CHAPTER 3 GOLD DENOMINATED FINANCING—LEGAL AND PRACTICAL ASPECTS AND PROJECT FINANCE APPLICATIONS

• Jurisdiction: United States

Gold Mine Financing
(Jan 1988)
CHAPTER 3
GOLD DENOMINATED FINANCING—LEGAL AND PRACTICAL ASPECTS AND PROJECT FINANCE APPLICATIONS
Peter J. Doyle
Mallesons Stephen Jaques
Sydney, Australia

TABLE OF CONTENTS

SYNOPSIS

1. Aspects of Gold Loans, Gold Leases and Gold Backed Paper

• Development of Gold Financing Techniques in Australia

• Types of Debt Financing

• Legal Characterisation of Gold Loans

• The Cost of Debt Financing

2. Aspects of a Gold Based Finance Package

3. Aspects of Documenting a Gold Loan

• General

• Barter or Forward Sale

• Close-Out on Default

• Frustration

• Margin Calls

• Other Matters

4. Issues for the Gold Producer in Negotiating the Finance Package

• What do I need?

• What can I get?

• How must will it cost?

• Once finance is arranged, when do I need it?

• What am I liable for during the term of the financing?

• When am I off risk?

• What protection do I have if things go wrong?

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• Can I develop my other projects?

• Can I maximise my cash flow?

• Can I get out early?

5. Issues for the Bullion Banker

• Set-off Rights

• Undertakings

• Predelivery

• Reporting

• Conditions Predecent

• Warranties/Undertakings

• Preparation of Documents

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1. ASPECTS OF GOLD LOANS, GOLD LEASES AND GOLD BACKED PAPER

Development of Gold Financing Techniques in Australia

1.1 Up until 1983/84, the majority of Australian gold mining companies were relatively small "single product" enterprises selectively mining patchy ore bodies with limited mine life and only 1-3 years reserves proven up in advance of mining. The exposure of these companies to fluctuations in the gold price, the inadequacy of their proven ore reserves and lack of balance sheet strength did little to inspire the confidence of bankers. Accordingly, gold mining activities in Australia during this period were financed almost exclusively by equity capital.

1.2 Also, until recent changes in Australian tax laws, gold mining companies enjoyed a substantial tax shelter which reduced significantly the cost of equity capital relative to other sectors of the market. Equity finance was also advantageous in that it did not require the gold mining company to meet a fixed repayment schedule; servicing of equity capital (i.e. by way of dividend payment) could coincide with the profitability of the project.

1.3 However, as a result of changes in Australian tax laws which have lessened the protected position of gold mining companies, the cost of equity financing in Australia has been very high relative to say the United States and Canada. Until the spectacular rise in the Australian Stock Exchange Gold Index during the past eighteen months, price earnings ratios for established gold mining companies in America have been up to two to three times higher than those prevailing in Australia.

1.4 As a result of the high cost of equity capital in Australia, over the past three to four years there has been a trend by emerging gold producers to seek debt financing for the development of new gold projects. This trend has been assisted by the fact that there have been a number of gold mines brought on stream in response to the resurgence in the gold price, the advent of new technology which has permitted bulk open pit mining of low grade ore bodies and the fact that there currently is no income tax payable by an Australian gold producer in respect of income derived from gold mining. The use of the gold loan as a project financing tool was pioneered in Australia some five to six years ago in response to the impetus given to gold mining development in the early 1980's by the factors mentioned above.

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1.5 The project finance gold loan was initially developed to enable small to medium sized gold mining companies to finance the development of their projects at what was initially believed to be extremely low funding costs compared to traditional interest bearing cash loans. Although bullion banks have generally emphasised the low interest aspect of a gold loan and the natural hedging aspect of the financing, one must take care in comparing the cost of a gold loan to a conventional cash loan. This matter is discussed later in the paper.

1.6 It is estimated that gold loans have been used to finance at least two-thirds of gold mines brought into production in the last two years in Australia. One Australian commentator has noted that over the last three years there have been at least 39 gold loan transactions of a dollar value of greater than A$2,000,000 per transaction concluded in Australia, the transaction sizes ranging from A$1,000,000 up to A$50,000,000.

1.7 The use of the gold loan in the project financing of gold mines has been substantially refined in Australia and project financing techniques involving the use of gold loans are now at a relatively sophisticated level; the development of these project financing techniques in Australia has perhaps preceded their development in the United States and Canada.

Types of Debt Financing

1.8 Debt financing of the gold industry in Australia can be divided into two broad categories:

• corporate debt (with full recourse to the borrower's assets generally); and

• limited recourse project financing (where recourse is limited to project assets).

1.9 The first issue that needs to be addressed by a gold mining company proposing to develop a new project by way of debt financing is whether the borrowing will be way of a corporate loan or project financing. In both instances, three types of lending are available to the borrower:

• cash loan;

• gold loan (whether in its own right or perhaps as part of a lease); and

• gold linked bond and/or warrant.

1.10 In all three cases, the funding may be by way of corporate risk, where the lender has recourse to the whole of the borrower's assets, or by way of limited recourse project financing, where the security will usually be limited to the assets of the specific project.

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1.11 Cash Loans: A simple cash loan from a bank (whether single or multiple currency), structured as a term loan or interest only loan, is the main form of debt used in the corporate sector and can be used to finance the development of a gold mine. In the case of a gold mining company, however, the banker may require, and in fact may insist, that the borrower protect the price component of its production revenue by forward selling or by some form of floor price scheme to provide comfort that the proceeds of sale will be adequate to repay and service the debt.

1.12 The concept of a cash loan linked to a forward sale or floor price program is sometimes referred to as a "synthetic gold loan". Synthetic gold loans are simply a combination of interest bearing loans taken out in conjunction with a series of forward sales or floor price arrangements and constructed in such a manner so as to match revenues from forward gold sales against loan repayment obligations. Such synthetic gold loans have been found attractive by some diversified resource companies (i.e. companies which have other resource interests apart from gold) in Australia as they can give rise to "creative" accounting and tax opportunities, e.g. companies may be able to obtain an effective tax deduction for interest paid on these loans against income derived from activities other than gold mining in one tax year whilst repaying the principal of the loan from income from the forward sale of gold which is exempt from tax and can be brought to account in a later tax year.

1.13 Gold Loans: In its simplest form a gold loan is a transaction whereby a bullion bank provides a quantity of existing gold in exchange for future deliveries of gold sourced from mine production. For the gold mining company/borrower a gold loan may offer a low nominal interest rate and will remove the commodity price risk in that gold "borrowed" is repaid from gold mined thereby creating a natural hedge avoiding currency and price risk exposure.

1.14 Usually, the gold loan agreement will provide that the bullion bank will make available to the gold mining company a specified quantity of gold which the bullion bank will then sell on behalf of the gold mining company (perhaps to the bullion bank itself) for cash which is then to be used to finance the development of the relevant project. The gold mining company in turn undertakes to deliver to the bullion bank the same quantity of gold as that drawn down in accordance with an agreed schedule of redeliveries, such gold being obtained from the project. Usually the bullion bank will charge the gold mining company a "borrowing fee" which the gold mining company will be required to pay in gold. As security for the "repayment" of the gold borrowed, the bullion bank may take security over the project assets or may rely upon a letter of credit or bank guarantee from a third party bank.

1.15 Gold loans can in fact be structured to allow the borrower to drawdown in either gold or currency initially, with the option to switch to the other medium later and then back again thereby allowing the borrower to ensure that its financing is always cost effective.

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1.16 Gold Leases: A gold lease is a facility that adds to the advantage of a gold loan, the depreciation (and any other tax allowance) benefits attaching to ownership of plant and equipment; it is therefore a form of tax based financing involving the leveraged lease concept. In essence a gold lease is a normal leveraged lease where the debt component is funded by way of a gold loan rather than cash loan.

1.17 Under a gold lease, a gold loan is made available to the leasing partnership and the dollar proceeds from sale of the gold borrowed is used by the leasing partnership to purchase the mining plant. The leasing partnership, as owner, then enters into a lease whereby the gold mining company (or an interposed company) obtains the use of the plant as lessee in return for a...