Collectors who buy to hold and traders who buy to flip share a common sentiment: They both hope that their artwork will increase in value. What separates them is somewhat intangible. A collector who purchases art with a long-term view can be driven by a multitude of factors, from the desire to reframe cultural narratives, promote an artistic vision, reflect their interest or simply to establish social status, while traders may take a more pragmatic approach of selling at a profit within a short period of time after they purchased the work. Although there will always be art market participants at each end of the spectrum, the lines are getting more blurred. Collectors may monetize their collection, treating their works of art as an asset in a diversified portfolio, and those promoting art as an investment may draw on the yearning of those who want to partake but may not have the time, expertise or access to the art market.
What’s Fractional Ownership?
Fractional ownership means that the cost of acquiring the asset is shared among multiple individuals. Those joint owners will share in the upside but also the downside when the underlying work of art is sold. Fractional ownership can occur naturally from various individuals wanting to purchase an artwork jointly; dealers may occasionally join forces to purchase an artwork and share in the upside. Fractional ownership may also be the business model in which the goal is to raise capital from a pool of investors who will then jointly own the works of art. Those investors will either be shareholders or limited partners in the entity holding the work(s) of art and take their share of profits and losses. Selling fractional interest in an artwork and selling shares of an entity owning an artwork may in fact be no different than selling shares of a company on the New York Stock Exchange.
Securities Law
However, raising capital from U.S. investors by selling shares in an entity or tokenizing an asset has regulatory implications and will require an analysis under the U.S. federal securities laws. The analysis to be conducted will determine if selling a fractional interest in an artwork is akin to selling a “security.” If the fractional ownership or interest in the artwork is deemed to be a security, then the issuance and resale of the fractional interest has to be registered with the Securities and Exchange Commission unless it’s subject to a statutory exemption or safe harbor. In addition to the registration process, the SEC will require extensive disclosure about the entity, its business and the risks of the investment so that investors can make informed decisions. This transparency comes at a price: It’s costly and time consuming to register and then to maintain those disclosure requirements over time.
Is a fractional interest a security? The Howey test. Pursuant to the Securities Act of 1933, a “security” is defined broadly to include stocks, bonds, transferable shares and an “investment contract.” In SEC v. Howey Co.,1 the U.S Supreme Court found that an investment contract exists when:
(1) there’s the investment of money,
(2) in a common enterprise,
(3) with a reasonable expectation of profits, and
(4) to be derived from the efforts of others.
This determination is fact-based with an emphasis on the substance of the relationship rather than the form of the structure used. This means that the analysis will take into account the circumstances and impact rather than how the transaction is papered. For example, right now, the SEC is focusing on whether certain digital assets like non-fungible tokens (NFTs) or fractionalization of an asset through the use of tokens should be deemed to be securities.
NFTs and f-NFTS. An NFT is a unique digital token representing an underlying asset, whether it’s a video, digital work of art or physical work of art. Each unique NFT usually represents one work or a collection of works that’s owned by one owner at any given time and can be purchased and sold, not unlike a traditional artwork, except that the transaction occurs using blockchain technology.
As the price of NFTs skyrocketed, amplified by auction sales with astronomical results, owners or creators of NFTs saw an opportunity in this unregulated field to use NFTs to represent a fractionalized ownership interest in one asset—a fractionalized NFT (or f-NFT). An NFT owner or creator can break up the ownership of their NFT into multiple f-NFTs that together represent 100% ownership of the underlying asset. The value of the f-NFT is tied to the value of the underlying NFT. Art market participants seized the opportunity born out of this new technology to tokenize a physical or digital asset by breaking it into asset tokens representing a percentage ownership of the underlying work of art. While the NFT market was buoyant and the art market was going strong with record-setting prices, platforms tokenizing artworks, fractionalizing ownership and treating art as an asset class emerged and strived.
But now, the regulators are playing catch-up and closely looking at the industry. Although the SEC has yet to weigh in on whether sellers of NFTs, f-NFTs or other digital assets are securities, it seems clear that the SEC will be looking at those fractionalization endeavors through the lens of the Howey test to determine if a token or NFT is a security. It may take years to get clarity from the SEC. While the traditional NFT model of a token associated with a unique work of art may likely fail the Howey test and be treated similarly to the purchase and sale of a work of art, the f-NFTs may, depending on the facts, be deemed to be a security. But not everyone chose the wait-and-see approach. Some companies chose to avail themselves of the SEC rules from the start and use the exemptions and safe harbors available under the securities regulations to be exempt from the registration requirements or to limit the disclosure obligations.
Funds. Among the first structures used to turn art into an investment asset class were art funds, a structure borrowed from the private equity finance world. If resources can be pooled to invest in companies, why not apply the same model to the purchase of works of art? Art funds are definitely within the orbit of the SEC but will usually be set up as a private placement offering, which is exempt from the registration requirements.
An art fund is typically a close-ended fund in which the fund manager will seek to raise capital from a limited number of institutional or accredited investors. Accredited investors are individuals or entities meeting certain wealth and income thresholds as well as certain measures of financial sophistication, while institutional investors are entities that typically invest substantial amounts of money in the market. Those pre-qualified investors will invest capital during what’s called the “subscription period,” and in turn they receive some form of shares or interests in the fund. Once the minimum capital fundraising goal is met, the fund manager will close the funds to other investors and deploy the capital raised to purchase works of art while keeping enough cash to cover the administrative fee that they’ll charge to maintain the asset. The fund will hold the works and sell them opportunistically. And this can take years.
When artworks are sold, the proceeds will be disbursed in accordance with the art fund documentation, which will often provide for a return of capital to the investors, a performance fee (usually calculated as a percentage of the fund’s profits) to be paid to the fund manager and then payment of the remainder upside to the investors creating a financial incentive to align the interests of the fund manager and the investors.
Regulation A Offering
Another model of fractionalizing artwork emerged more recently. In 2015, the SEC adopted a final set of rules allowing private companies to launch a simplified registration process and raise funds from “qualified purchasers.” The law was passed with the goal of facilitating crowd funding and raising capital from small companies. Investors in a Regulation A (Reg A) offering have to be accredited investors, and if they’re not accredited investors, investors may still participate. But their investment may be limited in scope and amount.
With a Reg A offering, a company can raise up to $20 million under Tier 1 and up to $75 million under Tier 2 from any investors during a 12-month period. Under both tiers of this exemption, the company must file an Offering Circular on Form 1A that will contain some information with respect to the company and its operations, and the Offering Circular will be and remain publicly available. Under a Tier 2 offering that won’t be listed on a securities exchange, companies can raise capital from the general public so long as each individual investor’s commitment doesn’t represent more than 10% of their annual income or net worth (for individuals) or 10% of the revenue or net assets at fiscal year-end (for companies).
Masterworks, a platform for investing in art, launched its first vehicle in 2018 through a Reg A offering and since then, it’s spun off 161 vehicles. Each vehicle holds one work of art that’s been purchased by Masterworks’ parent company at auction or privately and is then contributed to a Delaware limited liability company (LLC). Shares representing membership interest in the Delaware LLC are then offered to the public at a value of $20 per share, and Masterworks will issue the number of shares necessary to cover the purchase price for the work of art as well as additional fees. In addition, Masterworks receives an annual share grant as compensation for its services and will receive 20% of the profits on the sale of the work of art.
The publicly available Offering Circular may contain even more information than an auction sale would typically provide. The Offering Circular discloses the purchase price Masterworks paid for the work of art, whether it was acquired at auction or privately and will include the name of the auction house involved in the sale of the work, if one was involved. Information regarding the artist, the painting and the art market is also included but often reads more as a pitch than a true connoisseur’s critical assessment of the artist’s market.
The vehicle will then hold the work and sell each of them opportunistically and just like with art funds, this may take years. Out of 161 vehicles created in the past five years, it appears that only three artworks have been sold.
The shares of the vehicle are also somewhat illiquid. They aren’t traded on any national exchange and can’t be sold to the general public. They can be traded among existing Masterworks shareholders but whether a sale can be achieved is up to the goodwill of those shareholders so again, patience and a long-term view are necessary.
Factors Affecting Value
The intrinsic value of an artwork or artist depends on a myriad of factors, some of which require an in-depth knowledge of the market and the artist specifically—whether an artwork failed to sell or sold to the third-party guarantor at auction, whether there are authenticity concerns past or future, which series or period of an artist will become softer or more desirable and the provenance and the condition. Some of these factors depend on external conditions like the state of the economy. Fractionalization of ownership means that investors have to trust the professionals to have the right background and expertise and trust that they’ll make the right purchasing, bundling and selling decisions. This isn’t without risks. So looking at artwork as an asset class and investment opportunity may have a place: It should be part of a diversified and balanced investment portfolio, and it’s important to understand the risks. But its place within an investment strategy needs to be clear; it should be within the higher risk investment category with a potential for soaring but also for bursting.
Endnote
1. SEC v. Howey Co., 328 U.S. 293 (1946).