XNYS:BID Sothebys Class A Quarterly Report 10-Q Filing - 6/30/2012
Effective Date 6/30/2012
| • 10-Q • CEO 302 CERT • CFO 302 CERT • CEO 906 CERT • CFO 906 CERT • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA DOCUMENT • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION LABEL LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE DOCUMENT | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of the Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No ý As of July 31, 2012, there were 67,765,887 outstanding shares of Common Stock, par value $0.01 per share, of the registrant. ______________________________________________________________________________________________________ TABLE OF CONTENTS
2# PART I: FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS SOTHEBY’S CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (Thousands of dollars, except per share data)
See accompanying Notes to Condensed Consolidated Financial Statements 3# SOTHEBY’S CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) (Thousands of dollars)
See accompanying Notes to Condensed Consolidated Financial Statements 4#
See accompanying Notes to Condensed Consolidated Financial Statements 5#
See accompanying Notes to Condensed Consolidated Financial Statements 6# SOTHEBY’S NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. Basis of Presentation The Condensed Consolidated Financial Statements included herein have been prepared by Sotheby’s pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States of America (the “U.S.”) have been condensed or omitted from this report, as is permitted by such rules and regulations; however, management of Sotheby’s believes that the disclosures herein are adequate to make the information presented not misleading and that all adjustments necessary for a fair statement of results are reflected in the interim periods presented. It is suggested that these Condensed Consolidated Financial Statements be read in conjunction with the financial statements and notes thereto included in Sotheby’s 2011 Annual Report on Form 10-K. 2. Seasonality of Business The worldwide art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. Accordingly, Sotheby’s auction business is seasonal, with peak revenues and operating income generally occurring in those quarters. Consequently, first and third quarter results have historically reflected a lower volume of auction activity when compared to the second and fourth quarters and, typically, a net loss due to the fixed nature of many of Sotheby’s operating expenses. 3. Earnings Per Share Basic earnings per share—Basic earnings per share attributable to Sotheby's common shareholders is computed under the two-class method using the weighted average number of common shares outstanding during the period. The two-class method requires that the amount of net income attributable to participating securities be deducted from consolidated net income in the computation of basic earnings per share. In periods with a net loss, the net loss attributable to participating securities is not deducted from consolidated net loss in the computation of basic loss per share as the impact would be anti-dilutive. Sotheby's participating securities include unvested restricted stock units, which have non-forfeitable rights to dividends. Diluted earnings per share—Diluted earnings per share attributable to Sotheby's common shareholders is computed in a similar manner to basic earnings per share under the two-class method, using the weighted average number of common shares outstanding during the period and, if dilutive, potential common shares outstanding during the period. Sotheby's potential common shares include the following:
7# For the three and six months ended June 30, 2012, 1.0 million and 1.1 million potential common shares, respectively, related to unvested performance share units were excluded from the computation of diluted earnings per share as the profitability targets inherent in such awards were not achieved as of the balance sheet date. For the three and six months ended June 30, 2011, 0.5 million and 0.6 million potential common shares, respectively, related to unvested performance share units were excluded from the computation of diluted earnings per share as the profitability targets inherent in such awards were not achieved as of the balance sheet date. The table below summarizes the computation of basic and diluted earnings per share for the three and six months ended June 30, 2012 and 2011 (in thousands of dollars, except per share amounts):
8# 4. Segment Reporting Sotheby’s operations are organized under three segments—Auction, Finance and Dealer. The table below presents Sotheby’s revenues and income (loss) before taxes by segment for the three and six months ended June 30, 2012 and 2011 (in thousands of dollars):
For the three and six months ended June 30, 2011, Finance segment income before taxes includes non-operating gains of $2.1 million and $2.6 million, respectively, related to the remeasurement of foreign currency denominated client loan and intercompany balances. The reconciling item related to Revenues represents charges from the Finance segment to the Auction segment for short-term, interest-free or other below market consignor advances with maturities typically ranging between 3 and 6 months (see Note 5). The reconciling item related to segment income (loss) before taxes represents Sotheby's pre-tax share of losses (earnings) related to its equity investees. Such (losses) earnings are included in the table above in the results of the Dealer segment, but are presented net of taxes in the Condensed Consolidated Statements of Operations. The activities of Sotheby's Dealer segment principally include the activities of Noortman Master Paintings ("NMP"), a wholly-owned art dealer. In the third quarter of 2011, following the fifth anniversary of the acquisition of NMP and the expiration of the related financial performance targets (see Note 10), management initiated a plan to restructure NMP’s business and sales strategy. As a result of the restructuring of its business and sales strategy, NMP has reduced its inventory of lower valued Old Master Paintings and has shifted its focus to a select group of high-valued works of art. In continuance of this strategy and due in part to a lower level of profitable sales, management is consolidating NMP's operations into its London office and closing its Amsterdam office, thereby reducing headcount. These actions are expected to be completed in the second half of 2012 at a cost that is not material to Sotheby’s. The table below presents Sotheby's assets by segment, as well as a reconciliation of segment assets to consolidated assets as of June 30, 2012, December 31, 2011 and June 30, 2011 (in thousands of dollars):
9# 5. Receivables Accounts Receivable (Net)—In its role as auctioneer, Sotheby’s represents sellers of artworks by accepting property on consignment and by matching sellers to buyers through the auction process. Sotheby’s invoices the buyer for the purchase price of the property (including the commission owed by the buyer), collects payment from the buyer and remits to the seller the net sale proceeds after deducting its commissions, expenses and applicable taxes and royalties. Sotheby’s commissions include those paid by the buyer (“buyer’s premium”) and those paid by the seller (“seller’s commission”) (collectively, “auction commission revenue”), both of which are calculated as a percentage of the hammer price of the property sold at auction. Under Sotheby’s standard payment terms, payments from buyers are due no more than 30 days from the sale date and consignor payments are made 35 days from the sale date. However, extended payment terms are sometimes provided to buyers in order to support and market a sale. Such terms typically extend the payment due date from 30 days to a date that is no greater than one year from the sale date. When providing extended payment terms, Sotheby’s attempts to match the timing of cash receipt from the buyer with payment to the consignor, but is not always successful in doing so. Under the standard terms and conditions of its auction sales, Sotheby’s is not obligated to pay consignors for property that has not been paid for by buyers. However, on a limited basis and subject to approval under Sotheby’s policy, the consignor may be paid the net sale proceeds before payment is collected from the buyer and/or the buyer may be allowed to take possession of the property before making payment. In situations when the buyer takes possession of the property before making payment, Sotheby’s is liable to the seller for the net sale proceeds whether or not the buyer makes payment. As of June 30, 2012, Accounts Receivable (net) of $884.8 million includes $92.7 million related to situations in which the buyer has taken possession of the property before making payment to Sotheby’s. Included in this $92.7 million balance is $33.6 million associated with purchases made by related parties (see Note 12), of which $30 million is attributable to affiliates of Sotheby's partner in an equity method investment and $3.6 million is attributable to a relative of a member of Sotheby's Board of Directors. As of July 31, 2012, $20.3 million of these related party receivables had been collected. Management believes that adequate allowances have been established to provide for probable losses on any Accounts Receivable balances. As of June 30, 2012, $119.9 million, or 14%, of Accounts Receivable (net) was due from one buyer. As of June 30, 2012, Sotheby's had possession of the property underlying this receivable balance and had not paid the consignor of the property. Sotheby's collected the entire amount of this receivable balance on August 1, 2012 and remitted the consignor's share of the proceeds to the consignor before the date of this Form 10-Q filing. Notes Receivable (Net)—As of June 30, 2012, December 31, 2011 and June 30, 2011, Notes Receivable (net) consisted of the following (in thousands of dollars):
Notes Receivable (Finance Segment)—Through its Finance segment, Sotheby’s provides certain collectors and art dealers with financing secured by works of art that Sotheby's either has in its possession or permits borrowers to possess. The Finance segment generally makes two types of secured loans: (1) advances secured by consigned property to borrowers who are contractually committed, in the near term, to sell the property at auction (a “consignor advance”); and (2) general purpose term loans secured by property not presently intended for sale (a “term loan”). A consignor advance allows a seller to receive funds upon consignment for an auction that will typically occur up to one year in the future, while preserving for the benefit of the seller the potential of the auction process. Term loans allow Sotheby's to establish or enhance mutually beneficial relationships with borrowers and may generate future auction consignments. In certain situations, loans are also made to refinance clients' auction and private sale purchases. For the six months ended June 30, 2012 and 2011, Sotheby's advanced $54.6 million and $15.6 million, respectively, of such loans. These loans are accounted for as non-cash transfers between Accounts Receivable (net) and Notes Receivable (net) and are, therefore, not classified in the statement of cash flows as Cash Used By Investing Activities. Upon repayment, the cash received is classified in the statement of cash flows as Cash Provided 10# By Operating Activities. As of June 30, 2012, December 31, 2011 and June 30, 2011, Notes Receivable (net) included $79.2 million, $36.7 million and $19.8 million, respectively, of such loans. The collection of secured loans can be adversely impacted by a decline in the art market in general or in the value of the particular collateral. In addition, in situations with competing claims on the collateral and/or when a borrower becomes subject to bankruptcy or insolvency laws, Sotheby’s ability to realize on its collateral may be limited or delayed. The target loan-to-value (“LTV”) ratio, which is defined as principal loan amount divided by the low auction estimate of the collateral, is 50% or lower. However, loans are also made at an initial LTV ratio higher than 50%. In addition, as a result of the periodic revaluation of loan collateral, the LTV ratio of certain loans may increase above the 50% target due to decreases in the low auction estimates of the collateral. The revaluation of loan collateral is performed by Sotheby’s specialists on an annual basis or more frequently if there is a material change in circumstances related to the loan or the disposal plans for the collateral. Management believes that the LTV ratio is the critical credit quality indicator for Finance segment secured loans. The table below provides information regarding the LTV ratio of Finance segment secured loans as of June 30, 2012, December 31, 2011 and June 30, 2011 (in thousands of dollars):
From January 1, 2011 through June 30, 2012, Sotheby’s recognized $0.1 million of cumulative losses related to specific impaired Finance segment secured loans. The table below provides other credit quality information regarding Finance segment secured loans as of June 30, 2012, December 31, 2011 and June 30, 2011 (in thousands of dollars):
Management considers a loan to be past due when principal payments are not paid in accordance with the stated terms of the loan. As of June 30, 2012, $12.4 million of the Notes Receivable (net) balance was considered to be past due, of which $1.4 million was more than 90 days past due. Management is continuing to accrue Finance Revenue on these past due loans. The collateral securing these loans has low auction estimates of approximately $35.9 million and $14.7 million, respectively. In consideration of the collateral securing these loans, current collateral disposal plans and negotiations with the borrowers, management believes that the principal and interest amounts due for these loans will be collected. A non-accrual loan is a loan for which future Finance Revenue is not recorded due to management’s determination that it is probable that future interest on the loan is not collectible. Any cash receipts subsequently received on non-accrual loans are first applied to reduce the recorded principal balance of the loan, with any proceeds in excess of the principal balance then applied to interest owed by the borrower. The recognition of Finance Revenue may resume on a non-accrual loan if sufficient additional collateral is provided by the borrower or if management becomes aware of other circumstances that indicate that it is probable that the borrower will make future interest payments on the loan. As of June 30, 2012 and December 31, 2011, Sothebys Finance segment had no such non-accrual loans. As of June 30, 2011, Sotheby's Finance segment included a non-accrual loan from one borrower totaling $0.9 million. 11# A loan is considered to be impaired when management determines that it is probable that a portion of the principal and interest owed by the borrower will not be recovered. If a loan is considered to be impaired, Finance Revenue is no longer recognized and bad debt expense is recorded for any principal or interest that is deemed uncollectible. During the period January 1, 2011 to June 30, 2012, activity related to the allowance for credit losses was as follows (in thousands of dollars):
Finance segment loans are predominantly variable interest rate loans; however, short-term, interest-free advances with maturities typically ranging between three and six months are provided to certain consignors in order to secure high-value property for auctions and can represent a significant portion of the client loan portfolio as of the end of certain quarterly reporting periods in advance of peak selling seasons. The carrying value of the Finance segment loan portfolio approximates its fair value. As of June 30, 2012, loans to two borrowers totaling $49.4 million (LTV of 61%) and $38 million (LTV of 64%) comprised approximately 14.3% and 11% of the Notes Receivable (net) balance, respectively. No other individual loan exceeds 10% of the Notes Receivable (net) balance. Notes Receivable (Auction Segment)—Sotheby’s is obligated under the terms of certain auction guarantees to advance all or a portion of the guaranteed amount prior to auction. Such Auction segment consignor advances are recorded on Sotheby's balance sheet within Notes Receivable (net). As of June 30, 2012 and June 30, 2011, no such consignor advances were recorded. As of December 31, 2011, auction guarantee advances totaled $7.5 million. (See Note 9.) Under certain circumstances, Sotheby's, through its Auction segment, finances the purchase of works of art by unaffiliated art dealers through unsecured loans. The property purchased pursuant to such unsecured loans is sold privately or at auction with any profit or loss shared by Sotheby's and the art dealer. As of June 30, 2012, December 31, 2011 and June 30, 2011, one such unsecured loan totaled $2.1 million. Sotheby's is no longer accruing interest with respect to this unsecured loan, but management believes that the $2.1 million balance is collectible based on discussions with the borrower. Notes Receivable (Dealer Segment)—From time to time, Sotheby's Dealer segment provides secured loans to certain art dealers to finance the purchase of works of art. In these situations, the Dealer segment acquires a partial ownership interest in the purchased property. Upon its eventual sale, any profit or loss is shared by Sotheby's and the dealer according to their respective ownership interests. As of June 30, 2012, Notes Receivable (net) included one such loan of $7.4 million. As of December 31, 2011 and June 30, 2011, there were no such loans outstanding. Weighted Average Interest Rates—For the three months ended June 30, 2012 and 2011, the weighted average interest rate earned on consolidated Notes Receivable (net) was 5.4%. For the six months ended June 30, 2012 and 2011, the weighted average interest rates earned on consolidated Notes Receivable (net) were 5.5% and 5%, respectively. 6. Debt Revolving Credit Facility—On August 31, 2009, Sotheby's and certain of its wholly-owned subsidiaries (collectively, the “Borrowers”) entered into a credit agreement (the “Credit Agreement”) with an international syndicate of lenders led by General Electric Capital Corporation (“GE Capital”). The Credit Agreement was amended by Sotheby's, GE Capital and the lenders named therein (collectively, the “Lenders”) on November 23, 2010. This amendment, among other things, extended the maturity date of the Credit Agreement, reduced borrowing costs and fees, and provided additional flexibility to Sotheby's. The following summary does not purport to be a complete summary of the Credit Agreement, as amended, and is qualified in its entirety by reference to the Credit Agreement and each of the respective amendments, copies of which were filed as exhibits to previous SEC filings. Terms used, but not defined in this summary, have the meanings set forth in the Credit Agreement and each of the respective amendments. 12# The Credit Agreement, as amended, provides for a $200 million revolving credit facility (the “Revolving Credit Facility”) and has a feature whereby any time on or before March 1, 2014 the Borrowers may request, subject to Lenders' approval, an increase to the facility by an amount not to exceed $50 million. The amount of borrowings available under the Revolving Credit Facility is limited by a borrowing base which is determined by a calculation that is primarily based upon the level of Sotheby's loan portfolio and art inventory balances. In addition, up to $10 million of the borrowing capacity under the Revolving Credit Facility may be used to issue letters of credit. As of June 30, 2012, no Revolving Credit Facility borrowings were outstanding and the amount of borrowings available under the Revolving Credit Facility was approximately $173.7 million, as calculated under the borrowing base. Sotheby's has not borrowed or issued any letters of credit under the Revolving Credit Facility since its inception. Borrowings under the Revolving Credit Facility are available in either Dollars to U.S. Borrowers or Pounds Sterling to U.K. Borrowers. The U.S. Borrowers and, subject to certain limitations, the U.K. Borrowers, are jointly and severally liable for all obligations under the Credit Agreement, as amended. In addition, certain subsidiaries of the Borrowers guarantee the obligations of the Borrowers under the Credit Agreement, as amended. The obligations under the Credit Agreement, as amended, are secured by liens on all or substantially all of the personal property of the Borrowers and the Guarantors. Borrowings under the Revolving Credit Facility may be designated by the Borrowers as either Dollar Index Rate Loans (for U.S. Borrowers only) or LIBOR Rate Loans. Dollar Index Rate Loans bear interest at an annual rate equal to (a) the highest of (i) the “Prime Rate” as quoted in The Wall Street Journal, (ii) the Federal Funds Rate plus 0.50%, or (iii) the LIBOR Rate plus 1.0%, plus (b) the Applicable Margin, which is generally between 1.50% and 2.00% dependent upon the level of outstanding borrowings. The LIBOR Rate for Dollars or Sterling, as the case may be, for an interest period is equal to (x) the offered rate for deposits in such currency for a period equal to such interest period on the Reuters Screen LIBOR01 Page, plus (y) the Applicable Margin, which is generally between 2.50% and 3.00% dependent upon the level of outstanding borrowings. The Credit Agreement, as amended, contains certain customary affirmative and negative covenants including, but not limited to, limitations on capital expenditures, limitations on net outstanding auction guarantees (i.e., auction guarantees less the impact of related risk and reward sharing arrangements) and limitations on the use of proceeds from borrowings under the Credit Agreement, as amended. The Credit Agreement, as amended, also restricts quarterly dividend payments to the lesser of $0.10 per share or $8 million. However, the maximum level of quarterly dividend payments may be increased depending upon the achievement of a certain Fixed Charge Coverage Ratio in any period. Management believes that Sotheby’s is in compliance with the covenants and terms of the Credit Agreement, as amended. The Credit Agreement, as amended, also contains certain financial covenants, which are only applicable during certain defined compliance periods. These financial covenants were not applicable for the twelve month period ended June 30, 2012. The maturity date of the Credit Agreement, as amended, is September 1, 2014, subject to Sotheby's meeting certain liquidity requirements during the period commencing on December 15, 2012 and ending on the date Sotheby's 3.125% Convertible Notes are converted or discharged (see "Convertible Notes" below). Management expects to meet these liquidity requirements throughout this period. Sotheby’s has incurred approximately $9.9 million in life-to-date fees related to the Credit Agreement, as amended, which are being amortized on a straight-line basis to Interest Expense over the term of the facility. Additionally, Sotheby's is charged commitment fees of 0.625% per year for undrawn amounts committed under the Revolving Credit Facility. 13# Long-Term Debt—As of June 30, 2012, December 31, 2011 and June 30, 2011, Long-Term Debt consisted of the following (in thousands of dollars):
(See the captioned sections below for detailed information related to the York Property Mortgage, the Senior Notes and the Convertible Notes.) York Property Mortgage—On February 6, 2009, Sotheby's purchased the land and building located at 1334 York Avenue, New York, New York (the “York Property”) from RFR Holding Corp. (“RFR”) for a purchase price of $370 million. The York Property is home to Sotheby's sole North American auction salesroom and its principal North American exhibition space, as well as its corporate headquarters. Sotheby's financed the $370 million purchase price through an initial $50 million cash payment made in conjunction with the signing of the related purchase and sale agreement on January 11, 2008, an $85 million cash payment made when the purchase was consummated on February 6, 2009 and the assumption of an existing $235 million mortgage on the York Property (the “York Property Mortgage”). The York Property Mortgage matures on July 1, 2035, but has an optional pre-payment date of July 1, 2015 and bears an annual rate of interest of approximately 5.6%, which increases subsequent to July 1, 2015. It is Sotheby's current intention to either pre-pay or refinance the mortgage on or about July 1, 2015, subject to economic and financial market conditions and available cash balances. In conjunction with the final accounting for the York Property purchase in February 2009, the York Property Mortgage was recorded on Sotheby's balance sheet at its $212.1 million fair value. The fair value of the York Property Mortgage was computed using a discounted cash flow approach based on a market rate of interest, which was estimated by management. The resulting $22.9 million debt discount is being amortized to Interest Expense over the remaining expected term of the loan. Sotheby's paid fees of $2.4 million in conjunction with the assumption of the York Property Mortgage, which are also being amortized to Interest Expense over the remaining expected term of the loan. As of June 30, 2012, the fair value of the York Property Mortgage was approximately $238 million and is based on a present value calculation utilizing an interest rate obtained from a third party source. The York Property and the York Property Mortgage are held by 1334 York, LLC, a separate legal entity of Sotheby's that maintains its own books and records and whose results are ultimately consolidated into Sotheby's financial statements. The assets of 1334 York, LLC are not available to satisfy the obligations of other Sotheby's affiliates or any other entity. Senior Notes—On June 17, 2008, Sotheby's issued $150 million aggregate principal amount of 7.75% Senior Notes, due June 15, 2015. The net proceeds from the issuance of the Senior Notes were approximately $145.9 million, after deducting the initial purchasers' discounts and fees. Each of Sotheby's existing and future domestic subsidiaries have jointly, severally, fully and unconditionally guaranteed the Senior Notes on a senior unsecured basis to the extent such subsidiaries guarantee borrowings under the Credit Agreement, as amended. The Senior Notes have an effective interest rate of 8%. Interest on the Senior Notes is payable semi-annually in cash on June 15 and December 15 of each year. 14# Through June 30, 2012, Sotheby's had repurchased an aggregate principal amount of $70 million of its Senior Notes for an aggregate purchase price of $65.3 million. These repurchases have resulted in a life-to-date non-cash net gain of approximately $2.5 million, net of fees, consisting of a $7.8 million gain recognized in the fourth quarter of 2008, a $1 million gain recognized in the first quarter of 2009 and a $6.3 million loss recognized in the fourth quarter of 2010. There were no Senior Notes repurchases in 2011 or during the current year-to-date period. As of June 30, 2012, the $80 million principal amount of Senior Notes that remain outstanding had a fair value of approximately $88.8 million based on a broker quoted price derived via a pricing model using observable and unobservable inputs. As such, this fair value measurement is considered to be a Level 3 fair value measurement in the fair value hierarchy as per Accounting Standards Codification 820, Fair Value Measurements ("ASC 820"). Convertible Notes—On June 17, 2008, Sotheby's issued $200 million aggregate principal amount of 3.125% Convertible Notes, due June 15, 2013. The net proceeds from the issuance of the Convertible Notes were approximately $194.3 million, after deducting transaction costs. Each of Sotheby's existing and future domestic subsidiaries have jointly, severally, fully and unconditionally guaranteed the Convertible Notes on a senior unsecured basis to the extent such subsidiaries guarantee borrowings under the Credit Agreement, as amended. Interest on the Convertible Notes is payable semi-annually in cash on June 15 and December 15 of each year. Sotheby's may not redeem the Convertible Notes prior to their stated maturity date. As of June 30, 2012, the $181.9 million principal amount of Convertible Notes that remain outstanding had a fair value of $206.2 million based on a broker quoted price derived via a pricing model using observable and unobservable inputs. As such, this fair value measurement is considered to be a Level 3 fair value measurement in the fair value hierarchy as per ASC 820. Upon conversion, the principal amount of the Convertible Notes is payable in cash, shares of Sotheby's Common Stock, or a combination thereof, at the option of Sotheby's, based on an initial conversion rate of 29.4122 shares of Common Stock per $1,000 principal amount of Convertible Notes, which is equivalent to a conversion price of approximately $34 per share (the “Conversion Price”). The maximum number of shares of Common Stock that may be issued upon conversion is approximately 5.3 million shares. The conversion rate for the Convertible Notes is subject to adjustment for certain events. The Convertible Notes may be converted at any time beginning on March 15, 2013 and ending on the close of business on June 14, 2013. Prior to March 15, 2013, the Convertible Notes may only be converted under certain conditions, including, if during any fiscal quarter (and only during such fiscal quarter), the closing price of Sotheby's Common Stock exceeds $44.20 per share (i.e., 130% of the Conversion Price) for at least 20 trading days in the period of 30 consecutive trading days at the end of the previous quarter (the “Stock Price Trigger”). Upon conversion, Sotheby's will pay or deliver, as the case may be, cash, shares of Common Stock, or a combination thereof, at its election. It is Sotheby's current intent and policy to settle up to the principal amount of the Convertible Notes in cash. Additionally, depending on the level of available cash and liquidity, as well as the amount of conversion requests received at any one time, Sotheby's may elect to settle the entire conversion obligation (i.e., the principal amount redeemed plus any conversion premium) in cash. On April 1, 2011, the trustee for the Convertible Notes notified bondholders that the Convertible Notes would be convertible at their option for a period beginning on April 1, 2011 and ending on June 30, 2011 as a result of the closing price of Sotheby's Common Stock exceeding $44.20 for 20 trading days in the 30 consecutive trading days ending on March 31, 2011. As such, the entire carrying value of the unamortized Convertible Notes ($181.3 million) was included within Current Liabilities on Sotheby's balance sheet as of March 31, 2011. In June 2011, Sotheby's received conversion requests totaling a principal amount of $18.1 million from holders of the Convertible Notes. In accordance with the terms of the Convertible Notes, the conversion obligation was based on a formula, which is the sum of 1/30th of the product of the applicable conversion rate and the daily per share volume weighted average stock price for 30 consecutive trading days beginning three days after the conversion request is received from the trustee. The conversion obligation of $22.5 million related to these conversion requests, which consisted of $18.1 million related to principal and approximately $4.4 million related to the conversion premium, was settled entirely in cash in August 2011. Accordingly, $16.6 million of the Convertible Notes (representing the principal amount redeemed, net of unamortized discount) was reflected within Current Liabilities on Sotheby's June 30, 2011 balance sheet, with the remaining carrying value ($166.6 million) reported within Long-Term Debt. In the third quarter of 2011, Sotheby's recognized a $1.5 million loss representing the write-off of a proportionate amount of the unamortized discount and deferred transaction costs related to the Convertible Notes redeemed. In August 2011, simultaneous with the settlement of the June 2011 Convertible Note conversion requests, Sotheby's received $4.4 million in cash to fund the conversion premium through its exercise of a portion of the Convertible Note Hedges (see discussion below). 15# On January 1, 2009, upon the adoption of ASC 470-20, Debt - Debt With Conversion and Other Options, the liability and equity components of the Convertible Notes were separately accounted for in Sotheby's financial statements. The liability component was initially valued at $161.8 million using Sotheby's nonconvertible debt borrowing rate, which was estimated to be 7.75% at the date of adoption, and was accounted for as Long-Term Debt. The equity component (i.e., the embedded conversion option) was initially valued at $38.2 million ($21 million, net of taxes) and was accounted for as a component of Additional Paid-In Capital within Shareholders' Equity. The corresponding debt discount is being amortized to Interest Expense over the life of the Convertible Notes using the effective interest rate method. The amount recorded in Shareholders' Equity is not remeasured as long as it continues to meet the conditions for equity classification. As a result of the cash settlement of the June 2011 conversion requests, $8.2 million ($5.4 million, net of taxes) of the amount originally attributed to the embedded conversion option and recorded within Shareholders' Equity no longer met the conditions for equity classification as of June 30, 2011. As a result, this amount was reclassified to Other Current Liabilities in Sotheby's June 30, 2011 balance sheet and was subsequently settled in August 2011. As of June 30, 2012, the unamortized discount related to the Convertible Notes was $7.8 million and the carrying value of the embedded conversion option recorded in Shareholders' Equity was $30 million ($15.6 million, net of taxes). As of June 30, 2012, management evaluated the remaining embedded conversion option and concluded that it continued to meet the conditions for equity classification. Accordingly, the carrying value of the remaining embedded conversion option was not remeasured as of June 30, 2012 and remains recorded as a component of Additional Paid-In Capital within Shareholders' Equity. The Stock Price Trigger inherent in the Convertible Notes was not met as of December 31, 2011. Therefore, as of that date, the entire carrying value of the Convertible Notes ($170.3 million) was reflected within Long-Term Debt on Sotheby's balance sheet. As of June 30, 2012, the entire carrying value of the Convertible Notes ($174.1 million) is reflected within Current Liabilities on Sotheby's balance sheet because the Convertible Notes are due on June 15, 2013, which is within twelve months of the current balance sheet date. Convertible Note Hedges and Warrant Transactions —On June 11, 2008, in conjunction with the issuance of the Convertible Notes, Sotheby's entered into convertible note hedge transactions (the “Convertible Note Hedges”) that allow Sotheby's to purchase its Common Stock from affiliates of Bank of America and Goldman Sachs & Co. (collectively, the “Counterparties”) at a price equal to the Conversion Price of the Convertible Notes. The Convertible Note Hedges will cover, subject to customary anti-dilution adjustments, approximately 5.3 million shares of Sotheby's Common Stock. The Convertible Note Hedges may be settled in cash, Sotheby's Common Stock, or a combination thereof, and are intended to offset the impact of any conversion premium upon potential future conversions of the Convertible Notes. In the event that Sotheby's elects to settle the conversion premium related to any Convertible Note redemptions in cash, the Convertible Note Hedges allow Sotheby's to recover this amount in cash. In the event that Sotheby's elects to settle the conversion premium related to any Convertible Note redemptions in shares of its Common Stock, the Convertible Note Hedges offset the dilutive impact of any shares issued. The Convertible Note Hedges expire upon the maturity of the Convertible Notes. As previously discussed, in June 2011, Sotheby's received conversion requests totaling a principal amount of $18.1 million from holders of the Convertible Notes. As a result, in June 2011, Sotheby's exercised the portion of the Convertible Note Hedges related to these conversion requests, which enabled it to receive $4.4 million in cash, which was equal to the amount of the conversion premium paid upon settlement of the Convertible Notes in August 2011. The Convertible Note Hedges initially met the conditions for equity classification and, as a result, in June 2008, the related $40.6 million cost ($22.5 million, net of taxes) was recorded on Sotheby's balance sheet as a component of Additional Paid-In Capital within Shareholders' Equity. As a result of the cash settlement of the Convertible Note Hedges exercised in June 2011, $8.2 million ($5.3 million, net of taxes) of the amount originally recorded in Shareholders' Equity no longer met the conditions for equity classification as of June 30, 2011. As a result, this amount was reclassified in Sotheby's June 30, 2011 balance sheet to Other Current Assets and was subsequently settled in August 2011. As of June 30, 2012, the carrying value of the Convertible Note Hedges recorded in Shareholders' Equity was $32.4 million ($17.2 million, net of taxes). As of June 30, 2012, management evaluated the remaining Convertible Note Hedges and concluded that they continued to meet the conditions for equity classification. Accordingly, the carrying value of the remaining Convertible Note Hedges was not remeasured as of June 30, 2012 and remains recorded as a component of Additional Paid-In Capital within Shareholders' Equity. 16# On June 11, 2008, Sotheby's also entered into warrant transactions, whereby it sold to the Counterparties warrants (the “Warrants”) to acquire, subject to customary anti-dilution adjustments, approximately 5.8 million shares of Common Stock at $44.905 per share that may only be exercised beginning on the June 15, 2013 maturity date of the Convertible Notes. As of June 11, 2008, the Warrants met all of the applicable criteria for equity classification and, as a result, the $22.3 million in net proceeds received from the sale of the Warrants was recorded on Sotheby's balance sheet within Additional Paid-In Capital in Shareholders' Equity. As of June 30, 2012, management evaluated the Warrants and concluded that they should not be accounted for separately as a derivative financial instrument because they continue to be indexed to Sotheby's Common Stock. Accordingly, the $22.3 million in net proceeds received from the sale of the Warrants remains recorded as a component of Additional Paid-In Capital within Shareholders' Equity. Future Principal and Interest Payments—As of June 30, 2012, the aggregate future principal and interest payments due under the York Property Mortgage, the Convertible Notes and the Senior Notes are as follows (in thousands of dollars):
As previously discussed, the York Property Mortgage matures on July 1, 2035, but has an optional pre-payment date of July 1, 2015 and bears an annual rate of interest of approximately 5.6%, which increases subsequent to July 1, 2015. It is Sotheby's current intention to either pre-pay or refinance the mortgage on or about July 1, 2015, subject to economic and financial market conditions and available cash balances. Interest Expense—For the three and six months ended June 30, 2012 and 2011, Interest Expense consisted of the following (in thousands of dollars):
Other interest expense consists primarily of the amortization of debt issuance costs related to the Senior Notes and Convertible Notes. For the three and six months ended June 30, 2012 and 2011, Interest Expense related to the Convertible Notes consisted of the following (in thousands of dollars):
17# 7. Defined Benefit Pension Plan Sotheby’s sponsors a defined benefit pension plan covering a portion of its U.K. employees (the “U.K. Pension Plan”). For the three and six months ended June 30, 2012 and 2011, the components of the net pension benefit related to the U.K. Pension Plan are (in thousands of dollars):
In 2012, Sotheby’s expects to contribute approximately $4.3 million to the U.K. Pension Plan, of which $3 million was contributed through June 30, 2012. 8. Commitments and Contingencies Employment Arrangements—As of June 30, 2012, Sotheby’s had employment arrangements with certain senior employees, which expire at various points between March 2013 and March 2017. Such arrangements may provide, among other benefits, for minimum salary levels and for incentive compensation under Sotheby’s incentive compensation programs which is payable only if specified Company and individual goals are attained. Additionally, certain of these arrangements provide annual share-based payments, the accelerated vesting of certain share-based payments, severance payments, other cash compensation, and continuation of benefits upon termination of employment under certain circumstances. The aggregate remaining commitment for salaries and other cash compensation related to these employment arrangements, excluding any participation in Sotheby’s incentive compensation and share-based payment programs, was approximately $15.2 million as of June 30, 2012. Lending Commitments—Sotheby’s enters into legally binding arrangements to lend, primarily on a collateralized basis and subject to certain limitations and conditions, to potential consignors and other individuals who have collections of art. Unfunded commitments to extend additional credit were $29.1 million as of June 30, 2012, of which $0.8 million is committed to an employee of Sotheby’s who is not an Executive Officer. Tax Contingencies—Sotheby's is subject to laws and regulations in many countries involving sales, use, value-added and other indirect taxes which are assessed by various governmental authorities and normally imposed on certain revenue-producing transactions between Sotheby's and its clients. The application of these laws and regulations to Sotheby's unique business and global client base is complex and requires a significant amount of judgment. As of June 30, 2012, the total liability related to such tax contingencies was $5.5 million, consisting of charges recorded to General and Administrative Expenses of $4.9 million in the fourth quarter of 2011 and $0.6 million during the six months ended June 30, 2012, representing Sotheby's estimate of the amounts owed for uncollected sales taxes. The ultimate tax paid in respect to this liability may be higher or lower than the amount accrued. Legal Actions—Sotheby’s becomes involved in various claims and lawsuits incidental to the ordinary course of its business, including the matters described below. Management is required to assess the likelihood of any adverse judgments or outcomes in these matters, as well as potential ranges of probable losses. A determination of the amount of losses, if any, to be recorded as a result of these contingencies is based on a careful analysis of each individual exposure with, in some cases, the assistance of outside legal counsel. The amount of losses recorded for such contingencies may change in the future due to new developments in each matter or a change in settlement strategy. Management does not believe that the outcome of any of these pending claims or proceedings will have a material adverse effect on Sotheby’s consolidated results of operations, financial condition and/or cash flows. 18# Sotheby's Inc. v. Halsey Minor is an action commenced by a subsidiary of Sotheby's in September 2008 in the U.S. District Court for the Southern District of New York, seeking to collect amounts due for three paintings that Mr. Minor purchased in auctions conducted by Sotheby's in the spring of 2008. Mr. Minor filed a counterclaim in that action. During the course of the litigation, Sotheby's reoffered and sold the three paintings initially purchased by Mr. Minor in the spring of 2008 for $9.5 million, thereby reducing the amounts due from him. In March 2010, the court granted Sotheby's motions for summary judgment, denied Mr. Minor's motion for partial summary judgment and entered a judgment in Sotheby's favor in the amount of $6.6 million, which was collected by Sotheby's in the second quarter of 2010. This judgment included $4.4 million for the shortfall resulting from the resale of the three paintings when compared to the original purchase prices and $2.2 million in interest and late charges owed to Sotheby's. The judgment also included an award of attorney's fees, in an amount that the court later determined to be $2.5 million. In April 2010, Mr. Minor filed a notice of appeal of the court's order and judgment. In January 2011, Sotheby's entered into an agreement with the California Franchise Tax Board (the “CFTB”) that provides for the release by the CFTB of potential claims it might have had to the $6.6 million that Sotheby's had collected from Mr. Minor. In February 2011, Mr. Minor and Sotheby's entered into a settlement agreement pursuant to which Mr. Minor dismissed his pending appeal and agreed to pay Sotheby's an additional $2.5 million in exchange for a release by Sotheby's of the uncollected $2.5 million judgment that it has against Mr. Minor and any claim for additional attorney's fees. As a result of the agreement with the CFTB in January 2011 and the February 2011 settlement with Mr. Minor, Sotheby's recognized a benefit of $3 million in its statement of operations in the first quarter of 2011. This benefit relates to interest earned on Mr. Minor's overdue balance ($2.2 million), compensation for lost auction commissions ($0.4 million) and partial reimbursement of legal fees ($0.4 million). As of June 30, 2012, approximately $0.4 million of the $2.5 million settlement amount was paid by Mr. Minor and has been recognized in Sotheby's financial statements. It is uncertain how much of the remaining $2.1 million owed under the settlement will be paid and, as a result, this amount has not been recognized in Sotheby's financial statements. Sotheby's is not currently aware of any other asserted claims against Mr. Minor that could compromise or adversely impact its position in any of the judgments discussed above. Estate of Robert Graham, et al. v. Sotheby's, Inc. is a purported class action commenced in the U.S. District Court for the Central District of California in October 2011 on behalf of U.S. artists (and their estates) whose artworks were sold by Sotheby's in the State of California or at auction by California sellers and for which a royalty was allegedly due under the California Resale Royalties Act (the “Resale Royalties Act”). Plaintiffs seek unspecified damages, punitive damages and injunctive relief for alleged violations of the Resale Royalties Act and the California Unfair Competition Law. In January 2012, Sotheby’s filed a motion to dismiss the action on the grounds, among others, that the Resale Royalties Act violates the United States Constitution and is pre-empted by the United States Copyright Act of 1976. In February 2012, the plaintiffs filed their response to Sotheby's motion to dismiss. The court heard oral arguments on the motion to dismiss on March 12, 2012. On May 17, 2012, the court issued an order dismissing the action on the ground that the Resale Royalties Act violated the Commerce Clause of the U.S. Constitution. The plaintiffs have appealed this ruling. It is currently not possible to make an estimate of the amount or range of loss that could result from an unfavorable outcome of this matter. Sotheby's believes that there are meritorious defenses to the appeal. (See Notes 9 and 11 for information on other contingencies. See Notes 6 and 7 for information on other commitments.) 9. Auction Guarantees From time to time in the ordinary course of its business, Sotheby’s will guarantee to consignors a minimum sale price in connection with the sale of property at auction (an “auction guarantee”). In the event that the property sells for less than the guaranteed price, Sotheby’s must perform under the auction guarantee by funding the difference between the sale price at auction and the amount of the auction guarantee. Sotheby’s is generally entitled to a share of the excess proceeds (the “overage”) if the property under the auction guarantee sells above the guaranteed price. If the property does not sell, the amount of the auction guarantee must be paid, but Sotheby’s has the right to recover such amount through the future sale of the property. In these situations, the guaranteed property is recorded as Inventory on Sotheby's balance sheet at the lower of cost (i.e., the amount paid under the auction guarantee) or management’s estimate of the property's net realizable value (i.e., expected sale price upon disposition). The sale proceeds ultimately realized by Sotheby’s in these situations may equal, exceed or be less than the amount recorded as Inventory on Sotheby's balance sheet. 19# Sotheby’s may reduce its financial exposure under auction guarantees through risk and reward sharing arrangements, which include:
The counterparties to these auction guarantee risk and reward sharing arrangements are typically major international art dealers or major art collectors. Sotheby’s could be exposed to losses in the event any of these counterparties do not perform according to the terms of these contractual arrangements. As of June 30, 2012, Sotheby’s had outstanding auction guarantees totaling $6.2 million. The minimum guaranteed price for each of these auction guarantees was below the pre-sale auction estimates for the underlying property. Sotheby's financial exposure under these auction guarantees was offset by irrevocable bids and the underlying property was sold at auction in July 2012. As of June 30, 2012, the carrying value of the liability representing the estimated fair value of Sotheby’s obligation to perform under its auction guarantees totaled $0.3 million and is recorded on Sotheby's balance sheet within Accounts Payable and Accrued Liabilities. As of July 30, 2012, Sotheby’s had no outstanding auction guarantees. 10. Share-Based Payments and Dividends Share-Based Payments—Share-based payments to employees include performance-based stock awards, shares of restricted stock, restricted stock units and stock options. Each of these share-based payments are explained in more detail below. Compensation expense related to share-based payments is recorded as a component of Salaries and Related Costs in the statements of operations. For the three and six months ended June 30, 2012 and 2011, compensation expense related to share-based payments was as follows (in thousands of dollars):
For the six months ended June 30, 2012 and 2011, Sotheby's realized $3.3 million and $7.2 million, respectively, of excess tax benefits related to share-based payment arrangements. These tax benefits represent the amount by which the tax deduction resulting from the exercise or vesting of share-based payments exceeded the tax benefit initially recognized in the financial statements upon the amortization of compensation expense for these awards. Such excess tax benefits are recognized in the balance sheet as an increase to Additional Paid-in Capital and are classified in the statement of cash flows as Cash Provided by Financing Activities. As of June 30, 2012, unrecognized compensation expense related to the unvested portion of share-based payments was $29.8 million. This compensation expense is expected to be amortized over a weighted-average period of approximately 3.2 years. Sotheby’s does not capitalize any compensation expense related to share-based payments to employees. Sotheby's Restricted Stock Unit Plan—The Sotheby's Restricted Stock Unit Plan (the “Restricted Stock Unit Plan”) provides for the issuance of unvested shares of Common Stock (“Restricted Stock”) and Restricted Stock Units (“RSU's”) to employees, subject to the approval of the Compensation Committee of Sotheby's Board of Directors (the “Compensation Committee”). In making awards under the Restricted Stock Unit Plan, the Compensation Committee takes into account the nature of the services rendered by employees, their present and potential contributions to Sotheby's success, and such other factors as the Compensation Committee in its discretion deems relevant. 20# Restricted Stock and RSU's generally vest evenly over a four year service period. Prior to vesting, holders of Restricted Stock have voting rights and are entitled to receive dividends, while holders of RSU's do not have voting rights, but are entitled to receive dividend equivalents. Dividends and dividend equivalents paid to holders of unvested Restricted Stock and RSU's are not forfeitable. Restricted Stock and RSU's may not be sold, assigned, transferred, pledged or otherwise encumbered until they vest. Performance Share Units—Performance Share Units (“PSU's”) are RSU's which vest ratably, generally over four years, if Sotheby's achieves certain profitability targets. Prior to vesting, holders of PSU's do not have voting rights and are not entitled to receive dividends or dividend equivalents. Dividend equivalents are credited to holders of PSU's and are only paid for the portion of PSU's that vest. PSU's may not be sold, assigned, transferred, pledged or otherwise encumbered until they vest. The Compensation Committee believes that PSU's better align Sotheby's variable compensation strategy with its financial performance and the cyclical nature of the art market and further align the interests of Sotheby's management with its shareholders. Accordingly, Sotheby's intends to grant future share-based payment awards only in the form of PSU's with both performance and service conditions. In February 2012, Sotheby's issued 716,798 PSU's with a fair value of approximately $27.5 million as follows: (i) 609,573 PSU's with a fair value of $23.4 million related almost entirely to Sotheby's incentive compensation programs and (ii) 107,225 PSU's with a fair value of $4.1 million issued to William F. Ruprecht, Sotheby's President and Chief Executive Officer, in relation to his September 2010 employment agreement. Summary of Restricted Stock, RSU’s and PSU’s—For the three and six months ended June 30, 2012, changes to the number of outstanding Restricted Stock shares, RSU’s and PSU’s were as follows (shares in thousands):
The aggregate fair value of Restricted Stock and RSU’s that vested during the six months ended June 30, 2012 and 2011 was $28.1 million and $44.9 million, respectively, based on the closing stock price on the dates the shares vested. As of June 30, 2012, 1.2 million shares were available for future awards pursuant to the Restricted Stock Unit Plan. Stock Options—Stock options issued pursuant to the Sotheby's 1997 Stock Option Plan are exercisable into authorized but unissued shares of Common Stock. Stock options vest evenly over 4 years and expire 10 years after the date of grant. As of June 30, 2012, 35,000 shares of Common Stock were available for the issuance of stock options under the Stock Option Plan. For the six months ended June 30, 2012, changes to the number of stock options outstanding were as follows (options and aggregate intrinsic value in thousands):
The aggregate intrinsic value of options exercised during the six months ended June 30, 2012 and 2011 was $0.5 million and $3.2 million, respectively. For the six months ended June 30, 2012 and 2011, cash proceeds received as a result of stock option exercises were $0.7 million and $2.6 million, respectively. For the six months ended June 30, 2012 and 2011, the related excess tax benefit realized from the exercise of stock options was $0.1 million and $0.8 million, respectively. 21# Noortman Master Paintings (“NMP”)—On June 7, 2006, Sotheby's entered into a sale and purchase agreement (the “Purchase Agreement”) with Arcimboldo S.A. (“Arcimboldo”) pursuant to which Sotheby's acquired all of the issued and outstanding shares of capital stock of NMP. Pursuant to the Purchase Agreement, Sotheby's paid initial consideration (the “Initial Consideration”) in the form of 1,946,849 shares of Sotheby's Common Stock. Pursuant to the Purchase Agreement, if NMP failed to achieve a minimum level of financial performance during the five years following the closing of the transaction, up to 20% of the Initial Consideration would be returned to Sotheby's. For the three and six months ended June 30, 2011, Sotheby's recorded expense of $0.2 million and a benefit of $0.6 million, respectively, to Salaries and Related Costs as a result of adjustments to management's estimate of the number of shares of Common Stock expected to be returned to Sotheby's following the five-year financial performance period. Dividends—During the three and six months ended June 30, 2012, Sotheby’s paid dividends of $5.4 million and $11.0 million, respectively. On August 7, 2012, Sotheby’s Board of Directors declared a quarterly dividend of $0.08 per share (approximately $5.5 million) to be paid to shareholders of record as of September 4, 2012 on September 17, 2012. The declaration and payment of future dividends to shareholders is at the discretion of Sotheby’s Board of Directors and will depend on many factors, including Sotheby’s financial condition, cash flows, legal requirements and other factors as the Board of Directors deems relevant. 11. Uncertain Tax Positions As of June 30, 2012, Sotheby’s liability for unrecognized tax benefits, excluding interest and penalties, was $34.5 million, representing a decrease of $0.2 million when compared to December 31, 2011. As of June 30, 2011, Sotheby’s liability for unrecognized tax benefits was $31.8 million. As of June 30, 2012 and 2011, the total amount of unrecognized tax benefits that, if recognized, would favorably affect Sotheby’s effective tax rate was $17.8 million and $15.0 million, respectively. Sotheby’s believes it is reasonably possible that a decrease of $2.3 million in the balance of unrecognized tax benefits can occur within 12 months of the June 30, 2012 balance sheet date as a result of the expiration of the statute of limitations and expected settlements of currently ongoing tax audits. Sotheby's is subject to taxation in the U.S. and various state and foreign jurisdictions, and as a result, is subject to ongoing tax audits in various jurisdictions. Sotheby's U.S. federal and various state and foreign tax returns are currently under examination by taxing authorities. The earliest open tax year for the major jurisdictions in which Sotheby's does business, which include the U.S. (including various state and local jurisdictions), the U.K. and Hong Kong, is 2005. Sotheby’s recognizes interest expense and penalties related to unrecognized tax benefits as a component of Income Tax Expense. The accrual for such interest and penalties increased by $0.3 million for the six months ended June 30, 2012. Sotheby's policy is to record interest expense related to sales, value added and other non-income based taxes as Interest Expense in its statements of operations. Penalties related to such taxes are recorded as General and Administrative Expenses in its statements of operations. Interest expense and penalties related to income taxes are recorded as a component of Income Tax Expense in Sotheby's statements of operations. 22# 12. Related Party Transactions From time-to-time, in the ordinary course of business, related parties transact with Sotheby's to buy and sell property at auction and through private sales. For the three and six months ended June 30, 2012, Sotheby’s recognized total auction and related revenues of $4.6 million and $4.9 million, respectively, related to the sale and purchase of property by related parties. These revenues represent approximately 2% and 1%, respectively, of total revenues for those periods. For the three and six months ended June 30, 2011, Sotheby's recognized total Auction and Related Revenues of $1.8 million and $5 million, respectively, related to the sale and purchase of property by related parties. These revenues represent approximately 1% of total revenues for those periods. As of June 30, 2012, December 31, 2011 and June 30, 2011, Accounts Receivable (net) includes $35.6 million, $24.4 million and $13 million, respectively, associated with purchases made by related parties. These purchases represent approximately 4%, 4% and 1%, respectively, of Accounts Receivable (net). Included in the related party receivable balance as of June 30, 2012 is $30 million attributable to affiliates of Sotheby's partner in an equity method investment and $5.6 million attributable to a relative of a member of Sotheby's Board of Directors. As of July 31, 2012, $20.3 million of these related party receivables had been collected. 13. Recently Issued Accounting Standards In September 2011, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") 2011-08, Intangibles - Goodwill and Other: Testing Goodwill for Impairment, which is codified in Accounting Standards Codification 350, Intangibles - Goodwill and Other. This update gives entities testing goodwill for impairment the option of performing a qualitative assessment before calculating the fair value of a reporting unit in step 1 of the goodwill impairment test. If entities determine, on the basis of qualitative factors, that the fair value of a reporting unit is, more likely than not, less than the carrying amount, the two-step impairment test would be required. Otherwise, further testing would not be needed. This update became effective for Sotheby's quarterly and annual financial statements beginning in the first quarter of 2012. Early adoption was permitted. Sotheby's did not adopt this standard early in 2011 and is currently evaluating whether to perform the qualitative assessment allowed under ASU 2011-08 in 2012 as part of its annual goodwill impairment test to be conducted in the fourth quarter of 2012. 23# ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Seasonality The worldwide art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. Accordingly, Sotheby's auction business is seasonal, with peak revenues and operating income generally occurring in those quarters. Consequently, first and third quarter results have historically reflected a lower volume of auction activity when compared to the second and fourth quarters and, typically, a net loss due to the fixed nature of many of Sotheby's operating expenses. Use of Non-GAAP Financial Measures GAAP refers to generally accepted accounting principles in the United States of America. Included in Management's Discussion and Analysis of Financial Condition and Results of Operations (or “MD&A”) are financial measures presented in accordance with GAAP and also on a non-GAAP basis. EBITDA, EBITDA Margin and Net Liquidity, as presented in MD&A under “Key Performance Indicators,” are supplemental financial measures that are not required by or presented in accordance with GAAP. Sotheby's defines EBITDA as net income, excluding income tax expense (benefit), interest expense, interest income and depreciation and amortization expense. Sotheby's defines EBITDA Margin as EBITDA as a percentage of total revenues. Management cautions users of Sotheby's financial statements that amounts presented in accordance with its definitions of EBITDA and EBITDA Margin may not be comparable to similar measures disclosed by other companies because not all companies and analysts calculate such measures in the same manner. Management believes that EBITDA and EBITDA Margin provide important supplemental measures of Sotheby's performance and that these measures may be used by securities analysts, investors, financial institutions and other interested parties in the evaluation of Sotheby's. Management also utilizes EBITDA in analyzing Sotheby's performance and in the determination of annual incentive compensation. A reconciliation of EBITDA to net income derived in accordance with GAAP is presented below in “Reconciliation of Non-GAAP Financial Measures.” Sotheby's is predominantly an agency business that collects and remits cash on behalf of its clients. Consequently, Sotheby's defines Net Liquidity as the amount of cash and cash equivalents that would remain assuming that all accounts receivable were collected and that all consignor payables, accounts payable and current accrued liabilities were paid as of each balance sheet date. This measure, among others, is used by management to assess the amount of available liquidity, excluding available borrowings under Sotheby's revolving credit facility. Net Liquidity should not be considered as an alternative to cash and cash equivalents as reported in accordance with GAAP. A reconciliation of Net Liquidity to cash and cash equivalents reported in accordance with GAAP is presented below under “Reconciliation of Non-GAAP Financial Measures.” 24# RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011 This discussion should be read in conjunction with Note 4 (“Segment Reporting”) of Notes to Condensed Consolidated Financial Statements. Overview For the three and six months ended June 30, 2012, Sotheby's net income decreased $41.8 million (33%) and $54.9 million (42%), respectively, when compared to the same periods in the prior year. The unfavorable comparison to the prior periods is primarily due to lower auction commission revenues resulting from quarter and year-to-date decreases in Net Auction Sales of 13% and 17%, respectively, as the same periods in 2011 included an unprecedented level of sales of single-owner collections. Additionally, there was a decrease in auction commission margin in the current periods attributable to competitive pressures and to the sales mix, as a greater proportion of high-value consignments were sold in the current period. These factors are partially offset by lower incentive compensation costs in the current periods in respect to Sotheby's lower level of earnings relative to the prior year periods. See the discussion below for greater detail on the significant factors impacting Sotheby’s results for the three and six months ended June 30, 2012 and the comparison to the prior period. Outlook Management believes that Sotheby's first half results were impacted in part by a sluggish global economy, particularly the tempering of growth in China and the ongoing economic crisis in Europe. However, management continues to remain confident in the global art market, where demand and prices continue to be strong, particularly at the high-end of the market. It appears that clients may be seeking liquidity through their art collections, as evidenced by the significant growth of Sotheby's loan portfolio as well as an active level of consignment activity to-date for fourth quarter sales. Management is committed to stabilizing auction commission margins and maintaining a rational cost structure while continuing with measured investments in the strategic initiatives that are vital to Sotheby's future. (See statement on Forward Looking Statements. In addition, the art market has historically been cyclical; please refer to Item 1A, Risk Factors, which summarizes the factors that could significantly influence and cause variability in Sotheby's operating results and liquidity.) 25# Results of Operations for the Three and Six Months Ended June 30, 2012 and 2011 The table below presents a summary of Sotheby’s results of operations for the three and six months ended June 30, 2012 and 2011, as well as a comparison between the two periods (in thousands of dollars):
26#
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