The Promise and Perils of Gold Clauses
Protect yourself from dollar depreciation by using this new freedom…prudently.
Now that Americans have regained recognition of their right to make contracts specifying payments in terms of gold—and incidentally, in terms of foreign currencies—how can they exercise it? Those who expect a sudden flood of sure-fire, can't-lose gold-clause insurance policies, securities, and the like are apt to be disappointed. Those things may come in time, but it seems likely such institutional offerings will await development of gold-clause experience with smaller, private contracts.
While there are kinks to be worked out and legal refinements to be made, individuals can begin to take advantage of the inflation protection that gold-clause freedom can provide—so long as they act prudently. So, let's examine some of the potential pitfalls and see how to skirt them successfully.
BACK TO GOLD?
The gold-clause legislation, which became effective the minute President Carter signed it on October 28, 1977, was greeted with a mixture of hope, doubt, fear—and some misinformation. Major publications like the New York Times and the Washington Post heralded the law as an effective reestablishment of the gold standard. Sen. Barry Goldwater, addressing the New Orleans "Gold, Monetary, and Economic Conference" in November, commended it as a "means for establishing a private gold standard." The US Treasury, on the other hand, in giving its endorsement, obviously felt it was merely contributing further to the "demonetization" of gold (and reducing it to the status of "just any commodity").
At least one gold-clause contract, involving a ship lease, went into effect immediately. According to the New York Times, it called for dollar payments to increase (or decrease) by the same percentage as the London gold price when the lease comes up for renewal in three years. (Other possible formulas will be reviewed below). A condominium owner was reportedly tying payments on his units to the gold price. Utility companies were openly talking about issuing gold-backed bonds in order to get lower interest rates. On the international scene, where gold-clause contracts have never really been illegal, there was speculation that the Arabs might now index oil prices to the gold market. And there were a number of actual inquiries about the law from various Japanese companies.
Meanwhile, there were others who raised legal questions about the tax treatment of gold-clause contracts and about various government regulations that could affect them adversely. New York Law School Dean Donald Shapiro discoursed at length in New Orleans on the proper writing of these novel contracts. His and others' recommendations will be examined later.
Even the bill's sponsor, Sen. Jesse Helms, had his concerns, vowing to the New Orleans gold bugs to "take every step I possibly can to prevent regulatory repeal of this legislation." After the conference he sent letters to then Federal Reserve Chairman Arthur Burns, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and others to determine whether they planned any regulations governing such contracts.
Thus far, only the SEC has responded to Senator Helms, saying it "plans no regulations affecting gold clause instruments" but has "adopted a wait-and-see policy," according to Helms Legislative Assistant Howard Segermark. "If someone contacts them with a proposal to issue a gold clause security [the SEC] will review it and see if it conforms with basic standards," said Segermark.
While investors await the issuance of new gold-clause securities, some brokers have rushed to hawk gold-clause bonds of pre-1933 vintage as prime speculations. One such broker, Robert Ellison of Bache Inc., in Seattle, was cited in the November 30 issue of Inflation Survival Letter. In a mailing to investors, Ellison states, "the new law is neutral regarding the enforceability of these obligations" and goes on to call these old railroad and utility bonds—issued prior to the gold-ownership prohibition—"an ideal speculation" (emphasis added).
ENSURING PAYMENT
Unfortunately for would-be purchasers, however, the law specifically states that gold-clause enforceability applies only "to obligations issued on or after the date of enactment of this section"—not exactly "neutral" phrasing. In fairness to Ellison, he conceded in a recent interview that he is aware of this provision but said he is "very hopeful" that ongoing litigation to require gold payment on these bonds will be successful on constitutional grounds. "I'm certain it's going to be appealed all the way to the Supreme Court," he stated, adding, "There is that outside chance that the Supreme Court will see the light."
And anyway, Ellison asserted, even if suits seeking gold payment are overruled, the purchasers of these bonds will not have lost, because they bear "no significant premium when compared to other bonds of similar rating and maturity." If one is really determined to buy antique corporate bonds, which may or may not be a good investment, Ellison's point that it can't hurt to buy one with a contested gold clause seems ostensibly sound. But realistically, the chances of these bonds ever paying off in windfall gold profits are extremely remote. Asked if there was a chance the old obligations would be enforced, Segermark asserted, "Not at all."
Ellison did make one good point, however, in which he is not alone. That is that, so long as the abrogation of pre-1933 contracts goes unvindicated, many people will be reluctant to enter into new ones for fear the precedent will be repeated. It might be observed that the circumstances were different in the 1930's, when the Supreme Court narrowly killed gold clauses. (The United States was still on the gold standard, and the government had a more plausible reason for intervening to "regulate the value" of money.) But doubts will remain. In the event of hyperinflation and a skyrocketing gold price, who's to say the government wouldn't once again side with debtors and suspend their obligations to pay in gold or gold-valued dollars? As First National Bank of Chicago's Eugene A. Birnbaum put it in a letter to Senator Helms, "Questions would probably arise regarding the credibility of its enforcement in the event of a similar circumstance occurring in the future."
A related question—however the courts rule—concerns the ability of a debtor to pay if gold goes through the roof. A gold clause won't do a lender much good if the borrower simply declares bankruptcy. This issue is dealt with by Howard Ruff in the December 1, 1977, Ruff Times. Ruff urges that a loan contract require the borrower to hedge his obligation in the futures market, so that if gold rises to unexpected levels, the profits on his futures contract will allow him to pay it. Of course, this assumes the prospective borrower is willing to enter into such an unorthodox loan contract. But if he's unwilling, he might better be avoided.
Ruff is adamant as he explains how the hedge would work: "The contract must require that he buy gold futures contracts, at the commencement of the agreement, equal to at least the number of ounces of gold stated in your loan agreement—in this agreement one 100 ounce contract, and he must maintain that futures position for the length of the loan agreement. If the price of gold rises, his contractual obligation to you increases, but he has a corresponding profit from his 'hedge' position in the futures market, so he breaks even. If the price of gold goes below $160 an ounce, he immediately sells out his position (using a stop loss order). He's not speculating, because his profits are equaled by his obligation to you. By insisting on this, you have protected his ability to repay you." (Ruff suggests the contract specify that the lender get monthly statements from the borrower's broker to insure that he is not speculating.)
Ruff notes that the hedge is no substitute for good collateral and ability to pay. Naturally, there will be commissions for the hedging borrower to pay, and it may be necessary for the lender to take these into consideration in fixing the interest rate.
Ruff offers to solve another problem: how borrowers and lenders interested in using gold clauses can get together. He offered to serve as an intermediary between those of his subscribers who are willing to enter into gold-clause transactions.
AIR-TIGHT CONTRACTS
What are the other ingredients of a well-drafted gold-clause contract? First of all, as Shapiro and other legal minds have recommended, the "points of reference" should be clearly stated. In other words, no matter which of the possible indexation formulas are used, you should specify the starting and ending points that will determine the amount of payment. Thus, if payment is to reflect a percentage change in the market price of gold from the time the contract is made to the time payment falls due, the contract should state the time and date of a specific gold market.
Shapiro recommended that the starting date be placed at least a week prior to the actual contract-signing date. So, if you were signing a lease or loan agreement, for instance, on July 9, 1978, the contract might take as its "reference point" the London afternoon gold fixing on June 30, and so specify in the contract. Likewise, future payment should be made contingent on the market price in a specified gold market at a specified date and time one or two or three years hence—whatever the term of the contract happens to be. An alternative method, if you're worried about unfavorable market fluctuations, is to base payment on an average price from the month preceding the payment date.
Further, the type of payment should also be specified—whether it be bullion or coins or dollars measured by them. If bullion is used, specify the fineness. Shapiro counseled against using numismatic coins because of the difficulty of separating intrinsic value and rarity value. He suggested specifying a certain type of bullion coin (for example, Krugerrands, Austrian 100-koronas, Mexican 50-pesos).
Another caveat is to be aware of the usury laws in your state and in the state of the other contracting party. Usury laws, which impose an interest rate ceiling, generally do not protect corporations, but if you are dealing with a private individual, as in a personal loan, you must take proper precautions. In their August 1974 article in the Americal Bar Association Journal, Rene A. Wormser and Donald L. Kemmerer suggest a corporation could even be "created for the purpose," and a "personal endorsement of the loan by an individual concerned could be demanded to guarantee payment." But if that is not possible or worthwhile, the problem can still be obviated in most cases by simply leaving interest payments out of the gold-clause arrangement.
If only the principal, and not the interest, were specified payable in gold or in dollars measured by gold, "I don't think that would be usurious," Shapiro stated. Wormser and Kemmerer elaborate further in their 1974 tract: If it were one of long-term capital gain, any accretion in dollar value should be treated merely as an addition to capital gain. If there is an interest factor, however, then the possibility of a defense of usury may be present. If a legal interest rate were always applied to the value of the initial obligation, usury could not result. If, however, the interest rate were to be applied to a figure resulting from an upward adjustment through a gold clause, the debtor might claim that the result was usurious." (emphasis added)
Even if the gold clause were applied to the interest as well as to the principal, Wormser and Kemmerer held that the contract "ought" to be upheld. The key question, they say, is one of "usurious intent." And since "the contract does not assure a usurious interest rate, inasmuch as the contract may operate, if the price of gold declined, to produce less than the initially stipulated interest rate," the lawyer-economist team contended no "usurious intent" could be inferred—except in cases where "the effective rate of interest could not be less but might be more than the initially stipulated rate." They went on to suggest that "declaratory judgments" on the issue could be sought from state courts. To be on the safe side, Shapiro's advice that interest not be made adjustable to the gold price seems like the best bet.
TAX PITFALLS
In choosing the type of contract one wishes to enter into, a major consideration is tax treatment. The question of whether dollar gains resulting from gold clauses are to be taxed at ordinary income rates or at capital gains rates has not yet been decided. Different observers have varying views on what the most likely treatment will be.
By all rights, gains should not be taxed at all, since the purported purpose of the gold clause is not to make actual gains but to hold constant the value of one's capital invested in the contract. But the IRS is no more likely to adhere to this principle in the case of gold clauses than it does in the case of consumer price index or any other type of escalator clauses—unless one specifies payment in kind, that is, in actual gold (or foreign currency), not in gold-indexed dollars. If one lends gold, assuming one can find an interested borrower, and receives gold in repayment, Shapiro stated, "I think you can get away without any gain." The only tax resulting from such a gold-in—gold-out (or Swiss franc-in—Swiss franc-out) contract, certainly, would be on any interest charged on the value of the gold loan. (It does seem likely, however, that capital gains would be charged in the event that the lender sold the gold he received in repayment.)
This type of deal, therefore, is attractive from a tax standpoint but is probably unrealistic for the great majority of potential gold-clause contracts, at least at the present time. For until gold becomes more widely recognized and accepted as a monetary medium in this country, it will be difficult enough to find a party willing to enter any kind of gold-clause agreement—unless one is in a strong enough bargaining position to demand it—much less one specifying actual bullion or coin transactions.
It then becomes a question of getting the lowest possible tax rate—capital gains, assuming that Congress does not eliminate the present favorable treatment altogether, as threatened. "If you phrase your contract properly you should get capital gains," Shapiro maintained. He wasn't terribly specific on the point, but until the IRS rules otherwise, there is no reason why a taxpayer should report anything but capital gains on such a transaction. Wormser and Kemmerer recommend it is "advisable to attempt to secure rulings from the Internal Revenue Service." The writers' own opinion was that "it would seem worthwhile to use a gold clause, despite the tax risk. If an alleged, although false, 'profit' were taxed as a long-term capital gain, a substantial net protection against inflation would still remain. If the false 'profit' were taxed as ordinary income, there would even then be a small net benefit from the use of a gold clause."
Interest would certainly be taxed at ordinary rates, say Wormser and Kemmerer, who add that the IRS might even contend that "any accretion in dollar value would constitute the equivalent of ordinary interest and be taxable as such." That type of argument "should be rejected by the courts," they write. But the higher tax rate could still be imposed, they continue: "The nature of the tax would depend on the nature of the underlying transaction. If it were one normally taxed as a long-term capital gain, any dollar accretion should be taxed, if at all, as an additional long-term capital gain. On the other hand, if the transaction were one normally taxed as a short-term capital gain or as an ordinary income transaction, the accretion could be taxed, if at all, as ordinary income."
A less sanguine view on the tax issue was taken by a New York law firm that sent a memorandum on the subject to Senator Helms. Looking at the question in the light of both a "currency revaluation" and as a "commodities contract," this particular legal opinion concluded on the basis of case law: "The likely result under the present Internal Revenue Code would be to look upon gains…as ordinary [rather than capital] gains, taxable at the rate that the individual is then presently at." Cases cited were Bates v. United States, 103 F. 2d 407 (7th Cir. 1939) cert. denied, 309 U.S. 666 (1940); and Corn Products Refining Co. v. Commissioner of Internal Revenue, 350 U.S. 461 (1955).
NEGOTIABILITY
There is yet another ticklish area of which would-be gold-clause users should be aware. The Uniform Commercial Code maintains a restrictive definition of "negotiable instruments": writings signed by the maker or drawer containing an unconditional promise or order to pay a sum certain of money to the bearer on demand or to order. The key words are "a sum certain." Obviously, a gold-indexed (or currency-indexed) payment cannot be a "certain" amount, although a fixed amount of actual gold could. For that reason, the law firm quoted above also expressed the opinion that "the use of a gold clause in an otherwise negotiable instrument…[requiring payment] in money based on gold equivalent…would be rendered non-negotiable under the Uniform Commercial Code."
This is a pretty dim view, but it is not insurmountable. After all, gold clauses were successfully used for years before 1933, and similar uncertain indexation or escalator clauses are successfully used today in everything from mortgage loans to pension plans to employment contracts, without apparent infringement of the code.
Gerald T. Dunne, a professor of commercial law at St. Louis University, who has given some thought to this seeming dilemma, did not dismiss the problem in a recent interview, but he stated, "I think it's okay. I think the difficulty is far more imagined than real. Because, as you say, if this were fatal, every escalator clause would be likewise fatal." This belief is seconded in Robert S. Getman's article on gold clauses in the Winter 1976 Brooklyn Law Review, where he writes, "If the gold legislation were intended to make gold a commodity 'like everything else,' enforcement of escalator clauses based upon the value of gold should encounter no greater legal obstacles than would enforcement of other commodity indexing devices."
Of course, not all gold-clause contracts would fall under the definition of "negotiable instruments." As Dunne noted, "if it's not a bill of exchange or a note, then the problem doesn't even exist." Still, there may be cases where, ordinarily, a negotiable instrument might be desirable, and a gold clause could then present legal difficulties. In view of the code, Wormser and Kemmerer advise, "Either a non-negotiable note should be used, or reliance should be placed wholly on the contract of loan or sale itself."
The best advice of all is Dunne's injunction that "you should consult counsel and let him guide you. The person shouldn't be his own draftsman." That advice could just as easily apply to all of the foregoing areas. As Segermark said after passage of the law, gold-clause contracts need to be "written very gingerly," and the best way to insure that is to seek competent legal help. You may even be pleasantly surprised to find that the opportunities are not nearly so limited as some of the foregoing discussion might make it appear.
GOLD-CLAUSE FORMULAS
For those who are willing to try gold clauses, what are the mechanics? Keeping in mind the rules and caveats discussed above, which also apply generally to "multicurrency" contracts, there are several different types of clauses. Let us assume for purpose of discussion that we're talking about a personal loan contract, since at the moment that seems to be the most accessible type.
The old type of gold clause, which developed in the late 19th century amid "greenback" depreciation and uncertainty over whether the United States would stay on the gold standard, merely specified payment in US gold coins "of or equal to the present standard of weight and fineness." That was when US gold coins were recognized, circulating, legal tender. Now, however, with the growing numismatic value of even common-date coins, they might not make good standards of value for purposes of a gold clause. Better to specify bullion or bullion coins—or the dollar equivalent. But, if two contracting parties really want to deal in US gold coins and agree to specify payment in, say, 10 Double Eagles, it doesn't seem likely that a court would declare it unenforceable in most cases.
The most obvious and simple formula would involve a loan of a certain amount and type of gold—either bars of bullion or specified bullion coins—and repayment in kind, plus a fee or "interest" for the use of the gold over the course of the contract, which might best be imposed on the initial value of the gold. This avenue has legal and tax advantages. In addition, as the Gold Standard Corporation mentioned in its October 1977 newsletter, they would be "far more prudent" than "dollar denominated gold agreements" in the event of price controls on gold.
Nevertheless, most contracts will probably provide for gold indexation (or "measure of value" or "maintenance of value") clauses, which seem safe enough and are probably infinitely more marketable. One method has already been mentioned: simply require that principal (and/or interest) payments be tied to the percentage increase (or decrease) in the (properly designated) gold price. Thus, if you lend $10,000 for a year, and the price of gold increases 10 percent, you are repaid $11,000, plus interest.
Another method would be to state the contract in terms of a certain number of ounces based on the current market equivalent of the dollar amount you wish to lend. Ruff gives the example of a $16,000 loan initiated at a market price of $160 per ounce. This yields a gold equivalent of 100 ounces. When the loan comes due, the borrower is then obliged to pay back the then-prevailing market value of 100 ounces of gold (plus interest).
Ruff adds a somewhat troublesome twist, however. He suggests a contract with three payment options: (1) actual payment of the 100 ounces in gold, (2) payment in the dollar equivalent of the 100 ounces, or (3) payment in the original cash value. The lender would then be able to cash in on the appreciation of gold in event of inflation but would also be able to "demand payment of the face value in dollars" in the event of a fall in the price of gold. If you can get such a deal, fine, but it sounds a bit too much like "heads I win, tails you lose." A good many borrowers might insist that the lender hitch his wagon to gold either entirely or not at all—and accept the downside risk. Ruff would argue that a hedged borrower would have no objection to the cash-value provision, since he will have insured himself against all risks.
This may present no problem; it may be quite possible to arrange such terms, particularly with more aggressive, that is, more risky, borrowers. Obviously the more desperate a person is to borrow money, the more he will be willing to "sweeten" the deal for the lender. From the high-risk borrower's point of view, the gold clause may be just what he needs to get credit. At the same time, the lender must realize that to get a really creditworthy borrower and make a sound loan, he is not always going to be able to arrange the kind of made-in-heaven contract Ruff envisages—with enforced forward hedging, the original cash-value option, etc.
It's worth noting that European multiple-currency ("Lombard") bonds, which allow the investor to receive payment in a choice of currencies, have similar low-risk features. But precisely because of that, multicurrency bonds have become almost extinct in today's world of sharply fluctuating currency values. For a complete list of such bonds still on the market, see David Smyth's You Can Survive Any Financial Disaster (Regnery, 1976). The newer European Unit of Account ("Eurco") bonds also have multiple-currency features but are far less advantageous for the purchaser, since the exchange rate for each currency, on which redemption value is calculated, is fixed at the time of issue.
COMPLEXITIES ABOUND
Even more elaborate formulas could be devised. For example, according to a Library of Congress study, two 1973 French bond issues-subsequent to the "Pinay bonds"—contain quite complex gold clauses. In one 4½, 34-year bond, floated to retire a similar 1958 issue, the redemption value, which is determined twice a year for redemptions taking place after June 1 and after December 1, "is equal to the nominal value multiplied by a coefficient which equals the average price of the 20-franc gold piece (Napole'on d'or) on the Paris free gold market during the 100 business days immediately preceding, respectively, May 15 and November 15, divided by 36 francs" (presumably the value—in "new francs" of 1960—of the Napole'on d'or at the time of issue of the 1948 series). The study observed that the redemption price of this bond "is not lower than 250 francs for each 100 francs nominal value, the apparent redemption value of the 1958 bonds at the time of the October 1973 conversion."
It is explained in the same study: "Another 7% issue contains a 'maintenance of value' guarantee that: is not tied directly to gold but instead to the ratio between the official gold content of the franc and that of the unit of account (U.A.) of the European Economic Community, the latter equal to the pre-1971 devaluation gold content of the US dollar (0.88867088 grams fine). The guarantee becomes effective when this ratio as it exists on January 1 of the year in which the transaction involving a bond takes place has lower value than the same ratio as it existed on the day of issue (January 16, 1973). The adjustment coefficient, applicable to both the redemption value and interest payments, equals the result obtained by dividing the day-of-issue ratio with the latest January 1 ratio. In effect, if the gold content of the franc decreases…the adjustment coefficient is greater than 1 and the redemption value in current francs is greater than the nominal value."
Only a government could come up with such Byzantine formulas! For the average person, the simpler the better.
One device, frequently mentioned as a gold-clause payment vehicle, is the gold deposit certificate, which is simply a warehouse receipt for gold. The most well known (and least-expensive) certificate is the Deak Gold Deposit Certificate, offered by Deak & Co. (Washington, DC). At this time it is not negotiable, however. Ownership of the certificate can only be transferred on the company's "Certificate Register" by surrendering it at Deak's Washington office and requesting the issuance of a new certificate to a designated person or persons.
In his letter to Arthur Burns, Senator Helms specifically asked, "Do you foresee any restraints or regulatory prohibitions against banks issuing negotiable gold certificates?" He urged that any regulations be issued "with a view toward modifying them should it appear that they are unduly restricting opportunities of individuals and organizations to utilize the advantages these devices may offer." However the banking authorities rule, it is probable that any company attempting to issue fully "negotiable" certificates would find itself subject to onerous securities regulation by the SEC, even though their use in gold clauses would seem to be perfectly legal now.
The Gold Standard Corporation offers gold "transfers," similar to gold checking accounts, which could conceivably be specified as payment media in contracts. While these "transfers" are apparently gaining customers, they are far from being widely accepted. (Bank of America has recently come forward with a proposal to offer accounts and credit in foreign currencies. Senator Helms is shepherding this proposal through the regulatory corridors, having sent a letter on its behalf to the chairman of the Federal Reserve Board.)
Gold Standard has also been in the vanguard, along with certain other interests, of those investigating possibilities of gold insurance. This, of course, is an area that comes under the bailiwick of the individual state's insurance regulatory bodies. Gold Standard's Marcus Braun said his company contacted the Missouri Insurance Commission and got some good news and some bad news from its general counsel. The good news is that "insurance policies may be issued with the premiums and benefits in terms of gold." But the bad news is that "the reserves must be held in dollar-denominated assets." That, as Braun noted in a recent interview, "would destroy the whole thing. No insurance company in their right mind could afford to issue something like that." And, since insurance regulations tend to be uniform throughout the states, the same policy probably holds true in all 50 states, although there could be exceptions.
There is another interesting possibility. Braun said he and other individuals are working on an annuity-type program that would get around these objections. It would involve storing gold and paying out a certain amount in installments up to a certain age. Here is how such a plan might work: A person would put, say, $100,000 in gold into the program at age 40. Then two to five percent of that gold would be released to the investor each year until age 95, at the then-prevailing market price—either in terms of dollars or gold or gold "transfers." In the meantime, the gold deposits would be held in safekeeping. Conceivably, gold loans or gold collateral loans might be made, adding to the earnings of the investors' deposits. As Braun conceives it, "We would take 10% only when a person gets out of the program—10% of the residue. And then the rest of it would be divided equally between the estate of the depositor and the remaining depositors. That way, if you live long enough you could get substantially more than what you put into it." Shortly before press time, however, the Missouri Insurance Commission ruled that this plan would constitute an insurance program, and hence, gold could not be held as a reserve. But Braun has now persuaded a legislator to introduce a bill legalizing gold insurance reserves. While this action is pending, Sen. Helms has made inquiries about the feasibility of gold-clause pension plans with the Employee Plans Division of the IRS.
And so, for now the application of the gold-clause law is in a state of flux. But this new freedom has too much potential to be wasted. Whether you be an employer, a valued employee, a landlord, or a provider of venture capital or a seeker of same, you can begin to use gold clauses to start living easier with dollar depreciation. Just keep in mind some of the rules and precautions noted above. You should be all right if you consult your lawyer (and/or relevant authorities) and deal with persons you know and trust.
Mr. Beckner is the editor of Deaknews, Washington, DC.