By Jeff Nielson of Bullion Bulls Canada

Given my scathing criticism of most (so-called) bullion-ETFs, I frequently get reader questions about the prospectus of one fund or another. I freely confess to not having read these documents. My (stated) reasons for not doing so are that I do not, and would not hold such investments, and that I have already provided enough reasons to doubt the legitimacy of these investment vehicles that such an analysis would be moot.

However, at the persistent urging of one reader, I finally caved in and went through the prospectus of The Mother of all Bullion Scams: GLD. It was at this point I had to deal with my third, unstated reason for avoiding these documents -- they make your head hurt. This is especially true for those with a background in law, as we have been trained to attempt to discern the "intent" of every word of such documents, which means attempting to reconstruct the thinking of the lawyer(s) at the time the document was drafted.

At first glance, the SPDR Gold Trust ( GLD) is the epitome of simplicity. In the first paragraph of the Prospectus Summary, it states:

"The Trust holds gold bars..."

Then, a few paragraphs later, is a section titled "Trust's Gold Holdings as of March 31, 2010." It lists the total holdings as approximately 36.5 million ounces, almost all of it in "allocated" gold bars. So far, so good. The problem is that as soon as one scratches the surface, to attempt to verify that this ETF behemoth is actually the straightforward "trust" that is presented, we immediately encounter one serious issue after another, which I am labelling the "seven sins" of GLD.

1. Lack of transparency:

In the page that immediately follows details of the Trust's "gold holdings," is "The Offering." In that section, it lists the total number of units of the Trust. Two facts leap out at us. First, the total number of units is more than 390 million, with the date of that total being May 26, 2010.

Given that GLD is priced, and presented by the media as one unit equalling 1/10 ounce of gold, we immediately see that there are 7% more units than there should be at that rate of conversion, or in other words, the units clearly represent less than 1/10 ounce of gold. The problem is that it is impossible to determine precisely how much less, because of the inexplicable gap in reporting.

"Total gold holdings" are reported only up to the end of March. Presumably, the "custodian" of all that bullion (the infamous bullion-short HSBC) is keeping track of the bullion it stores in its vault, and thus the time it would have taken to get "total gold holdings" up to May 26 (to synchronize the dates) would be the time it takes to send a fax. Clearly, the fund's sponsor (none other than the "World Gold Council") refuses to provide synchronized dates, to make it impossible to ascertain the amount of "dilution" in the fund, or (alternately) the precise "premium" that new unit-holders are paying when they buy in.

Similarly, if this fund were really the simple "trust" that it pretends to be, it would have been very easy for the sponsor to say that the objective of the Trust was to provide "a cost-effective investment in gold" for unit-holders, but the fund deliberately avoids any such language. Instead, it defines the Trust's investment objective as merely to "reflect the performance of the price of gold bullion."

It then immediately goes on to say:

"The Sponsor believes emphasis mine that, for many investors, the Shares represent a cost-effective investment in gold."

The choice of wording here is enormously important, given that in a preceding page of the prospectus, the word "believe" is expressly designated as a "forward-looking statement."It then says that with respect to all such "forward-looking statements" that:

"They are only predictions. Actual events or results may differ materially."

Given my background, I fully understand the necessity of including such legal "weasel words" with respect to any statements made in the prospectus concerning future developments in the gold market, such as the price of gold itself. However, with respect to the current holdings in the fund, how can the sponsor merely "believe" that units represent "... an investment in gold"?

Defenders of this ETF will argue that the sponsor's "belief" is with respect to "a cost-effective investment in gold," and thus the sponsor is unable to warrant that GLD will be "cost-effective." However, insertion of the words "cost effective" is totally voluntary. The only "warranty" that the sponsor has chosen to provide (i.e., the "investment objective") is that the fund will "reflect the performance of the price of gold bullion." Whether or not there is (actually) any gold in this fund is merely a "belief" of the sponsor and thus may not be relied upon by unit-holders.

To provide a hypothetical example, suppose that the "custodian" for the fund (HSBC) has done extensive research and found that the price of chickens tends to be almost precisely correlated with the price of gold (i.e., they closely track each other). Given that HSBC has other things it would like to do with its gold (such as dumping bullion onto the market, or backing its massive short position), it decides that instead of going to all the bother of acquiring and storing such a massive quantity of gold that it will buy and hold chickens instead.

While much bulkier than gold, the "storage costs" associated with stationing a sleepy, security guard outside the freezers of a few meat-packers certainly cannot compare with the overhead of managing a bullion-vault capable of storing billions of dollars worth of bullion, not to mention the logistical costs associated with transporting (and insuring) all the bullion being bought and sold by this massive fund.

Critics will scoff at my hypothetical example as being too absurd to be of any analytical value, because if GLD were actually holding chickens instead of gold that the sponsor would be sued, and/or the "custodian" of the fund. This brings us to the second sin.

2. Damages

Even without reading the prospectus, I have warned unit-holders that if there were some fraud or default associated with the fund, that all that unit-holders would ever be able to recover from the fund is paper. In other words, they could sue to get their (paper) money back, but they could never sue to force the sponsor (and/or "custodian") to provide them with the gold they thought they had bought. Such a legal remedy is known as "specific performance," and (under the best of conditions) is a relatively rare outcome to any civil action.

Given this underlying reality, the language used in the prospectus to protect the sponsor and the "custodian" (HSBC) from liability can only be characterized as overkill. Not only does the document seek the normal waiver with respect to acts of God, war, or terrorism, but it also seeks to indemnify both the sponsor and custodian from fraud, negligence, or willful default.

Specifically, even under the worst acts of malfeasance, investors could never recover anything other than the market value of their holdings (i.e. paper money) as of the day the fraud was discovered, or default occurred. While (to some extent) language like this is common in such legal documents, we must attach considerable importance to the deliberate choice of the words "willful default," rather than just the generic term "default" -- which most reasonable readers would assume would imply some involuntary event.

Instead, if HSBC defaults on its custodian agreement, and even if it actually did have enough gold currently in its possession to cover its obligation, it could simply refuse to turn over the gold it held. Suddenly, my example of the hypothetical chickens doesn't sound quite so preposterous. In the event of a willful default, it could liquidate its chickens to cover its custodian agreement, keep all its gold -- and unit-holders could do nothing.

3. Structure

GLD does not sell its shares directly to unit-holders. I hesitate to use the word "shares" to describe these units (despite how the Trust does so again and again) because the prospectus clearly states on many occasions that unit-holders to not possess many of the rights of a normal shareholder. It is hard not to construct the analogy that GLD sells "shares" that aren't really shares, as an equitable interest in "gold" that isn't really gold.

Beyond that, GLD has chosen to market its shares exclusively in baskets, with each basket having a current market value of over $10 million. Only those institutions capable of buying these $10 million chunks of units are able to directly retail them to the general public.

This seems like a deliberate device for steering most of the commissions for the purchase of these units to big banks. Presumably, smaller institutions could (in turn) pick up smaller blocks for themselves -- but only from the big banks (who presumably take a "cut" for themselves at that point).

This needless injection of extra banker commissions is clearly a cost that must ultimately be passed along to unit-holders -- despite the appearance that GLD is the "cheapest" way to buy/own "gold," and brings us to our next sin.

4. Fees

As stated earlier, the sponsor of GLD certainly wants to create the appearance (or "belief") that GLD is a "cost-effective" means for investors to buy/hold gold. Media talking heads and a legion of investment shills depict each unit as representing 1/10 ounce of gold, making the administrative fees of the fund appear to be near-zero. Indeed, I have referred to that outward facade as yet another reason to doubt the legitimacy of the fund. However, the truth is that no one (outside of the fund) can ascertain the precise quantum of fees, due to lack of transparency.

It is here that we come to another inexplicable reality with this fund: ever-increasing administrative costs. Keep in mind that the entire purpose in designating one of the largest offenders in gold manipulation as custodian for this supposed hoard of bullion is economies of scale. If you're going to hire the fox to guard the hen house, then at the least the fox should give you a better rate (per hen) as the flock that it is "guarding" grows larger. This is not how GLD operates.

It explicitly states that (over time) the gap between the 1/10 ounce of gold per unit which it is purported to hold, and the actual amount of gold actually held by unit-holders will steadily increase. This makes no sense. Indeed, the only justification for having a custodian hold the Trust's gold is that it should minimize administrative costs.

If the fund were actively managed, that is, if it were continually active in the gold market buying and selling gold to look to capitalize on imbalances/opportunities that occasionally present themselves, then it would be understandable how administrative costs would/could increase over time as the fund grew larger.

However, the prospectus explicitly states that the fund is not actively managed. Given that, in even a worst-case scenario per-unit administrative costs should be flat, but more likely economies of scale should operate to reduce those per-unit costs.

This leads to one of two implications. Either the sponsor or (more likely) the custodian simply plans to "skim more off the top" for itself each year, or the "gold" in HSBC's vault is "evaporating," causing the actual amount of "gold" held by unit-holders to steadily decrease over time. What should greatly alarm current unit-holders is that the long-term (guaranteed) rise in administrative "costs" is currently being hidden for the first seven years of this fund's existence, because there is a "cap" on those fees. When this seven-year period expires on Nov. 11, 2011 (or the 11th day, of the 11th month, of the 11th year) we can only refer to this event as...

5. "D-Day"

Readers can choose what they want the "D" in "D-Day" to represent, with my own suggestions being "default" or "destruction." Indeed, the deliberate choice by the sponsor of such a memorable date for termination seems to indicate that they expect this date to represent a dramatic event in the evolution of this fund.

Given that there is no economic reason for the Trust to incur ever-increasing costs, the fund is essentially being "managed" according to "principles" very similar to those of a Ponzi scheme. Specifically, only those buyers who get in (and get out) early are able to extract their undiluted gains in this fund, with later buyers receiving less "gold" when they buy in and even less than that when they subsequently dispose of their units.

Given the deliberate lack of transparency of the fund, the price-gouging fee structure and the clear warning to unit-holders that "all bets are off" when the 11th day of the 11th month of the 11th year arrives, surely even those unit-holders who have remained oblivious to the many reasons to question this fund won't be reckless enough to continue to hold those units until "D-Day"?

6. Quality

By now, every investor even pondering investing in gold bullion has heard the rumors of tungsten-filled gold bars being littered about various gold vaults around the world. What is the attitude of GLD's sponsor and custodian regarding this rumor?

To sum it up in three words "ignorance is bliss." Neither the sponsor or custodian will guarantee that any of the "gold bars" it claims to possess today are legitimate, despite the fact that such testing is both relatively quick and easy. (Of course, if GLD is actually holding chickens instead of gold, then "testing" for tungsten-fillings would be totally unnecessary).

7. Custodian

The World Gold Council, which "sponsors" GLD is itself an association that primarily represents the world's largest gold-miners, who founded and funded it. As I have written previously, these mining companies have a "long relationship" with the handful of "bullion banks" in the world.

Given that past and given that a close examination of the fund reveals that there are no long-term economic benefits in entrusting tens of billions of investor dollars to the promises of bankers (see "Morgan Stanley Pays Damages for Precious Metals Fraud"), the choice of the world's largest "shorter" of gold as "custodian" for this fund is nothing less than Machiavellian. Indeed, it follows the pattern of abuse-victims in giving their abuser additional opportunities to commit further crimes.

While I hope that my analysis of the GLD prospectus can help investors to avoid the obvious dangers of this fund, it really shouldn't be necessary. This is a document that screams caveat emptor ("buyer beware") in almost every paragraph. We already know that a fox has been put in charge of the hen-house -- and for all we know that hen-house may (in fact) actually hold nothing but hens.