Mining for high risk capital – by Lisa Davis (The Lawyers weekly – July 19, 2013)

In a tight market, flow-through share issuers require close scrutiny

If there was ever any doubt that the mining exploration sector is pinched for cash, consider recent reports that more than one-third of the companies listed on the resource-heavy TSX Venture Exchange have less than $200,000 of working capital — barely enough to maintain a public listing — and 70 per cent of them are trading at below 20 cents a share.

For what should be obvious reasons, lawyers acting for flow-through share issuers and intermediaries in this cash-dry environment need to be particularly diligent in ensuring resource-sector issuers fulfil their obligations and that investors get the tax benefits they bargained for.

In order to attract high-risk capital for mineral exploration, early stage resource exploration companies are able to issue flow-through shares entitling investors to a tax deduction equal to the subscription amount (plus additional tax credits specific to surface exploration and provincial incentives).

Under the flow-through regime, funds raised in Year 1 have to be spent by the end of Year 2. Therefore, investors and those protecting investors, including intermediaries and their counsel, should be satisfied at the outset that the issuer has the working capital necessary to pay its general and administrative expenses during the period of exploration without the pressure of encroaching upon funds raised and designated for exploration.

However, as an ever-increasing number of junior mining issuers run out of working capital, we are seeing a significant increase in issuers using capital raised in flow-through financings for ineligible expenses.

Unfortunately, while publicly listed companies are obliged to disclose material financial information and contingencies, in our view, such disclosure is often opaque.

One solution is to arrange for your clients’ subscriptions in flow-through shares to be donated to registered charities across Canada, while focusing diligence on the risks associated with issuers’ current and likely future compliance with the provisions of the Income Tax Act, thus giving a clear perspective on the issues of flow-through compliance and disclosure.

For example, we recently reviewed the financial statements of a TSX Venture Exchange-listed mining issuer. The quarterly public filing disclosed that the issuer had a commitment to spend several million dollars on mineral exploration within Canada before a set date. A detailed review revealed that the issuer spent a good portion of the money on general administration expenses, rather than prescribed exploration activities, and was out of cash. Under a contractual indemnity, the issuer has a liability to the investors who bought the flow-through shares and who will likely be reassessed by the CRA as a result of the issuer’s actions. However, the hard reality is that the company doesn’t have the money to reimburse the investors, nor does it have any realistic prospect of raising more capital to reimburse them in these markets.

The only practical way in which an early-stage exploration company can raise capital is through flow-through share offerings. However, in the case of this issuer (and many others), a flow-through financing would be flawed from the outset, since new funds would first have to be used to meet the previous flow-through obligations.

One possible audit response is that one could deduce this result from a combination of the disclosure of the issuer’s unspent commitment amount and the “going concern” note which forms part of the financial statements. However, virtually all financial statements of mining exploration issuers contain a going concern note, since the continuation of the business is dependent upon continually raising fresh capital for operations and exploration. As a result, many people familiar with flow-through financings have been conditioned to minimize or disregard the going concern note as pro forma disclosure for every pre-production issuer.

The fact is, the typical flow-through share subscription and renunciation agreement requires the issuer to renounce flow-through expenditures on a “first in, first out” basis. This raises a few interesting questions:

If a new flow-through financing is authorized by a company’s board of directors when they know or ought to know that proceeds from previous offerings have not been properly spent, do subscribers have a right of action against them and, by extension, the issuer’s counsel and auditors?

Is it incumbent upon the board to establish a compliance system to ensure that the company does not breach its obligations to flow-through subscribers?

And finally, for the auditor of the company, should the publicly filed financial statements more clearly articulate the indemnity liability?

With these questions looming, it is incumbent upon counsel to ensure the proper due diligence is completed and that the planned expenditures fall within the proper definitions set out in the tax legislation. The tight capital situation in the mining sector further underscores this need.

The situation is not completely dire. For instance, we offer a format that expands the universe of potential capital sources by transforming retail flow-through share offerings into financings in which institutional and offshore capital pools can be deployed. This approach allows Canadian subscribers to take tax benefits in the same transaction in which global investors can acquire the equity at a discount reflective of current market uncertainties.

Lisa Davis, a former corporate and securities lawyer, heads up the legal and operations team for Toronto-based PearTree Financial Services Ltd.

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