Knoedler’s Holding Company and Its Sole Shareholder Face Potential Liability In Connection With Forgeries Following Recent Ruling; Trials Set For This Summer
05/23/2019This blog has for years followed the Knoedler scandal, in which a venerable New York gallery closed in disgrace in 2011 following revelations that it had sold dozens of artworks—about $60 million worth of paintings purported to be by Rothko, Pollock, Motherwell, and other major Abstract Expressionists—that turned out to be forgeries. And the fallout from Knoedler’s implosion is ongoing even now; just this month, a federal judge issued a decision with important implications for the upcoming trials in two Knoedler cases. The ruling also is of general interest to anyone in the art business because it emphasizes the importance of clear business procedures, corporate oversight and legal formalities when it comes to closely held business entities.
Background On the Knoedler Saga
By way of background (see a few of our earlier posts here, here, here, and here for more), the works all came to Knoedler through a Long Island art dealer, Glafira Rosales, who claimed to represent an anonymous collector selling off his father’s collection of previously-unknown masterpieces. But the anonymous seller did not exist; the works were actually painted for Rosales by a little-known artist in Queens. Rosales and her co-conspirators have either fled the country or pled guilty to federal charges.
Several of the collectors who unknowingly bought the fakes have brought civil lawsuits against various Knoedler-related defendants, including not only the gallery entity, but also its former director, Ann Freedman; its owner, an entity called 8-31 Holdings, Inc.; and the holding company’s principal, Michael Hammer. Broadly speaking, most of the plaintiffs’ legal claims are grounded in the theory that the Knoedler-affiliated parties must have, or at least should have, known the works were forged. Many of those cases have reached out-of-court settlements prior to (or, in one notable case, during) trial.
But two swindled Knoedler customers still have lawsuits pending as of this writing. One is the Martin Hilti Family Trust, an entity based in Lichtenstein who bought a “Rothko” from Knoedler for $5.5 million. See Docket No. 13-cv-00657-PGG-HBP (S.D.N.Y.). The other is California collector Frances White, who bought a fake “Pollock” for $3.1 million. See Docket No. 13-cv-001193-PGG-HBP (S.D.N.Y.). Several of the defendants originally named have been dropped from the lawsuit; notably, Ann Freedman settled with the plaintiffs in 2016. The remaining defendants are Knoedler LLC (the corporate entity still exists and has not filed for bankruptcy, although the gallery itself is no longer operating), 8-31, and Hammer. Most of the claims in both cases have already survived motions to dismiss; discovery is complete, and trials are scheduled (July for Hilti, and August for White).
This Month’s Summary Judgment Opinion
On March 31, Judge Gardephe of the Southern District of New York issued a summary judgment ruling that, among other things, will allow the plaintiffs to try to prove, at trial, that Hammer, 8-31, and Knoedler are alter egos of one another, and each may be held liable on claims asserted against any of them. And just this month, the court issued a comprehensive opinion explaining its reasoning. See Martin Hilti Family Trust v. Knoedler Gallery, LLC, 2019 WL 2024808 (May 8, 2019).
The claims at issue on summary judgment included claims under the federal racketeering statute (RICO), fraud and fraudulent concealment, conspiracy to commit fraud, conspiracy to commit fraudulent concealment, aiding and abetting fraud, and aiding and abetting fraudulent concealment. Defendants had sought summary judgment on several grounds: Hammer sought summary judgment on all claims against him; 8-31 sought summary judgment on the RICO claims against it in Hilti, and on all claims against it based on an alter ego theory of liability; and Knoedler LLC sought summary judgment on all claims against it in White, and on the RICO claims alleged against it in Hilti.
The decision was not a complete loss for the defendants. For example, the Court rejected the viability of several fraud and RICO claims against Hammer individually, with the Court holding that there was insufficient evidence that Hammer himself took an active role in the gallery’s day to day operations or the marketing of the Rosales works, nor that he appreciated the massive profits the gallery was reaping on the Rosales works in particular. There was also insufficient evidence that he was aware of certain inconsistencies in Rosales’s stories about the works, or that he otherwise was aware that there were reasons to doubt the paintings’ authenticity. The court also granted summary judgment on all of the RICO claims in Hilti on the ground that RICO requires a “domestic injury” and the plaintiff there was injured in Liechtenstein, where it is based. The elimination of any RICO liability in Hilti is important because RICO claims can sometimes expose a defendant to treble damages; note, however, that the defendants still face potential RICO liability as to White.
Critically, the Court ruled that the plaintiffs are entitled to pursue, at trial, their theory that Hammer, 8-31, and Knoedler LLC should all be treated as alter egos of one another for purposes of plaintiffs’ fraud-based claims. Alter ego liability generally requires a plaintiff to prove that two entities essentially operated as a single economic entity, and that there was an overall element of injustice or unfairness. If plaintiffs are successful, each defendant would be financially liable for any successful fraud-based claims against any of the others.
Here, as between Knoedler LLC and its sole member, 8-31, the Court held there was substantial evidence of mingling between the two entities’ operations, and a disregard of corporate formalities in their interactions; they shared personnel, an email system, an accounting department, office space and other infrastructure. And financial dealings between them had little formality; “Knoedler LLC simply and regularly transferred money to 8-31 whenever 8-31 needed money and Knoedler LLC had cash on hand… These transfers were unrelated to any services performed by 8-31 for Knoedler LLC.” The Court also pointed to evidence that, when Knoedler LLC came under criminal investigation around 2010, the entities changed the way they had for years been classifying certain “interdivisional receivables”; defendants argued that this was done simply to correct a previous accounting oversight, but the Court held that it should be up to a jury to decide whether to credit that explanation, or whether the change instead represented 8-31’s attempt to siphon off more than $13 million from Knoedler LLC to shield that money from the reach of law enforcement or civil litigation in light of the then-brewing forgery scandal.
Likewise, as between Hammer and 8-31, the Court held there was sufficient evidence to leave it up to the jury to decide whether Hammer had siphoned off money from 8-31, particularly in light of his sometimes-extravagant personal purchases made with 8-31 funds. While Hammer says he generally reimbursed 8-31 for any personal expenses, there was little oversight or recordkeeping; Hammer did not submit explanations of his alleged business-related charges to 8-31, and no one at 8-31 regularly reviewed the charges Hammer designated as business expenses. And there was significant evidence to suggest that many such business expenses were actually personal, and that Hammer either could not recall the business purposes of certain charges, had intended to but failed to reimburse 8-31, or miscategorized personal purchases as business expenses. Between 2005 and 2010, he apparently purchased no less than seven luxury cars under circumstances that suggest they may well have been only for personal use, and that no one from 8-31 was meaningfully monitoring such decisions by Hammer. There was further evidence that Hammer made decisions for 8-31 without informing anyone else at 8-31, and indeed that he sometimes signed agreements on behalf of both himself and 8-31; he also approved a liquidation plan for Knoedler LLC by signing on behalf of both Knoedler LLC and 8-31, without consulting officers at 8-31. Finally, in terms of injustice, the Court cited evidence that Hammer had initiated the reclassification of interdivisional receivables discussed above.
What It Means and What’s Next
This month’s decision marks what is likely to be the last substantive court decision in the Knoedler cases before this summer’s trials. It crystallizes the issues that will be in play at that trial—a trial which will be closely watched by the art community, given that the problem of forgeries generally continues to loom large in today’s art landscape.
Note that while the White and Hilti cases have been before the same judge and have been closely coordinated for purposes of earlier phases of the litigation, they will go to trial separately; the plaintiffs had pushed for a single consolidated trial, but the Court declined to do that. Similarly, the defendants had urged the Court to first conduct a trial on the alter ego issues in the case, before actually adjudicating liability on each remaining claim. The plaintiffs, for their part, opposed this idea, arguing that an advance alter ego trial would be inefficient and duplicative because much of the same evidence and witnesses would be presented during both the alter ego and fraud/RICO phases, and a resolution of the alter ego issues alone would be unlikely to lead to a settlement. The court ultimately decided not to bifurcate the trial so as to try the alter ego issues first.
Knoedler aside, Judge Gardephe’s opinion represents an important exploration of the concept of alter ego liability. And that topic is relevant to anyone in the art world who does business via a corporate entity. Corporations, LLCs, and other corporate forms can be an important legal tool that can provide individual owners or shareholders, or related entities, with certain protections from being held responsible for the actions of a business; for example, if a company breaches a contract or even is caught up in a fraudulent transaction, the company’s shareholders and other related persons or companies are generally not automatically “on the hook” for such claims simply by virtue of their association with the company. But the alter ego doctrine provides an exception to that rule. If two companies are separate on paper, but essentially function as one—or if an individual owner treats a company as an extension of his own individual finances—such blurred lines can lead to increased exposure for those related persons and companies, should one of the corporate entities get into legal hot water. This decision is a strong reminder of the importance of observing corporate formalities, maintaining rigorous corporate oversight practices, and avoiding the intermingling of finances between a business and any related people or entities.
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