Investing In Art Backed Loans: Five Considerations

Tarter Krinsky & Drogin LLP

Art backed loans are growing in popularity as art collectors seek to unlock the value of their collections. For investors who desire to diversify their debt portfolios into this expanding market but lack the expertise in fine art necessary to evaluate the proposed collateral, certain specialty lenders offer the opportunity to purchase participations in the art backed loans they make to collectors.

This article discusses the nature of art backed loans and participations and raises five considerations to be undertaken when evaluating a participation in an art backed loan.

Art Backed Loans

An art backed loan is a loan collateralized by a work or works of fine art. Although larger lenders may make such loans on a recourse basis, giving the lender access to the borrower's other assets if there is a default, a "true" art backed loan is made with recourse only to the work or works of art pledged as collateral.

Participations in Art Backed Loans

A participation in an art backed loan is much like a participation in any other asset-backed loan. Where, for example, the investor purchases an 85% participation, the investor will be entitled to a negotiated interest rate (typically an index-referenced floating rate) on 85% of the outstanding principal balance and the right to receive its pro rata share of the borrower's principal repayments. Typically, the lender will hold the balance of the loan as its "retained interest." Because the lender typically engages its own affiliate to service the loan and its collateral pursuant to a servicing agreement, the retained interest is intended to incentivize the servicer to service the loan properly to protect the lender's retained interest. As is the case in most participations, the investor is in contractual privity with the lender and servicer through participation and servicing agreements, but not in privity with the borrower.

Five Considerations

Below is a short list of five issues central to protecting the value of an investment in an art backed loan.

1. Responsibility for Evaluating the Collateral
If you are considering taking on exposure to the fine art market as a participant rather than a lender, you likely recognize that you do not have the expertise to evaluate ownership, authenticity, marketability and other metrics essential to determining the value and quality of proposed collateral. Accordingly, it is best that your participation agreement reflects both parties' acknowledgment that the benefit to you of participation versus direct lending is that you need not have such expertise because the lender undertakes all due diligence concerning the collateral.

To be clear, this does not mean that the lender guaranties the collateral's value; what it means, as a practical matter, is that if it is later revealed that the lender acted negligently or in bad faith when evaluating the collateral causing you to suffer losses because the collateral cannot be sold or sold for the value stated in the event of a default, the lender cannot argue that you are not entitled to recovery because you failed to perform your own due diligence.

2. Obligations for Servicing Fees and Expenses
As the purchaser of a loan participation, you should not be assuming direct liability for servicing fees or expenses unless you expressly agree to do so, which would be unusual. As with virtually any asset-backed loan, servicing fees and expenses should be paid at the top of the waterfall leaving all remaining income to be distributed pursuant to the subsequent priorities. Unless expressly agreed otherwise, the waterfall should place payments on your participation ahead of payments on the lender's retained amount. Although this should be obvious, disputes have arisen from lenders' insistence that they can properly deduct servicing fees and expenses from the participant's distribution, even though the documents expressly provide for distribution of all such amounts at the first step of the waterfall.

As a measure of further protection, it is best to include language confirming that the participant has no obligation to pay servicing fees or expenses and that it is the lender's obligation to pay any such amounts in the event of a shortfall in borrower payments.

3. Reporting and Access to Records
Too often, a servicing agreement's language concerning the servicer's obligation to provide the participant with periodic reporting and access to servicing records lacks the clarity and specificity needed to compel sometimes recalcitrant servicers to provide essential loan level information to the participant. At a minimum, your participation agreement should state plainly that at all times during the term of the loan, the servicer must, upon a specified number of days prior notice, afford the participant and/or its agent access during specified business hours to the loan's "Servicing Records." That term should be defined carefully in the servicing agreement to include all potentially relevant information relating to the loan's servicing, including information concerning borrower payments and collateral status.

It is best if the provision identifies by position and/or name the servicer's employee(s) who will assist the participant or its agent in locating and examining the Servicing Records and state expressly that the participant may copy those records in their native format (i.e., paper to paper, electronic files to electronic files) and take the copies upon departure. For further assurance, the provision should state expressly that the servicer acknowledges and agrees that it may not place any further conditions on the participant's examination or use of the records and that the participant need not provide any explanation concerning the reason for the examination or the intended use of any information.

4. Loan Default Triggers
As is typical of most loan participations, an Event of Default with respect to an underlying art backed loan will trigger not only enhanced rights for the lender under the loan agreement, but also for the participant under the participation agreement. For the participant, such rights will most certainly include default interest, increased access to information and the right to remove the servicer upon notice and without a cure period. Accordingly, you need to understand the circumstances giving rise to an Event of Default on the underlying loan that will trigger your enhanced rights under the participation agreement.

For example, it seems obvious that a borrower's failure to pay its obligations within a contractually stated cure period will give rise automatically to an Event of Default under the loan agreement. However, there are loan agreements in the market providing that a borrower's failure to timely satisfy a payment obligation does not give rise to an Event of Default unless and until (i) the servicer notifies the lender of the payment failure and (ii) the borrower fails to make the delinquent payment within a cure period stated by the servicer in its notice.

While this nuance may seem innocuous, in fact it puts the participant at the lender's mercy. If the servicer and/or the lender determines that its own best interests are served by postponing an Event of Default, such language will allow them to end run customary language of the servicing and participation agreements providing that (i) the servicer cannot extend the term of the loan without the lender's written consent and (ii) the lender cannot direct the servicer to extend the term of the loan without first obtaining the participant's written consent. This nuance would allow an unscrupulous lender and/or servicer to postpone the Event of Default - in effect, extending the term of the loan - to benefit itself while denying the participant the enhanced rights to which it would otherwise be entitled.

5. Tracking the Collateral
Specialty art lenders typically require that borrowers place the artworks securing their loans in a storage facility specializing in fine art storage in an account held in the lender's name. In such cases, a participant is best served when the underlying loan agreement and the servicing and participation agreements are clear and consistent as to the circumstances under which (i) the collateral may be moved or released from the lender's control and (ii) the timing and content of notice to be provided and consent to be obtained from the participant. Likewise, the documents should be clear and consistent as to the steps required for a borrower to take possession of a piece of collateral temporarily; for example, to include an artwork in an exhibition.

Typically, borrowers are required to provide a substitute work or works of art of equal or greater value to be held until the released artwork is returned to the lender's storage account. To the extent the parties agree to allow a borrower to provide cash rather than artwork as temporary collateral, the documents should be clear as to the mechanism through which the cash is provided and the documentation required. This will obviate later disputes over whether the money provided by the borrower was temporary cash collateral or a principal repayment, the latter of which would reduce the loan's principal balance and entitle the participant to repayment of its pro rata share. Such clear contractual terms mitigate the risk that an unscrupulous lender and/or servicer could deny a participant payment of its pro rata share of a borrower's principal repayment by claiming that such payment was merely a temporary deposit of cash collateral.

As with any asset-backed investment, disputes concerning art backed loans may arise in connection with a range of issues including collection and distribution of income, valuation and management of collateral and investor access to information. However, careful thought and concise drafting prior to closing will produce agreements providing clear guidance to mitigate the risk of such disputes. Moreover, in the event that a lender and/or servicer behaves unscrupulously, clear, concise agreements will greatly enhance the investor's chances of enforcing its rights through legal process.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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