLC were commenced in 2006. New York State subsequently assessed Mr. Santo for the LLC's unpaid sales taxes, totaling almost $200,000 (including interest and penalties).

In March of 2009 a New York Administrative Law Judge ("ALJ") held Mr. Santo not liable for the LLC's unpaid sales because he "lacked the power to exercise the tax collection responsibilities on behalf of the LLC." The ALJ stated that Mr. Santo was "not an investor, was not involved in the day-to-day operation of the restaurant and was not responsible for the financial management of the business."

The ALJ did not address the statutory provision that imposes strict liability on members of LLCs and applied instead a different provision that holds the officers and employees of a business (whether organized as a partnership, corporation or LLC) personally liable for the business' unpaid sales tax if the officer or employee is "under a duty to act" for the business in complying with the applicable provision of the tax law. After finding that Mr. Santo was not under such a duty to act for the LLC, the ALJ cancelled the Department's assessment against him for the restaurant's unpaid sales taxes.

Mr. Santo's success was short-lived. In December of 2009 the New York State Tax Appeals Tribunal reversed the ALJ decision, ruled that the ALJ applied the wrong standard to Mr. Santo, and held him strictly liable for all of the LLC's unpaid sales taxes by reason of his status as an LLC member:

The Santo case is the first reported decision of the Tribunal that reflects the Department's shift in enforcement policy.

A striking anomaly.

Enforcing per se liability may result in the collection of more sales tax, but the rule is inconsistent with the general New York law governing limited partnerships and LLCs, the rules governing other "trust fund" taxes such as federal and state withholding taxes on wages, and rules governing the liability for sales taxes of officers or employees of corporations. The New York State Bar Association, as well as tax practitioners have called for a change in the law; as of the date of this article, the New York Legislature has failed to act.

Partnership and LLC Law. The sine qua none of limited partnership law is the limitation on personal liability of an investor who does not participate in the management of the partnership. Similarly, under the New York State Limited Liability Law a person cannot be held personally liable for an LLC's debts "solely by reason" of the person's status as an LLC member. The imposition of personal liability for unpaid sales taxes on limited partners and LLC members is an anomaly, wholly at odds with the usual treatment of LLCs, limited partnerships and the those who own them.

"Trust Fund" Tax Regimes: The strict liability rule is also at odds with the rules governing other "trust fund" taxes. "Trust fund" taxes are taxes primarily imposed on one party, but collected and paid over to the government by another party. For example, federal and state taxes on wages are collected by an employer by withholding money from its employee's wages and then paying it over to the government. Sales taxes are considered "trust fund" taxes because the tax is primarily imposed on the purchaser of goods, but is collected and held by the business "as trustee for and on account of the State." Businesses (including art galleries) that fail to collect and pay over sales tax are liable for the tax, as well as interest and penalties.

"Trust fund" tax regimes typically impose personal liability only on "responsible persons," that is persons involved with a company's business and responsible for collecting the tax and paying it over to the government. For example, federal law imposes personal liability for unpaid federal withholding taxes (plus interest and penalties) upon persons required to collect, truthfully account for, and pay over the tax, who willfully attempt in any manner to evade or defeat it or the payment of it to the federal government. With respect to LLCs and limited partnerships, the IRS has ruled that it will impose personal liability on their partners and members for unpaid federal withholding taxes on wages only when the person is generally liable under state law for the debts of the entity. With respect to employment tax withholding, New York closely follows the federal rules and generally imposes personal liability for the failure to collect employment taxes only on "responsible persons."

The New York and federal rules imposing personal liability on "responsible persons" for employment withholding taxes make equitable and intuitive sense. After all, persons involved in the day-today business will have the relevant knowledge to ensure compliance and generally will be in a position to control the collection and payment of the tax. As intuitive and equitable as it may be, however, it is not the law when it comes to New York State sales tax.

Arcane laws can have surprising consequences.

Any number of dealers and galleries may be organized as limited partnerships or LLCs. These forms of organization have benefits that may suit the particular business (or portion of a business) of the gallery. However, galleries that have passive or minority investors or partners may want to revisit their corporate structure in order to protect those individuals. Investors in galleries or other art-related LLC'smay want to consider restructuring how they support the gallery – perhaps, for example, shifting from being a limited partner or LLC member to being a creditor. Alternatively, passive or minority investors and partners may want to consider requiring the gallery to certify periodically that all sales taxes have been duly paid. Absent legislation from Albany, these sorts of measures may be the only way to limit what could otherwise be substantial liability

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