Deferred consideration in mining deals, a note of caution in times of financial distress

Whilst mining royalties for successful mining projects are extremely valuable, two recent court-decisions¹ in Western Australia highlight that contractual mining royalties are potentially vulnerable to being extinguished by a deed of company arrangement (DOCA).

These decisions have significant implications for any party negotiating mining M&A transactions. The decisions also have implications for deferred consideration arrangements in M&A transactions more generally.

As both decisions are subject to appeal, there may be further developments once the appeals process is completed.

In brief

• Private mining royalties allow the seller of a pre-development mining asset to obtain economic exposure to future upside from mining operations (without needing to fund the development costs).
• This is often key to unlocking the sale of a mining asset which the seller views as highly prospective, but which requires a significant amount of time and development expense (over many years) to commence operations.
• Mining royalties can also be a valuable asset in their own right (for example, there is an active M&A market for trading in private mining royalties).
• However, two recent court decisions confirm that private mining royalties can be vulnerable to extinguishment via a DOCA, following the tenement holding entity entering voluntary administration.
• As a result of these decisions, we expect to see greater negotiation of royalty securities as part of mining M&A transactions. This can have a number of consequential impacts for transactions (such as FIRB approval requirements or shareholder approval requirements under the ASX Listing Rules).
• Parties undertaking distressed M&A in the mining sector should also carefully consider whether the terms of any proposed DOCA will preserve (or extinguish) existing royalties over the relevant tenements.
• Whilst the focus of these decisions (and this article) is on mining royalties, analogous considerations would apply to other forms of deferred M&A consideration in other sectors (for example, earn-outs or deferred milestone payments).

What is a mining royalty?

A private mining royalty is a contractual right (ie right in personam) granted to a royalty holder to receive payments from a mining project owner or operator based on the extraction and/or sale of minerals. This is distinct from a statutory mining royalty, which are government-imposed charges on a miner for extracting State-owned minerals and which function more like taxes.

The Kirkalocka Case and Franco-Nevada Case both confirm mining royalties are vulnerable to DOCAs – but only in one of the cases was the royalty extinguished

Considering the prevalence of mining royalties as deferred consideration in mining M&A transactions, a note of caution arises for royalty holders when the mining project owner or operator faces financial distress.

In particular, two recent cases have considered the question of whether a DOCA, by reason of section 444D(1) of the Corporations Act 2001 (Cth) (Act), extinguishes a royalty holder's entitlement to be paid royalties under a pre-existing royalty deed and instead replaces that entitlement with a right to be paid a dividend under the DOCA.

This has a number of important commercial implications:

• the commercial value of a royalty often lies in the fact that (subject to the terms of the royalty) it is not capped in time, so can become payable many years after the initial grant (should the royalty area ultimately prove to be prospective and result in an operating mining project);
• an insolvency event affecting the royalty grantor is more likely to occur before there is a mining operation on the tenement – therefore, the key risk is that (via a DOCA) the unsecured royalty is extinguished during the pre-production period and the royalty holder will no longer have any upside should the project eventually commence production and generate royalties;
• for the acquirer of a distressed mining asset, the ability to cleanse the tenement holding entity via a DOCA may provide the acquirer with an opportunity to extinguish private mining royalties which would otherwise apply to the asset; and
• as security interests and proprietary interests are carved out from the operation of the DOCA (by section 444D(1) of the Act), one way for a royalty holder to protect its interests is to obtain security over the relevant mining tenure.

Future royalty payments are contingent claims and provable under a DOCA

In the Kirkalocka Case, Justice Jackson held (at [94]) that it was "tolerably clear" that, by operation of section 444D(1) of the Act, a DOCA can extinguish monetary claims, including claims for damages for breaches of obligations owned by the company, where the obligations existed before the date fixed in the DOCA but the breaches had not occurred by that date.

It was held (at [114]-[115]) that Kirkalocka was subject to an obligation to pay the royalty that existed as at the date of appointment of the voluntary administrators, although any resulting liability to pay the royalty was contingent upon Kirkalocka mining and producing gold in a given quarter. While that was within Kirkalocka's control and discretion, as at the appointment date, it remained a future event that may or may not have happened and was therefore a contingent claim.

While this analysis and conclusion (when read in in conjunction with the terms of the applicable DOCA) had the practical effect of allowing Kirkalocka to continue in business and to mine free of the royalty that previously attached to it, Jackson J said (at [116]) that this was a question to be resolved by appropriate drafting of the DOCA (ie to preserve the royalty holder's claim to royalties) or, if necessary, by an application by the royalty holder to have the DOCA terminated pursuant to section 446D of the Act, for example, on the grounds that the DOCA was oppressive, unfairly prejudicial or unfairly discriminatory against one or more creditors.

Claims to royalty payments are often ‘in personam’ contractual rights, not caveatable proprietary interests

In the Kirkalocka Case, the royalty holder (SCL) also sought to argue that it had a proprietary interest in the relevant mining lease, relying in particular on a clause in the DOCA (clause 8.5) which provided that the parties had agreed that Kirkalocka's rights and obligations under the royalty deed, including the obligation to pay the royalty, were intended to run with the ownership of the mining lease.

Like most mining royalties, the royalty in the Kirkalocka Case was calculated by reference to the production of a mineral. No other routes to a proprietary interest, such as a royalty agreement that creates a profit à prendre² or a rentcharge³, were applicable. In those circumstances, Jackson J held that no proprietary interest in the mining lease existed and that principles of privity of contract meant that clause 8.5 was ineffective at creating a covenant that ran with the mining lease ([173]).

As SCL's entitlement to receive the royalty payments was extinguished by the DOCA, it necessarily followed that the consent caveat, which had been lodged by SCL to protect rights which were released and extinguished by the DOCA, was (in effect) ordered to be removed ([200]).

Powers under DOCAs are a matter of construction

It is important to note, however, that mining royalties will not automatically be released or extinguished by a DOCA. Rather, a company will only be released from a debt by a DOCA to the extent that the DOCA provides for the release and the creditor is bound by the DOCA.

This is illustrated by the Franco-Nevada Case, where Justice Hill concurred that a mining royalty was a contingent claim which is provable (and capable of being extinguished) by a DOCA (ie applying the same analysis outlined above). In this case, Justice Hill concluded that the precise terms of the DOCA did not extinguish the royalty.

Therefore, unlike the Kirkalocka Case (where the private mining royalty was extinguished), the private mining royalty continued to be due and payable to Franco-Nevada in relation to current mining on the royalty area.

Implications for M&A deals

The two cases demonstrate the importance of ensuring that appropriate security or credit arrangements are in place to support contingent consideration structures which are calculated (or payable) over an extended period of time, and are therefore susceptible to an insolvency event occurring before the event / milestone triggering the payment occurs.

Whilst the two cases discussed relate to mining royalties, similar principles are relevant to other deferred consideration structures which operate on an unsecured contractual basis.

For practitioners of distressed M&A, the differing outcomes in the two cases demonstrates the importance (and power) of the precise language in the DOCA instrument to deliver unencumbered ownership of an asset via a voluntary administration process.

As at the date of this article, an appeal to the Kirkalocka was being decided in the Full Federal Court and an appeal is pending for the Franco-Nevada Case.