CHAPTER 8 NEGOTIATING AND DRAFTING OF NET PROFITS AGREEMENTS
| Jurisdiction | United States |
(May 1981)
NEGOTIATING AND DRAFTING OF NET PROFITS AGREEMENTS
Holland & Hart
Denver, Colorado
INTRODUCTION
In many areas of the United States and Canada, the traditional way of obtaining rights to explore for, develop and exploit hard minerals is by means of an agreement between the owner of the mineral estate and the would be developer under which the price to be paid to the owner of the minerals for such rights takes the form of a royalty which is expressed as a percentage of "Net Smelter Returns" ("NSR"). Over the years, the use of a NSR royalty to compensate the mineral owner has been found to have disadvantages to the Operator or Investor — which are also, in a broader sense, disadvantages to the mineral rights owner as well. A primary problem with NSR royalties has been that, by their nature, they are payable anytime there is a smelter settlement which exceeds the cost of transportation from mill to smelter, and thus place a tremendous burden on the Investor when a mine is operating near the margin or at a loss. In some instances, this has forced the closing of mines resulting in a financial loss to the operator of the mine, financial loss to the mineral owner who collects nothing because there is no production and hence no smelter settlements, and a loss to the public because otherwise valuable minerals are left in the ground never to be recovered.
One of the devices which has been developed to avoid this and certain other disadvantages of a NSR royalty is the use of royalties which are expressed as a percentage of "Net Profits" or "Net Proceeds" which are a share of the Investor's "profits" or "proceeds" and which are intended to compensate the mineral owner according to the profitability of the venture at any given time.
The purpose of the three papers to be presented this morning is to consider various aspects of the use of NSR and Net Proceeds royalties.
Dick Brown's paper provides some fascinating information concerning the impact of each type of royalty on a number of hypothetical ore bodies under various assumptions and explores
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economic aspects of the use of each of the royalties. Bill Bristol discusses a number of the problems that are created by the use of a Net Profits royalty for the people who must administer the contract and whose concerns are often given too little attention in the process of negotiating and drafting new agreements. This paper will examine the characteristics of two types of royalty and the distinction between them from the viewpoint of the draftsmen and of the negotiator. I would point out at the outset, however, that to do an effective job of either negotiating or drafting, one needs a thorough familiarity with the economics discussed in Dick Brown's paper and the accounting and administration considerations in Bill Bristol's paper.
CHARACTERISTICS OF NET SMELTER RETURNS ROYALTIES
The terms "Net Smelter Returns" and "Net Profits" do not sound all that dissimilar to one not acquainted with the mining industry. As a starting point, let's examine what is meant by these terms. Of the two, Net Smelter Returns comes closer to having a generally accepted meaning. A representative definition of Net Smelter Returns in a mining lease might read as follows:
Net Smelter Returns. The term "Net Smelter Returns" shall mean the net amount of money received from the sale of ore, or ore concentrates or other products from the leased premises to a smelter or other ore buyer after deduction of smelter and/or refining charges, ore treatment charges, penalties, and any and all charges made by the purchaser of ore or concentrates, less any and all transportation costs which may be incurred in connection with the transportation of ore or concentrates, less all umpire charges which Lessee may be required to pay. Milling costs shall not be deducted in calculating net smelter returns hereunder.
A mine operator, looking at his various costs, might well wonder why the word "net" had been used in the name of this royalty because the only item specifically deducted from the payment he will receive from the purchaser of the ore or concentrates will be transportation costs and a possible umpire charge. A closer look will, however, reveal that the royalty
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is figured on the amount of metal recovered from the ore, rather than on the amount of metal contained in the ore or the concentrates and no royalty is paid on metals not recovered in the mill or on metal losses provided for in the smelter schedule. Thus the use of the word "net" serves to distinguish this type of royalty from a royalty which is based upon the gross mineral content of ores mined and removed from the property. Oliver Gushee, in his article on drafting royalty clauses in Volume 21 of the Rocky Mountain Mineral Law Institute, includes an example of a royalty clause which would require payment for all minerals contained in ore which is mined, including those which are not recovered and find their way to the tailings dam and the slag heap. I have never seen such a clause in a lease intended for nonferrous metals requiring payment for the gross amount of mineral contained in ore that is mined under a lease, although such clauses can be found in some uranium leases. It is unfortunate, therefore, that confusion is generated by the use of the word "net" to denote "net mineral recovery." Inasmuch as most people associate the word "net" with the concept of subtracting costs and the word is used in that sense in connection with Net Profits Interests, it is fair to regard the phrase "Net Smelter Returns" as somewhat of a misnomer for "gross receipts". There is no deduction for milling costs, mining costs or other costs associated with the production of the mineral products; the NSR royalty is a function of "gross receipts" of the operation.
Because mining and milling costs are not deducted before computing the royalty, it is a fact that under this type arrangement, royalties will be due the lessor anytime the amount due from the smelter exceeds smelting charges and costs incurred in transportation from the mill to the smelter, even though mining and milling costs far exceed the payment from the smelter. This added burden during periods of depressed metal prices increases the pressure on an operator to close down an operation, even though he knows that closing down may cause loss of the lease or may cause such deterioration in the mine that is unlikely it will ever be reopened.
CHARACTERISTICS OF NET PROCEEDS ROYALTIES
On the theory that a mine operator could afford to pay the property owner more when times were good, if he knew he did not have to pay him as much when times were tough, the notion of a "Net Profits" or "Net Proceeds" royalty was developed. In this paper, I will use the phrase "Net Proceeds" instead of "Net Profits" because the word "profits" is a term of art for accountants and tax experts and we are using it in a somewhat broader sense.
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In one sense, any deduction of costs beyond those deducted in arriving at NSR could be considered to give rise to a Net Proceeds interest. In fact, there is no hard and fast definition of Net Proceeds and one finds seemingly countless versions in use. The most common notion, however, is that the subtraction from gross proceeds of all costs but depletion, depreciation and income taxes gives rise to "Net Proceeds."
It is possible to consider methods in use in North America of compensating the owner of mineral rights for production of minerals under grants of those rights as constituting a spectrum with one end of the spectrum being the delivery to the mineral rights owner of a share of the production at the mine mouth free of costs, such as the typical landowner's royalty under an oil and gas lease, and the other end being a true partnership in which all profits and losses are shared in accordance with the partnership...
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