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BCSC Action Reinforces Lessons for Continuous Disclosure

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This article was written by Alan J. Hutchison

A recent Notice of Hearing issued by the British Columbia Securities Commission (“BCSC”) may require mineral exploration companies to re‐visit their continuous disclosure practices. On April 24, 2012 the BCSC issued a Notice of Hearing against four current and former directors of Canaco Resources Inc. (“Canaco”) alleging that they breached applicable securities laws in connection with the disclosure of drill results from Canaco’s Magambazi gold exploration project in Tanzania, as well as in connection with certain stock option grants around the same time. While none of these allegations have as yet been proven, certain facts have emerged from both the BCSC’s allegations and Canaco’s public response that merit discussion of common continuous disclosure practices by mineral exploration companies.

Background

In late November 2010 management of Canaco received assay results from eight holes from an ongoing drill program at Magambazi. The results were circulated to the directors and it appears that management and the board considered the assays to be good results. Canaco staged the announcement of the drill results over three news results over a two week period. The share price increased significantly following each news release, with one day increases of 10.9%,14.6% and 5.9%. The Company did not file a material change report following any of the news releases.

Between the time the management and board of Canaco became aware of the assay results and the date that the first news release was announced, the board of directors authorized the Company’s customary annual grant of stock options to directors, officers and consultants.

Following the increase in the share price following the release of the assay results, the TSX Venture Exchange required the Company to re‐price the stock options to the price of Canaco’s shares following the announcement of all of the assay results. It appears that Canaco and the option holders did this voluntarily and to the satisfaction of the TSXV, and the matter was resolved in March 2011.

The BCSC’s allegations are twofold: (1) that Canaco breached section 85 of the Securities Act (British Columbia) by failing to disclose all assay results immediately upon receipt, and (2) that the directors of Canaco acted inappropriately by granting stock options when in possession of material undisclosed information. The crux of Canaco’s defence is that the assay results were not material as the drill holes constituted infill drilling and simply confirmed the extent of mineralization previously demonstrated in earlier drilling. Canaco has sought expert opinions from third parties affirming this position, most notably from Micon International Ltd. Although not expressly stated in the BCSC’s Notice of Hearing, it is submitted that it is noteworthy that the Magambazi deposit did not have a resource estimate.

The intent of this article is not to question the facts or attempt to form a judgment on any of the matters set out in the BCSC’s Notice of Hearing. But even prior to a judgment being rendered, there are a number of lessons for exploration mining companies.

Timing of Announcements of Drilling Results

A frustrating reality for every mineral exploration company is that with the boom in mineral exploration over the past few years the turnaround time for assay results has lengthened considerably. What used to be a one or two week wait is now commonly eight weeks. Most companies prefer not to announce hole by hole results, as it can be more difficult to put results in proper context to properly disclose the geological ramifications for the project of the drill results. The result is that there is a considerable time lag between raising capital, expenditure on mineral exploration and announcement of results. The additional challenge for many companies is the reality that it is not easy to generate regular news flow necessary to keep shareholders engaged in the company’s story. Plus, the seemingly fickle attention span of the market compels companies to focus on key points and not to overwhelm the market with more information it can absorb. As a result, most companies do exactly what Canaco did in this situation – accumulate a cluster of assay results and then release them in stages over one or two weeks once the company can properly analyze the results and ensure that the company obtains the requisite internal and NI 43‐101 approvals for the news release. The BCSC’s allegations in this instance suggest that this practice is contrary to securities laws. It may be necessary for companies to announce the assay results immediately and then seek to provide analysis and context in a subsequent news release. Given the technical nature of the disclosure, presumably few companies would be interested in doing this voluntarily.

Hindsight is 20‐20

Continuous disclosure requirements imposed by Canadian securities laws and stock exchange rules require public companies to assess materiality for every change or development affecting the company. Usually materiality is assessed on a forward looking basis, namely as to whether the news or development would reasonably be likely to impact the value or market price of the company’s securities. This requires companies to assess not only the change or new development itself, but the asset or project to which it relates in the context of the company as a whole. What is material to one company is not necessarily material to another, so while general principles can be ascertained, management and directors must ultimately assess their companies on an individual basis.

It is apparent in the Canaco situation that the BCSC did not accept Canaco’s position that the assay results are not material. Certainly at first glance it appears that the market considered the assay results to be material, as all three news releases resulted in significant increases in Canaco’s share price. However, that does not preclude an argument that management, directors and consultants of Canaco considered the materiality of the assay results in good faith and determined prior to announcement that they were not material, even though the market reached a different conclusion.

Accepting Canaco’s defence at face value, the concerning aspect of this case is that in a regulatory proceeding materiality is often applied with the benefit of hindsight. As a result, public companies are reminded that it is better to err on the side of caution and adopt a conservative assessment of materiality. To draw on a couple of specific facts from the Canaco example, it is worth noting the following principles:

• Prior to the completion of a mineral resource estimate, which typically resets materiality for a mineral project, companies should consider that all drill results are material. Even if the geological knowledge of a project is not enhanced by a drill program, one should not consider such drill programs to be infill drilling per se until the stage of drilling to reduce spacing between drill holes to confirm or upgrade categories of mineral resources.

• Companies should avoid granting stock options or other share based compensation to insiders when in possession of undisclosed assay results. It is submitted that the grant of options prior to the dissemination of the news releases announcing the drill results was the principal factor that caused the BCSC to commence a proceeding in this case. Without that inciting factor it is doubtful that the Notice of Hearing would have proceeded. As Canaco notes in its defence, this may result in extremely narrow windows to grant stock options, and possibly several months after the customary timing for issuing options, but to do otherwise can result in regulatory problems.

Material Change Reports

Canadian securities laws require public companies to file material change reports within 10 days of the occurrence of a material change in its business or affairs. However, the material change report is probably the continuous disclosure requirement that is most inconsistently applied, especially by smaller issuers. It seems that companies either file material change reports for every news release in order to ensure compliance, or they hardly ever file material change reports at all. In almost every instance material change reports are given little attention or thought, but have become perfunctory compliance documents duplicating the company’s news release.

This is a good reminder that material change reports should not be overlooked as a continuous disclosure obligation. Applicable securities laws require public companies to assess the materiality of a particular occurrence or development to determine whether a material change report is required to be filed.

Multiple Layers of Securities Regulation

It is also worth noting that Canadian public companies have to deal with multiple layers of securities regulation. The provincial securities commissions, stock exchanges and self regulatory organizations (i.e. IIROC) all have a regulatory function that aims to preserve the integrity of the Canadian capital markets. While most of the time these organizations work together in an attempt to harmonize their rules and enforcement practices, that is not always the case. Over the past couple of years we have seen some noteworthy differences of opinion between securities commissions and the TSX. The facts here suggest that the TSXV questioned Canaco about the grant of stock options almost immediately following the announcement of the assay results. It appears that there was a significant dialogue between the TSXV and Canaco, which culminated in the re‐pricing of the stock options. There is no indication that the TSXV challenged the conduct of the directors of Canaco to the extent that the BCSC is doing now. This is a good reminder that securities regulators can take different perspectives on an investigation and can reach different views on what constitutes an appropriate resolution.

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