Why CME Waited 5 Years To Apply A Disclaimer To The Comex Report

The information in this report is taken from sources believed to be reliable; however, the Commodity Exchange, Inc. disclaims all liability whatsoever with regard to its accuracy or completeness. This report is produced for information purposes only. - CME legal disclaimer placed on the Comex daily gold and silver warehouse stock reports

I wanted to elaborate on Friday's post to make it crystal clear to everyone WHY the CME suddenly slapped that disclaimer on the Comex gold/silver warehouse inventory reports. It seemed to me that the CME might be liable for legal claims - when the Comex ultimately defaults - which seek damages based on the argument that the Plaintiff relied on the CME reports in making a decision to invest in a gold/silver futures contract prior to the date that the disclaimer first appeared.

What I'm really trying to ferret out here is exactly why the CME waited five years after acquiring the Comex before applying the disclaimer to the inventory report. My assessment is that, per my article Friday, given the extreme decline in gold inventory on the Comex the beginning of the year, the CME - by invoking the disclaimer - is worried about the reliability of the gold/silver inventory reports. Recall that the reports are generated based on paper reports submitted by banks who operate the Comex vaults. In other words, the CME is relying on the reliability of these reports without actually verifying that the content of the reports is based on a provable fact - i.e. that the inventory reported by the banks exists as reported without doing an independent physical audit to verify that the reports are legally valid.

As it turns out, based on Federal Rules of Civil Procedure (FRCP), even though the CME waited 5 years before invoking and applying the disclaimer on the inventory reports, the CME has for all intents and purposes legally insulated itself for any legal claims that may arise from publishing the inventory when the Comex defaults and has shifted the burden to the individual vault operators who submit the data that the reports are based on. I called on a friend and colleague who is one of the sharpest attorneys I have ever met to give his assessment of the timing of the CME's application of the inventory report disclaimer:

The disclaimer language at issue appears to be tailored specifically not only to forestall ALL fraud cases based on that element, but to do so at the pleading stage of the case, i.e., BEFORE THERE IS ANY DISCOVERY OF THE DEFENDANT'S DOCUMENTS AND INFORMATION, by way of a dismissal under [Federal Civil Rules of Procedure] 12(b)(6) or the State court equivalent.

One of the trickier elements in a civil fraud case (criminal is slightly different on this point) is proving that you reasonably relied on the misrepresentation at issue, meaning you did in fact rely on it, and that your reliance was reasonable (an objective standard to winnow out idiotic plaintiffs). The intent behind the disclaimer is to provide a legal override of such facts, like a trump card.

Federal Civil Rules of Procedure 12(b)(6) allows a defendant to ask a judge to dismiss the lawsuit before any real litigation takes place based on a "failure to state a claim even accepting all facts stated in plaintiff's complaint as true." In order to compel a judge to deny the Defendant's motion to dismiss under this Rule, the Plaintiff must show that it's possible for him to prove a set of facts in court that shows he is legally entitled to the "relief " (damages from investing in this situation) requested in the legal claim because he bought Comex futures in reliance on the truthfulness of the CME Comex inventory reports at the time he made the investment. As my friend states: "the intent behind the disclaimer is to provide a legal override of such facts, like a trump card" - which leads to the Defendant's argument that the Plaintiff failed to state a claim. As applied to the CME situation, the Plaintiff will fail in its pursuit in damages against the CME.

Think about what FRCP 12(b)(6) requires if someone were to go after the CME because they bought a gold futures contract in May 2013 - before the disclaimer was slapped on the Comex gold inventory report - expecting to stand for delivery of the gold at contract expiry. The Comex defaults. The Plaintiff (person who bought the contract) files a claim against the CME for fraudulent misrepresentation because the Plaintiff relied on the Comex gold inventory report published by the CME in making his decision to get long the contract on the basis that the Comex had enough gold to make on the delivery of the gold.

You see the problem here in satisfying the requirement under FRCP (or State-equivalent) 12(b)(6)? The Plaintiff has to produce evidence showing several things, including some kind of proof that shows beyond reasonable doubt that his decision (the "claim") was made specifically with reliance on the CME/Comex report before the disclaimer was slapped on it. In order to satisfy that a bona fide claim has been stated under the Rules of Evidence requirement, it would minimally have to be something like a dated journal entry with a date-stamp on it and a witness affidavit that testifies that the witness watched the plaintiff make the journal entry on the date as shown. Even that would be questionable. The only thing I can think of that would satisfy this would be to write yourself a memo and mail it to yourself in order to get a postal stamp on the envelope and leave the envelope sealed. Anyone ever go to this length before executing a trade?

It is clear to me, and to my friend who is an attorney, that the CME's lawyers determined it was necessary at this point in time to invoke the disclaimer because the risk of fraud is clear and present with regard to the reports being submitted by JP Morgan (JPM), HSBC Holdings Plc, (HSBC) and Bank of Nova Scotia (The), (BNS) in relation to the extreme and unprecedented rate of decline in the reported Comex gold and silver inventory. And this particular disclaimer gives the CME a shield of legal protection that extends all the way back to its date of acquisition.

The bottom line here is that it is highly probable that the real inventory that is sitting in the gold and silver vaults of JP Morgan, HSBC and Scotia is quite a bit less than the inventory being reported in the daily stock reports. This conclusion, of course, is consistent with the type of fraudulent behavior for which these banks have already been successfully prosecuted and/or forced to settle. What it implies is that the Comex may indeed be closer to default than any of us can possibly understand. In this context, and notwithstanding Ted Butler's dismissal of this matter, it is clear that CME is concerned enough about this possibility and was compelled to invoke a powerful legal shield from liability in order to evade the potential legal liability to which its member banks will be exposed. It is also clear that business entities that rely on the Comex as a source of safekeeping and of deliverable physical gold are taking an increasingly large amount risk in relying on the Comex for this purpose.