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KMW Blog Apr 29, 2016: Andrew Bells seeks perspective from John Kaiser on the TSXV Zombie Plague


Posted: Apr 29, 2016JK: Andrew Bells seeks perspective from John Kaiser on the TSXV Zombie Plague
Published: Apr 26, 2016BNN: Attack of the Zombie Miners
Lately there has been a surge in press about the zombie situation among the Canadian resource juniors. Andrew Bell of BNN interviewed me on Tuesday, April 26, 2016 about "The Attack of the Zombie Miners". There was nowhere near enough time to dive into the topic, so here is an extended discussion about why, in my view, we should worry about something other than zombies, namely the systematic degradation of the Canadian resource junior market by the listing policies of the TMX Group. For the latest statistics about the resource junior market, check out the Junior Resource Sector Crisis Center.

After a five year resource sector bear market the TSXV has ended up with 57% (689) of its 1,206 resource sector listings having negative working capital totaling CAD $2.5 billion while the remaining 43% has $1.5 billion in working capital left as of their last financial filings. That number is going to get worse before it gets better, because the majority of TSXV listings have December 31 year-ends and last reported on September 30. Their year-end financials are due at the end of April, and their March 31 quarterlies will be due at the end of May. With just over $200 million raised by TSXV resource juniors from January through March, most of which was concentrated in a handful of juniors, the zombie picture will get uglier before the benefits of the turnaround now underway materialize. The majority of this debt, $1.8 billion, is owned by TSXV resource juniors trading below $0.10. Since mid January there has been a signficant exodus of juniors from the below $0.10 price range. It has not been the financially challenged juniors, which lurk like discarded junk at the bottom of the grayish-brown Fraser River at the base of the Knight Street Bridge in Vancouver where I used to fish as a kid and lose my tackle on snags. I do not think anybody fishes there anymore. So what is the big deal about "Zombie Miners"?

Zombies are companies which are still listed and trading but have negative working capital, which is the difference between current assets and liabilities. Negative working capital is not necessarily bad if the company has assets whose value exceeds that of total liabilities. But when the company is a venture junior listed on the TSXV, the so called long term assets that show up on the balance sheet usually represent money spent on an exploration project that was capitalized rather than expensed. The real value of such "assets" is usually zero because the money spent on exploration was an attempt to demonstrate that something of value, rather than nothing, is present on the property in the form of a deposit that could be profitably mined. With more advanced deposits where resource estimates have been completed, and possibly even economic studies, the "sunk exploration cost" still carried on the books does have a value even though at prevailing metal prices the deposit's economics may not meet profitable mine development thresholds. Residual value exists in these cases because the deposit has an "optionality" value in the sense that if metal prices were to move up while costs remained constant, the deposit would end up "in the money" and a producer would buy the company in order to develop the deposit. Companies that write off the capitalized expense of a property they have not abandoned are in fact doing a treacherous dis-service to the market. If the information about the deposit is 43-101 compliant, it is worth at least part of the money spent generating it, as well as a time value for how long it would take to generate the information from scratch. The danger with this type of resource junior is that creditors will bankrupt the company in order to secure title to the property which they can inventory as an "optionality" until a bull cycle develops. These are not zombie companies; they are living companies at death's doorstep. Only when they are tainted by an environmental liability that no creditor wishes to inherit do they qualify among the living dead.

Zombie juniors are those whose properties consist of earlier stage projects where past exploration work failed to deliver any meaningful resources. The capitalized exploration expense may not yet have been written off, but the resale value of that property approaches zero. Such juniors have no money to spend on advancing any projects, nor can they raise fresh equity until they have paid off their existing creditors because the latter will sue to intercept any new money. But none of the creditors will act to bankrupt such a junior because they will only end up with less than nothing for their effort. Meanwhile management lets its salaries accrue and only lends real money to pay for bills that absolutely have to be paid with cash such as TSXV listing fees. Otherwise, if the stock gets suspended and delisted by the TSXV for not paying those fees, its ability to reorganize itself by settling debt for paper, raising new capital and securing a new story for a fresh speculation cycle disappears. And then the "asset" being cultivated by management in the form of accrued salaries evaporates.

Rather than handing the company keys to the creditors or even stock exchange officials, management sees value in letting unpaid salaries and other management fees pile up with compounding interest even though they are not performing any productive work for the junior. (It is not entirely a free lunch, for completing all the mindless paperwork demanded by regulators is a punishing ordeal in its own right.) Because creditors live in eternal hope of eventually receiving something rather than nothing for past services rendered, and management is happy to let money owed to itself pile up, these juniors can stay listed and trading forever. They are dead as far as new wealth creation potential is concerned, but they can seemingly live on forever. In some cases management gives up and hands the keys to the stock exchange, with the zombie soon suspended, eventually delisted, and ultimately dissolved. In some cases where the zombie status was a matter of bad luck and the management team is credible, the financial affairs will get cleaned up on terms that do not brutalize minority shareholders. Using the KRO search engine to track down such juniors trading in the pennies that are not truly zombies can be very lucrative for KRO members; bottom-fishing for falsely accused zombie juniors is something I prefer to do for my own account, not just to corral a big reward for myself, but also to avoid having to explain the very high risk of total loss if I bag what turns out to be an actual zombie junior. I'm also not sure how well a Zombie-Fishing Report would sell. This Zombie Search link (stocks below $0.10, negative working capital, more than 20 million shares issued, and insiders declared as owning 5% or more) will not generate any results unless you are already logged on as an active KRO Member, but those of you who qualify should give it shot to see if you can spot the future winners among the living dead. (The second company that shows up as of April 29, 2016 is such a false zombie.)

The more general destiny of a zombie junior is a reorganization that begins when management tires of paying real bills to keep the stock trading and listed. First management goes to all the creditors and either negotiates a paper based settlement, or buys the debt through third parties at a deeply discounted price. Once the settled debt has been swapped for paper at some random deemed price, the zombie undertakes a 10:1 or worse rollback that wipes out minority shareholders and blows the post-rollback price of the settlement paper into the stratosphere where the stock price mathematically ends up. The stock price promptly collapses while the creditors sweat out the 4 month hold. By the time their paper is free trading they have settled at the 90% deep discount the management proxies initially offered. Meanwhile, with the zombie stock back in the pennies, management undertakes a debt settlement for the accrued salaries (usually structured as amounts owed to "third party" administrative entities to avoid the TSXV's efforts to curb fake salary accrual strategies, a policy that seems to harm real employees more than deter false billing), and cheap private placements with full five year warrants are announced (has anybody else noticed that we no longer hear much from Jabba the Five Year Warrant Hutt whose non-zombie victims have been among the worst performers in the recent turnaround?), some of whose proceeds are used to pay off at face value the unsettled debt management proxies had bought at a deep discount from the original creditors. Lo and behold, the zombie listing has been transformed into a shell with some working capital, ostensible management with a decent equity stake, and most of the rest of the paper parked in friendly "non-insider" hands from where it can be dumped when suckers once again invade the market. All the junior needs is a new story, which may require a change of business process if it involves something non-resource such as marijauna, but usually just means going to a prospect generator and optioning a "property of merit". (Prospect-generators have been the worst performers in the recent turnaround because the producers are not yet in a mood to farm into prospects, and the life-style juniors that are the most likely candidates to farm into another junior's prospects so far have no ability to raise new exploration capital, and in most cases are caught in the zombie trap. Most of the zombies end up recycled as tightly held shells through some variation of this process that will enable $2.5 billion in negative working capital to disappear from the balance sheets and resurface as nearly cost-free paper owned by the custodians of the zombie listings.

Lately a number of people, spurred on by the work Tony Simon has done documenting the dismal financial status of these zombie juniors, have been calling for a mass delisting of these companies on the grounds that they degrade the reputation of the TSXV as a venture capital market and divert risk capital investors would otherwise allocate to juniors with a viable shot at new wealth creation. They argue that the continued presence of zombie listings harms the reputation of the TSXV and nudges living companies into the realm of the living dead by starving them of scarce capital. They want these zombies suspended and delisted so that the market can focus on the survivors. They do not want these zombies recycled into a sea of dormant shells that spring into action when risk capital floods back into the juniors.

I disagree with some of this thinking. The reputation of the TSXV has long been under siege by the TMX Group, owner of both the TSXV and the TSX. Since 2000 after the VSE and ASE merged to form the CDNX which eventually was renamed the TSXV, the TSXV has listed 1,206 capital pool companies, effectively shell companies that raise a couple hundred thousand dollars by spraying 1,000 share board lots among a broker's clients to achieve a supposed "public distribution". These capital pool companies (CPC) have a deadline to complete a qualifying transaction that gives them a venture focus. Many capital pools were used to acquire advanced projects during the super-cycle driven feasibility demonstration boom that ran from 2003-2011, of which a fair number moved onto the TSX, raised substantial capital, and were even taken over by much bigger companies. Some ended up with a non-resource story. But quite a few escaped CPC status and possible suspension by acquiring a "property of merit", which is any property on which money has previously been wasted and for which the wisdom of experts can be tapped to declare in writing that the property is not entirely hopeless. A lot of these are controlled by shell packagers and life-style management teams who have no real ability to generate a promising exploration prospect, let alone design and execute a meaningful exploration program that could deliver new wealth in the form of a potentially economic discovery. But when the market is in its bull cycle, these juniors masquerade as exploration juniors and do suck up risk capital from novice investors attracted by the buzz about a resource sector bull market.

By allowing the proliferation of these pretend resource juniors through the CPC program, the TMX Group has deliberately degraded the brand of the TSXV as the go-to place for resource junior venture capital. There has been some hand-wringing about the gradual disappearance of the smaller brokerage firms by simply closing their doors or merging with slightly bigger firms, but those tears are misplaced because many of these firms did little in the form of financing other than float capital pool companies ($436 million raised by IPO since 2000 and wasted on administrative costs associated with finding a bogus project that sets the clock ticking for the three year staged release of escrow stock purchased for a penny by the shell packagers. Even after a 5 year bear market a couple new CPC's limp onto the exchange every month, a testimony to the myopia of some brokerage firms and their brokers.

The TMX group has also undermined the TSXV brand by encouraging the more successful listings to migrate to the TSX, the senior exchange where revenue producing companies trade, as well as a myriad of exchange traded funds and products constructed by the establishment bank controlled brokerage firms. A TSX listing has historically been treated as a green light for institutions to buy a stock because supposedly such a listing is a cut above the nasty stuff that dwells on the TSXV. This worked out really well during the Bre-X boom of 1995-1997 when Bre-X managed to secure a TSX listing with its fraudulant Busang gold project in Indonesia. Ironically it was the brand of the Canadian resource junior that was harmed by the success of Bre-X in attracting instititional capital rather than the greedy dumb-asses that ran the Toronto Stock Exchange as it was then called. But even in the post-Bre-X environment where NI 43-101 established a new reporting standard the glorification of the TSX and stigmatization of the TSXV has continued.

Most of the TSXV to TSX migrations were resource juniors trying to demonstrate that their projects were economically viable in a context of super-cycle and gold-bubble inflated metal prices. The only thing that distinguished TSX from TSXV resource juniors was the amount of capital Bay Street brokerage firms raised from their institutional clients. The presence of these resource juniors among all the producer listings and structured products did nothing to enhance the reputation of the TSX, but did plenty to cultivate the reputation of the TSXV as the place that the losers in the venture capital game stayed. Rather than tighten the TSX listing requirements so that only revenue generating companies can get listed, companies whose value can be measured by the income history and the nature of the product or service sold, the TMX allowed TSX listings whose measurable value boiled down to guesses about the level of future metal prices. Those TSX listed resource juniors in which institutions loaded up that were not bought out ended up down more than 90% from their 2010-2011 peaks. Did the reputation of the TSX as the cradle of these failures suffer? No, what suffered was the reputation of the Canadian resource juniors which, of course, everybody knows trade on the TSXV.

Resource companies which do not have a producing mine belong on an exchange whose rules are designed around the peculiarities of venture capital and whose nature as a venture capital market is fully understood by every investor. Disguising resource juniors favored by powerful Bay Street brokerage firms among the TSX resource listings deceives the public about the quality of both TSX and TSXV listings by falsely implying that what migrates to the TSX is of a lower risk category while what stays on the TSXV is of a higher risk quality "unsuitable" for most investors, especially those aged 55 or older.

By failing to confine non-producing resource juniors to the TSXV, the TMX Group muddied the definition of a venture listing. If the TMX had been clear about the venture capital nature of the TSXV, it would have resisted the insistence by Canadian anti-trust regulators that alternative trading platforms be allowed to co-exist with the TSXV trading platform by arguing that the necessary accompanying elimination of the uptick short selling rule compromised the ability of an exchange to function as a price discovery mechanism for venture listings. By definition the value of a venture or any startup is difficult to quantify. By allowing short-selling on a down-tick by algo traders using "day trading" accounts exempt from the need to borrow stock before selling short, the TMX Group in conjunction with the regulators injected a structural down-ward bias into the TSXV market that was especially harmful when the junior listing had lots of widely held, issued stock outstanding. Listings with tighly controlled structures, like those re-manufactured zombies described above, are not affected because any algo trader blind to the difference between real juniors and rig jobs is in danger of suffering severe losses courtesy of a short squeeze.

In a This Week in Money with Jim Goddard audio interview on April 16, 2016 (Uptick Rule and Naked Short Selling) produced by Tom Allen's HoweStreet.com, I discuss the problems created by market fragmentation such as facilitating investor risk capital stripping by algo traders and the demolition of the "first come first serve" trade execution principle venture investors, especially retail investors, hold dear. I argue that as long as competing market order books are allowed, the uptick rule cannot be reinstated because with multiple order books that brokers are mandated to navigate in search of the "best fill" it is impossible to prove that the uptick rule was not violated. I make the suggestion that the TMX Group should decide that its venture listings henceforth would be exclusively confined to the TSXV, and petition the government to allow an exemption from alternative trading systems. Since 90% of the TSXV's pitiful value traded goes through the TSXV order book, bannishing the alternative trading systems would cause far less business harm than their continued presence causes to the overall Canadian resource junior eco-system. Without the alternative order books, every trade goes through a time-stamped pipeline and functions as a benchmark to establish what the last different traded price was (the uptick rule decrees that you can only sell short when the price you are selling at is higher than the last different traded price). The short selling uptick rule can be reinstated if the TMX Group decides that a venture capital exchange is a fragile eco-system that deserves protection from the predations of any out of control trading culture.

It is time for the TMX Group to rethink how the TSXV fits into the Canadian market and to make the changes needed to rebuild the resource venture brand and lay the foundation for expanding it into other sectors as proposed by the Revitalizing TSXV White Paper released on December 1, 2015. Everybody should take their guidance from Renaissance Gold Inc, one of my prospect-generator bottom-fish recommendations, which on November 6, 2015 announced its decision to move from the TSX to the TSXV because "the majority of the Company's peers trade on the TSX-V and it is a better fit for the Company at this stage of its development." All stakeholders in the Canadian junior resource sector should insist that the TSXV be properly branded as the market for Canada's venture capital juniors which includes the abolition of alternative trading platforms as a required option for brokerage firms executing their clients' orders for TSXV listed companies. And in doing so force the reinstatement of the uptick rule for short selling. I think this is a much bigger concern than zombie juniors. Those who care about the resource junior eco-system need to confront the market competition purists in Ottawa with the argument that fragmentation of a venture capital market causes far greater harm than benefits in the form of lower trading costs. And I might even go one step further and argue that a venture capital market's order execution costs should be regulated in the style of a utility so that we do not need the fear the price gouging Ottawa expects a profit-oriented entity such as the TMX group to pursue once it has a functional monopoly..

I think the antipathy towards the TSXV zombie listings is misguided because I believe these juniors will simply fade away or get reorganized. Furthermore, I am of the view that if an investor, simply because the stock is listed on the TSXV, manages to buy a zombie junior that finally joins the cemetary of defunct listings, such investor deserves to pay the price for being lazy in not bothering to check the financials, stupid in not thinking through what the wealth creation strategy of the junior might be and how it is being funded, and foolish by placing bets on a horse that isn't even in the race lineup. I have no sympathy for such people, but then, of course, I am biased in that I sell a service designed to assist investors in placing intelligent bets on resource juniors, including checking how much money the junior has.

As for the concern that when money starts to flow back into the resource juniors these zombies will re-energize and intercept incoming risk capital, I think the feasibility demonstration nature of the past decade has irrevocably raised the bar for what counts as a legitimate exploration junior, a bar that is becoming much more prominent and visible than it has been in the past. The transition from a discovery exploration culture that prevailed during the eighties and nineties into the feasibility demonstration culture of the Noughties allowed many pretend juniors to slide along on the coattails of a bull cycle that wasn;t about their stories. That transitional honeymoon is over; today your exploration play must make just as much sense as your advanced feasibility demonstration play.

Furthermore, the client relationship model (CRM) that the regulators invented as a way to curb the willingness of financial advisors to encourage or even allow investors to make "unsuitable" bets on resource juniors is wiping out "mushroom" brokers inclined to cultivate relationships with life-style juniors by keeping their clients in the dark and feeding them manure about their positions. As the pool of financial advisors with specialized knowledge of the resource junior sector shrinks, investors will increasingly have to take responsibility for their own decisions. When one has only oneself to blame for a bet gone wrong, one tends to think a little harder about which bets to make. Never mind the existential lament that humans work very hard at structuring their lives so as to avoid the angst of making choices with uncertain outcomes.

There is another potential obstacle to a Zombie Comeback. The Outcome Visualization System I am developing will harness the power of the crowd to generate collective wisdom about the fundamental potential of a junior's project (what I present through Kaiser Research Online is merely a demonstration of the outcome visualization concept applied by one individual). Every junior's project will have a spot on the map, but the degree that it attracts a "boomtown" community of visualizers who sift through the company disclosures and stitch together the dots to form potential outcomes they share with the world, outcomes whose assumptions get critiqued by visualizer peers, will depend on the quality of the management team and the way it generates, presents and operates its exploration-development projects. It will no longer be financial advisors, analysts or newsletter writers who quietly shun unworthy juniors; it will be the conspicuous non-attention or even hostile attention of a greedy, manipulative crowd, each of whose anonymous but "branded" members is intent on evolving his or her power to influence the behavior of fellow visualizers as well the market for resource juniors, that will spotlight unworthy juniors as horses that will never end up even at the starting gate of a real race. The zombies play no role in the future of the Canadian resource juniors. A revolution is coming for resource juniors publicly traded in a regulatory jurisdiction that enforces meaningful disclosure about project fundamentals. It will unleash a battle royale between Canadian and Australian juniors that the Canadians will lose if the TSXV is not reformed to allow a venture capital market to function.

 
 

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