Monex: The Fraud Case in Context

By Joshua Gibbons – About.Ag – for CoinWeek ….
 

I first started following Monex in late 2014, about a year after the U.S. Commodities Futures Trading Commission (CFTC) started their investigation. Their investigation, as you have likely heard, resulted in a lawsuit alleging “one of the largest precious metals fraud cases in the history of the Commission”. The CFTC believes that the leveraged accounts Monex offers are illegal, and that Monex deceived thousands of retail customers to the tune of over $290 million.

Who is Monex and What Do They Offer?

Monex is a group of several related companies that sell bullion to retail investors (generally high-net-worth individuals), doing roughly $4 billion of business annually and claiming to be the leading retail dealer of precious metals in the United States. Monex Deposit Company (MDC) is the company customers deal directly with to purchase bullion. Monex Credit Company (MCC) is the piece that loans money to customers behind the scenes. There are a few other related companies that customers do not interact with.

Monex was originally started by Louis Carabini in 1967 as Pacific Coast Coin Exchange, which by 1987 morphed into Monex Deposit Company when it started offering its Atlas program, which allows retail customers to buy metal with leverage. The majority share of the Monex companies are owned by Louis Carabini and his son Michael Carabini (directly or through trusts).

About 75%-85% of Monex’s business is comprised of standard retail physical sales (the CFTC refers to this as “fully paid”), where you pay money and get bullion delivered to you (or a depository). The CFTC has no problem with that. The remainder of their business is their Atlas Account, which involves leverage — something almost no other bullion dealers offer. That is what the CFTC believes is illegal.

With the Atlas Account, you might invest $25,000 to control $100,000 of metal. The financing is done behind the scenes. You send in your check for $25,000. If you do not use leverage, you might order 20 ounces of gold at $1,200/oz, spending $24,000 and having $1,000 of cash left in your account (shown on statements as a negative loan balance). But if you decided instead to order 80 ounces of gold, you could do so: you would get $96,000 worth of gold (delivered to a depository Monex has an agreement with), using up the $25,000 you sent in, and you would now have a loan balance of $71,000. If you later were to sell at exactly break-even, you would get $96,000. The first $71,000 of that would pay off the loan, leaving you with your $25,000 that you invested.

Gold Eggs

The loan is all done behind the scenes, once you have signed the loan agreement. You never ask for money, they never send you money, there is no set dollar credit limit. What happens is that they allow you to buy more metal than you have cash. When this happens, you now have a positive loan balance, and you owe money (even though there is no notification that this happens, other than lines on the monthly statement). So when you deposit $25,000, you start with a loan balance of -$25,000. You can then simply go ahead and buy that $96,000 of metal, in which case your loan balance goes up to $71,000, and you have borrowed $71,000. No new paperwork is required, no authorization beyond the acknowledging the trade is required.

With leverage, some things work a bit differently than you would be used to if you never used leverage. First, while Monex buys and transfers title of all the metal to you, it will sit in a depository where you cannot access it unless you pay off the balance of what you owe Monex. Monex can sell the metal at any time at their discretion (although it normally only sells the metal without notice if your equity level goes below 7% (in the above example, if gold went down about 22%, not factoring in expenses). Also, Monex uses the metal as collateral for its loan from banks. So in theory the banks Monex uses could cause your metal to be sold.

The other major difference between leverage and outright physical purchases is exactly what leverage is designed for: to multiply profits and losses. If all goes well, you make a tidy profit — much more than you would make without leverage. If the price of gold goes up 10%, you would make $9,600 (before expenses), which would earn you a 38% profit (again, before expenses). That’s a pretty good selling point.

The catch with leverage, however, is that it works both ways: if gold goes down 10%, you would lose $9,600, a 38% loss (again, before accounting for spreads, commissions, interest and fees). Next, if your equity (the value of your metal minus the loan) goes below 14%, you get a margin call: you have to send them more money to keep playing. And if your equity gets down to 7%, they automatically liquidate your position, giving you whatever is left after all the expenses have been paid.

Down GoldAnd one more thing: Monex allows short trading, which has an unlimited potential for loss. Fortunately, I have not heard of any Monex customers getting hit by the unlimited loss potential. With a traditional long position, the most you could lose (in theory) would be the entire value of the metal (although in reality you would almost certain lose no more than whatever you invested, due to their automatic liquidations when the account goes below 7% equity).

How Do Accounts Get Set Up?

The process almost always starts with a potential customer calling Monex. Often they are responding to an ad, although about 25% of Monex customers come through referrals. During the initial phone call, the potential customer is assigned a sales rep. The sales rep likely only gets paid commission (they only get paid a salary during a training period). If all goes well, the customer will open an account. The account agreement includes a “Loan, Security and Storage Agreement” where the customer essentially agrees to pay back any money they borrow.

Most customers only buy physical metal, either for delivery to them or to be stored. However, either at the beginning, or at some point later, about 15% use leverage. They should all be making the trading decisions themselves, and should all know that they are using leverage. However, despite the documents they signed and verbally acknowledged and verbally confirming trades, a number of customers have claimed that their sales rep made trading decisions for them, and that they were unaware that they were borrowing money.

CFTC Accusation #1: Monex is engaging in illegal, off-exchange retail commodity transactions

Commodity Futures Trading CommissionThis is the first of the two major CFTC allegations. The Dodd-Frank Act of 2010 added Section 2(c)(2)(D) to the Commodities Exchange Act, which covers Retail Commodity Transactions. This section of the law causes certain types of leveraged, margined, or financed transactions to be regulated by the CFTC. The CFTC says that the Dodd-Frank Act makes it “illegal to offer or enter into leveraged commodity transactions with retail customers, unless the transactions are conducted on a regulated derivatives exchange, among other requirements.” The CFTC believes that the Atlas program constitutes leveraged commodity transactions with retail customers.

Not all financed transactions qualify as retail commodity transactions. The main exception is that transactions are not covered by the Act if “actual delivery” occurs within 28 days. There is an important reason for the quotes there: the exact meaning of the term “actual delivery” is hotly debated. The idea behind the 28-day delivery exception seems to be that it is OK to finance physical metal purchases controlled by the purchaser: if a dealer wants to let you buy $100,000 of metal with $25,000 down, that’s fine, but only if they deliver all the metal to you within 28 days (which puts the risk on the dealer if you do not pay them back).

The CFTC issued an interpretation of what “actual delivery” means in December, 2011 (http://www.cftc.gov/PressRoom/PressReleases/pr6151-11), and a related and nearly identical interpretation in August, 2013 (http://www.cftc.gov/PressRoom/PressReleases/pr6673-13).

With Atlas accounts, like COMEX transactions, most investors never see their metal and end up closing their accounts by selling whatever metal they have remaining. Only about 6% of investors take delivery of the metal. By delivery here, I mean have the metal shipped to their house or other location of their choosing. When a customer makes a financed purchase, Monex will deliver all the metal (including the financed portion) to a compliant depository.

Once the depository gets confirmation from Monex that the metal belongs to the customer, the depository sends the customer a non-negotiable CTTN (Commodity Title Transfer Notice). A CTTN is also sent when the metal is sold or removed, to let the customer know that the depository is no longer holding the metal. A CTTN is also issued when a customer shorts metal. The purpose of the CTTN is simply to inform the customer that the metal is titled to them.

Monex believes that the CTTN is sufficient to meet the “actual delivery” exception. CFTC believes that the CTTN notices are a sham, that they are really just a trade confirmation.

Monex back as far as 2012 was convinced that their business model was not subject to the Dodd-Frank Act. In February, 2012 Monex submitted a comment to the CFTC that Congress was aware of Monex’s operations when they wrote the “actual delivery” section of Dodd-Frank (2(c)(2)(D)(ii)(III)(aa)), and that “Congress did not intend the legislation to prohibit or change the terms of Monex’s financed sales to customers or grant the Commission jurisdiction over those transactions.” The Monex comment did not discuss whether or not Monex complies with “actual delivery”; Monex was concerned about customers that would sell metal very quickly after purchasing it (before the metal was delivered to a depository).

From this lawsuit, the CFTC seems certain that the CFTC has jurisdiction and that these are illegal off-exchange retail commodity transactions. And from Monex’s 2012 comment, and their recent statement about the CFTC lawsuit, it is clear that Monex is certain that the 28-day actual delivery exception applies, and that the CFTC does not have jurisdiction.

Accusation #2: Monex is “defrauding customers on a massive scale”

Gold Investing Made Easy

The second allegation is that the CFTC claims that Monex is defrauding customers with Atlas transactions. The CFTC claims that between July 16, 2011 and March 31, 2017, approximately 90% of Atlas customers lost money, with realized losses totaling $290 million, while Monex over-represents the likelihood of profit, underrepresents the risk of loss, touts the benefits and safety of its program while structuring it so that losses are all but inevitable.

To help with their case of fraud, the CFTC included declarations from 10 different Monex customers. Common themes included: customers signing the agreement without realizing that they might be borrowing money, sales reps allegedly making trading decisions for customers, and customers not realizing that they had borrowed money (typically in conjunction with a sales rep making a trading decision).

Monex does have all financed customers sign a loan agreement. The customers are also required to verbally acknowledge a disclosure that is recorded, and verbally acknowledge each trade.

The Size of the Problem

The CFTC says this is “one of the largest precious metals fraud cases in the history of the Commission” and came up with the number $290 million, the amount Atlas customers lost. That certainly sounds like a massive fraud.

However, without context, that number is meaningless. It refers to a net loss, meaning that if all the money all customers invested were in a single account, it would have lost that much money. So we know a large loss occurred, but we are missing some things, mainly: [1] how much total was invested, and [2] how the market fared during that time. Otherwise, this could be a small loss (e.g. if $10 billion were invested, $290 million would be about a 3% loss), or just due to market conditions (e.g. when the price of silver plummeted in 2011).

The CFTC did not, from what I can see, divulge the total amount of money invested. I can estimate the total volume of trades during that time, but that is significantly more than the amount invested (since the average customer has multiple trades). I can even estimate the average equity, but that acts more like the value of the investment at some point after the investment was made, not how much was initially invested. So I cannot put the $290 million loss in the proper perspective.

That said, there are some other numbers that can help provide a better picture. The total volume of trades during the time period the CFTC covers (July 16, 2011 through March 31, 2017) was about $3.5 billion, or about $600 million per year. The data show that the total of all loans at any given time during that period was about $170 million.

When factoring in unrealized losses (losses on metals positions customers have not yet sold), the largest loss for any account was $11 million, and the largest profit for any account was $310,000. So the largest loss was 35 times the largest gain. The average loss (for accounts that lost money) was $32,000; the average gain (for accounts that had a profit) was $4,100. So the average unprofitable account had a loss of more than seven times the gain of a profitable account.

Gold BullionAccording to a presentation in 2014, there were 4,213 loan accounts at that time with a total of $164 million financed, an average of about $39,000 borrowed per account.

During the 2011-2017 timeframe, the CFTC says that Monex earned $95 million in the bid-ask spread, took in $57 million in interest payments, received $14 million in commissions, and over $6 million in service fees. That adds up to $173 million that Monex brought in, accounting for about 59% of the $290 million customers lost.

Customer Stories

The CFTC also includes declarations from 10 Monex customers, explaining what happened and how they lost money. To be fair, the CFTC likely chose these specific customers because their experiences fit the picture that the CFTC wants to portray. The CFTC obviously would not include a declaration from a customer who was pleased with their experience with Monex.

The experience I chose to look at closely was one that included transcripts of portions of two phone calls between the customer and a Monex sales representative. The customer opened an account in 2010, and within a few months invested nearly $300,000 (and later put in more money). She was told early on that she needed to sign a contract in order to continue trading, which she alleges she was told was just a “formality”.

All seemed to go well until she got a new account rep, who after about a year convinced her to make some new trades (he was one of Monex’s top-earning sales reps). Before he started making trades, she claims that she agreed (around March 2015) to let him do the trades “only if he guaranteed me that he would not lose my retirement money by doing so because I would need to start using that money in 2016.” The customer alleges that the rep never said she would be borrowing money to make these trades. The customer alleges that he made all the trading decisions, although she would agree to them when the trading desk asked for confirmation.

It is hard to imagine that any investment advisor would allow someone to make any type of risky investment with a significant portion of their savings a year before needing the money for retirement.

In February, 2016, the customer saw “TOTAL OWNED COMMODITY: $651,636” and says that she thought she had that much in her account. She included a transcript of a recorded call where the sales rep explained to her that she really only had about $190,000, and when the reality starts to hit her, she says “Oh, my God.”

She also alleges that her account rep made short trades on her account before recording her acknowledgement of a disclosure, against company policy, and tried hard to get her to record it after the fact, even though he knew she did not understand how shorts worked, and was unable to get her to understand.

I am a Monex Customer; is my account safe?

I do not see anything in the CFTC allegations that suggests any wrongdoing that would jeopardize existing account positions. This is very different than the Bullion Direct and NWT Mint fiascos, where those companies were in terrible financial shape and “poached” stored metal to stay afloat. Monex appears to be in excellent financial shape, and an audit of metal was done in early 2016 that satisfied Farmers & Merchants Bank, who had loaned Monex money using some of the customer metal as collateral.

That said, if you have any leveraged positions, by their very nature they are fairly risky — unlike physical metal, their value can (and does) go to zero. If you like the idea of investing in physical metal, but want to minimize your risk, stick with physical metal with no financing. Leverage should normally only be used either with just a small portion of your investable money, or if you are willing to accept high risk.
 

1 COMMENT

  1. MY THEORY: When the price of gold goes down, MONEX issues a margin-call in order to insure that additional funds are deposited by the investor/customer. All the while MONEX hedges their bets by taking up short positions on the Commodities Exchange in order to ensure company profits regardless of market performance. The kicker is, in my opinion, when the value of gold goes up, MONEX convinces their clients to simply take a bigger position and increase their exposer to the market, rather than increasing their equity (actual physical gold). In other words, if I initially invest $10,000-a $40,000 position-and gold goes up 10% (a $4,000 profit), they’ll encourage me to increase my position to $44,000 rather than increasing my equity to $14,000. This way, they’d never have to settle any accounts! Its clear to me that they had a clear game plan to encourage high risk, highly leveraged investment strategies in order to make profits regardless of the well being of their customers. However, we really have to keep an open mind; we’ve only heard one side of the story!

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