At times of uncertainty attention traditionally turns to gold and other precious metals. Since the outbreak of the COVID-19 pandemic, the gold price has reached new highs. 

A recent case which illustrates this involved a UK Court of Appeal decision relating to gold owned by the Government of Venezuela [FN1]. In the midst of the economic problems exacerbated by the pandemic, Venezuela turned to the US$1 billion or so of gold it had stored at the Bank of England. However, when it gave instructions for the gold to be released, a legal dispute ensued over who the UK recognised as the President of Venezuela and who therefore had the authority to give instructions for the release of the gold. 

In this context of the increased interest in precious metals, and having seen examples of misinterpretation of some of the key terminology used in precious metals transactions, this Client Alert explores the principal features of loans, leases and repos involving precious metals, together with the associated legal and credit risk implications. 

Common Features, Differences and Terminology

Loans, leases, and repos involving precious metals have some common features but serve different commercial purposes. There are also important structural and transactional differences which have an impact on the related legal and credit risks.  

Some confusion can arise in the terminology, particularly in the context of loans and leases, where these expressions are sometimes used interchangeably.  Outside the precious metal market, loans are used in the context of currencies and securities, whilst leases generally refer to other asset classes. This discrepancy in the market has arisen due to some precious metals (especially gold) having characteristics of both a commodity and a currency.  

We also set out below the meanings of some other relevant terminology:  Precious Metals: Broadly, precious metals include gold, silver, platinum and palladium. However, lesser known metals which fall under this heading include ruthenium, rhodium, osmium, iridium, germanium, beryllium, indium, gallium and tellurium.  Bullion: Bullion is only gold and silver that is officially recognised as being at least 99.5% pure and is in the form of bars or ingots. The word “bullion” comes from the French word bouillon, which meant “boiling”, and was the term for the activity of melting metal to create the ingots or bars from the raw material. Loco: Loco (short for location) means a specific place, where physical precious metals are delivered. Allocated: Allocated bullion is physically segregated, identifiable bars or ingots of metal “allocated” to a customer. Dealers will usually hold it on their customers’ behalf under a custodial contract. Unallocated: Unallocated bullion, much like money in a bank account, is a right to receive bullion from the dealer which holds the account. The specific bullion that the holder of an unallocated account may own is not physically identifiable but is recorded by a book entry.

Basic Elements of a Precious Metal Loan

A precious metal loan transaction involves the lending and borrowing of precious metals. This type of transaction is similar in nature to a currency or a stock loan.

One party borrows an agreed quantity of precious metal and makes periodic rate payments over the term of the transaction. The other party lends precious metal and receives rate payments.  

Upon delivery of the precious metal to the borrower at the start of the transaction, legal title passes from the lender to the borrower.

On maturity, the borrower is then obliged to deliver precious metal of the same type, quantity and quality to the lender. The delivery of equivalent precious metal is possible because of the fungible nature of (most) commodities. The borrower may, depending on what has been agreed with the lender also have the option to settle its delivery obligation in cash by reference to the spot price at maturity.

Basic Elements of a Precious Metal Lease

A precious metal lease transaction has some similarities with a loan, and as mentioned above the expressions “lease” and loan” are sometimes used interchangeably. Whatever commercial nomenclature is used under the transaction, the detailed contractual provisions will determine the nature and extent of the parties’ respective legal rights and obligations.

Most precious metal lease transactions involve the use of unallocated accounts.  Deposits (or credits) of the metal, as well as withdrawals (or debits), may be made in and from the account by book entry. A client (or lessee) may take an unallocated lease of precious metal, credited to it by book entry, usually in return for a lease rate. It is important to note that the client does not acquire any legal rights to specific metal – there is no transfer of title to the client of any metal.  Instead, the client merely has a contractual claim to the general stock of metal held by the dealer (or lessor).  

Precious metal leases and loans may be used, for example, by manufacturers including where precious metals are used as a catalyst in industrial processes, or by miners or jewellers who are exposed to the price of such metals. 

Basic Elements of a Precious Metal Repo

A precious metal repo transaction has some similarities with a loan, but there are important differences.  The commercial purpose of a repo is usually to monetise metal that a commercial party has in storage or holds during transit. 

Under a repo, one party agrees to deliver precious metal (of an agreed type, quantity and quality) at the start of the transaction in return for a commitment from the other party to deliver equivalent metal on maturity.  

Typically, the transaction has two inter-related legs, an initial sale and a subsequent repurchase on maturity.  At the start of the transaction, title to the precious metal is transferred in return for a cash price.  There are no periodic interest rate payments. Upon maturity, title is transferred back to the original repo seller again in return for payment of a cash price.  The difference between the sale price and the (higher) repurchase price constitutes the profit margin.

Legal & Credit Implications

Loan: The implications under English law of a precious metal loan transaction are as follows.  Legal title to the metal is held by the borrower throughout the term of the transaction.  In the absence of collateral support, the lender has exposure to the borrower for the periodic rate payments and for the delivery of the metal on maturity. 

Lease: For a precious metal lease transaction, the legal and credit position is the reverse.  Legal title to the unallocated metal remains vested with the dealer (or lessor). The dealer (or lessor) has exposure to the client (or lessee) for the lease rate.  The client (or lessee) has exposure to the dealer and has only a contractual claim to the general stock of metal held by the dealer. 

Repo: For a precious metal repo, title to the metal passes to one party at the start of the transaction and the other receives cash in return. If the repo buyer defaults on the second leg of the transaction the repo seller will be entitled to sell the metal elsewhere to recover its loss. The associated credit risk is therefore limited to any changes in the value of the metal over the life of the transaction. Any exposure that arises can be addressed by a separate obligation to provide additional collateral. 

In addition to the issues highlighted above, there will be other practical questions to consider in any precious metal transaction, including the following: 

• Accounting treatment: How are loan, lease and repo transactions are treated for each of the parties?
• Storage: In respect of allocated transactions, what terms are in place for the storage of the precious metal and is the repo seller or the borrower of precious metals able to benefit from those terms? Is due diligence necessary in relation to such storage?
• Local Law due diligence: For example, how is title to the precious metals held and transferred in the jurisdiction where the precious metals are located?
• Delivery: How is delivery of the metal to be effected and what evidence of delivery is required?
• Risk and insurance: In an allocated transaction, does risk in the metal transfer (and, if so, when) and which party is responsible for obtaining insurance? 
• Re-characterisation: For example, is there a risk that a repo transaction could be re-characterised as a loan instead of a sale and separate repurchase?

Footnotes:

FN1 – Maduro Board v Guaidó Board [2020] EWCA Civ 1249

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The information contained in this Client Alert is intended to be a general guide only and not to be comprehensive, nor to provide legal advice. You should not rely on the information contained in this Client Alert as if it were legal or other professional advice.