First, let me preface this article by stating that it contains my opinions and speculation based upon no concrete evidence, but primarily upon information contained within the SLV and GLD prospectuses, and secondarily upon instincts cultivated over a decade of research into gold and silver markets. While there is no smoking gun regarding some of the issues I raise in this article, there is plenty of smoke.

Ever since the launch of the US gold ETF, GLD, in November, 2004 and the launch of the US silver ETF, SLV, April 2006, a debate has raged in analyst circles regarding the legitimacy of these two investment vehicles as a proxy for physical gold and physical silver. Though all evidence against investing in these two trusts has been entirely circumstantial, plenty of red flags exist in both the GLD and SLV prospectuses that should steer any logical, rational human being that wishes to own gold and silver away from these two investment vehicles.

Conflicts of Interest

Let’s begin with the obvious. Is it not a huge conflict of interest that JP Morgan (JPM), a bank that perpetually ranks among the largest short positions against silver on the COMEX, is the custodian for the iShares Silver Trust (SLV)? According to silver analyst Ted Butler, JP Morgan is consistently among the one or two U.S. banks that hold more than 80% to 90% of the entire commercial net short position in COMEX silver futures. If you have positioned yourself to make huge profits from drops in the price of silver, is it reasonable for you to simultaneously desire investors to buy more physical silver (if indeed the SLV holds the amount of physical silver it claims)?

Is it also not a conflict of interest that HSBC (HBC) bank, a bank that allegedly holds some of the largest short positions against gold on the COMEX, is the custodian for the SPDR Gold Trust (GLD)? If these banks profit when gold and silver drop, and they manage the largest ETFs in the US regarding these respective metals, is it unreasonable to state that these two banks should be barred from acting as custodians of the GLD and SLV? In fact, how is this situation any different than Goldman Sachs’s (GS) actions in the past when they originated CDOs and then made a fortune by shorting them, actions that back then, were apparently unknown even to the firm’s own traders? On the surface, it certainly appears to be another classic case of the fox guarding the hen house.

Alice in Wonderland Prospectuses

I have maintained for a long time now, ever since I carefully read the GLD and SLV prospectuses, that any investor that buys the GLD and the SLV and believes that these two investment vehicles are as risk-free and as sound as purchasing physical gold and physical silver is highly delusional. I call the prospectuses of the GLD and the SLV “Alice in Wonderland prospectuses” because it is literally impossible to ascertain what information contained within them is fact or fiction. Of course, investment advisers that sell their clients the SLV and GLD depend upon their customers not reading the prospectuses, or perhaps even reading them, but not understanding them. Some may say that the word delusional is a harsh term, but a mere glance at the GLD and SLV prospectuses explains my use of this term. Both the GLD and the SLV prospectus contain the following two statements:

“Neither the Securities and Exchange Commission [SEC] nor any state securities commission has approved or disapproved of the securities offered in this prospectus, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense” (emphasis mine); and

“The trust is not an investment company registered under the Investment Company Act of 1940. The trust is not a commodity pool for purposes of the Commodity Exchange Act, and its sponsor is not subject to regulation by the Commodity Futures Trading Commission as a commodity pool operator, or a commodity trading advisor.

Furthermore, the SLV prospectus additionally states, “As an owner of iShares, you will not have the protections normally associated with ownership of shares in an investment company (emphasis mine) registered under the Investment Company Act of 1940, or the protections afforded by the Commodity Exchange Act of 1936.”

Does anyone else besides me not find it ludicrous that both the SEC and the CFTC have not examined either the GLD or SLV prospectus to determine if it is truthful or complete, and that in fact, any claims that the prospectus is truthful and complete is a “criminal offense”? So with nothing in the marketing materials of how these trusts operate or what exactly they buy on behalf of shareholders vetted by an independent third party, how is it that both of these respective trusts are still allowed to cumulatively sell tens of billions of dollars worth of shares to shareholders based upon a prospectus that could possibly be a complete fabrication?

Would you buy a house if you were handed a report that stated the house was structurally sound, there were no harmful gases leaking from the ground, the water source was safe, and no murders were committed inside or on the house grounds within the past year, but were then subsequently handed a disclaimer that stated: “No one has determined whether the information contained in these reports is truthful or complete. Any representation to the contrary is a criminal offense”? If you answered no to this question, then there is absolutely no way that you should believe that buying the gold ETF and the silver ETF is the same as buying physical gold and silver, or even a proxy for buying physical gold or silver.

Multiple Claims on the Physical Gold and Physical Silver Held on Behalf of GLD and SLV Shareholders?

The appointed custodians of the SLV and the GLD, responsible for safekeeping the silver and gold bars owned by the trusts, respectively are JP Morgan and HSBC Bank USA. The GLD prospectus states, “Gold held in the Trust’s unallocated gold account and any Authorized Participant’s unallocated gold account will not be segregated from the Custodian’s assets.” Only Authorized Participants, and no shareholders, have the right to redeem shares for actual gold.

In my opinion, there are several potential huge problems with this arrangement. Physical gold held by the GLD should be held in allocated accounts specifically for the trust. The fact that physical gold held for the GLD may be held in unallocated gold accounts where gold is not segregated from the Custodian’s assets may mean that multiple entities have claims on the same gold bars. In theory, the gold held in the Custodian’s vaults may be used for delivery against shorts they hold in the futures markets if necessary even though GLD shareholders have a claim on this gold.

A mechanism to apply the fractional reserve banking system to physical gold, an action that many thought impossible to execute with physical gold, may actually be occurring through the gold ETFs. While the prospectus states that “Authorized Participants Unallocated Accounts may only be used for transactions within the trust”, it does not specify how the custodian may use this gold.

In analyzing the SLV prospectus, the following statement can be found: “The trust does not trade in silver futures contracts on COMEX or on any other futures exchange. The trust takes delivery of physical silver that complies with the LBMA silver delivery rules. Because the trust does not trade in silver futures contracts on any futures exchange, the trust is not regulated by the CFTC under the Commodity Exchange Act as a ‘commodity pool’, and is not operated by a CFTC-regulated commodity pool operator.”

Elsewhere in the SLV prospectus, the following claim is also made: “Accordingly, the bulk of the trust’s silver holdings (emphasis mine) is represented by physical silver.” If the bulk of the trust’s silver holdings is represented by physical silver, what constitutes the “remainder”? Clearly, the SLV prospectus states that there is a “remainder”. If you read this statement carefully, the statement clearly refers to the “trust’s silver holdings.” Thus, this statement implies that some of the SLV’s funds are allocated to something else other than physical silver. So what is the rest of the trust’s silver holdings? Paper silver future contracts, air, or something else?

But even were the bulk of the SLV’s holdings physical silver, remember that this claim could be false and still contained in the prospectus due to their qualifying statement at the beginning of the prospectus that:

“Neither the Securities and Exchange Commission [SEC] nor any state securities commission has approved or disapproved of the securities offered in this prospectus, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.”

Perhaps this is the reason why the prospectus warns: “Investors in the trust do not receive the regulatory protections afforded to investors in regulated commodity pools, nor may COMEX or any futures exchange enforce its rules with respect to the trust’s activities. In addition, investors in the trust do not benefit from the protections afforded to investors in silver futures contracts on regulated futures exchanges.”

The very structure of the GLD and SLV ETFs has always bothered me as the structures of these trusts are reminiscent of Vatican City, a completely sovereign entity subject only to its own laws and rules that operates in relative secrecy. I have always believed that the opacity of the operations of the GLD and the SLV would allow the custodians of these trusts, if they so desired, to execute manipulative schemes harmful to the trusts’ shareholders in much the manner that Goldman Sachs shorted subprime mortgages at the same time it was selling CDOs backed by subprime mortgages to its clients.

Where is the Gold?

Furthermore, more suspicion should be raised by the prospectus description of where the gold that is purchased on behalf of GLD shareholders is held. The prospectus states that “the Custodian has agreed that it will hold all of the Trust’s gold bars in its own London vault premises except when the gold bars have been allocated in a vault other than the Custodian’s London vault premises” (emphasis mine). This stuff is too good even for a skeptic like myself to make up. The prospectus then goes on to explain that other vaults allowed may reside at the Bank of England, Brinks Ltd., Via Mat International, and LBMA (London Bullion Market Association) market making members, and that in turn, these sub-custodians may appoint further sub-custodians to hold the trust’s gold if they so desire.

In regard to ensuring that the gold actually exists, the prospectus then states that “the Trustee may have no right to visit the premises of any sub-custodian for the purposes of examining the Trust’s gold bars or any records maintained by the sub-custodian, and no sub-custodian will be obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such sub-custodian.” In other words, the gold reputedly held by the GLD on behalf of shareholders may be held on the moon and no one would have a right to know this but the custodian.

In fact, given the entirely suspicious elements of these prospectuses, were every investor to liquidate their positions in the GLD and SLV and take their cash and buy physical gold and silver instead, I would speculate that the price of gold and silver would rise substantially, though according to the prospectuses, this is an event that should not happen under any circumstance. Now, according to a GATA report by Adrian Douglas, it appears that there may actually be grounds for my past speculations regarding the fact that the GLD and SLV funds may actually be used to help suppress the price of gold and silver on the futures markets.

Alchemy: Turning Physical Gold into Paper

According to a July 11, 2009 article titled “The Alchemists”, Douglas states: “delivery notices at the COMEX cannot be reconciled with movements of metals from and into the warehouse. Clearly these are not going to match on a daily basis, just as orders into a factory will not match shipments out on any given day, as there is a time lag. But when averaged over a month, the “flow” of metal inventory should be comparable to the delivery notices issued. This is just basic accounting. But I have observed that reconciliation is almost impossible with the COMEX data. The only explanation I could think of is that settlement of contracts must be bypassing the warehouse. But how could this be possible, as I thought all contracts had to be delivered via a COMEX registered warehouse?”

In an attempt to reconcile this discrepancy, Douglas asks the all important question of what qualifies as “physical gold” according to COMEX guidelines. Douglas believes he has found a loophole in Exchange Rule 104.36, which governs exchange of futures for physicals (’EFP’) transactions on the COMEX Division. Exchange Rule 104.36 “refers to a ‘physical commodity’ as one of the required components of an EFP transaction but also indicates that the physical commodity need only be substantially the economic equivalent of the futures contract being exchanged.”

Exchange Rule 104.36 further states, “The purpose of this Notice is to confirm that the Exchange would accept gold-backed exchange-traded funds (’ETF’) shares as the physical commodity component for an EFP transaction involving COMEX gold futures contracts, provided that all elements of a bona fide EFP pursuant to Exchange Rule 104.36 are satisfied.”

An EFP transaction is an Exchange of Futures for Physicals [EFP] whereby the buyer or seller may exchange a futures position for a physical position of equal quantity. EFPs may be used to either initiate or liquidate a futures position. Thus, quite incredulously, Douglas has discovered that COMEX allows for paper ETF gold shares to pass as “physical gold” in EFP transactions that are allowed to close out futures positions.

Again, if I understand Douglas’s assertion correctly, this could conceivably allow a firm like JP Morgan to open up massive shorts against gold in the COMEX markets and to close out their own short positions by delivering shares of a gold ETF in an EFP transaction. If this has indeed occurred in the past, then this loophole would easily explain why, in the past, gold ETF inventories have curiously risen or remained virtually steady during periods when the price of gold futures contracts on the COMEX was plummeting. As Douglas stated in his paper, this would indeed be the ultimate alchemy of regulating gold prices by turning physical gold into paper. Instead of purchasing a long futures contract to cancel out a short futures contract, gold ETF shares could be purchased to achieve the same effect.

The CFTC Should Investigate the GLD and the SLV, Audit their Holdings, and Report Their Findings to the Public

Thus, if the new CFTC Chairman Gary Gensler is truly sincere in his public comments about increasing transparency in the commodity markets, I suggest he begin with an investigation of the unregulated SLV and GLD ETFs to

(1) Determine the exact composition of the holdings within these trusts; and

(2) Determine if the custodians of these ETFs are engaging in activities outside of those stated in their prospectuses to unduly influence and / or manipulate the price of gold and silver markets.

It is entirely ludicrous to allow the custodians of these two ETFs to operate with zero outside regulatory oversight given the numerous troubling statements in both of their prospectuses, the tip of which I’ve explored within the realm of this article. If these trusts are operating according to the statements made within their respective prospectuses, then they should have nothing to hide and therefore should welcome an independent audit of their vaults to dispel all naysayers. Of course, since there is a complex web of custodians, sub-custodians, and sub-custodians of the sub-custodians, perhaps it would be impossible to conduct such an audit.

The latest data reported on July 8, 2009 by the SPDR Gold Trust, the GLD, states that 1,109.81 metric tons of gold are being held on behalf of GLD shareholders. In some manner, an independent auditor should be allowed to confirm that the custodian of the GLD holds 1,109.81 metric tons of gold that have no claims on it other than the GLD shareholders. If this happens, then all speculation regarding the GLD ETF will disappear into the sunset.

Until then recall this 2005 story about silver custodian Morgan Stanley:

NEW YORK, June 12 (Reuters) – Morgan Stanley plans to settle a class-action lawsuit, brought by clients over the purchase and storage of precious metals, in a deal worth $4.4 million, according to a court filing. The proposed settlement, which still needs to be approved by the federal court in Manhattan, includes a cash component of $1.5 million and economic and remedial benefits valued at about $2.9 million, according to the filing on Monday.

The lawsuit, filed in August 2005, alleged that Morgan Stanley had told clients it was selling them precious metals that they would own in full and that the company would store. But Morgan Stanley was actually making either no investment specifically on behalf of those clients or making an entirely different investment of lesser value and security, according to the complaint (emphasis mine).

Morgan Stanley was not immediately available for comment. But it has argued that there were no violations of law and no default or failure to perform or deliver precious metals, according to the filing. The suit was filed by Selwyn Silberblatt, on behalf of himself and others, who bought precious metals — gold, silver, platinum and palladium in bullion bar or coins — from Morgan Stanley DW Inc. and its predecessors and paid fees for their storage, according to the filing.

The suit covers investors who did so between Feb. 19, 1986, through Jan. 10, 2007. Silberblatt, a resident of Maine at the time of the complaint, bought silver bars from Morgan Stanley during the period.

Owning the GLD and SLV is Not the Same as Owning Physical Gold and Physical Silver

In the end, as long as the GLD and SLV prospectuses are allowed to contain misinformation if it so desires according to the words contained within their own prospectuses, then GLD and SLV shareholders may find themselves holding nothing but a bag of hot air just like Selwyn Silverblatt. Furthermore, as long as the issues I broached in this article remain unresolved I imagine that the debate will continue onward about the legitimacy of the GLD and SLV ETFs. Undoubtedly, given the opinions I presented in this article, I would be highly curious to see the outcome and effect upon gold and silver prices were every shareholder of the GLD and SLV to exchange their shares for physical gold and physical silver instead.

There will always be vast amounts of paper gold and paper silver available to be sold, but only a limited amount of physical gold and physical silver. Perhaps this is why the real thing is becoming increasingly difficult to come by these days. On Tuesday, the US Mint once again reported that it has temporarily suspended minting of nearly all its gold uncirculated and proof coins and nearly all of its silver uncirculated coins due to very limited availability of blanks. As the saying goes, with gold and silver, “Get it while you can!” Just ensure that the gold and silver you buy clanks, not floats, when you drop it.

Disclosure: No positions

J.S. Kim

SmartKnowledgeU