Negotiating an overseas property agreement (1)

This 2-part article describes the principal elements of the standard mineral option and joint-venture agreement used in Canada and the U.S., and highlights some points of misunderstanding that can arise when trying to implement the same kind of business arrangement in a Latin American country. It also addresses the negotiating process generally, and the differences in thought processes and drafting techniques that exist between common law and civil law lawyers — factors which can render contract negotiations exasperating, time-consuming and expensive.

Elements of the standard North American agreement Frequently the owner of the mineral rights to a property will seek the assistance of a mining company to help fund and carry out exploration and development. The first thing the company will do is ask to see the geological information pertaining to the property. On the basis of that information, if the company believes the property merits further investigation, it will arrange for one of its geologists to make a site visit.

If the geologist believes the property contains sufficient mineralization to warrant exploration, the company will begin negotiations with the owner to determine how much of a percentage of the mineral rights the company may “earn” in return for making cash option payments to the owner, incurring exploration expenses on the property and/or granting the owner the right to receive either a share of the net profits of the venture or, in exceptional cases, a net smelter return royalty.

The less money the owner has invested in the property and the less advanced the exploration, the higher the percentage interest the company may earn. Money spent on grassroots or early-stage exploration is a high-risk investment, and the company will expect its potential return to be equally high to compensate for that risk. If, on the other hand, the property is in the middle or advanced stages of exploration, the company and the owner might agree to form a 70-30 or 60-40 joint venture. The company, being the venturer with the largest participation, will almost always act as the “operator” of the venture.

Typically, the business arrangement is documented in two agreements, an option agreement and a joint-venture agreement.

Under the first, the owner grants the company the right to earn a stated percentage of the rights to the property (commonly called an “interest”) in return for the company incurring certain minimum amounts on exploration over a certain period. Owners frequently also ask for cash option payments to compensate them for their investment in the property, but companies would prefer that most, if not all, of the money be spent on exploration. For example, a 4-year option to earn an 80% interest in an early-stage property might require the company to incur expenditures of at least US$100,000 in year one, US$300,000 more in year two, US$600,000 more in year three and US$1 million more in year four. Expenditures in excess of the minimum are credited to subsequent years, and shortfalls may be paid in cash to the owner to maintain the option in good standing. The first year’s expenditure is often “committed,” but the company may permit the option to lapse at any time thereafter.

In our example, as soon as the company has incurred expenses totaling US$2 million, its percentage interest would vest, and it and the owner would be deemed to have entered into the joint-venture agreement. Thereafter, the company would own 80% of the mineral rights and the owner 20%. Each venturer would now be required to fund its proportionate share of annual exploration budgets (failing which, its interest would be diluted according to a formula). Following completion of a feasibility study and a decision to build a mine, called a “production decision,” each venturer would have 60 to 90 days to raise its share of mine financing, failing which it would be deemed to have relinquished its ownership interest to the other venturer in return for the contractual right to receive a percentage of the net profits of the mining operation.

Assuming both venturers are able to finance their respective shares, each venturer will take its share of product in kind. Alternatively, the operator of the venture may sell the non-operator’s share in return for a sales commission. The venturers divide the production, not the profits, and the legal relationship between them is that of co-owners of property, as tenants in common.

The arrangement I have just described is one that will be familiar to most North American mining executives, and it has infinite variations. Some of our readers from Latin America may be wondering why I have not mentioned the formation of a company. This is because the venture is purely contractual. The principal reason for this is to allow the venturers to deduct the exploration expenses against their taxable income. If the expenses were incurred by a corporation formed by the two venturers, the expenses would be deductible by that corporation only, which may never have any taxable income. Sometimes the venture is incorporated at the time of a production decision in order to limit liability, but usually not before. This avoids having to incorporate a new company every time you explore a property, only to have to wind it down if the property is abandoned.

— The author, Placer Dome’s country manager in Venezuela, will continue this article next week. He worked previously in Placer’s legal department and prior to that was an associate at the Caracas office of international law firm Baker & McKenzie.