DON'T BUY GOLD ETF's !!!!!!
Freemarket Gold & Money Report
Letter 335-19
December 8, 2003
SEC vs WGC
By James Turk
Copyright 2003, Freemarket Gold & Money Report
Since the spring of 2002 the World Gold Council has
been developing an exchange-traded fund for gold. The
objective is to eliminate the hassle and inconvenience
of handling physical metal by providing the ownership
of gold through a listed security that can be conveniently
purchased and sold through stockbrokers.
I have been following the WGC's efforts closely because
I wanted to see if their ETF would have a comparable level
of governance to what my colleagues and I have achieved
in GoldMoney. A product launched by the WGC could have
some competitive impact. Additionally, GoldMoney has
been exploring the possibility of creating its own ETF using
goldgrams as the underlying asset.
In May 2003 the WGC submitted to the Securities and
Exchange Commission (SEC) the S-1 registration statement
required to obtain approval for a New York Stock Exchange
listing. Subsequently, two amended versions of the S-1 have
been submitted to the SEC, the most recent being last month.
Why hasn't the filing been accepted by the SEC?
The SEC doesn't disclose the reasons for its actions, and the
WGC isn't talking. But a lot can be gleaned from reading the
WGC's most recent SEC filing as well as the prospectus for
a fund that the WGC plans to launch Tuesday, December 9,
in London. The SEC may be on to something meaningful and
important.
Both of these WGC funds have very loose custodial controls.
This custodial structure opens the possibility that the fund is
not completely supported by physical metal. In other words,
the fund may have fractional reserves, which would of course
mean that shareholders to some extent could be buying
paper promises rather than physical metal.
This possibility was first raised in an article by Tim Wood of
MineWeb that was posted on May 15, 2003, soon after the
S-1 was first made public. Tim noted the shortcomings of the
proposed WGC fund by comparing it to GoldMoney. See:
mips1.net
BF?OpenDocument
Even though he doesn't mention GoldMoney by name, Tim's
comments appear to be directed toward us and to one of our
strengths -- exceptional governance procedures that mitigate
risk and provide customers with assurances of integrity.
Tim wrote: "A notable feature of digital gold operations is their
fetish over the gold entrusted to them in terms of ensuring its
purity and location." He then notes that those same controls
are lacking in the WGC's ETF: "Whilst a problem is
unimaginable given the players involved, it is nevertheless odd
that Equity Gold has been unable to secure ironclad (forgive
the mixed metaphors) insurance, purity, creditor, and
custodianship guarantees. It might be nitpicking, but it does
illustrate the issue of counterparty risk, which does not vanish
just because the underlying product is gold."
There is a problem here that needs fixing. The custodial control
of the WGC funds needs to be strengthened. These funds need
to provide assurances about the physical metal segregated in
allocated storage. As these funds are now structured, these
assurances are lacking because the custodian has no control
over the sub-custodians or the sub-sub-custodians.
To illustrate my concerns, I include below quotes from the
prospectus of the UK fund that is about to begin trading,
Gold Bullion Securities Limited, which can be downloaded
from:
goldbullion.com
Page 11: "The gold will be held in custody by the Custodian,
sub-custodians, or their delegates...."
Page 22: "All Trust Gold will be held by the Custodian at its
London vault premises or in the vaults of any sub-custodian
or by a delegate of a sub-custodian."
Interestingly, the prospectus doesn't list the location of the
vaults of the sub-custodians or their delegates. What is the
political risk in those countries where those vaults are located?
How secure are the vaults of the sub-custodians or their
delegates? Even more importantly, WHO are these delegates?
Further, the Custodian is not held accountable for the
sub-custodians or their delegates.
Page 38: "The Custodian Agreement requires the Custodian
to use reasonable care in the selection of those sub-custodians
and provided that is (sic) shall not be liable for any act or
omission, or for the solvency, of any sub-custodian it appoints
unless the appointment of that sub-custodian was made by it
negligently or in bad faith."
Page 38: "The Custodian is under no duty or obligation to make
or take, or require any sub-custodian it appoints to make or
take, any special arrangements or precautions beyond those
required by any applicable rules of the LBMA, the Bank of
England, or any other applicable regulatory authority."
But the prospectus makes clear that there is no regulatory
supervision over custodial services in London.
Page 28: "Custodial services offered by the Custodian and
any sub-custodian are presently not a regulated investment
activity subject to the supervision and rules of the Financial
Services Authority, the United Kingdom's financial services
regulator (or the Bank of England)."
And as noted in the MineWeb article, the fund does not have
any requirement that the gold be insured.
Page 27: "There is a risk that the Trust Gold could be lost,
stolen, or damaged. ... If the Custodian fails to take out
suitable insurance then Security Holders may have to rely on
having a claim against the Custodian. The Custodian's liability
is limited in various ways."
So there is a lot of risk here. Is the gold really in the vault?
Or is some sub-custodian or delegate just accepting dollars from
people buying shares in exchange for paper?
Given this existing custodial arrangement, there is no way of
knowing for sure.
Consequently, it is reasonable to conclude that this deficient
custodial control may explain why the SEC has not accepted
the WGC's proposed U.S. fund.
The U.S. fund -- like its UK counterpart -- has the same loose
custodial structure because not only the Custodian but also
the subcustodians can handle the gold owned by the U.S. fund.
And the fund's Trustee has no control over the subcustodians.
The following quote is taken from the WGC's proposed U.S.
prospectus:
"The Trustee does not undertake to monitor the performance of
any subcustodian. Furthermore, the Trustee may have no right
to visit the premises of any subcustodian for the purposes of
examining the Trust's gold or any records maintained by the
subcustodian, and any subcustodian may not be obligated to
cooperate in any review the Trustee may wish to conduct of the
facilities, procedures, records, or creditworthiness of such
subcustodian.
"In addition, the ability of the Trustee to monitor the performance
of the Custodian may be limited because under the Allocated
Bullion Account Agreement and the Unallocated Bullion Account
Agreement (together, the Custody Agreements) the Trustee has
only limited rights to visit the premises of the Custodian for the
purpose of examining the Trust's gold and certain related records
maintained by the Custodian."
Why should a gold ETF be different from any other
exchange-traded fund already registered with the SEC?
These other ETFs provide for complete control over the custodian
as well as all sub-custodians. It is only through such control that
shareholders can be certain that a fund owns physical gold that
is safely and securely stored in a vault.
I assume that the WGC has structured its funds this way in
recognition of how the bullion market operates. The processes for
trading in the bullion market are based on one principle -- moving
paper around is easier and less expensive than moving metal. So
these funds are structured to accommodate the way bullion banks
now operate, therefore providing the WGC funds access to the
liquidity these banks offer as well as avoiding the imposition of the
fees that would result if the banks were continually moving metal
between themselves instead of paper.
Basically, the London bullion banks operate using 19th-century
procedures. Their procedures never entered the 20th century, let
alone the 21st. The principle of these procedures is "my word is
my bond," which may work in some circumstances but probably
does not work where fund managers have an obligation to carry
out due diligence for their clients and/or where investors want
assurances that when they are buying something reported to be
gold, the gold in fact is actually there.
In short, these WGC funds may in practice be only fractional
reserves, and not 100-percent gold. The prospectus allows that
possibility and discloses the risks relating to it.
Further, the U.K. and U.S. prospectus each ring-fence the
liability of the custodian and the trustee, relieving them of any
responsibility if it turns out that there is "fiddling" by any
subcustodian.
So it seems understandable that the SEC would be reluctant
to accept for filing the WGC prospectus.
Lastly, in the past I have had no concerns about the WGC's
Australian gold fund, which has been operating for a few months.
However, in view of these new discoveries about the uncertainty
surrounding the custodial arrangements of the other WGC funds,
I have now also looked again at the prospectus of the Australian
fund.
Clearly, the Australian authorities seem to allow a lot less
disclosure than the regulatory authorities in the United State
or even the United Kingdom, for that matter. So it is hard to draw
any clear conclusions about the safety of assets in custody,
which in itself is a concern.
But the prospectus for the Australian fund does allows the
Custodian to appoint subcustodians, which presumably creates
the same risk that exists in the WGC's proposed U.S. and U.K.
funds.
So, based on my reading of the Australian prospectus in view of
the risks disclosed in the U.K. and U.S. filings, I cannot
recommend the WGC's Australian fund.
The risks of the WGC's funds appear too great. Until more
questions are answered and/or the fund's structure is changed
to eliminate its loose custodial controls, I do not recommend
that these funds be purchased. |
