|
Since
the spring of 2002 the World Gold Council (WGC) has been developing
an exchange-traded fund (ETF) 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 & 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 9th 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 completed 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.com
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:
http://www.mips1.net/MGGold.nsf/Current/4225685F0043D1B285256D28000B31BF?OpenDocument
Even though he
doesn’t mention GoldMoney by name, Tim 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. He 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
iron clad (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:
http://www.goldbullion.com
p 11- “The gold will be held
in custody by the Custodian, sub-custodians or their delegates...”
p 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.
p 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.”
p 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.
p 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 Kingdoms 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.
p 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 Custodians 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 US fund.
The US 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 US fund. And the fund's Trustee
has no control over the subcustodians. The following quote
is taken from the WGC's proposed US 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 the WGC has structured their funds this way in recognition
of how the bullion market operates. The processes for trading
in the bullion market are based upon one basic 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 core 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, that the gold in fact
is actually there.
In short, these WGC funds may in practice only be fractional
reserves, and not 100% gold. The prospectus allows that possibility,
and discloses the risks relating to it. Further, the UK and
US 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 als o 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 US, or even
the UK 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 US
and UK funds. Therefore, based on my reading of the Australian
prospectus in view of the risks disclosed in the UK and US
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.
December 8th, 2003
***
©
2003 by The Freemarket Gold & Money Report
James Turk is the editor of Freemarket
Gold & Money Report
and the founder of GoldMoney
|
