Morgan Stanley's Failure To Segregate Client Assets Creates Default Risk

by: Avery Goodman

Under traditional concepts of allocated precious metals storage, the legal relationship between the warehouse facility and the owner is one of bailment. That means that the warehouse must segregate your property so that it is capable of being identified specifically as yours. It must be able to identify every exact coin, bar and/or piece of jewelry, and to do that it is customary to list the weight, manufacturer, bar number, fine purity and specified location inside the warehouse.

But, with precious metals prices soaring, everyone and his brother is trying to get onto the golden bandwagon. Brokerage houses, like Morgan Stanley (NYSE:MS) cannot resist the temptation of big profits, and sometimes they go too far in trying to profit by slicing off a piece of the lucrative precious metals pie, putting customers at great risk. The Morgan Stanley company has done this, boldly going where no honorable men would choose to go. It is now offering to sell you gold, silver and platinum bars, and to keep them "safe", but in a scheme in which they refuse to segregate client assets that they falsely label "allocated" ownership.

Customers who take them up on the offer are going to be cheated. They will not be purchasing metal in allocated storage. Instead, they will actually be purchasing an unsecured bond with repayment promised in the form of gold, silver or platinum. They will be investing money, not to purchase real metal, but, rather, to fund the operations of a fractional banking scheme involving precious metals.

Apparently, investors who are looking to buy precious metals, for the first time, are reading enough, beforehand, to know that they are supposed to be demanding that their holdings be placed in allocated rather tha unallocated storage. So, in its description of metal storage, Morgan Stanley offers customers something that it chooses to call "allocated" ownership. But, the company's version is actually not anything of the kind. It is a mere deception designed to lure well-read, cautious, but inexperienced precious metals buyers.

The Morgan Stanley offering is NOT allocated storage, as defined under any industry standard, practice, or relevant law. Yet, its website states the following:

Allocated ownership means that the physical precious metals (bars and coins) you order from Morgan Stanley Smith Barney's Precious Metals Trading Desk are purchased and stored on your behalf, but no specific metal bar or coin is specifically identified as belonging to you. Your precious metals will be stored together with precious metals that are owned by and stored for other customers. Storage costs are generally higher for allocated metal than for unallocated metal.

Unallocated ownership means that your investment is held in book-entry form in your Morgan Stanley Smith Barney account and is backed by physical metal stored in either the United States or London. Unallocated metal cannot be physically delivered. Storage costs are generally lower for unallocated metal than for allocated metal.

None of this is true, except the fact that precious metals buyers do pay more for allocated versus the unallocated form of storage. Investors are simply being tricked into becoming new sources of funding for company operations. The scheme appears designed to allow pledging of such metal as collateral for derivatives trades, and, if Morgan Stanley ever goes under, in all probability, all vault metals will go directly to derivatives counter-parties.

Customers who deposit money, thinking they are buying metal, are nothing more than unsecured creditors under the scheme. They hold an unsecured promise to repay in unspecified abstract metal, but have no claim on particular bars of gold, silver or platinum.

The World Gold Council defines allocated storage as follows:

An account in which the client's metal is individually identified as his, and physically segregated from all the other gold in the vault; in the event of a default by the holding bank, the investor becomes a secured creditor.

Unallocated storage is defined as:

An account in which the client's bars are not specifically ring-fenced, and which may be cheaper than an allocated account as some banks do not charge for storage. The client carries higher counterparty risk, however, as he is an unsecured creditor in the event of a default by the holding bank.

As with all non-allocated storage, Morgan Stanley's fake "allocated" scheme is simply another iteration of a gold backed bond, many of which were commonly issued prior to 1933. The difference is that gold bonds, issued in the pre-Roosevelt days, bore a rate of interest. But, like other companies involved in unallocated storage, Morgan Stanley offers no interest at all. Not one penny. Instead, it is bold enough to levy so-called "storage charges" on customers!

Non-allocated storage, no matter what it is called, facilitates widespread manipulation of the metals market, and puts customers at risk. Participants have no protection against counter-party risk. Bear Stearn, Lehman Brothers, and now MF Global have already collapsed. The other big investment banks are still operating with very high leverage and exposure to all sorts of hazards. Morgan Stanley, in particular, is said to be highly exposed to problems in the Euro zone.

When and if the Federal Reserve's policies are finally discredited, and many people are buying gold, silver and platinum exactly because they believe those policies WILL be discredited, it will lose control over the value of the dollar. Their ability to prop up banks like Morgan Stanley, and keep them running, in the face of big counter-party losses, will be lost. Such firms may fail, even though they are supposed to be "too big to fail". For more information on the dangers of unallocated storage, see the article found here.

There have already been a number of lawsuits against investment banks who have allegedly misled customers about precious metals storage. In March 2011, for example, UBS was sued for selling and charging "storage fees" for silver that was allegedly never purchased by the company. Before that, in 2007, Morgan Stanley paid $4.4 million to settle a class-action lawsuit which alleged that the company sold precious metals that it never purchased, and charged hefty fees for "storage" of what turned out to be essentially vault air. No doubt, for each instance in which a misdeed is sued upon, there are usually a hundred potential lawsuits lurking in the background that no one ever discovers.

Apparently, Morgan Stanley executives have learned a lesson, but it isn't the one that the legal system was designed to teach them, nor is it the lesson that most reasonable people would have expected. Instead of being scrupulous about buying real metal when it proposes to sell it to others, the company has chosen to continue the misbehavior it has been accused of, in the past. But, having learned something, it seeks to protect itself from more lawsuits by redefining the meaning of "allocated storage" into something that has no relation to what the term actually means.

People often put their trust in large institutions, and don't read every word of their investment contracts. I would hesitate to label Morgan Stanley a "bad" company, in the abstract. But, it appears to be relying on client innocence to increase the profitability of its precious metals operations, at great risk to its customers. The vast majority of people who work at Morgan Stanley are honorable people, but, with a multitude of departments, sub-divisions, managers and sub-managers, some parts of the company can be top notch, wheras others are engaging in questionable activities.

The much-maligned (NYSEARCA:GLD), (NYSEARCA:IAU) and (NYSEARCA:SLV), though poor quality vehicles for use in the purchase of gold, are better deals than what Morgan Stanley is offering. Other options include the Sprott Gold Trust (NYSEARCA:PHYS) which you can be sure contains real gold but sells for a hefty premium, as well as (NYSEARCA:SIVR) for silver and (NYSEARCA:PPLT) for platinum. Unless Morgan Stanley changes its terms to conform to a legally enforceable industry standard bailment, customers should insist on physical delivery, and take the resulting metal somewhere else.

When choosing a storage facility, make sure you are dealing with an ultra-reliable institution. Some will enter storage arrangements on a common law bailment basis. But, if you are presented with a written contract, read it very thoroughly. In order to claim ownership of your property, when and if the vault operator runs into financial difficulties, the arrangement must be a true bailment, as outlined in paragraph 1 of this article.

Disclosure: I am long SIVR.