Citation: 2006TCC105
Date: 20060220
Docket: 2002-2085(IT)G
BETWEEN:
WESTWARD EXPLORATIONS LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Rip J.
[1] Westward Explorations Ltd. appeals an income tax assessment for its 1995 taxation year in which the Minister of National Revenue applied subsection 69(1) of the Income Tax Act ("Act") and reduced the appellant's Cumulative Canadian Development Expense ("CCDE") pool, described in subsection 66.2(5) of the Act, by $1,589,295. The Minister applied subsection 69(1) on the basis that the fair market value of a Canadian mineral resource property, namely a 11.12 per cent interest in a resource property known as Magnacon Mine ("Mine" or "Magnacon Property"[1]), acquired by the appellant from its principal shareholder, Windarra Minerals Ltd. ("Windarra"), was $333,600 and not the $1,922,895 purchase price agreed to by the appellant and the vendor.[2]
[2] The issue before me is whether the fair market value of the interest in the Mine when acquired by the appellant on September 29, 1995 ("Acquisition Date") was $333,600, $1,922,895 or some other amount.
[3] The Mine is located in the MishibishuLake area in the District of Thunder Bay and is approximately 35 air miles from Wawa, Ontario. Immediately prior to the appellant's purchase, the Mine was owned by a joint venture consisting of Windarra, Muscocho Exploration Limited (N.P.L.) ("Muscocho") and Flanagan McAdam Resources Inc. ("Flanagan"). Prior to the sale, Windarra had a 22.23% interest in the Magnacon Property[3].
[4] At all relevant times the appellant and Windarra were publicly traded corporations listed respectively on the Vancouver Stock Exchange ("VSE") and the Toronto Stock Exchange ("TSE"). According to the appellant's Information Circular to shareholders for a meeting to consider the purchase of an interest in the Mine, Windarra was the owner of 9,628,425 shares, or 76.25 per cent of the appellant's outstanding shares.[4]
[5] The purchase price of $1,922,895 was determined at the behest of a committee of independent directors of the appellant (who were not directors of Windarra) by Watts, Griffis and McOuat Limited, consulting geologists and engineers ("WGM"), who valued the Mine as at May 15, 1995 ("WGM Report"). The authors of the WGM Report, Messrs. Ross D. Lawrence and W. J. Mullins, concluded that:
... the Fair Market Value for the Canadian Resource Property Component of the Magnacon Mine at the Valuation Date ranged from $12.8 million to $21.8 million. Accordingly the 25% interest of Windarra ranged from $3.2 to $5.45 million.
In WGM's opinion, an appropriate value for Windarra's interest was at the midpoint of that range, or $4.3 million.[5]
[6] The Agreement of Purchase and Sale between the appellant and Windarra was dated, for reference, July 7, 1995 and was subject to regulatory approval. The purchase price of $1,922,895 was satisfied by the appellant issuing from its treasury to Windarra 3,845,790 common shares in its capital stock at a "deemed" price of $0.50 per common share for an 11.12 per cent interest in the Mine. The appellant did not acquire any right, title or interest in the mill on the Magnacon Property and was obligated to pay Windarra a fee for use of the mill in the event the Mine went into production. The transaction between the appellant and Windarra was approved by a majority of the appellant's minority shareholders at a meeting held for that purpose on August 30, 1995. The transaction closed on September 29, 1995, a day before the appellant's year end.
[7] The TSE accepted notice of the disposition of the interest in the Mine without comment. The VSE however advised the appellant that its approval would be withheld until a supplemental valuation was prepared by WGM which, among other things, restricted the valuation opinion expressed to the value attributable to the proven and probable reserves of the Mine. Ultimately, WGM did provide a revised valuation report, dated October 20, 1995, which satisfied the VSE. This valuation applied the comparable approach and not the discounted present value of the Mine. Accordingly, the revised value of Windarra's 22.23 per cent interest was
estimated in the range of $0.5 million to $0.6 million, a 100 per cent interest having a value in the range of $2.25 million to $2.27 million.
[8] Both parties, of course, produced valuation reports for purposes of the appeal. The appellant retained WGM to "review ... the valuation opinion WGM provided to Westward in 1995" for purposes of the transaction. Mr. Lawrence testified as an expert witness for the appellant.[6] Mr. Graham Farquharson, President of Strathcona Mineral Services Limited ("Strathcona"), testified on behalf of the respondent.
[9] The experts for both parties also referred to other reserve estimates of gold in the Mine, including:
- an estimate prepared by Mr. Colin McAleenan in 1989 when he was Chief Mine Geologist with Muscocho when it owned the Mine ("McAleenan Report"); Mr. McAleenan was also a witness for the Crown;
- a report prepared by the mining staff of Muscocho when the Mine was closed in 1990 ("Muscocho Report"); the Muscocho Report was in no small part based on the McAleenan Report; and,
- a valuation prepared by WGM of the same and another property for Muscocho, Flanagan and McAdam Resources Inc. on November 12, 1993 ("WGM November 1993 Report").
[10] The expression "fair market value" was understood by Cattanach J. in Henderson Estate v. M.N.R.[7] to mean:
... the highest price an asset might reasonably be expected to bring if sold by the owner in the normal method applicable to the asset in question in the ordinary course of business in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm's length and under no compulsion to buy or sell. ...
and each of the parties' experts have adopted the sense of this definition in making their valuations.
[11] Each of the McAleenan and Muscocho Reports provide estimates of gold reserves in the Mine as at the effective date of the particular report:
Table 1
McAleenan Report Estimate of Geological Reserves - (December 31, 1989)
|
|
|
|
|
Cumulative
|
|
Category
|
Tons
|
oz Au/ton
|
Oz Au/ton (c)
|
|
Tons
|
Oz Au/ton
|
Oz Au/ton (c) *
|
|
Proven
|
110352
|
0.351
|
0.259
|
|
110352
|
0.351
|
0.259
|
|
Broken
|
76226
|
0.162
|
0.135
|
|
186578
|
0.274
|
0.208
|
|
Probable
|
86716
|
0.31
|
0.23
|
|
273294
|
0.333
|
0.246
|
|
Possible
Accessible
|
83889
|
0.257
|
0.209
|
|
357183
|
0.31
|
0.235
|
|
Inferred
|
1115515
|
0.172
|
--
|
|
1472698
|
0.189
|
--
|
(Total = 1,472,698 tons; 0.182 Grade) Total ounces 278,340
Note: Cut-off grade = .100 oz Au/ton for Proven, Probable and Possible categories
Cut-off grade = .050 oz Au/ton for Inferred category
* = Cutting to 1.000 oz Au/ton
Table 2
Report of Estimate of Reserves by Muscocho Mining Staff 1990 (Muscocho Report) [8]
|
Category
|
Tons
|
Oz Au/ton (c)*
|
Contained Gold ounces
|
|
Proven
|
91,965
|
0.229
|
21,060
|
|
Probable
|
39,526
|
0.217
|
8,577
|
|
Possible
|
119,745
|
0.21
|
25,146
|
|
Drill Indicated
|
1,115,515
|
**0.172
|
191,869
|
(Total = 1,366,751 tons)
* Reserve cut to 1 ounce for Proven, Probable, Possible
** Reserve uncut for Inferred
[12] In Appendix 1 to his report Mr. McAleenan sets out the definitions he employed to classify the ore:
Proven Ore:
An oreblock that has been exposed by drifting, raising or mining with average grades and widths based on detailed, systematic chip sampling. The block is extended, within acceptable geological limits, a maximum vertical distance of 25 from the assay data.
Probable Ore:
An oreblock extending a maximum vertical distance of 25 feet from a Proven oreblock. The width and grade of this block is taken as that of the contiguous Proven block as well as from diamond drill information. The grades and widths of any diamond drill intersections within the block are factored in at one third influence.
Possible Ore- Accessible:
(1) A block extending a maximum vertical distance of 50 feet, within geological limits, from a Probable Ore block. Grades and widths of the block are computed from the grades and widths of the contiguous Probable block (1/3 influence) and from diamond drill intersections (2/3 influence). Blocks in this category can also be based purely on drill intersections.
(2) A block extending a maximum distance of 50 feet, within geological limits, from the end of a drift with the face in ore. The block is extended both up and down a maximum vertical distance of 50 feet from where the drift would extend. The grade of the block is taken from the adjacent Probable Ore blocks (1/3 influence) and from diamond drill intersections (2/3 influence).
Possible Ore blocks must be located above the lowermost level of the mine and be accessible through a minimal amount of development and/or mining.[9]
Inferred Reserves:
A potential ore block intersected by diamond drilling on a structure or in a zone for which there is no background information from underground or surface workings. The drill hole density is such that a reliable picture of the grade and/or the structure is not possible. A significant amount of development is implied in order to access a block in this category.
By definition, and for convenience, ore blocks located below the lowermost level of the mine have been placed in this category even though they may be based on chip sampling of the 6th Level drift.
An inferred block is centred over one or more drill intersections with grades equal to or exceeding .050 oz Au/ton over a minimum horizontal width of 5 feet. Rather than blocking out every individual drill hole intersection a single regional block is superimposed on the data. The block is extended a maximum vertical or horizontal distance of 100 feet from the data. The half-way rule between drill holes is applied at the boundaries of the regional block. The grade and the width of the block is obtained by taking the arithmetic average of the grades and the widths of the drill intersections.
Some intersections below the cut-off grade are included in the block if they are surrounded by intersections above the .050 oz Au/ton cut-off.
The justification for using this method for blocking out the Inferred Ore lies in the experience gained from drifting through the 'C' Zone on the 4th level. Grades obtained from chip sampling of the vein are significantly higher that those indicated by the 100 foot centred diamond drill hole intersections. Thus the rule "drill for structure, mine for grade" would seem to apply in this case.
[13] Mr. McAleenan testified that he arrived at his ore and grade figure with the aid of longitudinal section maps that were produced at trial. He said that the Mine
was operated in a reasonable manner and that the highest grade ore was mined first and concluded that inferred reserves have a lesser value than proven or probable reserves. The highest grade material is usually extracted first from a mine, Mr. McAleenan asserted, because the mining company would usually have debt which it would want to reduce as quickly as possible.
[14] In Mr. McAleenan's view most of the mine structures were narrow veins. He also stated that the Mine had dipping veins, some of which were fairly steep (i.e., 60 - 70 degrees), and others of which dipped 20 degrees or so. He said that dipping veins are generally harder to mine.
[15] Mr. McAleenan suggested how value would be influenced by the grade of ore in the ground:
Today if you were to buy a property with measured ounces in the ground that hadn't been mined yet, you would pay-you might pay 70 or 80 dollars or even $100 an ounce to the company to acquire those ounces.
An indicated ounce would fetch less, and these are always negotiable of course, but depending on how, what the mining costs would likely be. But the lowest category would be the inferred and typically they would fetch, I don't know, maybe 15 or 20 dollars an ounce if your measured and proven, if you like, if they were getting, say, 100 dollars. I would say your inferred would be considerably less, maybe in the order of 20 dollars an ounce or so.
[16] TheCanadian Securities Administrators classified reserves in their National Policy 2-A, entitled Guidelines for Engineers, Geologists and Prospectors Submitting Reports to the Provincial Securities Administrators. The definitions of the reserve categories described in National Policy 2-A, Messrs. Lawrence and Farquharson acknowledged, represent the industry standard at the relevant time. The policy statement cautions that "care should be taken in the use of the word 'ore'". National Policy 2-A defines "ore" and delineates it into three categories:
(a) "Ore" means a natural aggregate of one or more minerals which, at a specified time and place, may be mined and sold at a profit, or from which some part may be profitably separated;
(b) "Proven Ore" or "measured ore" means that material for which tonnage is computed from dimensions revealed in outcrops or trenches or underground workings or drill holes and for which the grade is computed from the results of adequate sampling, and for which the sites for inspection, sampling and measurement are so spaced and the geological character so well defined that the size, shape and mineral content are established, and for which the computed tonnage and grade are judged to be accurate within limits which shall be stated and for which it shall be stated whether the tonnage and grade of proven ore or measured ore are 'in situ' or extractable, with dilution factors shown, and reasons for the use of these dilution factors clearly explained;
(c) "Probable ore" or "indicated ore" means that material for which tonnage and grade are computed partly from specific measurements, samples or production data, and partly from projection for a reasonable distance on geological evidence, and for which the sites available for inspection, measurement and sampling are too widely or otherwise inappropriately spaced to outline the material completely or to establish its grade throughout;
(d) "Possible ore" or "inferred ore" means that material for which quantitative estimates are based largely on broad knowledge of the geological character of the deposit and for which there are few, if any, samples or measurements, and for which the estimates are based on an assumed continuity or repetition for which there are reasonable geological indications, which indications may include comparison with deposits of similar type, and bodies that are completely concealed may be included if there is specific evidence of their presence, and
(i) estimates of "possible ore" or "inferred ore" shall include a statement of conditions within which the inferred material occurs, and
(ii) since the arithmetical average of any amount of sampling is not necessarily representative unless the distribution of values and number of samples are properly taken into account, a statement of how samples were taken shall be given, and where mineralization is erratic, the method of treating the erratic values shall be given in the narrative of the report.
(iii) possible or inferred reserves must not be added to other categories of reserves and their inclusion is not acceptable in any economic analysis or feasibility study of a project.
Where the word "ore" may not properly be used, such terms as "mineralization", "mineralized bodies" or "concentrations", etc. should be used.
[17] Mr. McAleenan acknowledged that some of the parameters he set out in classifying the mineralization were not mandated by National Policy 2-A. He also acknowledged that changing the parameters he used (i.e. extension parameters of 30 feet instead of 25 feet) could result in a portion of possible ore being reclassified as probable and possible ore being extended further. He further admitted that National Policy 2-A did not distinguish between inferred and possible resources, as he had done.
Appellant's Expert
[18] Mr. Ross Lawrence, one of the authors of the WGM Report, was the appellant's expert witness defending its position that the market value of the 11.12 per cent interest it acquired in the Mine was $1,922,895. Mr. Lawrence graduated in 1956 from the University of Toronto with a degree in Applied Geology; he has also received a Master of Commerce degree in Mining Finance. He is one of the founders of WGM and, at the time of trial, was semi-retired.
[19] The gold reserves in the Mine estimated in the WGM Report differ significantly from the reserves estimated by Mr. McAleenan in 1989, the Muscocho mining staff in 1990, as well as a mine inventory review of the Mine prepared for Windarra by Kilborn Engineering (BC) Ltd. in February 1990 ("Kilborn Report").[10] According to the Kilborn Report, the reserves were as follows:
Table 3
|
|
Tons
|
Grade: oz Au/ton
|
|
Proven
|
----
|
----
|
|
Probable
|
224,000
|
0.24
|
|
Possible
|
84,000
|
0.21
|
|
Inferred
|
1,115,000
|
0.17
|
|
Surface stockpile
|
49,000
|
0.10
|
[20]The authors of the WGM Report concluded that the potential for the development of additional ore at the Mine was very good, especially at depth, and projected an additional 980,000 tons and assessed a grade of 0.20 oz Au/ton as possible reserves that were not considered in other reports. It is this additional tonnage that in no small part contributes to the dispute between the parties. The Mine reserves classified by WGM are incorporated in the WGM Review:
Table 4
|
Reserve Classification
|
Tons
|
Grade
|
Ounces Gold
|
|
Proven and Probable Ore
|
250,000
|
0.22
|
54,730
|
|
Possible Ore
|
1,115,000
|
0.20
|
223,000
|
|
Possible Ore
|
980,000
|
0.20
|
196,000
|
|
TOTAL
|
2,345,000
|
0.20
|
469,000
|
[21] According to WGM, the standard industry practice was to report "possible" and "inferred" reserves in the same category because the terms "possible" and "inferred" were in fact used interchangeably among industry professionals. Hence, in its own assessment, WGM placed "possible" and "inferred" reserves in the same category whereas Mr. McAleenan drew a distinction between possible and inferred reserves.
[22] WGM reclassified all of the reserves (proven, possible and probable) as "proven and probable ore reserves". Mr. Lawrence pointed out that Mr. McAleenan did not adhere to the definitions set out in National Policy 2-A in categorizing reserves.
[23] In the WGM Review, Mr. Lawrence reaffirmed the findings in the WGM Report. He explained in the Review that:
We ... concluded that the information available at the mine, and comparisons with other mines with similar geology, made it reasonable to project an additional 980,000 tons, mostly at depth below the mine workings, but where some diamond drilling had been completed. ...
Our projection of 980,000 tons was supported by mining experience at Magnacon, intersections in drill holes below the existing mine workings and examples of other gold mines in greenstone belts with a similar style of geology and mineralization which show persistent vertical continuity of gold mineralization in similar circumstances. ...
The bulk of the tonnage shown in the first two rows in Table 1 (1,365,000 tons) lies within or adjacent to the Magnacon mine workings. The upper level of the mine is at an elevation of 1450 feet while the lower level is at 1050 feet. Allowing for an additional 50 feet on account of ore blocks that are above the upper level or below the lower level, the vertical extent for most of the Magnacon Mine's reserves is about 450 feet. This calculates into approximately 3000 tons of ore per vertical foot. ...
The possible ore of 980,000 tons that we estimated will, in general, extend below the lower level, ... At 3000 tons per vertical foot, this means that the reserve would extend over a vertical distance of about 325 feet below the lower level of 1050 feet, or to about 700 feet in elevation. What evidence do we have that reserves might extend to this depth? One supporting piece of evidence is longitudinal section #7, on the Main Vein, which shows ore grade drill hole intersections down to the minus-100-foot elevation. There are several other examples on other longitudinal sections. ...
Finally, we can make comparison with similar property. A good example ... is the Renabie Mine located about 50 miles northeast of Magnacon on the same greenstone belt. ... The mine produced 4.7 million tons of ore at a feed grade of 0.219 oz. Au/ton. This is a typical example of a gold mine in a greenstone belt in Archean terrane.
[24] The authors of the WGM Report also increased the grade of all reserves, with the following justification for doing so:
Based on mining experience at Magnacon and results from a large number of deposits in Archean greenstone belts, we believe that it should be possible to mine at a higher average grade than is indicated by exploration diamond drilling. Accordingly, we assume that it should be possible to achieve a grade of 0.20 oz Au/ton, and applied that grade to all of the reserves used in our projections.
[25] WGM relied for its primary valuation considerations on the calculation of Net Present Value ("NPV") based on discounted cash flow ("DCF") projections. The approach requires one to estimate the capital costs to bring a mine into production, the operating costs to mine and mill the ore and to recover the gold, and to prepare an estimate of the cash flow resulting there from year by year for the life of the reserves. The net cash for each year is then discounted back to the present, using appropriate discount rates, in order to arrive at NPV.
[26] WGM also sought comparable transaction information in order to test the validity of the values calculated using the DCF approach.
[27] WGM estimated that the Mine's mill would produce 175,000 tons of mill feed in the first year of operation, 210,000 tons per year for the next ten years, and 70,000 tons in the final year. It was estimated that a total of 2,345,000 tons would be mined over 12 years (1995 to 2007) at an average grade of 0.20 oz Au/ton.
[28] Total operating costs were estimated at $66.00 per ton, and new capital requirements at $16.541 million, including $3.25 million for mining and process equipment, and $13.291 million for mine development.
[29] Gold prices used by WGM in modelling the project cash flow from the mine ranged from US$375 to US$425 per ounce and the exchange rate was assumed to be US$0.75 = C$1.00. NPV's were calculated based on projected cash flows using discount rates of 5, 10, 15 and 20%; constant dollars; a 12-month production schedule; and, a mine life of 11 years.
[30] On these bases WGM concluded that an appropriate value range for the Mine was $11.5 million to $22 million and that, accordingly, the value of a 25 per cent interest in the Mine ranged from $3.2 million to $5.45 million.
Respondent's Expert
[31] Strathcona is a firm that provides a variety of consulting services to the mining industry including: preparing and auditing ore reserve estimates; undertaking sampling and exploration programs on behalf of clients; preparing technical reports on mining properties; and, valuing investment opportunities in the mining industry for its clients. Mr. Farquharson graduated as a mining engineer from the University of Alberta in 1964 and in 1969 he obtained a Master's degree in Business Administration from Queen's University. Mr. Farquharson is presently a director of Placer Dome Inc. and Cambior Inc. Although Mr. Farquharson is not a professional valuator, he has broad experience in the mining industry and has been called upon to consider the value of ore properties. I concluded that his extensive background in the industry would assist me in considering the value of the Mine and permitted him to testify for the Crown. I refer to the report filed by Mr. Farquharson as the "Farquharson Report" or the "Strathcona Report".
[32] Mr. Farquharson opined that in 1995 an eleven per cent interest in the Magnacon Property "had a very modest fair market value of between $100,000 and $350,000". He based his conclusion on the history of the exploration, development and production on the Mine ending in 1990 and subsequent period of inactivity on the Magnacon Property until mid-1995 "despite a continuing reasonable gold price in Canadian currency".
[33] The annual reports of Muscocho were the main source for Mr. Farquharson's review of the Mine's history. The early years were full of optimism; the later years, full of despair. The 1987 annual report expected a pay-back of the invested capital within two years of the start of the Mine's production. Gold production was forecast at up to 80,000 ounces per year at a cost of C$225 per ounce. Ore grade was predicted to be higher than that indicated by core drilling. In its next annual report, Muscocho reported development of the Mine was in progress and construction of the mill to treat 800 tons of ore per day was almost completed. It was expected to produce 40,000 ounces of gold in 1989, with a possible increase of up to 100,000 ounces per year at a unit cost of US$200 per ounce or less.
[34] However, according to Muscocho's 1989 annual report, gold production for 1988 was only 14,900 ounces and commercial production was not achieved. The grade of the ore resources was reduced from 0.25 oz per Au/ton to 0.20 with a possibility of a further reduction to 0.18 oz per Au/ton should cutting of high grade assays be necessary. Further, there was also a deficiency of capital. Echo Bay Mines Ltd. ("Echo Bay"), a major mining corporation, agreed to join a joint venture and obtain 50 per cent interest in the Magnacon Property and another mine, the Magino Mine, located in the same area of Northern Ontario that was being developed by the Muscocho Group, and to provide funding to support the ongoing development. At the same time Muscocho wrote down $6.2 million on the book value of its 25 per cent interest in the Mine.
[35] Mining of the Magnacon Property stopped in June 1989; the Mine had not achieved commercial production. Milling continued until October 1990, processing all surface stockpiles and available material with gold production for the year amounting to 19,397 ounces. Muscocho stated that a lack of underground development and low gold prices precluded continuing the operation. Substantial further investment and higher gold prices were needed to justify operation of the Magnacon Property, according to Muscocho. Echo Bay reported ore reserve grades were lower and mining costs higher than had been forecast when it joined the joint venture. Echo Bay's annual report for 1990 informed the reader that as a result it wrote off its $42.4 million investment, deciding "not to throw good money after bad". Muscocho's interest in the Mine increased to 36.8 per cent in 1989 and later to 38 per cent due to dilution of other parties who did not maintain their contributions for funding the project. Muscocho took a further write-down of $11.7 million, reducing the carrying value for its 36.8 per cent interest to $5.2 million. In 1991, 1992, 1993 and 1994 Muscocho wrote down the value of its interest to $2 million, $1.8 million, $1.6 million and to $1.4 million respectively.
[36] Although the Magnacon Property was inactive in 1991, an agreement was reached to sell the mill for $2 million. The proposed sale of the mill did not close as expected in 1992 but was sold in 1996, after the Acquisition Date, to a mining company operating in the area.
[37] During the period 1987 to 1994, according to Mr. Farquharson, information was provided to shareholders of Muscocho that estimated Magnacon's ore reserves at the end of 1989 at 1.47 million tons, with a grade of 0.20 to 0.25 oz Au/ton, for a combined gold quantity of approximately 300,000 ounces.
[38] Mr. Farquharson compared these reserves to the reserve estimate of the Magnacon mining staff on the closing of the Mine in 1990 (Table 2). He explained that the reserves in Table 2 are geological reserves, which, he explained, means "that mining dilution must be added which would result in an increase in tons and a lowering of the gold grade". In his view mining dilution was a significant problem at the Mine because of the narrow width of the ore veins and the frequent shallow dip of the ore veins; thus, additional waste rock had to be mined and milled, lowering the gold grade of the ore and increasing the cost per ounce of gold produced.
[39] Mr. Farquharson viewed the Magnacon mining experience, while in production, to be very relevant to the valuation of the Magnacon Property. Mining during 1989 and 1990 resulted in the extraction of 266,000 tons at a grade of 0.15 oz Au/ton from which 34,300 ounces of gold were recovered. The tonnage mined was a large portion of the tonnage that is combined in Table 2 under the categories of proven, probable and possible reserves. Mr. Farquharson stated that there was no reason to predict, or to expect, that the remaining reserves listed in Table 2, prior to mining dilution, would not result in a similar mining grade of 0.15 oz Au/ton as occurred during 1989 and 1990.
[40] The category of "drill indicated" reserves in Table 2 is not a term that was sanctioned by National Policy 2-A, but its ranking in the list of Magnacon geological reserves, Mr. Farquharson wrote, would indicate that less information on which to base a reserve estimate was available than for the possible or inferred category, and would most likely not meet the requirements for public disclosure when raising funds from the investing public. In addition, the grade indicated for the "drill indicated" reserves would need to have any high-grade gold assays reduced to limit their influence as was done by Magnacon for the other categories, and before adding mining dilution. The "drill indicated" category in Table 2 can be considered potential tonnage, he acknowledged, but with a very high degree of uncertainty, with respect to both tonnage and grade.
[41] Mr. Farquharson recalled that in general, during the period of the early 1990's, the term "drill indicated" reserves was occasionally used by junior mining companies to indicate that results from widely-spaced drillholes were encouraging but were not sufficient to support either assumption of continuity of grade or dimensions between drillholes, as would be required for possible reserves.
[42] To determine whether the remaining Mine ore reserves in the proven, probable and possible categories in Table 2 could have been mined at a profit Mr. Farquharson assessed the economics of mining one ton of average grade. For his calculations the Magnacon Property ore was based on the following:
· Average grade of 0.15 oz Au/ton based on past mining experience;
· Gold recovered from the mined ore in the milling process of 90% as Magnacon reported was achieved in 1990;
· Gold price of C$447 per ounce in 1990 and C$527 per ounce in 1995 at the time of the transaction between Windarra and the appellant;
· Operating costs for mining and milling of $75 per ton which was the estimate in the Feasibility Study but which was never achieved. From reviewing the Muscocho financial statements it would appear that in 1989 Mine operating costs per ton were in excess of $100 per ton;
· There was also a royalty on gold sales from the Mine, once commercial production was attained, of 3% of revenue for the first three years of operation and 5% thereafter, which would be a deduction of a further $2 or $3 per ton, which Mr. Farquharson had not included in his analysis, as the operating margins were already negative before the deduction of the royalty on revenue.
[43] In Table 5, below, Mr. Farquharson summarized the operating margins for treating a ton of ore at the Mine in 1990 and 1995 based on the foregoing. He concluded the Mine lost money on every ton of ore mined in 1990 and would have continued to do so in 1995 had it still been in production, mining the same grade, and achieving the operating cost predictions in the Feasibility Study, even though the Canadian dollar gold price in 1995 was much higher than in 1990. Operating costs would have also been higher in 1995 simply because of normal inflationary pressures.
Table 5
Magnacon Operating Margins - 1990 and 1995
|
|
1990
|
1995
|
|
Gold grade - oz Au/ton
|
0.15
|
0.15
|
|
Gold recovery - %
|
90
|
90
|
|
Gold price - C$ per ounce
|
$447
|
$527
|
|
Revenue - C$ per ton ore
|
$60
|
$71
|
|
Operating costs - C$ per ton ore
|
$75
|
$75
|
|
Operating margin
|
-
|
-
|
[44] In Mr. Farquharson's view, positive operating margins are required, at a minimum, to pay for the ongoing mine development which would normally be capitalized, as well as the original mine development and capital expenditures for the process plant, infrastructure, etc. Consequently, his simple analysis of operating margins, he asserted, leads to the inevitable conclusion that the Magnacon Property "ore reserves" cannot be mined at a profit and cannot be designated as ore in accordance with traditional mining terminology and understanding as practised in the mining industry. There were, he concluded, no ore reserves at the Mine in 1990 or in 1995 when the transaction occurred between Windarra and the appellant.
[45] Mr. Farquharson agreed with Mr. Lawrence that in valuing a mining property with ore reserves it is normal practice to determine the net present value of cash flows resulting from mining the ore reserves on the property. In the case of the Magnacon Property, he argued, it was not possible to mine "ore reserves" at any time during the period 1989 to 1995 to achieve positive cash flow, primarily because the grade of the ore that would be delivered to the mill would be too low and less than forecast. Therefore, there would be no cash flow to form the basis of the valuation following the cash flow approach.
[46] The reported ore reserves in Table 2, including the reserves in the possible category as well as in the proven and probable categories in October 1990, Mr. Farquharson declared, represented less than two years of operation had the mine continued at its production rate. In addition the property had substantial bank debt and other obligations that could not be repaid in a two year period.
[47] In Mr. Farquharson's view, the category of "drill indicated" reserves should not be used for cash flow modelling, being too speculative and not in accordance with National Policy 2-A. He did concede that despite the restriction on using "drill indicated" reserves for projecting cash flows, that mineralized material does have some value.
[48] Mr. Farquharson does not deny a value to a mining property for the reason only that its ore reserves cannot be used for cash flow purposes. He agrees that gold in the ground of a resource property has value simply because investors will be prepared to accord a value to that gold. However, the value assigned would be less than to the gold in an operating mine or in a mine ready to go into production that is expected to have positive operating margins.
[49] The WGM Review referred to six property transactions during the period 1993 to 1995, where gold reserves changed ownership at values between $15 and $45 per ounce. Mr. Farquharson said that the range of values for gold transactions can often be even greater. The factors that affect those transactions, he stated, include the profitability of the mine per ounce of anticipated gold production, the size of the deposit, and therefore the indicated life of the property, and the prospects of adding more gold reserves or mineralization in the future.
[50] In Mr. Farquharson's view the Magnacon deposit could not be mined profitably in 1989 and 1990 and was unlikely to be mined profitably thereafter on a stand-alone basis unless there was a significant gold price increase as noted in statements by Muscocho management. The Magnacon deposit only had an indicated two-year life at the time of closure, although with some possibility of extending that life. In assessing the possibilities for the projected life extension of the Mine, Mr. Farquharson noted that the Magnacon Property has been rather extensively drilled in the past with 200,000 feet of exploration drilling in 1987 and 1988 alone. There may be more potential on the property, he surmized, but he thought it would be limited, given the amount of exploration that had already been done. To find more mineralization at depth on the property, which is where much of the material in the "drill indicated" category is, in Mr. Farquharson's opinion, would require much higher grades to be economic, given the higher operating costs associated with deeper mining, and larger capital investment to gain access to the gold mineralization at depth.
[51] Taking into account these factors that apply to the Magnacon mineral inventory, Mr. Farquharson allowed for the lower portion of the range of gold valuations per ounce of gold proposed by WGM in its analysis of comparative transactions. His valuation of the Magnacon mineral inventory is summarized as follows:
Table 6
Valuation of Magnacon Mineralized Inventory
|
Category
|
Contained Gold Ounces
|
Value per ounce
|
Value Rangemillions
|
|
Proven and Probable
|
29,600
|
$20 - 25
|
$0.6 - 0.7
|
|
Possible
|
25,100
|
$15 - 20
|
$0.4 - 0.5
|
|
Drill Indicated
|
192,000
|
$0 - 10
|
Nil - $1.9
|
|
Total
|
|
|
$1.0 - 3.1
|
[52] Based upon the range of valuation of $1.0 to $3.1 million for the entire Magnacon resource property, Mr. Farquharson concluded that the approximate 11% interest that was sold by Windarra to the appellant in 1995 should have a value in the range of $100,000 to $350,000. He acknowledged that such a value is low relative to the $1.9 million at which the transaction was done, but was influenced by the fact that the Magnacon Property remained idle for a five-year period from 1990 to 1995 while Muscocho made intensive efforts to find a buyer or investor to participate in the resumption of mining activities on the property without success.
[53] Nevertheless Mr. Farquharson admitted that there were a number of very positive features about the Magnacon Property that would normally have contributed to investor interest and they include: the underground mine was developed; a new processing plant was built; the Mine was well located to attract operating personnel and to provide support services; and the Mine was fully permitted. However, there was a negative perception that the mined grade of the ore reserves was too low for an economic project as had been demonstrated in 1989 and 1990, and the prospects for higher grade through further exploration were considered very limited. This situation was also recognized by Muscocho management and their auditors, when the carrying value of 75% of the Magnacon property was written-down to less than $4 million in 1992 and declined each year thereafter.
Appellant's Rebuttal Opinion
[54] Ross Glanville & Associates Ltd. ("Associates") was engaged by the appellant to provide a rebuttal opinion to Mr. Farquharson's report. Associates specializes in valuation of public and private mining and exploration companies, including producing mines, among other things. The company also provides "fairness" opinions and litigation support related to financial and technical issues. Mr. Ross Glanville is president of Associates and was the author of the rebuttal opinion. Mr. Glanville received a Bachelor of Applied Science degree (Mining Engineering) from the University of British Columbia in 1970 and became a member of the Association of Professional Engineers of British Columbia in 1972; in 1974 he received a M.B.A. degree and in 1980 became a member of the Certified General Accountants of British Columbia. He has valued over 500 mining and exploration companies and mining properties.
[55] In its original opinion Associates not only reviewed both the WGM Report and the Farquharson Report but also offered its own conclusion as to the fair market value of the appellant's interest in the Mine at the time of purchase. A conclusion as to fair market value is not warranted in a rebuttal opinion and I rejected the production of the opinion. Mr. Glanville subsequently amended his report, deleting all reference to his opinion as to fair market value and he was qualified as an expert witness.
[56] During cross-examination of Mr. Glanville it became obvious that his opinion was based on the WGM Review and Report. He relied on the WGM Report for the resource calculations, for example, the total tonnage was 2,345,000. Asked if he considered the reserve calculations made by the Muscocho staff when the Mine closed in 1990, Mr. Glanville remarked that "... it's hard to determine if they're relevant if I say I didn't review them in any detail and relied on WGM. That would be a stretch."
[57] As far as the additional 980,000 tons of ore that WGM included in its total tonnage of possible ore, Mr. Glanville stated the additional resources "were projected in areas where they had either very few or no drill holes beyond existing mineralization". He did not know the depth; he relied on WGM categories and numbers, accepting the "resource numbers" based on WGM's reputation as an "international firm of geologists and engineers".
[58] Mr. Glanville did not fully examine Mr. Farquharson's findings. He simply preferred the WGM findings and acknowledged that if the WGM Report and Review were flawed, his report was flawed insofar as it affected the resources component.
[59] Mr. Glanville's methodology was simply to measure Mr. Farquharson's numbers against WGM's. He used the latter to try to disprove the former, without independently investigating the veracity of either. Consequently, his opinion is generally not of assistance. I do, however, find some of Mr. Glanville's analysis helpful. For instance, he stated during cross-examination that the range of value per ounce of gold used by Mr. Farquharson in respect of proven and probable mineralization, $20 to $25, would be an acceptable value if it were applied across the board to all categories of gold. He stated that standard industry practice is to value mineralization in this way, as opposed to assigning specific values for each particular classification. As well, Mr. Glanville's report cites a number of factors which would indicate a higher value than that determined by Mr. Farquharson. It is noteworthy that there was the possibility of additional resource discoveries at the Mine and there was a potential for economies of scale with the combination of operations with other existing or future deposits in the area.
Submissions of Counsel
[60] Appellant's counsel compared the WGM and Strathcona opinions and found at least five points of disagreement in Mr. Farquharson's opinion: the quantity and quality of the mineral reserves at the Mine; discounted cash flow; expected operating costs per ton; expected grade that could be recovered; and, whether inferred reserves should be used in valuing the Mine property.
Upgrade and Reclassification of Resources
[61] Appellant'scounsel, Mr Cook, submitted there was sufficient evidence in the McAleenan and Muscocho reports to upgrade the "possible ore" to "probable ore". The definition of "possible ore" in National Policy 2-A is a qualitative analysis requiring a degree of subjectivity and professional judgment. There is no concrete delineation that distinguishes "possible" ore from "probable" ore. WGM's decision to upgrade the reserves at the Mine, counsel declared, was based on the inspection by WGM personnel of the property in 1993 and WGM's collective years of experience in reviewing and evaluating mineral properties.
[62] Counselfor the appellant distinguished the definition of, or standard for, "possible ore" or "inferred ore" in National Policy 2-A to Mr. McAleenan's definition of "Possible Ore - Accessible"[11] and submitted that there is nothing in National Policy 2-A's definition of "possible reserves" that requires any proximity to the lowermost level of the Mine or that there be accessibility to the Mine workings through a minimal amount of development.
[63] Mr. McAleenan's definition of "inferred" ore, appellant's counsel suggested, accords with the parameters set out in paragraph (a)(ii) of "possible ore" in National Policy 2-A and is consistent with Mr. McAleenan's treatment of the "inferred" reserves as "possible" reserves which were not above the lowermost level of the Mine or not accessible through a minimal amount of development. Mr. McAleenan's definition of "inferred" reserve is higher than that required of "possible ore" under National Policy 2-A since the latter does not require there be samples or measurements.
[64] Appellant'scounsel referred to Mr. McAleenan's interpretation of certain drill holes, for example, longitudinal section 8 of the Mine, which in counsel's view illustrates the "symmetry" between his definition of inferred reserves and that of possible or inferred reserves in National Policy 2-A. Mr. McAleenan acknowledged that what he classified as an inferred reserve in longitudinal section 8, section EZ.1, could be classified as possible ore based on geological interactions. Counsel stated that Mr. McAleenan's classifications were no accident; he divided what National Policy 2-A would qualify as "possible or inferred" into two categories, "possible accessible" and "inferred", reserves that were accessible to the Mine workings and those that were not.
[65] Mr. Cook did not accept Mr. Farquharson's view that the Magnacon staff who prepared the Muscocho Report had sufficient knowledge in evaluating and classifying the estimated reserve as compared to WGM's personnel. The Magnacon staff may have had experience at only one mine while the WGM has examined and assessed numerous resource properties and therefore had more experience by which it could classify mineralization and opine as to its existence. WGM's process in projecting an additional 980,000 tons of possible ore was proper.
[66] Appellant'scounsel also attacked Mr. Farquharson's rejection of additional tonnage. Mr. Farquharson relied on the following statement by management in Muscocho's 1989 annual report:
A review of indicated future production operating and capital costs, mine reserves and the foreseeable potential increases in reserves, and the operating capacity of the mill together with reasonable projection of likely oil prices has led management to conclude that the cost deferred to date with respect to exploration and development at Magnacon are not likely to be fully recovered from cash flows and hence $6,250,000 of deferred exploration and development expenditures have been written off.
[67] However, Mr. Cook declared, Mr. Farquharson failed to take into account the context within which the write down occurred, as noted in the same annual report:
The extended start up period and low grade price resulted in a severe cash drain ... Two major breakdowns in the mill during December resulted in serious production losses ... the ability of the Company to remain in business is dependant on the continued support of its bankers and other creditors until a refinancing is completed. The Company has been advised by its bank that it is not prepared to continue support indefinitely and wishes to see a refinancing program completed.
[68] Thewrite down took place, appellant's counsel argued, as part of the company's refinancing efforts and was designed to ensure that "future reserves will not be burdened with amortization costs that cannot be absorbed by those reserves,"[12] the write down should not be viewed as a reduction in the company's estimation of the Mine's fair market value.
Discounted Cash Flow
[69] Mr. Farquharson opined that since the Mine did not generate any profit no cash flow analysis could be applied to value the property. However, appellant's counsel states, Mr. Farquharson undertook no sensitivity analysis on his assumptions in reaching his conclusion; even a small change in any of his assumptions would have him conclude that the Mine and mill would be operated at a profit. Had he assumed an ore grade of 0.16 oz Au/ton, a recovery rate of 90 per cent, or gold price of $527 per ounce, and a cost of $75, he would have calculated a profit.
Operating Costs
[70] Asfar as cost is concerned, Mr. Farquharson adopted a cost figure similar to that applied in the Feasibility Study, which suggested a cost of $76.10 per ton. Farquharson assumed a cost of $75 but, says appellant's counsel, he did not account for the fact that the Feasibility Study anticipated that the actual operating costs would be lower than the figure used in the study due to the amount of long hole mining to be used at the Mine. The President of Muscocho, in Muscocho's 1989 Annual Report, blamed delays early in the year in providing power to the project causing the mill start up to be delayed; through this period the monthly costs continued at a high rate as the Mine was prepared for production. Appellant's counsel blamed the fact that the Mine was inadequately financed for its shut down less than a year and a half after operations began and before the Mine achieved commercial production.
[71] WGMconcluded that $66 per ton was a reasonable cost to use for its calculations. Mr. Lawrence considered actual cost experience in the later period of the Mine's production, discussions with Mine staff and plans to restart the Mine and the Mill. In May 1990, actual operating costs were $53.71 per ton, much less than $75 assumed in the Feasibility Study.
Recovery Rate
[72] Mr. Hendrich projected a gold recovery rate of 95 per cent in his Feasibility Study; Mr. Farquharson projected a rate of 90 per cent. Appellant's counsel blamed the actual recovery rate at the Mine to operational problems at the mill and the lower grade development rock being processed. There was also testimony that the poor filters at the mill negatively affected its output. As a result revenue from the Mine was reduced and costs were increased.
[73] Inappellant's view, if Farquharson had used a 95 per cent recovery rate, even with a grade of 0.15 oz Au/ton, a gold price of $527 per ounce and an operational cost of $75, he would have concluded that the Mine could operate at a profit.
[74] Similarly, Mr. Farquharson conducted no activity analysis for the price of gold, appellant's counsel stated. An increase of 5 per cent in the price of gold would also indicate a profitable operation in the appellant's view.
[75] Mr. Cook conceded that the WGM Review had not taken into account royalty fees that would otherwise be payable to the owners of the Mine. Mr. Lawrence testified that had he incorporated the royalty fees into his DCF analysis, the result would have been reduced by 10 per cent, thus a range between $10.3 million to $19.6 million. As far as the comparable approach used by WGM, the adjustment for the royalty would change the valuation range from the Mine to $12.8 million to $19.6 million; a 22.23 per cent interest in the Mine would be valued at approximately, $4,052,500.
Use of Inferred Reserves
[76] Thequestion of use of inferred reserves was an important part of the evidence and debate by counsel. Mr. Lawrence gave great weight to his estimate of inferred reserves in valuing the Magnacon Property. Mr. Farquharson referred to National Policy 2-A for support that "possible or inferred reserves" must not be added to other categories of reserves and their inclusion is not acceptable in any economic analysis or feasibility study of a project. The difference of opinion between these two witnesses put into question the correctness of a DCF calculation. Mr. Lawrence wrote a paper in the April 2001 issue of "Mining Engineering" asking the question "should discounted cash flow projections for the determination of fair market value be based solely on proven and probable reserves?" He concluded that DCF projections should be based upon all reserves and resources, including inferred reserves, and fair market value determined after making suitable allowances for the technical and financial risks involved.
[77] Theappellant's experts thought it correct to include inferred and possible reserves in a DCF analysis for a valuation of a mineral property. Mr. Glanville, for example, referred to an acquisition of Arequipa Resources ("Arequipa") by Barrick Gold Corporation ("Barrick") in 1996; despite indications from only nine drill hole samples, Barrick paid approximately one billion dollars for the property. Mr. Farquharson acknowledged Barrick placed a value on something other than "proven" or "probable" reserves in buying Arequipa. Also, in another transaction, Place Dome may have considered reserves other than "proven" or "probable" reserves when it acquired property in 1999 from Getchell Gold Corporation in Colorado.
[78] Finally, Appellant's counsel also criticized Mr. Farquharson for not reviewing any sales of comparable mining properties as did Mr. Lawrence and, in particular, did not comment on WGM's selection of properties it considered most comparable to the Mine.
[79] Counselfor the appellant added that Mr. Farquharson was tainted, in part, by events subsequent to the effective date of the valuation.
[80] Mr. Lawrence did not agree with Mr. McAleenan's and the Muscocho mining staff's estimates gold reserves in the Mine, the former estimated 1,472,698 tons for 278,340 ounces of gold and the latter 1,366,751 tons for 246,000 ore ounces. The Kilborn Report estimates 1,423,000 tons (plus 49,000 tons stockpiled in the surface). Of this amount 1,115,515 tons, with an average grade of 0.171 oz Au/ton, was inferred. Mr. Lawrence estimated 2,345,000 tons, an average grade of 0.20 oz Au/ton, for 469,000 ounces of gold; 250,000 tons is "proven and probable", the bulk of his estimate is "possible". Mr. Lawrence's estimate is approximately 1,000,000 tons more than earlier estimates. He upgraded the classifications of most of the reserves calculated by the Muscocho Mine Staff and to that added another 980,000 tons.
[81] Mr. Lawrence upgraded 119,000 tons classified as "possible" by the Muscocho Mine Staff to "probable" because he "concluded that all of the material that Muscocho classified as 'proven, probable and possible ore' should be classified as 'proven and probable ore reserves'." He found the work done by the mine staff to be too conservative. In his reserve classification, Mr. Lawrence combined the "proven" and "probable" ore categories as "proven and probable". In his DCF calculation, Mr. Lawrence only used "proven" so that what the Muscocho staff considered "possible" ore became "proven". I find this quite a leap. The Kilborn Report in 1990 cautioned that mine detailed diamond drilling and development was necessary for the reserve of 84,000 tons with a grade of 0.209 oz Au/ton to be placed in the "probable" category.
[82] Mr. Lawrence also moved the 1,115,000 tons of ore from drill indicated (by Kilborn) to "possible" as he considered the two to be synonymous. Mr. McAleenan and Mr. Farquharson considered them to be two distinct categories. As far as Mr. Farquharson is concerned "drill indicated" material must first qualify as ore before it could qualify as "possible ore". Ore must be capable of being mined and sold at a profit. In Mr. Farquharson's view since the criteria for including material in the "drill indicated" category only requires that it be above the grade of 0.05 oz per gold per ton it would be uneconomically viable and therefore it was inappropriate for Mr. Lawrence to upgrade the category to "possible".
[83] Mr. Lawrence's reasons for adding another 980,000 tons as "possible" are reviewed earlier in these reasons. At trial he provided a document entitled "Tabulation of Magnacon Ore Reserves by Zone and Estimate of Possible Ore at Depth"[13] to support the addition of the 980,000 tons.
[84] As I understand it, the calculation in this document was based on less than 1,800 tons/vertical foot, with varying vertical foot tonnage per vein/zone, and was based on a -200 ft. elevation, an additional 1200 feet, cumulating in a total projected tonnage of just over 2 million tons.
[85] Mr. Lawrence's trial methodology has overstated the tons/vertical foot in those areas where the resource extends beyond the lowest level of the mine workings, and has double counted those blocks. Further, his justification for extrapolating to the -200 ft. elevation ore reserves similar in ore quality in the mine workings, based on the fact that the Mine was in an Archean greenstone belt, is, as respondent's counsel submitted, an unsubstantiated generalization.
[86] The drilling results at the Mine did not support such an extrapolation as drill holes outside the delineated ore blocks showed very low or no grades. This, according to Mr. Farquharson, indicated that mineralization did not continue to depth as assumed by Mr. Lawrence, who appears to have assumed the existence of ore where drilling evidence suggests that such an extrapolation was unreasonable. Further, previous investors of the Mine also did not share Mr. Lawrence's optimism for the Mine's future potential. Echo Bay was not inclined to increase its investment with the Mine.
[87] The bulk of the tonnage of the ore reserve classified by Mr. Lawrence, 2,095,000 ore tons, some 90 percent, is in the "possible" category; I agree with respondent's counsel that this is too speculative to form the basis of a DCF.
[88] At best there is evidence for the potential existence of the 1,115,000 tons classified by the mine staff as "drill indicated", which Mr. McAleenan described as an indication of the potential of the Mine.
[89] Mr. Lawrence's addition of 980,000 tons to the "possible" ore category increased the reserve estimated by the mine staff by over 70%; this has a profound effect on any DCF calculation. If anything, this tonnage should be more accurately described as "speculative"; I am leery of using the 980,000 tons in any DCF calcuation.
[90] There is no question that the DCF method is an appropriate and acceptable method to assist in computing the net property value of a mine. However, a DCF is only as reliable as the veracity of the assumptions used in the calculations. When actual operating data results in a negative cash flow and reliance is placed on subjective data to produce a positive cash flow, one must view with great caution the use of the assumption in creating the positive cash flow[14]. Appellant's counsel accused Mr. Farquharson of not undertaking any sensitivity analysis in his study, arguing that even a small change is any of Mr. Farquharson's assumptions would indicate a profit. Counsel proceeded to increase, slightly, items such as ore grade, recovery rate and gold price and to reduce costs. However, while I agree with appellant's counsel that even small changes would demonstrate the Mine's capacity to operate profitably, slight changes reducing Mr. Farquharson's assumptions, for example, as to ore grade, recovery rates, gold price and increasing costs, would indicate an even greater loss from the operation of the Mine. The best indicators to apply to determine the DCF of a mine are the actual historic values, unless, of course, those values are greatly suspect and I have not found the values used by Mr. Farquharson to be suspect.
Grade
[91] Mr. Lawrence assumed that the grade of the ore he classified as "proven and probable" was 0.22 oz Au/ton and that the grade of the remaining tons was 0.2. Respondent's counsel argues that Mr. Lawrence has inflated the grade of the ore by:
(a) failing to take into account the effect of mining dilution;
(b) upgrading the "drill indicted" ore grade from 0.17 oz Au/ton to 0.2; and,
(c) projecting an additional 980,000 tons at 0.2 oz Au/ton.
[92] In his calculation of DCF, Mr. Lawrence took into account only the in situ or "geological" reserves as opposed to the "mineable" reserves which take into account dilution, and is therefore a lower grade of ore. At trial Mr. Lawrence agreed that the appropriate grade for a DCF is the diluted grade.
[93] Mr. Lawrence assumed a geological grade of 0.2 oz Au/ton for the "drill indicated" category despite the fact that the uncut and undiluted grade assigned by the mine staff, based on actual drill samples, was only 0.17. He did not "cut" the grade for the high grade (assay) samples used in estimating the "drill indicated" reserves. This would provide an estimate average grade of said reserves. Mr. Farquharson did undertake this exercise and determined that the average grade of the "drill indicated" reserves to be 0.156 oz Au/ton, but not yet diluted. Mr. Lawrence upgraded the 1,115,000 tons to 0.2 oz Au/ton, and also applied this grade to his additional 980,000 tons of projected ore, based on no samples.
[94] Mr. Lawrence referred to the mining experience at Magnacon and results from other mines in the Archean greenstone belt, where the Mine is located, as justification for a higher average grade than indicated by exploration diamond drilling. However, WGM's experience at the nearby Eagle River property, also in the Archean greenstone belt, and the experience at the Magnacon Property, as evidenced by a low millhead grade of 0.17 oz Au/ton in 1989 and 1990, did not support Mr. Lawrence's upgrading the gold content of the "drill indicated" from 0.17 to 0.2 oz Au/ton.
[95] I have difficulty in accepting Mr. Lawrence's explanation of how he determined the mineable grade. His findings are unsupported by the mine staff's own grade estimations. Mr. Lawrence's conclusion that the mineable grade would be higher (0.2) than the uncut undiluted geological grade (0.17) is questionable. Given the significant effect that a small change in grade can have on the NPV of a mining property, Mr. Lawrence's method of estimating grades results is an assumption that is too uncertain for use in a DCF calculation.
Mill Recovery Rate
[96] Mr. Lawrence used a mill recovery rate of 96%. The experience at the mine was a recovery rate of 85% in 1989 and 90% in 1990. While the Feasibility Study assumed a mill recovery rate of 95%, in May 1990 the mine staff had downgraded their expectation to 93.5%. Mr. Lawrence adopted the most ideal assumptions in his calculations.
Operating Costs
[97] The WGM Report stated that its DCF was based on assumed operating costs of $66/ton; however, it appears that Mr. Lawrence assumed operating costs of $64.50/ton, and, at trial, was unable to explain the discrepancy.
[98] As respondent's counsel demonstrated, Mr. Lawrence's operating cost assumptions have been inconsistent from one valuation to the next. The Feasibility Study projected operating costs of $76.10/ton. However, Mr. Lawrence testified that the costs at the Mine increased to around $100/ton in 1989, which he attributed to start-up problems. The evidence discloses that operating costs in 1989 were around $82/ton and increased in 1990 to an average of about $105/ton. I agree with respondent's counsel that the high costs were not attributable to operational start-up problems. Any falling costs in May 1990, the last month of production underground, Mr. Lawrence admitted, was probably due to some cutting of corners.
[99] That operating costs did increase is consistent with statements made by the Chairman of Echo Bay Mines, Robert Calman, in May 1990, when that corporation withdrew from the proposed deal with Muscocho. In 1989 the mill was operating very close to capacity and high costs cannot be the result of low throughput at the mill.
[100] I agree with respondent's counsel that there are other problems in the WGM Review. Problems in Mr. Lawrence's calculation of DCF include the following:
(i) Mr. Lawrence did not deduct royalties; I discussed this earlier;
(ii) Mr. Lawrence failed to deduct taxes, thereby over-estimating value;
(iii) In using the comparables approach, Mr. Lawrence assumed the same reserves and grade, with the result that the same problems inherent in his DCF approach are inherent in his comparables approach;
(iv) Mr. Lawrence's assumption that ore at depth (to the -200 ft. level) would be reached by way of ramp, is inconsistent with Mr. Farquharson's evidence that he is not aware of any mine in Canada that relies exclusively on that technique to access that depth;
(v) Mr. Lawrence did not include any capital costs in his DCF for ramp construction, nor does his operating cost reflect this added expense as the mine gets deeper; and
(vi) Mr. Lawrence's DCF produced an internal rate of return of between 49% to 72%; whereas he admitted that an internal rate of between 7% and 12 % is more usual. An otherwise successful mine would not have given as high a rate of return as that produced by Mr. Lawrence's DCF.
[101] WGM had valued the Magnacon Property on several occasions in 1992, 1993, June 1995 and at least two times after the effective date, October 1995 and July 1996. The values are not consistent.
[102] On July 29, 1993 WGM sent a draft opinion letter to Citibank NA in New York, with an attachment of a table entitled Magnacon DCF - NPV Model indicating a net present value ("NPV") of $29,132,000, (at 20%) to $50 million (at 5%). In cross examination Mr. Lawrence acknowledged an error in the NPV because the discounted value of $50 million (at 5%) was higher than the cash flow of $43 million, the amount being discounted. The NPV prepared for the Canada Customs and Revenue Agency shows a range of $6.9 million (at 20%) to $27.8 million (at 5%). Mr. Lawrence could not explain the discrepancy.
[103] WGM completed a formal valuation of the Magnacon Mine as well as another mine nearby, the Magino Mine, on November 12, 1993 and concluded that the Magnacon Mine had a value of $31 million. WGM's DCF ranged from $24 million to over $50 million, according to the valuation report. The DCF analyses are not included in the report but since the assumptions are very close to the assumptions made in 1992, respondent's counsel suggests a similar error was made in 1993 as well.
[104] WGM's June 8, 1995 report valued the Mine at $17,200,000, a drop of about $13 million from the valuation of 1993. Mr. Lawrence did not offer any explanation for the fall in value.
[105] The October 1995 valuation was required by the VSE. Apparently the VSE approved the transaction at approximately $1,400,000 on the basis that between $1,015,000 to $1,397,000 of value was attributable to the elimination of a tax liability and the balance as to the value of the Mine.
[106] Appellant's counsel found support that the purchase price for the 11.12 per cent interest in the Mine paid by the appellant to Windarra was a true value since the share price of the appellant did not drop when the purchase was announced. Evidence was heard that the market often recognizes that a purchase price of a mining asset reflects the value of resources of the transacting corporation. Since the price of the appellant's shares were not changed as a result of the purchase one must acknowledge that the Mine interest was purchased at fair market value. I do not accept this conclusion. The appellant was a closely held corporation, the vendor owned 76.25 per cent of its issued shares. Also, as a result of the purchase, the appellant incurred was anticipated CCDE of $1,922,895 to offset income from a prior sale of a mining interest. These two factors, as much as anything else, may have stabilized the share price of the appellant. In any event, there is no evidence to indicate the reason the share price did not change.
Mr. Lawrence's independence as a valuator
[107] Respondent's counsel argued that Mr. Lawrence was not an impartial witness, considering the number of valuations the appellant and related corporations engaged WGM to perform over the years. It is obvious that valuators are retained to support their client's claims as to value; they are not independent experts. The Court assesses the merits of the opposing values and arrives at a decision based upon the evidence presented.[15] Frequently, as Mr. Ovens writes, the Courts will decide upon a value somewhere between the figures submitted by the opposing litigants.[16] No judge believes any expert witness is independent or impartial; they are being paid for a reason.
[108] Mr. Lawrence had built a successful relationship with the appellant and related corporations. In such a circumstance he, like any professional, wants to help the client maintain that relationship. It is normal and not dishonest for him to search for any potential value inherent in the Mine that could advantage his client. I refer specifically to the addition of 980,000 tons of possible ore when nobody else suggested, let alone recognized, such a possibility.
[109] Mr. Lawrence offered reasons for the possible existence of the additional 980,000 tons but I have concluded he was grasping at straws. I would have been much more comfortable if the appellant had produced another valuator either to review the WGM Report or produce an entirely new valuation confirming the conclusions in the WGM Report.
[110] Appellant's counsel questioned whether National Policy 2-A was relevant to the determination of values for purposes of this appeal. The purpose of National Policy 2-A is, as its title states, a guide for engineers, geologists and proprietors. The reports must be engineering documents which are to be submitted to a provincial securities administration with the goal of raising money from the public. The engineering reports, counsel declared, are not valuations. In Mr. Cook's view National Policy 2-A offers industry accepted standard dictionary definitions for the classification of ore reserves but is not relevant to valuation practice. I agree. Neither National Policy 2-A nor the Standards and Guidelines for Valuation of Mineral Properties prepared for the Special Committee of the Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties ("CIMVAL") which replaced National Policy 2-A in 2003 after the Bre X affair, are rules for valuing mining properties. National Policy 2-A, as Mr. Cook stated, does offer industry accepted standard definitions of ore resources. How these classifications are to be applied in a valuation is the domain of the valuator. Ideally, if there are rules for valuing mineral properties, the rules should be consistent for valuing mines anywhere, in Canada, the United States, South America or Asia. Nevertheless the descriptions of ore in National Policy 2-A are helpful and ought not to be dismissed outright.
[111] To conclude: as between Mr. Lawrence's valuation and Mr. Farquharson's valuation I prefer the conservative approach of Mr. Farquharson and accept his estimate of estimated gold ounces in the Mine at the relevant time:
|
Category
|
Contained Gold Ounces
|
|
|
|
|
Proven and Probable
|
29,600
|
|
Possible
|
25,100
|
|
Drill Indicated
|
192,000
|
|
Total
|
246,700
|
[112] The above amounts of gold are based on surveys conducted by Kilborn Engineering and by Muscocho mining staff at the time of the Mine's closure. There is a consistency in Mr. Farquharson's rational that is not present in Mr. Lawrence's valuation. I do not fault Mr. Lawrence in including possible inferred reserves. Even though there is evidence that mining companies consider the inferred reserves in negotiating a price for the purchase and sale of a mining property, there is nothing in Mr. Lawrence's evidence that gives me comfort to support his estimate. With respect to the assignment of values per ounce of gold, however, I tend to agree with Mr. Glanville's suggestion that the high value of $20 to $25 should be applied to all of the reserves. This is a good indicator of a price that a willing and informed, arm's-length seller would insist upon for sale of this property. Mr. Farquharson's analysis values only the 'gold in the ground' and does not take account of the factors mentioned above, nor of the fact that the property exhibited significant structural development.
[113] Fair market value, by definition used by the valuator at bar, is the highest price which an asset might reasonably be expected to bring. Accordingly, it is not unreasonable to conclude that the fair market value of a 100 per cent interest in the Magnacon Property at the time of the transaction between Windarra and the appellant is the product of $25 and 246,700 ounces if gold estimated by Mr. Farquharson to be contained in the Mine: $6,167,500. On the basis, the fair market value of an 11.12 per cent interest in the Mine in 1995 was $685,826.
[114] The appeal is allowed and the assessment for 1995 is referred back to the Minister for reassessment and reconsideration on the basis that the fair market value of the 11.12 per cent interest in the Mine as at September 29, 1995 was $685,826. The respondent shall be entitled to 85 per cent of her costs based on partial success of the appellant and my view that the counsel for the respondent's cross examination of Mr. Lawrence was, at times, redundant and prolonged the trial.
Signed at Ottawa, Canada this 20th day of February, 2006.
"Gerald J. Rip"
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