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October 1997
Volume 15, Number 10

Trustbusters Target the Auction House
by Catherine Heilman

Princess Diana's navy velvet dress, auctioned at Christie's in New York City, went to the highest bidder for $200,000. Despite explosive media attention given to the sale, the bidder's identity and even nationality is unknown. The auction house, of course, is sworn to secrecy as a matter of contract.

The increase in absentee and anonymous bidding, by telephone and now the Internet, is one of many signs that auction markets are more dynamic and diffuse than ever. Technology and worldwide art markets have made it possible for anyone with good credit to participate in auctions, dramatically increasing competition--and making collusive behavior nearly impossible.

Meanwhile, the federal government has rocked the art market by conducting its broadest ever investigation of New York auction houses and dealers. Some two dozen reputable New York art dealers, including Christie's and Sotheby's, have received subpoenas for all types of bidding records.

They will spend millions gathering everything from price lists to post-it notes to satisfy regulators. So intense is the atmosphere of intimidation that many traditional buyers are shying away for fear of the law.

And what is that law? The Sherman Antitrust Act, the core of which was written before the advent of the automobile. It empowers the Antitrust Division of the U.S. Justice Department to ferret out crooked dealers and buyers that they imagine fill the salesrooms of auction houses across the country. What's more, the investigation is not about uprooting fraud or theft. Trustbusters are trying to unearth supposed evildoers who might violate regulatory strictures that forbid collusion and price-fixing.

In the auction industry, an illegal pricing practice takes the form of a dealer "ring." It is a group of people who informally agree to abstain from bidding against each other. This allows one ring member to purchase the piece at a lower-than-market price. Afterwards, the members of the ring perform a "knock-out" auction among themselves. The difference of the final sale and the lower auction price is divvied up among the conspirators.

Who are the victims of auction rings? The auction house is said to be cheated out of its profits--unless, of course, the auction house is involved, in which case regulators really lower the boom. Second, other bidders are said to be victimized because they do not get the benefit of bidding in a truly competitive environment. It takes the Justice Department to constantly police the industry--bidders and auctioneers--to make sure there are fair deals for all.

In fact, scare stories about rings in auction houses are the economic equivalent of urban myths. After centuries of experience, the industry has learned how to regulate itself apart from the intervention of outside agencies. Auction houses use several very effective deterrents to bid-pooling and bid-rigging, including setting "reserve prices," using experienced auctioneers, and encouraging absentee bidding.

An auction house claims the right to apply a limit--a reserve price--to any good which comes across the auction block. It is usually set at two-thirds of the median estimated auction price. This safety-mechanism serves as a protection device for the consignor, who is thereby prevented from losing property at a price he is unwilling to accept. If no bid exceeds the reserve price, the auction house "buys-in" the piece and returns it to the consignor. A ring can bid-pool all it wants, but unless it offers a market price, it is going to walk away empty-handed.

Every auctioneer reserves the right to decline a bid--a tactic which would only be used as a last resort in a critical situation. More often, a seasoned auctioneer recognizes collusive behavior while it is taking place. Using subtle clues, the auctioneer will hint to suspected ring members that he is aware of the group's intentions. This encourages defections from the ring, and shuts it down in a matter of minutes. Far from being a menace, this practice adds drama and spice to auctions.

Dealer rings, like all cartels operating in a market with free entry and exit, often collapse because of their own internal contradictions. It is in each member's interest to cheat the other members of the ring. If any member suspects another member may cheat, defectors are hard to contain. Even the possibility of defection can cause the ring to break down, long before government regulators catch on.

The growth of absentee and anonymous buyers, as in the case of Princess Diana's dress, at first appears to give rings a free ride, while thwarting Justice Department attempts to crack down. In fact, anonymity only makes it easier to double-cross ring partners, even while maintaining a good standing among fellow colluders. No government penalties against rings can possibly be as effective.

What about auction houses that cooperate with rings? All the incentives run the other way: houses have every incentive to remain ring-free. Typically, the house receives a premium of up to 15 percent of the final sale price. Thus, it wants to keep final sale prices as high as possible. An auction house also has its reputation to consider. Conducting a clean and fair auction is top priority for any established auction house.

Even the most effective ring cannot control bidding from non-members. The typical salesroom, such as those under investigation, is filled with eager buyers. Serious buyers act no differently with rings in their midst. Whether the bidder faces one competitor or one hundred, the individual's willingness to pay a certain amount for a piece of art remains unchanged. It is the value of the piece to the bidder, not the number of competitors, that determines the price he offers.

Government investigators are usually amateurs in the art market. Often, for example, they don't know how to distinguish between illegal rings and legal syndicates, which are groups of dealers combining financial resources. So long as syndicate partners share in the resale profits, they remain free of legal constraints. The line between rings and syndicates can be fuzzy indeed.

Every antitrust investigation has a deeper history of intra-industry intrigue, this one included. After the bear market in art in the early 1990s, a number of dealers fell on hard times. Both Sotheby's and Christie's-- which had shifted large volumes of business to New York to escape high London taxes--began buying them up. Just as those dealers once did, these auction houses began holding private showings, a practice that has not set well with remaining independent dealers.

In public statements and news accounts, these outside dealers have vowed revenge. Are they the real instigators of the draconian Justice Department inquiry? The investigation is secret, so we can't know for sure. But it so happens that the dealers who have reported receiving the subpoenas are the ones most closely connected to the large houses.

The investigations, and possibly prosecutions and settlements, may end up bringing about new regulations. Auction houses could find their ability to conduct private showings curtailed. Or they could be forced to reveal reserve prices before bidding begins. Such regulations will end up reducing real competition (versus the kind the regulators believe they are protecting). Unlike industry self-regulation, government antitrust investigations and regulations stifle auctions by replacing an atmosphere of rivalry with one of fear.

Adam Smith was right that "people of the same trade seldom meet together" when the conversation doesn't end in a "conspiracy against the public, or in some contrivance to raise prices." It is his caveat that is so rarely quoted: "it is impossible indeed to prevent such meetings by any law which either could be executed, or would be consistent with liberty and justice."

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Catherine Heilman is a summer fellow of the Mises Institute and a senior at Wellesley College.

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