For banks and corporations active in the mining and commodity finance market
A royalty is a right to receive payment based on a percentage of the minerals or other products produced at a mine or of the revenues or profits generated from the sale of those minerals or other products at a mine. Typically a royalty is granted in the following ways:
- as part of the consideration paid to land owners (either private or public entities) for the mining rights or the interests in land that the mining company acquires
- in exchange for capital or
- as a result of converting some other interest into a royalty, such as a joint venture interest or streaming interest. Traditionally royalties are common in the mining and energy sectors.
In most jurisdictions a royalty is not an interest in real property, although some jurisdictions permit the holder to register evidence of a royalty interest against the mining title or land registry. A royalty interest is usually established through a contract between the royalty holder and the property owner. In some jurisdictions, royalties are established through the mining legislation or code and are granted in favour of the government of that country or other relevant body. Generally, a royalty holder has no responsibility or obligation to contribute additional funds for any purpose, including (but not limited to) operating or capital costs, or environmental or reclamation liabilities. The unique characteristics of a royalty permits governments to obtain, or land owners to grant, a commercial benefit in the upside of the mining project which is insulated from increases in development or operational costs.
Although royalties are used frequently in the mining industry, there is no “standard form” structure a royalty should adopt. The mechanics of a royalty must be set out in an agreement between the parties and the drafting of such provisions differs greatly. Even where royalties are set out in mining legislation, supplementary regulations are often required to properly explain how they are to be calculated in practice. However, it is possible to class royalties into four general headings:
Profit Based Royalties
These are based on the profit generated by the mining operation. Typically these royalties are based on net profits, which can cause difficulties when identifying the costs that may be deducted in order to calculate the net profits of the operation. These are generally restricted to the costs of production after capital costs have been fully recovered.
Net Smelter Return (NSR) or Gross Revenue Royalties
A common option for precious metals, NSR or gross revenue royalties are based on the value of production or net proceeds received from a smelter or refinery, or from a purchaser. Depending on the terms of the royalty agreement, the proceeds received from the smelter, refinery or purchaser may be subject to deductions for insurance, transport, refining and smelting costs; sampling and assaying; or marketing. A NSR royalty provides the holder with cash flow that is free from operating or capital costs and environmental liabilities. Accordingly, the rates are typically lower than for profit based royalties.
Production Royalty (Fixed Rate Royalty)
These provide a fixed payment per tonne of production and therefore essentially equate to a fixed cost of production without reference to increases or decreases in market prices or operating costs. As such these royalties are less common and in certain cases can make deposits uneconomical to mine.
Royalty in Kind
A royalty in kind, such as a stream, grants the holder the right to take delivery and/or purchase a percentage of production.
Royalty holders come in many shapes and sizes. Governments and government bodies may hold royalties either through prescriptions in that country’s legislation or through separate agreements between the government and the mining operator at the time that the mining rights were granted. Similarly, a land owner may require a royalty in order to grant rights to the mining operator to exploit their land. For banks, companies and private investors providing financing to mining operations in the period between initial discovery of minerals and completion of a bankable feasibility study, royalties may be used in exchange for providing bridge financing.
Where a royalty is merely a contractual right against the mining operator (i.e. royalty that is not prescribed by legislation or attachable to the mining rights or interests in land), the royalty holder may be at risk of having that royalty extinguished either through the mining operator’s insolvency and subsequent liquidation or through a sale or transfer of the asset. Where a royalty is not attached to an interest in land, subsequent owners of the mining rights or property will not be bound by the royalty obligations of the previous owner.
To protect against the risk of insolvency or change of ownership of the assets, a royalty holder may insist on security. The extent of the security package will vary according to the timing of the investment and whether other creditors already have security over the key mining assets. In order for the security to protect the royalty holder in the case of the mining operator’s insolvency, the royalty holder and mining operator must agree a liquidated damages amount. The royalty holder can utilise this in the mining operator’s insolvency proceedings, however it may not protect against the risk that the mining operator, which is typically structured as a special purpose vehicle, transfers the mining assets in contravention of covenants not to do so. This would leave the royalty holder with a claim against a company with little assets. Royalty holders may therefore seek registered security against specific assets or, where available, a creditworthy guarantee.
Royalties are very common in the mining industry. Royalties which are prescribed in mining legislation or are payable to non-participatory land holders are widely recognised by project finance lenders as being an unavoidable operating cost of the project and therefore acceptable to be paid from the top of the cash cascade.
However, royalties can be used as a means to enhance returns to equity or subordinated debt providers, or be granted to private investors who may have provided bridge financing. In those circumstances, project finance lenders will often try to cap the amount that might rank ahead of them in the cash cascade or insist all is subordinated.
The extent to which royalty holders are granted security will also create intercreditor issues between project finance lenders and royalty holders. Project finance lenders will be reluctant to share senior security with royalty holders, particularly where breaches of the royalties may result in substantial liquidated damages claims by the royalty holders.
While royalties are not new to the mining industry, with the tightening of liquidity in the market, we are seeing mining operators using royalties as a means of raising bridge financing during the feasibility phase of the project or to provide enhanced returns to equity or subordinated debt providers. It is critical that providers of capital to mining operators recognise the impact of royalty arrangements to their rights as creditors.