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Encumbrances As They Relate To Title An Essay

Spencer’s Art Law Journal Edited by Ronald D. Spencer 
CONTENTS
Vol. 1, No. 2, Fall 2010

Editor’s Note
This is Volume 1, Issue No. 2 of Spencer’s Art Law Journal. This issue contains two essays, which will become available by posting on Arnet, September through November 2010.

As noted in Issue No. 1 of this Journal, art market custom and practice remain much as they were in the 19th and early 20th century. The legal structure we call art law (an amalgam of personal property law, contract, estate, tax and intellectual property law) supporting the acquisition, retention and disposition of fine art, often fits uneasily with archaic custom and practice. The result is that 21st-century art market participants are frequently unsure of their legal rights and obligations.

The goal of this Journal is to promote discussion of art law legal issues for lawyers and nonlawyers alike, so as to provide greater transparency, stability and predictability.

The two essays in this Fall issue continue to deal with two core issues for the ownership of visual art -- authenticity and title (who created it and who owns it?). The first essay addresses the U.S. income tax deductibility of a loss resulting from the purchase of fake or misattributed art. The second essay deals with due diligence by the art buyer to limit the risk of post-purchase third party claims.

Three times a year future issues of this Journal will address legal issues of practical significance to collectors, dealers, scholars and the general art-minded public, such as appropriate due diligence on the part of the buyer when provenance is incomplete or unclear, and the relevance of catalogues raisonnés for due diligence.

For inquiries or comments, please contact the editor, Ronald D. Spencer, at Carter Ledyard & Milburn LLP, 2 Wall Street, New York, N.Y. 10005, by telephone at (212) 238-8737, or at spencer@clm.com

ART BUYER’S DUE DILIGENCE. DO YOU OWN IT FREE AND CLEAR?

Gary D. Sesser and Kenneth S. Levine

This essay concerns actions and promises by prior art owners which result in claims against the new owner.

Gary D. Sesser is a partner, and Kenneth S. Levine an associate, in the litigation and art law groups at Carter Ledyard & Milburn LLP in New York. They regularly advise buyers on claims arising out of art purchases.

Buyers of art commonly worry that the work being purchased is not authentic, and scrutinize carefully the evidence about its history and authenticity. But since buyers of art often do not know the identity of the true seller -- sellers of art typically consign their works to art dealers, and buyers interact only with those dealers -- other problems also can arise. Behind every transaction is a risk that the undisclosed seller is withholding information, or did something before the sale that could raise problems later on. For instance, if the work had been stolen at some point, or wrongly appropriated during wartime, even an innocent purchaser cannot obtain good title.(FN 1) The seller also could have used the art as collateral for a loan and failed to disclose it to the dealer. Or, in more prosperous times, the seller may have promised to transfer the art to a museum, university, or other worthy institution, but neglected to tell the cultural institution or the art dealer about the change of plans. The charitable institution will not be happy to learn that the artwork once destined to support its worthy cause has now been sold, and may take action against the seller and purchaser. A pledge for a loan or promised gift by the former owner of a piece of art is like a latent defect that can rise up long after the ink on the purchase agreement has dried.

Buyers typically pay little attention to these concerns, relying, not unreasonably, on their dealers to rule out these potential defects. Art dealers, in turn, typically pass title to the work to the buyer, and represent and warrant to the buyer that the art is free and clear of all liens. If problems should arise with the transaction, the buyer would look to the art dealer for a refund or other compensation, not to the ultimate seller.

But buyers of art should also understand that merely purchasing art through a dealer will not necessarily protect them from a lawsuit, even if the buyer and dealer are unaware of some defect or the seller’s pre-sale actions or promises.(FN 2) Therefore, before purchasing a significant work of art, buyers should at least consider what would happen in case of any problems with the transaction. Since the buyer relies almost entirely on the dealer, how confident is the buyer that the dealer has checked for potential claims, and will still be solvent and in business in a few years in case problems arise?

This essay offers suggestions for ways buyers may protect themselves in art transactions.(FN 3) Buyers should consider adopting some or all of these procedures, or consult with their dealers on these procedures, depending upon their level of comfort with the dealer and the transaction itself.

Avoiding Pitfalls
First, before making a major purchase, buyers should make sure that either they or their art dealer search the Art Loss Register(FN 4) to make sure that the work has not been reported stolen, and the Uniform Commercial Code ("UCC") databases in states where the current owner resides or does business, to make sure that no liens were placed on the current owner and the work of art.(FN 5) Many dealers do not conduct these searches and, instead, rely on the seller for the promise of good title and that the art has not been pledged for a loan by the seller or the seller’s predecessor in ownership. But, even against an innocent purchaser, if the work has been stolen the sale does not convey good title, or if a party has a perfected security interest against the owner rather than the dealer, then title can be transferred but the sale may still be subject to the secured creditor's claim. Conducting these quick and inexpensive searches is the best way to screen for the most likely claims from prior owners or secured lenders.

Second, since the searches would not likely reveal potential claims from museums that have received only a promise of the art, buyers should make sure that the language in their purchase agreement explicitly rules out the possibility that the art has been transferred or promised to an institution. In the purchase agreement, the dealer should represent and warrant the following:

• the dealer has authority to sell the art;

• the art is currently free from any claim, lien, security interest, pledge or encumbrance;

• if the transaction will be completed at a later time, then, during the entire term of the agreement, the art will remain free from any claim, lien, security interest, pledge or encumbrance;

• no interest in the art has been promised or transferred to a museum or other third party;

• the dealer agrees to indemnify the buyer from any claims and expenses, including legal fees, that the buyer incurs in case of a breach of any of the preceding warranties;

• if the transaction is rescinded for any reason and the artwork is returned, the buyer shall receive the higher of the original purchase price or the current fair market value of the work.

Third, before completing the transaction, a buyer should have the art dealer conduct a "Google" internet search on the current art owner and specific piece of art, to see if any news items appear regarding a promise to an institution that may include the specific artwork. If there is any suggestion that the art has already been promised, a buyer should insist on additional information and, if necessary, a release from the promisee before purchasing.

Fourth, if the art dealer does not physically possess the art at the time of sale, the party who possesses the art must be notified prior to the completion of the sale. The buyer should also obtain written assurances from the party with possession that it does not object to the transfer. This is important as both a practical and legal matter, since the party holding the art is much more likely to sue if it feels it has legal interests in the art and the art needs to come off its walls.

Litigating Claims
Even when some or all of these steps have been followed, institutions or secured parties may still assert claims against the new owner when they discover that the art promised or pledged to them is now in new hands. The strength of the specific claims inevitably involves a close examination of the facts, including when and how the art was promised, pledged, encumbered, or sold, and what the buyer knew or should have known, as well as an evaluation of what jurisdiction’s law will apply. However, the disputes generally boil down to one or both of the two following key principles of law.

First, an owner’s promise to donate art in the future is not the same as an actual, present transfer of ownership. The key question is whether or not title to the art has actually passed from one holder to the next. The answer is sometimes difficult to discern, but evidence of a transfer of title may include a change in possession of the art, treatment of the transaction in tax returns, the language of other contemporaneous paperwork such as a deed of gift, and a change in the terms of insurance.(FN 6) If the prior owner only promised to give the art to a museum in the future, but did not actually effect a present transfer of ownership, then the innocent purchaser will retain title to the work as against the museum. The museum may have a claim for breach of contract against its putative donor, but not against the innocent purchaser.

Second, the "good faith" innocent purchaser of art must be truly acting in "good faith." A buyer cannot look the other way past suspicious details or open questions. If a buyer actually knows about an agreement between the seller and an institution, then the buyer can, potentially, be sued for interfering with that agreement (although the buyer would still retain title to the purchased art). The key question is whether the buyer was actually aware or should have been aware of the agreement.(FN 7)

In sum, every work of art may have, lurking beneath its captivating exterior, a claim that it has already been given or promised to another. Because there is no official registry to record title to art, buyers should be mindful that the art being purchased may be expected elsewhere, and they should think through how best to protect themselves in case someone else comes calling for the piece.

New York, New York
September, 2010

Gary D. Sesser
Kenneth S. Levine
Carter Ledyard & Milburn LLP
Two Wall Street
New York, NY 10005
email: sesser@clm.com
email: levine@clm.com
website: http://www.clm.com

 

NOTES
(1) See Solomon R. Guggenheim Foundation v. Lubell, 77 N.Y.2d 311, 317 (1991) ("New York case law has long protected the right of the owner whose property has been stolen to recover that property, even if it is in the possession of a good-faith purchaser for value.").

(2) The Uniform Commercial Code ("UCC") recognizes that buyers in the ordinary course who purchase through a dealer in a typical arm’s length transaction would be expected to take the purchased item free and clear of any liens. See New York UCC §9-320(a); New York UCC §2-403(2); James J. White & Robert S. Summers, Uniform Commercial Code 4, §33-8 (6th ed. 2010), p. 359 (noting that a consumer buying a refrigerator in the ordinary course would be expected to purchase it free and clear, and not expected to conduct a search before the purchase to see if the refrigerator was encumbered). However, precisely because artwork is not a household appliance, and its distribution pattern is therefore often more complex and circuitous than industrial goods, this general rule may not apply to a given fact pattern. See New York UCC §9-201(a). Many facts would sway the outcome of the specific case, including the nature of the security interest and the dealer’s relationship with the secured party.

(3) The same general concerns, and suggested protections, apply in cases where art is being used as collateral for loans. In those cases, the lenders will want to make sure that the art has not already been transferred or promised to an institution or pledged as collateral for a loan.

(4) http://www.artloss.com/. While the Art Loss Register is the most prominent database for stolen art, there is no designated central authority for such a list. Several other public and private institutions have databases of stolen art that can be checked, such as the Federal Bureau of Investigation’s Art Theft program, and Interpol’s art theft database. Buyers should also make sure that the art was not seized from Jewish owners by Nazis during the Second World War or otherwise looted. Again, there is no central database for such a search, but the following are two prominent databases that buyers should check: The Lost Art Internet Database, and lootedart.com. Many countries also maintain their own databases for the identification and return of looted or stolen Jewish property, links to which are provided at the International Council of Museums website, here.

(5) See http://www.coordinatedlegal.com/SecretaryOfState.html (providing links to UCC search databases in each state). Private service companies such as Article 9 Agents, www.A9A.com, will also conduct the searches for a nominal fee.

(6) Under New York law, an owner can transfer title to a work of art, but keep possession of it for his or her lifetime. In Gruen v. Gruen, 68 N.Y.2d 48 (1986), a father wrote letters to his son stating that he gave to his son, as a birthday present, a painting by Gustav Klimt, but was keeping the painting in his home for the remainder of his life. The court found that the present gift, with a reservation of a life estate, was valid, reasoning that the letters had sufficient formality to convey the transfer. See id. at 55 ("As long as the evidence establishes an intent to make a present and irrevocable transfer of title or the right of ownership, there is a present transfer of some interest and the gift is effective immediately"). Ideally, the son should have filed a UCC financing statement so that his father could not attempt to sell or pledge the Klimt to anyone else, and to buttress his own claims of ownership.

(7) In one case we litigated, an individual ("debtor") promised a valuable art collection to a museum, but then arranged for the same art collection to serve as collateral for a debt owed to a third party without disclosing this fact to the museum. The debtor defaulted on his debt, and the third party creditor sought to seize the collateral. The museum sued the creditor, claiming that the creditor was interfering with its gift agreement with the debtor, and that the creditor was aware or should have been aware of the gift agreement because an article published in TheNew York Times referenced the debtor’s donation. Ultimately, the case settled before a court could rule on the legal question of whether the newspaper article provided sufficient notice of the gift to the creditor.


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Real Estate Encumbrances: Deed Restrictions, Liens, Easements, and Encroachments

An encumbrance is a claim or liability against real estate, held by someone other than the fee owner of the property that affects the title to the property, and therefore its value. It does not confer any possessory interest, and therefore is not an estate, and does not necessarily prevent the transfer of title. Encumbrances can include property liens, deed restrictions, easements, profits à prendre (aka profits), and encroachments. Liens, easements, and profits are nonpossessory interests in real estate. Although a license to use land is also a nonpossessory interest, it is not an encumbrance, since it does not transfer with the land.

Deed Restrictions and Covenants

Deed restrictions, (aka conditions, covenants, and restrictions, or CC&Rs) are a common encumbrance, private agreements that restrict the use of the real estate in some way, and are listed in the deed—hence the name. The seller may add a restriction to the title of the property. Often, developers restrict the parcels of property in a development to maintain a certain amount of uniformity. Deed restrictions also limit alterations or additions in historic districts, to maintain their historicity. Deed restrictions may be temporary or they may be based on a covenant that runs with the land.

A covenant running with the land is a covenant that applies not only to the original parties but also to all of their successors with an interest in the land. For a covenant running with the land to be enforceable, 4 requirements must be satisfied:

  1. the covenant must be created in a written document — usually the one used to convey the land
  2. the parties intend that the covenant run with the land
  3. the covenant must, as lawyers like to say, touch and concern the land, meaning that it alters the use of the property
  4. the successive parties with an interest in the land must be in privity of estate to the original parties that created the covenant, meaning that the relationship between successors to the land must be similar to the relationship between the original parties that created the covenant, such as seller and buyer or lessor and lessee.

Because the privity of estate requirement arbitrarily restricts the covenant to certain successors in interest, even though it should logically apply to all successors in interest, the courts have developed an alternative interpretation called equitable servitudes, based on all the requirements for a covenant running with the land except the privity of estate requirement. An equitable servitude is created by an instrument complying with the Statute of Frauds, stating that the use of the land is restricted, and giving notice of the restriction to any purchaser of the land. However, the notice can be constructive, in that the deed or other conveyance document can refer to the restriction. For instance, the restriction can be registered on a subdivision map and referenced by the deed.

Liens

A lien is a claim against the property which serves as collateral for a debt. The lien holder has the legal right to go to court to have the property sold to satisfy the debt, if it is not paid. Liens have priorities, so that when the property is sold, higher priority liens are paid before lower priority liens. The liens transfer with the property, so if they are not paid when the real estate is sold, then the new owner becomes liable for the debts.

Generally, earlier recorded liens have higher priority over later liens, but liens for taxes, assessments, and homeowner association fees have the highest priority, regardless of when they were recorded. Liens with higher priority are classified as senior liens, while lower priority liens are junior liens. After any liens for taxes, assessments, and association fees, 1st mortgages have the most senior lien, since loans to pay for property are not granted for properties without a clear title, meaning, in part, that there are no outstanding liens on the property. Besides unpaid debt collateralized by property, anyone who works on the property and is not paid can file a mechanic's lien. A judgment lien can also be assessed against property for liabilities unrelated to the property. So if a homeowner loses a court judgment for a car crash, the injured party can record a lien on the property for unpaid damages.

Easements

An easement is the right of someone other than a fee owner to use a particular parcel of land for a particular purpose—most often it is the right to cross the property. An appurtenant easement (aka appurtenance) is a right to use adjoining property that transfers with the land. The parcel of land that benefits from the easement is the dominant tenement, whereas the servient tenement is the parcel of land that provides the easement. The appurtenant easement always transfers with the land unless the owner of the dominant tenement releases it.

An easement in gross is an individual interest to use the land—it benefits a person or an organization, in contrast to an appurtenant easement, which is part of the land, and transfers with it. A personal easement in gross is used to allow a neighbor to cross someone else's land, but unlike an appurtenant easement, does not transfer with the property and ends when the owner of the easement dies.

Often, businesses, such as railways and phone companies, hold commercial easements in gross so that they can conduct business. Utility easements, which allow utilities to run electric wires or pipelines across properties, are also easements in gross. Commercial easements in gross can be assigned or conveyed.

The Creation of Easements

Easements are created by express agreement, by will, by deed, or by implication. In many cases, an owner creates an easement for himself when selling a parcel of his land or gives an easement to a buyer of the property to pass over his land because of convenience or necessity.

One of the rights of owning land is to be able to enter or leave it, but some parcels of land are isolated from public thoroughfares by other private properties. In these cases, an appurtenant easement is created by a court order as an easement by necessity, because the dominant tenement owner has no other way of entering or leaving his property.

Sometimes the easement is created by implication, such as through long-time use or by prescription. An easement by prescription is created through long-term use, where the owner knew about the easement, but did not prevent its use. The length of time required is usually set by state law, typically 10 to 21 years, and the use must have been continual and without the owner's approval, but with the owner's knowledge. The required time period to establish the easement by prescription can be accomplished through tacking, where successive owners—successors in interest—of the dominant tenement continue to use the easement.

An easement by condemnation is created by eminent domain—owners of the servient tenement must, however, be compensated for providing the easement.

A party easement is created by written agreement between parties concerning a common boundary, such as a shared party wall, a fence, or a driveway, especially between adjacent townhouses or row houses.

The Termination of Easements

An easement can be terminated in numerous ways, especially when the reason for the easement no longer exists, or it makes no sense, such as when both dominant and servient tenements are bought by the same owner (termination by merger), or when the use of the easement changes significantly, for instance, by greatly increased traffic, or the owner of the dominant tenement releases the easement. An easement can be terminated if it is abandoned, but not if it is simply not used. In some cases, certain legal actions may be required before the easement is actually terminated.

Profits � Prendre

An easement allows a person to use a non-owned property but without taking anything from it. Similar to, but much less common than easements, profits Ã� prendre — usually shortened to just profits — allows the holder to take something from a property, such as crops, soil, rocks, or minerals without owning the property. Profits, like easements, are classified either as appurtenant or in gross. Profits can be created or terminated like easements.

Licenses

A license, unlike an easement, is having the permission of the owner—the licensor—to enter his land for a specific purpose. Unlike an easement, the license can be rescinded at any time. For instance, if you purchase a ticket to a theater and are not dressed appropriately, then the facility manager can refuse your entry, because he can revoke your license to enter. A license will also terminate upon the death of either the licensee or the licensor, or if the licensor sells the land. Hence, although a license is similar to an easement, a license is not actually an encumbrance on the real estate and does not transfer with the title.

Encroachments

An encroachment is an extension of some physical structure, such as a building, driveway, fence, or tree over the property lines from an adjoining property. Encroachments can affect the marketing of the title, and should be noted in a listing agreement or sales contract.

Encroachments can best be determined by a spot survey, which is a survey showing the locations, sizes, and shapes of the buildings on a lot. Visual inspection is not as accurate and should not be relied upon if there is a question of an encroachment.

The owner of the land subject to the encroachment can either sue for damages or have the structure extending over the property lines removed or trimmed back. However, the owner of the encroaching structure may have an easement by prescription if the time period of the encroachment exceeds the prescriptive time stipulated by state law for an easement by prescription.