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Using Family Heirlooms As Collateral For A Business Venture

In times when raising capital to fund a business venture can be difficult, clients may want to consider using valuable assets that their family have owned for many generations as collateral. This may not always be as easy or as commercially sensible as it might first appear. 

Let us assume that the hypothetical family owns valuable paintings by recognised artists which are readily marketable. On the face of it, using them as collateral for a business loan is perfectly feasible but actually it may not be that straightforward. Clearly, when lending to fund a business, the first question any bank will ask is whether the proposed business venture appears viable. Only if the proposal survives that test will the focus turn to how any such loan might be secured and the question of collateral arise. 

Once the bank is satisfied with the venture, the next issue to be overcome is that the proposed borrower (a limited liability company or partnership, if that is how the venture is to be conducted, or the individual family member, if intending to trade personally) may not in fact own the relevant works of art. If the paintings are 'in the family' they may not be his alone to pledge. The bank is therefore only likely to be willing to lend if personal guarantees are also volunteered. Here, the bank might take the existence of the paintings as evidence of personal wealth which would suggest that, should a guarantee be called, the guarantor has the ability to pay, either voluntarily or through enforcement action against other realisable assets. 

The question of ownership may pose further problems where the painting has been held for many generations. Provenance is everything, and the first test the bank will set will be to demonstrate how the paintings came to be in the hands of the person concerned. If ownership and provenance can both be demonstrated, then the paintings could become potentially valuable collateral. 

Even if all this is ascertained, however, there are obvious difficulties in using artwork as collateral. Not only is the value of the relevant assets a matter of subjective assessment, but what is 'in' today may be 'out' tomorrow. Added to that is the fact that works of art rarely produce any income which might be used to fund interest that will accrue throughout the term and (if the loan cannot be repaid) will continue to do so as the lender waits for appropriate market conditions in which to sell his security. The relatively high costs of selling any painting which may have been pledged through the leading auctioneers also needs to be considered. Overall, in our view the likely value of the artwork will need to be many times in excess of the borrowing before a bank would consider itself secured. 

Not all banks will regard works of art as acceptable collateral. The main clearing banks are likely to regard lending against paintings as too esoteric a proposition, but some of the private banks are in the market and will consider a proposition. 

Their normal approach is to require the principal behind the business to give a personal guarantee and to secure that obligation by giving a 'charge' over the relevant asset. The terms of any such 'chattel mortgage' will vary depending on whether or not the paintings concerned are to be handed over to the bank for safe custody, whether they are to remain with public galleries on any permanent loan arrangements, or whether they will be allowed to remain on the walls of the individual who is promoting the business venture. 

In every instance, the bank will want the terms to include clear powers to take possession of the painting and to have a power of sale if the security needs to be enforced. The bank will also require the paintings to be insured at the borrower's costs and will expect the borrower to foot the bill for periodic expert valuations and assessments of the security arrangements. 

So what should the owner of the paintings look for when negotiating terms with his friendly bankers? 

Perhaps the most critical point will be to place some restraint on the bank's ability to enforce its security, potentially at great long term cost to the owner of the paintings. Remember that the loan granted by the bank to the business may well be repayable on demand, a common feature in today's lending market even in what purport to be 'term-loans' for a number of years. The owner of the works of art would not wish to have his personal guarantee called on a Monday only to find the bank using the power of sale in the chattel mortgage to dispose of his paintings at the end of the week. 

The likelihood of course is that the bank would be sensible, and sensitive to the need to allow the art works to be appropriately marketed to realise their true market potential, but it can do no harm to have contractual terms in place which, at a minimum, require the lender to consult with one of the established auction houses or recognised art dealers as to how and when the works are to be offered for sale. 

Also to be borne in mind are the potential tax consequences of a disposal by the bank of works of art pledged as security. The exercise of a power of sale by the bank would trigger a disposal for tax purposes by the person who granted the security, thus in all probability crystallising a tax liability on the notional capital gain. If the paintings have been owned for a long time the base cost for tax purposes may be relatively low, leading to a significant tax charge for which there may be no surplus cash once the bank has settled its lending and the costs of enforcing the security. If the paintings were subject to a conditional exemption from inheritance tax, a sale would trigger the original inheritance tax (or even estate duty, possibly at a higher rate than 40%), although undertakings made to secure the conditional exemption may have prevented the use of the painting as collateral in any event. 

As if there were not enough other reasons why raising funds on the back of family heirlooms might be difficult, what if the paintings are in fact owned by a family trust? That would not seem unlikely where the paintings have been in the same family for several generations. In that case, the trustees of the family trust would need to consider if pledging trust assets in support of the business ventures of a single family member accords with their duties to safeguard the paintings for the benefit of the wider family. 

The bank would want to see evidence that such matters have been properly considered and the trustees would no doubt wish to take their own independent legal advice, all of which just adds to the complexity. What may have appeared no more complex than finding a ladder, lifting the Rembrandt off the wall and walking it down to the bank could in fact turn out to be quite a challenge.

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London
SE1 8NW
DX 53 Chancery Lane

Telephone: +44 (0)20 7629 7411
Fax: +44 (0)20 7629 2621
Email: bh@boodlehatfield.com

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