Owning GLD Can Be Hazardous to Your Wealth

by Dave Kranzler
February 12, 2009

Given that the stated amount of gold in the GLD Trust has grown to over 850 tons, it appears that a lot of investors believe and trust that investing in GLD is the same thing as buying physical gold bullion. A close reading and analysis of the GLD Prospectus, however, reveals that investing in GLD is drastically different from owning gold. This analysis will show why GLD is nothing more than another form of a derivative security which is loaded with counter-party default risk. Ultimately, the value of the GLD Trust, and the price of its stock, has the potential to experience substantial loss. Under certain circumstances GLD could be worthless. As an investment advisor, I do not recommend that anyone use GLD instead of buying physical gold because it is not an investment in gold and the legal structure of GLD is such that unsuspecting investors could end up losing all of their money. Furthermore, because the risks embedded in GLD are documented in the GLD Prospectus, investment advisors who recommend GLD and use it in client portfolios are exposing themselves to the risk of negligence lawsuits.

Introduction

GLD is a legal trust designed to track the price of gold, net of trust expenses. The Sponsor is the World Gold Trust Services (World Gold Council), the Trustee is The Bank of New York, the Custodian is HSBC Holdings and the Marketing Agent is State Street Global Agents (State Street Bank). My source of research is the S1 Prospectus filed on November 15, 2004.

GLD is a “derivative” because it is a piece of paper that is supposed to move with – or is derived from - the movement of the underlying asset, which is gold. It is also a derivative because unless a shareholder owns 100,000 shares, a GLD shareholder can never take physical possession of any GLD gold.

As shown below, the Trust has been legally structured in a way which makes it impossible to determine if the gold in the Trust is being leased. This is a huge problem because, if the Trust is indeed leasing gold, it could become difficult for the Trust to replace the leased gold in the event that the counter-party leasing the gold defaults. Furthermore, in the event that the Custodian becomes insolvent, and the gold has indeed been leased out by the subcustodians, shareholder’s have almost no legal ability to seek recovery from the Trust/Custodian.

GLD does not even promise that the gold is in the Trust

The biggest problem with GLD is there is no way to legally force the Trustee/Custodian to prove that the gold being kept by the Custodian is in the Custodian’s vault. The Custodian has the ability to use “subcustodians” to safekeep the gold. The subcustodians are permitted to use their own subcustodians to safekeep the gold.

The Trustee/Custodian/Subcustodian relationship is where the validity of GLD disintegrates into a maze of legal barriers which ultimately prevent anyone from physically verifying that the GLD Trust holds anything more than promises of gold. In other words, GLD has been set up by the Sponsor and Trustee, and the structure approved by the Securities and Exchange Commission, in a manner which would allow GLD subcustodians to lease out the gold being held by subcustodians, thus leaving nothing in GLD but lease-receivables.

I’ll start from the top and work down. The Trustee, upon reasonable notice, is permitted to visit the the Custodian’s vaults and examine the Custodian’s records twice a year. From the prospectus:

“The ability of the Trustee to monitor the performance of the Custodian may be limited because under the Custody Agreements the Trustee may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust’s gold and certain related records maintained by the Custodian.” (p. 37)

The auditor may also visit the Custodian’s premises in connection with their audit of the financial statements of the Trust - the auditor does not audit the actual gold. Please note that Trustee and auditor visits “will not be allowed when no gold of the Trust is held in the Custodian’s vault.” (p. 48). For clarification, this could occur when all of the GLD Trust gold is being held by subcustodians, who then turn could around and lease the gold. Just as the Trustee has limited oversight of the Custodian, the Custodian has limited responsibility and no oversight of the subcustodians:

“The Custodian is required to use reasonable care in selecting subcustodians, but otherwise has no responsibility in relation to the subcustodians appointed by it, and the Custodian is not responsible for their selection of further subcustodians. The Custodian does not undertake to monitor the performance by subcustodians of their custody functions or their selection of additional subcustodians. The Custodian is not responsible for the actions or inactions of subcustodians” (p. 44)

In addition to the above problems, and in what I believe is negligence on the part of the SEC, neither theTrustee nor the Custodian has any legal ability whatsoever to monitor or visit the premises of any subcustodians, or subcustodians of the subcustodians, for purposes of verifying that subcustodians are holding what they are supposed to be holding:

“In addition, the Trustee has 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 no subcustodian is obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian.” (p.37)

To make matters worse, the Prospectus states that there will be no written contractual agreements between subcustodians and the Custodian or the Trustee (page 11-12). The Prospectus further states quite clearly that “because neither the Trustee nor the Custodian oversees or monitors the activities of subcustodians who may hold the Trust’s gold, failure by the subcustodians to exercise due care in the safekeeping of the Trust’s gold could result in a loss to the Trust.” (p. 12).

As thus can be seen from its legal structure, the Trust does not have any legal safeguards in place to keep subcustodians from leasing out the GLD gold. As of the date of this prospectus, the subcustodians being used were: Bank of England, The Bank of Nova Scotia (ScotiaMocatta), Deutsche Bank AG, JPMorgan Chase Bank, and UBS AG (p. 47). Please note that all of these banks actively lease gold.

Shareholder Recourse

The Trust has been structured to make it difficult, if not impossible, for shareholders to seek recovery from losses which could occur from Custodian/subcustodian negligence or outright fraud. Shareholder recourse against the Trust is limited (p. 11). The Trust will not insure the gold. The Custodian is responsible for insurance and “shareholders can not be assured that the Custodian will maintain adequate insurance” (p. 11). Furthermore, “Custodian and the Trustee will not require any direct or indirect subcustodians to be insured or bonded” with respect to gold held by the subcustodians on behalf of the Trust (p. 11). “Consequently, a loss may be suffered with respect to the Trust’s gold which is not covered by insurance and for which no person is liable in damages” (p. 11). If subcustodians are used outside of the U.S., it may be difficult or impossible to seek legal remedy against the subcustodians (p. 12). This is significant because the Custodian’s primary vault is in London. The subcustodians’ vaults can be anywhere in the world.

A further, and not inconsequential, source of risk is the possible insolvency of the Custodian, HSBC. As described on page 13 of the Prospectus, “if the Custodian becomes insolvent, its assets may not be adequate to satisfy a claim by the Trust…In addition, in the event of the Custodian’s insolvency, there may be a delay and costs in incurred identifying the bullion held in the Trust’s allocated gold account.” On the surface, this makes it sound like the GLD Trustee can make a specific claim on those bars on behalf of the Trust. But let’s examine this a little further. That there may be a “delay and costs incurred identifying bars in the Trust’s allocated gold account” undoubtedly refers to the possibility that allocated bars may be held by subcustodians. And if these subcustodians have leased out those bars, it will take substantial time to call in those bars. Worse, if the subcustodians fail to return leased gold to the Custodian, there are no contractual agreements which enforce subcustodian performance by the Custodian. As noted above, the Custodian can not be held liable for actions of the subcustodians, thereby leaving GLD shareholders in line with other creditors in the event HSBC files for bankruptcy.

Yet another loophole in the GLD Prospectus which allows the gold to be leased

In consulting about this report with James Turk, a well-known precious metals market analyst and the founder of GoldMoney, Mr. Turk discovered another loophole in the legal language of the Prospectus which further bolsters the case to be made that the GLD Trust leases out its gold:

I’m reading the Aug 2008 prospectus, but it’s probably the same in earlier ones. It can be found in Use of Proceeds on page 3 (and in various other places too), which states: “Proceeds received by the Trust from the issuance and sale of Baskets consist of gold deposits and, possibly from time to time, cash.” Note the word “deposits”. This word has a precise meaning in the law, and is the exact opposite of “bailment”. To explain, if you deposit dollars in a bank, the bank gives you a certificate of deposit, checking account statement, savings book or some other evidence of its debt to you. You no longer own those dollars; the bank now owes them to you. Title/ownership changed from you to the bank, which can now do with those dollars whatever it wants. With bailment, the bank is simply storing for you an asset you placed with them for storage. There was no change in title. The asset continues to be owned by you. So if there were physical gold in GLD, the above statement should be changed to “Proceeds received by the Trust from the issuance and sale of Baskets consist of gold bailments and, possibly from time to time, cash.”

My point is that “gold” is one thing and a “gold deposit” is something entirely different. “Gold” is physical metal stored/bailed in a secure vault. A “gold deposit” is a liability of a financial institution. The former is a tangible asset (physical gold). The latter is a financial asset (paper gold). In summary, the GLD prospectus is full of legal loopholes. While GLD may in fact hold some physical gold, there is enough uncertainty with it that it seems clear much/most of GLD is paper. Otherwise, why doesn’t GLD audit the gold to prove that it exists?

As shown by Mr. Turk, the Sponsor of GLD has chosen to structure the Trust using language which would permit the Trust to purchase gold and immediately lease out that gold. The lease receivable document would then satisfy a strict legal interpretation of the use of the term “gold deposits” by the Prospectus. A lease receivable document has risks embedded in it which further increase the inherent derivatives risk of GLD. A lease receivable document is NOT physical gold.

As for the annual auditor’s report, found on pages 70-71 of the most recent GLD 10K filed 11/25/08, the auditor clearly states that their “responsibility is to express an opinion on the Trust’s internal control over financial reporting based on our audit.” As shown above, the internal controls rely on a tenuous chain of accountability from the Trustee down to the subcustodian’s subcustodians, with almost no legal means to independently verify the existence of physical gold in the vaults used to store GLD gold. The auditor of GLD is neither required nor, in the case of access to subcustodian vaults, allowed to perform an actual physical accounting of the gold reported to be held on behalf of GLD by the Custodian. Ultimately, the auditor certifies its accounting for GLD based on financial reports from the Custodian and subcustodians which could ultimately be based on lease receivables rather than actual physical gold.

As can thus be seen by the risky legal structure and superficial auditing of GLD, and the willingness of the Governmental regulatory agencies to look the other way, anyone investing in GLD is taking on the risk of being victimized by the misleading financial and accounting schemes that have deeply infected the U.S. financial system. I would be quite surprised if any of the vast majority of institutional and retail investors, or their highly compensated advisors, are even remotely aware of the acute risks embedded in the GLD Trust. Make no mistake about it, investing in GLD is completely different than investing in actual physical gold. GLD does not even accurately index the price of physical gold, as the premiums on physical gold products like bullion coins have expanded from 10% to 40% above the spot price of gold over the last five years. This premium is not reflected in the price of GLD. If you invest in GLD now, with the intent of selling GLD in the future and buying physical gold, you will discover that your investment proceeds from GLD will purchase substantially less gold than was represented by your paper investment in GLD.

I have no problem with the concept of using GLD for daytrading to make directional bets, long or short, on the short term swings in the price of gold. But if you invest in GLD with the intent of making a long term investment in gold, please be aware that GLD is NOT an investment in actual physical gold. GLD is nothing more than a piece of paper which proclaims, but does not promise, to have gold on the other side of its highly structured legal barriers. Furthermore, for the reasons shown above, there is the possibility that you might wake up one day to find out that the price of GLD has suddenly dropped well below the spot price of gold and that GLD could even end up worthless.