In a previous article, we warned investors against unallocated storage schemes. After the article was published, several people said our warnings were misplaced because only “sophisticated investors” store precious metals in London. Such investors are supposed to know exactly what they are buying into. Since then, it has become increasingly clear that small investors ARE very much a part of the London and/or London-style unallocated storage scheme.
With all the attention of the silver market focused on J.P. Morgan Chase (NYSE:JPM) these days, this was unexpected. A class action lawsuit has been filed against UBS Financial Services (NYSE:UBS), alleging that it defrauded small investors into believing they were purchasing physical silver when, in truth, the brokerage house actually provided a “position” in "silver" by means of unallocated storage at either a UBS or HSBC (HBC) vault. Both banks are members of LPMCL, a U.K. based organization that sets "standards" for both allocated and unallocated storage. Unallocated customers of member banks are unsecured creditors, and have no claim upon metal in the event of insolvency.
According to the lawsuit, customers were charged storage fees every month, even though the bank was not actually storing anything. It never purchased any physical silver. Instead, the bank allegedly used customer cash for its own purposes. In effect, customers ended up buying a non-interest bearing silver bond. Such bonds, based on a promise of repayment in precious metals, were typically issued in the late 19th and early 20th century. Back then, they bore a nice interest rate, payable in gold or silver. Today's version of the precious metal bond is unallocated storage, which takes money from investors but pays them nothing at all.
A very similar lawsuit was filed, in 2007, against Morgan Stanley (NYSE:MS). In that case, small investors were also claiming they had been defrauded into participating in unallocated metals storage. The bank defended itself by alleging, among other defenses, that it was simply following standard industry practices. In other words, the amount of information given to customers, the unallocated nature of the scheme, as well as the charging of "storage fees" for imaginary metal were "standard industry practices". In light of what we now know, maybe they were telling the truth. Morgan Stanley did eventually settle for a multi-million dollar payout, but it continued to deny liability. UBS has not yet answered. We don't know yet what their response may be.
As I pointed out in my previous article, the LPMCL website makes it clear that unallocated storage customers are unsecured creditors. It does not disclose, however, that the banks are in the habit of keeping only 1 bar for every hundred that are supposed to be in their vaults. Testimony at a March 25, 2010 CFTC hearing implies that this is so, and a reviewing court might someday hold that the ratio is so high as to be fraudulent. It might find that the reasonable expectations of parties to an unallocated storage contract do not encompass such a ratio, and that a failure to disclose it is a material omission of fact. The form unallocated storage agreement, notably, does contains a exculpatory clause that releases liability for fraud.
In the UBS class action, the ultimate issue is whether or not the nature and effect of what the small investors were buying (ie: unallocated storage of silver) was adequately explained. Did investors willingly purchase a silver "bond" that bore no interest? If not, the investors will win. Indeed, is is reasonable to argue that more disclosure and explanation is needed when dealing with small investors. Frankly, however, there are institutional investors who are unwittingly involved in such schemes. If you want to learn more about why you should avoid such arrangements, read my previous article.
In unallocated storage, you may never receive the metal you think is yours for a number of reasons. First, the metal isn't yours. It belongs to the bank's general inventory of metals. If they don't give it to you, you'll have to sue them, and the result of that suit will be the receipt of fiat money damages. Second, the bank may miscalculate the demand for allocated conversion (a/k/a demand for physical delivery) and it may not be able to get enough bars on a timely basis to fulfill a request. Third, generally speaking, if the bank collapses you will be an unsecured creditor, with no right to collect any particular property or assert a security interest. If you get any money, which unsecured creditors rarely get, it will be the same payment as other unsecured creditors. Not a penny more.
The allegations in both the 2007 class action against Morgan Stanley and the 2011 class action against UBS are troubling. They indicate that contrary to popular belief, small investors ARE involved with London-style unallocated storage schemes. For one reason or another, many do not seem to understand what they are getting involved in. The key question is whether or not the failure to understand was "reasonable" under the totality of the circumstances. The information provided by the bank, at the time the agreement was entered into, will be a critical factor that decides the final outcome. The decision will be up to the trier of fact.
Wise precious metals investors should review their metals holdings. Make sure your bank issues a statement, setting forth the exact weight, manufacturer and bar number of your property. If they are not able to do this, you are involved in an unallocated storage scheme. You should vigorously protest being placed into such a scheme, and do whatever is necessary to get out, including demanding the full weight of all the physical metal you thought you were buying.
Unless there is an appropriate interest payment to the participants, unallocated storage may be legal, but it is unethical. Banks make a lot of money lending metals and issuing derivatives based upon them. They should be sharing that profit with the investors who have given them their money and gotten involved in such schemes. Failure to do so is shameful.
That being said, it is wrong to paint all big banks as "bad" with a broad brush. Morgan Stanley, UBS and J.P. Morgan Chase are huge institutions, with hundreds of thousands of employees. Most of them are honest and hard-working, and are unaware of this seedy part of banking. Most Morgan Stanley brokers, for example, who sold the unallocated silver storage contracts to their customers probably thought they were doing the best for their customers. We doubt the brokers understood much more about unallocated storage as the customers did, which is little to nothing.
Disclosure: I hold precious metals long positions.