Unanswered Questions About the Silver ETF

April 9, 2007 – Over the past few years I have carefully analyzed the gold exchange-traded fund (NYSE ticker symbol: GLD) and written extensively about it. My principal conclusion is that GLD is not a viable alternative to owning physical gold. My articles explaining this conclusion can be read at the following link: www.financialsense.com

I have not looked at the silver ETF (Amex ticker symbol: SLV) -until now. SLV’s 10-K became available last week, so I downloaded it from the following link and started reading. www.secinfo.com

I approached this task with an open mind. Frankly, I did not expect any important or interesting revelations to come from reading SLV’s 10-K because I did not expect SLV to have the same loose custodial controls that plague GLD. These make GLD unsuitable for anything but trading, just like a futures contract is a trading vehicle and not an alternative to owning physical metal.

However, my preconceived view of SLV began to change with the very first page of its 10-K. Now, after many hours of reading and studying all of SLV’s disclosure documents, it is clear to me that SLV too is not an alternative to owning physical metal. There is too much uncertainty about its allocated (physical silver) and unallocated (silver IOUs) accounts. But I also reached a more disturbing conclusion.

I came across a shocker, which I discuss below. I discovered it buried deeply within the documents that SLV’s managers have filed with the SEC. After reflecting upon everything I read, it seems to me that not only is SLV not an alternative to owning physical silver, but because of the shocker and what I consider to be numerous ruses in its disclosure documents, it appears that parts of SLV’s disclosure documents were purposefully crafted to mislead investors into thinking that SLV was backed by silver when in reality it is not.

This conclusion may seem extreme, but I believe it to be reasonable based on the publicly available information that I have read. I encourage everyone to read all of SLV’s documents filed with the SEC to see whether you agree with me. They are listed at the following link: www.secinfo.com

In order to share with you some of my thinking, I select below several key sentences from various SLV disclosure documents, provide my comments on those disclosures and also list some of the many questions that arise. For now, the questions remain unanswered, but when taken together they create enough uncertainty about the integrity of SLV that its shareholders should rethink their reasons for owning it.

The following quotes in italics are taken from SLV’s 10-K, but first, one piece of advice. When reading these quotes, please read what they actually say, and not what you think they say or are supposed to say. Because we are preconditioned to think that SLV is backed by silver, we may read more into these quotes than they warrant, or even worse, make presumptions about them that are not supported in fact. Bill Clinton provided the world a great service by awakening it to the dark art of legal double-talk, when he noted in his rationalization to the grand jury that he wasn’t lying about Monica Lewinsky because his statement “depends on what the meaning of the word ‘is’ is.” So read through the ruses carefully and thoughtfully to see what the disclosure documents are really telling us about SLV.

1) “…there may be situations where the trust will unexpectedly hold cash. For example, a claim may arise against a third party, which is settled in cash.”

Why would there be any cash settlements? SLV is supposed to be holding physical silver and only transacting in physical silver, not derivative contracts. Cash settlement implies that SLV is involved in derivatives that settle for cash in the future (i.e., not a spot market transaction) if SLV’s counterparty does not have the physical silver required to meet its obligations to deliver silver when the counterparty’s obligations come due.

2) “The iShares are intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver.”

Clearly, while SLV may be “similar to an investment in silver”, it is important from each shareholder’s perspective to note that it is not an investment in physical silver.

3) The following is a highlighted bullet: “Backed by silver held by the custodian on behalf of the trust.” The next sentence then reads: “The iShares are backed by the assets of the trust.”

These two comments are contradictory. Titles/bullets often have no legal bearing within an agreement, so the first comment is irrelevant, and seems to be placed as a highlighted bullet to purposely mislead the reader. Only the second sentence -which fails to mention “silver” -is relevant. So are SLV’s shares really backed by silver? Or in other words, what really is the composition of the assets backing the trust?

4) “The trustee’s arrangements with the custodian contemplate that at the end of each business day there can be in the trust account no more than 1100 ounces of silver in an unallocated form. Accordingly, the bulk of the trust’s silver holdings is represented by physical silver, identified on the custodian’s books in allocated and unallocated accounts.”

Contemplate? That’s a very low standard to meet. Why not say “require”? Is it because there can be more than 1100 ounces of unallocated silver?

This conclusion is supported by the very next sentence. It should be read by ignoring the word “accordingly” because this word makes it seem that the content of the second sentence logically follows the first when in fact is does not.

It says that the custodian is holding physical silver for SLV in both “allocated and unallocated accounts”, which of course is an oxymoron. Unallocated accounts are only silver IOUs, and not physical silver.

What’s more, why does it say that the “bulk” of the silver “is represented by physical silver”? In fact, it should say all of the silver except 1100 ounces. By saying “bulk” instead of “all but 1100 ounces” one can only presume that the choice of “bulk” was deliberate, which suggests to me that much of the silver is not held in physical form. Was there malicious intent behind this choice of words -indeed, behind both of the two sentences quoted above -to mislead casual readers?

5) “Redemptions may be suspended only (i) during any period in which regular trading on the AMEX is suspended or restricted or the exchange is closed (other than scheduled holiday or weekend closings), or (ii) during an emergency as a result of which delivery, disposal or evaluation of silver is not reasonably practicable.”

This clause is a big red flag. If there is an emergency, even the Authorized Participants that create and redeem the iShares baskets in exchange for delivering silver to the vault can’t get their hands on any silver, assuming of course that the silver once delivered has actually been retained in the vault. This provision makes it very convenient for the custodian to avoid any delivery default by it, since presumably the custodian can declare the emergency if it doesn’t have the physical silver to deliver.

6) “If the process of creation and redemption of Baskets of iShares encounters any unanticipated difficulties or is materially restricted due to any illiquidity in the market for physical silver…“

What is the definition of “unanticipated difficulties”? Does “illiquidity” mean that there is not sufficient silver held by the custodian for the ETF to meet its redemptions? I guess so because this clause goes on to say: “If this is the case, the liquidity of the iShares may decline and the price of the iShares may fluctuate independently of the price of silver and may fall…“, i.e., to a discount below the silver price because owning the shares is fundamentally different from owning physical shares.

7) “Neither the sponsor nor the trustee has experience with a trust the only assets of which are expected to be silver.”

Why say “expected to be silver”? Why doesn’t it say that SLV’s assets “are silver”?

The seven points above and the many more quotes that I placed into my notes but excluded for the sake of brevity made me wonder whether SLV really holds physical silver. The numerous ambiguities that I discovered in the 10-K created enough uncertainty about SLV’s silver to cause me to dig deeper, so I next went to the prospectus, which can be downloaded by clicking here.

The prospectus did not help clarify things. In fact, it added to the uncertainty about the integrity of the silver. What’s more, it really got me thinking about whether parts of it were intentionally written to confuse potential investors.

For example, in the glossary “Unallocated” custodial control of silver is defined, but allocated storage is not. Allocated is only mentioned within the definition of “Unallocated”, but allocated storage is not itself listed as a defined term, which is very odd for a fund that is supposed to own physical silver. Does this mean that the custodian is not restricted to any predetermined definition of “allocated”, so this term can mean whatever the custodian wants it to mean? Was the exclusion of allocated storage as a defined term within the prospectus intentional?

Here’s another curious fact from the prospectus. In its description of the operation of the London bullion market, the term allocated is used and defined as follows: “According to the LBMA, these accounts are opened when a customer requires metal to be physically segregated and needs a detailed list of weights and assays.”

Note that it says “according to the LBMA”, and not to the glossary, which as I already stated doesn’t define allocated storage. So a casual reader is led to believe that that the silver in SLV meets the common understanding of allocated storage (i.e., how the LBMA defines this term), but there is no basis for that view because allocated is not a defined term within the prospectus.

This curious treatment of “allocated” appears purposefully deceptive, and raised my curiosity further, particularly because the prospectus states: “The custodian and any of its subsidiaries and affiliates may from time to time purchase or sell iShares for their own account, as agent for their customers and for accounts over which they exercise investment discretion.” Another disclosure states that the trustee may do the exact same thing.

Clearly, the trust and custodian are not a neutral fiduciary. If they can buy and sell SLV, these disclosures presumably also mean that they can sell SLV short.

It was clear to me at this stage that I needed to focus on the Custodian Agreement, and it is this agreement that held the big surprise. The Custodian Agreement can be downloaded here: www.secinfo.com

This agreement is between by Bank of New York, the trustee, and JP Morgan Chase, the custodian. It describes Morgan Chase’s responsibility, which interestingly is not for storing SLV’s silver. Rather, it is “to open and maintain for you [i.e., SLV’s trustee] the Account…and to provide other services to you in connection with the Account.”

This statement of responsibility is significant. I have had the opportunity to read Morgan Chase’s agreement for allocated bullion accounts, which states its responsibility to be as follows: “JPMorgan Chase Bank has agreed to hold Bullion for the Trustees and to provide other services in connection with Bullion.” So clearly, the Custodian Agreement is fundamentally different from an allocated bullion storage agreement.

But as important as this distinction of Morgan Chase’s different responsibilities is, it is not the real shocker. It is the following provision of the Custodian Agreement: “2.7 Substitution of Silver: With your prior approval (in consultation with the Sponsor), we [i.e., Morgan Chase] may substitute other Bullion for Bullion held in the Allocated Account, provided that there is no change in the total number of troy ounces of Silver held in the Allocated Account.”

What is “other Bullion”? This agreement defines bullion as follows: “‘Bullion’ means any Silver held by us or any Sub-Custodian in the Allocated Account from time to time.” It does not define “other Bullion”, but the process of substituting silver is further recognized in Clause 2.5(a), which states: “For each Business Day, not later than 9:00 a.m., New York time on the following Business Day, we will transmit to you information showing the movement of Silver into and out of the Account, identifying separately each transaction and any substitution of Silver made under clause 2.7.”

What should one make of this “substitution of Silver” by the custodian? One possible interpretation is that only silver stored within Morgan Chase’s London vault is allocated, and “other Bullion” is unallocated silver stored with sub-custodians. This interpretation is supported by the following statement in 2.8: “Upon at least ten days’ prior notice, during our regular banking hours, any such officer or properly designated representative… will be entitled to examine on our premises the Silver held by us on our premises pursuant to this Agreement and our records regarding the Silver held hereunder at a Sub-Custodian… Unless we have received at least ten days’ prior notice and reasonable assurances (in the our sole discretion) that any costs and expenses incurred in connection therewith will be indemnified to us, we shall not be required to move to our premises any Silver held at a Sub-Custodian for purposes of making it available for inspection as provided herein.” In other words, Morgan Chase as Custodian does not have to prove that the silver in sub-custodians really exists.

This arrangement is alarming, particularly in view of the following definition: “‘Sub-Custodian’ means a sub-custodian, agent or depository (including an entity within our corporate group) appointed by us to perform any of our duties under this Agreement including the custody and safekeeping of Bullion.” So taking together these different points from the Custodian Agreement, it seems entirely possible that Morgan Chase London is lending SLV’s silver to another entity within the Morgan Chase corporate group.

Do you recall the name Mahonia from a few years ago? It was one of the special purpose entities (SPE) used by Enron to disguise its fraudulent accounting, and Mahonia was directly involved with Morgan Chase.

An article from www.thelawyer.com dated July 5, 2004 states that: “WestLB alleges that Mahonia, a Jersey special purpose vehicle…was simply a “creature” of JPMorgan Chase rather than an independent trading company body. WestLB claims that JPMorgan Chase used Mahonia to present a fictional impression that the transactions were commodity trades.” (www.thelawyer.com)

So the obvious question now is whether SLV’s disclosure documents have been deviously crafted “to present a fictional impression” to casual readers not experienced with precious metal vaulting and storing arrangements that SLV owns physical silver, while in reality it has been substituted with “other Bullion” by Morgan Chase? Even for those knowledgeable about precious metal storage and vaulting, how many SLV existing or potential shareholders are going to download and read the Custodian Agreement?

An article in CFO Magazine on July 25, 2002 is entitled: “Enron’s SPEs: Can Banks Have It Both Ways?” It goes on to say: “According to court records, JP Morgan Chase was apparently skilled at having its cake and eating it, too — that is, keeping special purpose entities independent, yet exercising control.”(www.cfo.com)

Is Morgan Chase again trying to have it “both ways” with SLV’s physical silver? Is this so-called “other Bullion” in reality an unallocated account of an unnamed sub-custodian buried somewhere within the Morgan Chase “corporate group”? More to the point, is there spurious or devious accounting of the physical silver that SLV supposedly holds?

It is unlikely that the following clause of the Custodian Agreement will boost your confidence in the integrity of the storage procedures used by Morgan Chase for SLV’s silver. “2.6 Reversal of entries: We [i.e., Morgan Chase] at all times reserve the right to reverse any provisional or erroneous entries to the Account with effect back-valued to the date upon which the final or correct entry (or no entry) should have been made.”

In my nearly four-decade long business career, I have never encountered a clause like this one, either in or out of a legal agreement. Reversing incorrect accounting entries that were inadvertently made in error is one thing, which does not need its own clause within a legal agreement to allow these reversals. But reversing “provisional” entries and declaring it at all times to be a “right” seems to me an open invitation to back-date one’s financial records whenever it may suit or perhaps even more ominously, to conceal. For example, what is to prevent the custodian from making a provisional entry showing that SLV’s physical silver has been loaned out and is no longer in the vault, and then reversing that entry if the auditors were to investigate the custodian’s books?

I could go on, but I think two points are clear. First, and most importantly, SLV is not an alternative to owning physical silver. So like GLD, view it to be a trading vehicle. Use SLV for speculation, just like you would use silver future contracts to speculate on the silver price.

Second, there are many unanswered questions, the most alarming of which is, why the apparent deception and trickery instead of straightforward language in SLV’s disclosure documents? Is it because of the concentrated short position in silver about which Ted Butler has written so clearly? His work can be read by clicking here.

Let’s imagine the following scenario. The concentrated shorts in silver have a problem. They are naked short, having commitments to deliver far more silver than they own. But they recognize that if they go into the market to buy the physical silver they need to honor their delivery commitments, the price of silver will soar, given the limited stocks of silver available, causing the naked shorts to incur a huge loss.

We have recently seen a day of reckoning in nickel and other base metals -which reportedly also have large naked short positions -as their prices have soared. So to postpone their own day of reckoning, assume in my imaginary scenario that the silver shorts came up with a scheme.

It requires the Authorized Participants of SLV to deliver physical silver to the custodian. Once the physical silver is in its control, the custodian substitutes it with “other Bullion” so that SLV’s physical silver can be used to help the shorts manage their overwhelmingly large short position, while at the same time investors in SLV mistakenly believe that this ETF is backed by physical silver. What’s more, the custodian can back-date and reverse their storage record in order to conceal the true status of SLV’s silver. This imaginary scenario is speculation at this point, but I am at a loss to otherwise explain what my analysis of SLV’s disclosure documentation has revealed.

None of the above should surprise readers familiar with the work published by the Gold Anti-Trust Action Committee, which is available for free at: www.gata.org Though GATA has focused principally on the manipulation of the gold price, it also stands to reason that silver -gold’s first cousin -is also manipulated by the same cabal that has been capping the gold price. After all, when one looks at all the metals, base and precious, it is only gold and silver that are still far from achieving a new record high.

Lastly, SLV shareholders may think that the SEC is looking out for their interests. After all, don’t the normal regulatory protections provided to investors by the SEC also apply to SLV?

That question is easy to answer. It’s in the prospectus. “The trust is not registered as an investment company for purposes of United States federal securities laws, and is not subject to regulation by the SEC as an investment company. Consequently, the owners of iShares do not have the regulatory protections provided to investors in investment companies. For example, the provisions of the Investment Company Act that limit transactions with affiliates, prohibit the suspension of redemptions (except under certain limited circumstances)…” do not apply to SLV.

If you own SLV or are planning to buy it, the guiding principal is caveat emptor.