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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
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©
2003 by The Freemarket Gold & Money Report
James Turk is the editor of Freemarket
Gold & Money Report
and the founder of GoldMoney
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