OPERATIONS

Management's Discussion and Analysis of Financial Condition and Results of Operations (or, "MD&A") should be read in conjunction with Note 2 ("Segment Reporting") of Notes to Consolidated Financial Statements.

Critical Accounting Estimates

The preparation of financial statements and related disclosures in accordance with GAAP requires management to make judgments, assumptions, and estimates that affect the amounts reported in our Consolidated Financial Statements and accompanying notes. Actual results may ultimately differ from our original estimates, as future events and circumstances sometimes do not develop as expected. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of our Consolidated Financial Statements. In addition, we believe that the following are our most critical accounting estimates, which are not ranked in any particular order, that may affect our reported financial condition and/or results of operations.

In estimating the realizable value of art held in inventory and art pledged as collateral for SFS loans, we consider the following complex array of factors: (i) whether the property is expected to be offered at auction or sold privately, and the timing of any such sale; (ii) the supply and demand for the property, taking into account current art market conditions, as well as changing trends as to which collecting categories and artists are most sought after; (iii) recent sale prices achieved for comparable items within a particular collecting category and/or by a particular artist; (iv) the state of the global economy and financial markets; and (v) our intent and ability to hold the property in order to maximize its realizable value.

Due to the inherent subjectivity involved in estimating the realizable value of art held in inventory and art pledged as collateral for SFS loans, our estimates of realizable value may prove, with the benefit of hindsight, to be different than the amount ultimately realized upon sale.

See Note 1 of Notes to Consolidated Financial Statements for information related to inventory. See Note 4 of Notes to Consolidated Financial Statements for information related to SFS loans.

(2) Accounts Receivable— Accounts receivable principally includes amounts due from buyers as a result of auction and private sale transactions. The recorded amount reflects the purchase price of the property, including our commission. Under the standard terms and conditions of our auction and private sales, we are not obligated to pay the consignor for property that has not been paid for by the buyer. If a buyer defaults on payment, the sale may be cancelled and the property will be returned to the consignor. We continually evaluate the collectability of amounts due from individual buyers and, if we determine that it is probable that a buyer will default, a cancelled sale is recorded in the period in which that determination is made and the associated accounts receivable balance, including our auction commission, is reversed. Historically, cancelled sales have not been material in relation to the aggregate hammer price of property sold at auction.

In certain instances and subject to management approval under our internal corporate governance policy, we may pay the consignor the net sale proceeds before payment is collected from the buyer while we retain possession of the property. In these situations, if the buyer does not make payment, Sotheby's takes title to the property, but could be exposed to losses if the value of the property subsequently declines. In certain other situations and subject to management approval under our internal corporate governance policy, we allow the buyer to take possession of purchased property before making payment. In these situations, we are liable to the seller for the net sale proceeds whether or not the buyer makes payment and would incur a loss in the event of buyer default.

Our judgments regarding the collectability of accounts receivable are based on an assessment of the buyer's payment history, discussions with the buyer, and the value of any property held as security against the buyer's payment obligation. Our judgments with respect to the collectability of amounts due from buyers for auction and private sale purchases may prove, with the benefit of hindsight, to be incorrect. See Note 4 of Notes to Consolidated Financial Statements for information related to accounts receivable.

(3) Pension Obligations— The benefit obligation related to our defined benefit pension plan in the U.K. (the "U.K. Pension Plan") is based on an actuarial valuation. Inherent in this valuation are key assumptions and estimates, including those related to the discount rate, the expected long-term rate of return on plan assets, future inflation, and mortality, which are reviewed and updated, as appropriate, on at least an annual basis. In developing these assumptions and estimates, we consider current market conditions, market indices, and other relevant data.

The discount rate represents the approximate weighted average rate at which the obligations of the U.K. Pension Plan could be effectively settled and is based on a yield curve for a selection of high-quality corporate bonds with maturity dates approximating the length of time remaining until individual benefit payment dates. The discount rates as of December 31, 2015 used to calculate the service and interest cost elements included in the calculation of the $6.9 million net pension credit recorded in 2016 were 3.8% and 3.4%, respectively. A hypothetical increase or decrease of 0.1% in this assumption would result in a decrease or increase in net annual pension cost of approximately $0.4 million. As of December 31, 2016 , the discount rate used to calculate the $327.6 million benefit obligation was 2.7% . A hypothetical increase or decrease of 0.1% in this assumption would result in a decrease or increase in the benefit obligation of approximately $6.5 million.

The expected long-term rate of return is weighted according to the composition of invested assets and is based on expected future appreciation, as well as dividend and interest yields currently available in the equity and bond markets. In particular, the expected rate of return for growth assets represents our best estimate of annualized long-term returns by asset class. The expected rate of return on debt securities is based on interest yields currently available on long-dated U.K. government bonds and highly-rated corporate bonds. The expected long-term rate of return on plan assets used to calculate the $6.9 million net pension cost recorded in 2016 was 5.2% . A hypothetical increase or decrease of 0.25% in this assumption would result in a decrease or increase in net annual pension cost of approximately $0.9 million.

Assumed mortality rates are based upon standardized data tables used by actuaries in the U.K., taking into account the demographics of U.K. Pension Plan members and allowances for longer future life expectancies. A hypothetical 5% increase or decrease in life expectancies would result in an increase or decrease in 2016 net pension cost of approximately $0.4 million. Additionally, a hypothetical 5% increase or decrease in life expectancies would result in an increase or decrease in the December 31, 2016 benefit obligation of approximately $4.3 million.

As of December 31, 2016 , the accumulated after-tax net loss related to the U.K. Pension Plan that has not yet been recognized in our Consolidated Income Statements was ($14.2) million and is reflected in the Shareholders' Equity section of our Consolidated Balance Sheets. Unrecognized pension losses are generally the result of: (i) actual results being different from previous actuarial assumptions (for example, the expected return on plan assets); (ii) changes in actuarial assumptions between balance sheet dates (for example, the discount rate); and/or (iii) curtailment gains.

In periods when the unrecognized pre-tax loss reflected in Shareholders' Equity exceeds 10% of the greater of: (i) the market-related value of plan assets or (ii) the benefit obligation, the excess amount is amortized as a component of future net pension cost or benefit over the average expected future life of plan participants, which is approximately 30.8 years. It is expected that approximately $0.9 million ($1.1 million, pre-tax) of the ($14.2) million after-tax net loss related to the U.K. Pension Plan will be recognized as a reduction of the net pension benefit anticipated for the year ended December 31, 2017. (See statement on Forward Looking Statements.)

On April 30, 2016, after the completion of a statutory consultation process, the U.K. Pension Plan was closed to accrual of future service costs for active participants. See Note 8 of Notes to Consolidated Financial Statements for additional information related to the U.K. Pension Plan.

As of December 31, 2016 , we had a net deferred tax liability of $2.5 million, which includes gross deferred tax assets of $83.2 million, primarily resulting from deductible temporary differences which will reduce taxable income in future periods. To a lesser extent, we also have deferred tax assets relating to net operating loss carryforwards, which are partially offset by a valuation allowance of $2.8 million to reduce the deferred tax assets to the amount that we have determined is more likely than not to be realized. In assessing the need for a valuation allowance, we consider, among other things, projections of future taxable income and ongoing prudent and feasible tax planning strategies. If we determine that sufficient negative evidence exists (for example, if we experience cumulative three-year losses in a certain jurisdiction), then we will consider recording a valuation allowance against a portion or all of the deferred tax assets in that jurisdiction. If, after recording a valuation allowance, our projections of future taxable income and other positive evidence considered in evaluating the need for a valuation allowance prove, with the benefit of hindsight, to be inaccurate, it could prove more difficult to support the realization of these deferred tax assets. As a result, an additional valuation allowance could be required, which would have an adverse impact on our effective income tax rate and results. Conversely, if, after recording a valuation allowance, we determine that sufficient positive evidence exists in the jurisdiction in which a valuation allowance is recorded (for example, if we are no longer in a three-year cumulative loss position in the jurisdiction, and we expect to have future taxable income in that jurisdiction based upon our forecasts and the expected timing of deferred tax asset reversals), we may reverse a portion or all of the valuation allowance in that jurisdiction. In such situations, the adjustment made to the deferred tax asset would have a favorable impact on our effective income tax rate and results in the period such determination was made.

Due to the global complexity of tax regulation, we record liabilities to address potential exposures involving uncertain tax positions that we have taken, or expect to take, on income tax returns that could be challenged by taxing authorities. These potential exposures result from the varying applications and interpretations of income tax related statutes, rules, and regulations. As of December 31, 2016, our liability for unrecognized tax benefits, excluding interest and penalties, was $19.5 million. We believe that our recorded tax liabilities are adequate to cover all open years based on an assessment of the relevant facts and circumstances. This assessment involves assumptions and significant judgments about future events and potential actions by taxing authorities, as well as an evaluation of past experiences. The cost of the ultimate resolution of these matters may be greater or less than the liability that we have recorded. To the extent that our opinion as to the outcome of these matters changes, income tax expense will be adjusted accordingly in the period in which such a determination is made.

See "Income Tax Expense" below, as well as Note 16 and Note 17 of Notes to Consolidated Financial Statements.

In 2015, we granted a share-based payment award to Thomas S. Smith, Jr., our President and CEO, with a single vesting opportunity after a five-year service period contingent upon the achievement of pre-determined levels of price appreciation in our stock. The compensation expense recognized for this share-based payment is based on our estimate of the grant date fair value of the award. In developing this estimate, we considered then-current market conditions, historical data, and other relevant data. See Note 21 of Notes to Consolidated Financial Statements for additional information related to our share-based payment programs.

Seasonality

The global art auction market has two principal selling seasons, which generally occur in the second and fourth quarters of the year. In the aggregate, second and fourth quarter Net Auction Sales represented 82% and 78% of our total annual Net Auction Sales in 2016 and 2015 , respectively, with auction commission revenues comprising approximately 75% of our total revenues in each of these years. Accordingly, our financial results are seasonal, with peak revenues and operating income generally occurring in the second and fourth quarters. Consequently, first and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters and, typically, a net loss due to the fixed nature of many of our operating expenses.

In quarterly reporting periods, the comparison of our results between reporting periods can be significantly influenced by a number of factors, such as changes in the timing of when certain auctions occur, the level of non-recurring single-owner auction sale events, the level and timing of individually negotiated private sale transactions, and changes in certain accounting estimates that rely upon forecasted results such as variable incentive and share-based compensation expense and our estimated annual effective income tax rate. Accordingly, when evaluating our performance, we believe that investors should also consider results for six and twelve month periods, which better reflect the business cycle of the global art auction market. See Note 29 of Notes to Consolidated Financial Statements for our quarterly results for the years ended December 31, 2016 and 2015 .

Business and Industry Trends

Agency Segment —In late-2009, the global art market began a period of expansion that resulted in some of the most profitable years in our history. A significant driver of the expansion of the global art market and our profitability during this period was the growth of the Contemporary Art and Asian Art markets, as well as increased demand for art from clients in China and other emerging markets across several collecting categories.

Auction sale results in the fourth quarter of 2015 and throughout 2016 indicate that the global art market has entered a period of lower sales. With the art market declining from its most recent peak, consignors have exercised greater discretion in offering their works of art for sale, which has resulted in lower consignment levels, particularly in the Impressionist, Modern and Contemporary Art collecting categories. However, collectors continue to purchase top quality works of art for strong prices in these smaller and more selective sales, which have also recently experienced encouraging sell-through rates, and a greater proportion of sales exceeding their pre-sale low estimates. The lower level of sales has also been partially mitigated by an increase in Auction Commission Margin in each of the last four quarterly reporting periods beginning in the first quarter of 2016, relative to the same periods in the prior year.

Sotheby's Financial Services —In recent years, there has been an increase in the demand for art-related financing. In response, and in an effort to reduce our cost of capital and enhance returns, in January 2014, we established a separate capital structure for SFS through which client loans are predominantly funded with borrowings drawn from a dedicated revolving credit facility. The establishment of a dedicated revolving credit facility for SFS has allowed us to finance approximately 84% of the loan portfolio with debt as of December 31, 2016, and has contributed to a 42% increase in the client loan portfolio when compared to December 31, 2013 and a higher level of profitability for the segment.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

This discussion should be read in conjunction with Note 2 of Notes to Consolidated Financial Statements, which provides financial information about our segments.

Overview

In 2016, we reported net income of $74.1 million (or $1.27 per diluted share), representing an increase of $30.4 million when compared to 2015 when we reported net income of $43.7 million (or $0.63 per diluted share). The comparison to the prior year is most significantly influenced by a $65.7 million income tax charge recorded in 2015 related to the repatriation of foreign earnings. Excluding this and other charges in both years, Adjusted Net Income* is $99.6 million (or Adjusted Diluted Earnings Per Share* of $1.71 ), which is $43.5 million (30%) lower than Adjusted Net Income* of $143.1 million (or Adjusted Diluted Earnings Per Share* of $2.07 ) in 2015.

The lower level of Adjusted Net Income* is principally due to the recent decline in the global art market, which resulted in a $1.5 billion (29%) decrease in Net Auction Sales and an associated $112.9 million (17%) decrease in Agency segment gross profit. Notably, the impact of the decline in Net Auction Sales¹ was somewhat mitigated by an increase in Auction Commission Margin from 14.3% to 17.1%, as well as a lower level of incentive and share-based compensation and a lower effective tax rate, excluding discrete items.

Outlook

Based on the activity in the fourth quarter of 2016 and to date in 2017, we are encouraged with the direction of the art market and our prospects for the upcoming year. With respect to expenses, we expect a modest increase in spending over 2016 as we accelerate our investments in digital marketing and other technology initiatives. We also anticipate that our effective tax rate will increase slightly in 2016 as the jurisdictional mix of our earnings shifts back to the U.S.

With respect to the balance sheet, we plan to continue our efficient allocation of capital. Accordingly, in 2017, we will continue the process of converting inventory to cash through an aggressive sale plan. Any excess capital will be evaluated for its optimal use, including potential investments in the business, potential share repurchases and/or potential debt reduction.

(See statement on Forward Looking Statements.)

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Results of Operations for the Years Ended December 31, 2016 and 2015

The table below presents a summary of our consolidated results of operations and related statistical metrics for the years ended December 31, 2016 and 2015 , as well as a comparison between the current and prior year periods (in thousands of dollars, except per share data):

Agency Segment

Our Agency segment earns commissions by matching buyers and sellers (also known as consignors) of authenticated works of art through the auction or private sale process. To a much lesser extent, Agency segment activities also include the sale of artworks acquired principally as a consequence of the auction process.

Agency segment gross profit decreased by $112.9 million ( 17% ) in 2016 as a result of the decline in the global art market, most notably in the Impressionist, Modern and Contemporary Art collecting categories, which resulted in a significantly lower level of Net Auction Sales (29%) and auction commission revenues (15%). Also contributing to the decrease in Agency segment gross profit is a higher level of inventory losses. Somewhat mitigating the unfavorable comparison to the prior year is an increase in Auction Commission Margin from 14.3% to 17.1% and a lower level of auction direct costs. See below for a detailed discussion of the significant factors impacting the comparison of Agency segment gross profit between the current and prior year periods.

The table below presents a summary of Agency segment gross profit and related statistical metrics for the years ended December 31, 2016 and 2015 , as well as a comparison between the current and prior year periods (in thousands of dollars):