The downturn in Canada's natural resources sector over the past few years has caused industry and insolvency professionals to consider the complicated area of royalties in the context of insolvency proceedings. Two recent cases indicate the potential adverse effects of insolvencies on royalty owners whose interests do not meet the test for an "interest in land".

Nature of Overriding Royalties

Legal deliberation on the nature of oil and gas royalties traces back to the early 1930s. Cases discussing whether a particular royalty was an interest in land, or whether royalties by their character even could be found to be an interest in land, culminated in the Supreme Court of Canada (SCC) decision in Bank of Montreal v Dynex Petroleum Ltd.1 (Dynex). A stumbling block in earlier decisions was the common law doctrine that an interest in land cannot issue from an incorporeal hereditament (such as a profit à prendre or working interest). In Dynex, the SCC held that the parties "could not offer any convincing policy reasons for maintaining the common law prohibition on the creation of an interest in land from an incorporeal hereditament".2 Therefore, the customs of the oil and gas industry warranted a shift in the law to recognize overriding royalties as an interest in land, subject to the intentions of the parties.

Dynex set out a two-part test. An overriding royalty interest can be an interest in land if:

  1. the language used in describing the interest is sufficiently precise to show that the parties intended the royalty to be a grant of an interest in land, rather than a contractual right to a portion of the oil and gas substances recovered from the land; and
  2. the interest, out of which the royalty is carved, is itself an interest in land.3

Why is an "interest in land" Important?

An "interest in land" is a legal term denoting an interest that "runs" with the land.4 An interest in land allows the holder to register a caveat on the subject land title to give notice to potential purchasers and protect its interest against third parties. In contrast, a contractual interest governs a relationship between the royalty owner and royalty payor and does not attach to the lands. As a result, if the original royalty payor sells its interest to a third party purchaser without specific assignment and novation of the royalty agreement, the royalty owner cannot compel the new purchaser to comply with the royalty obligations.

The Decision in Walter Energy

The value of overriding royalties as interests in land is nothing new to the oil and gas industry, but as demonstrated in the recent British Columbia Supreme Court decision Re: Walter Energy Canada Holdings, Inc5 (Walter Energy), it is of paramount importance in the current climate of the industry. Walter Energy involved an application to the Court by the debtor companies for approval of a transaction for the sale of certain coal mining properties pursuant to the Companies Creditors Arrangement Act [CCAA]. The debtor companies had been granted protection to restructure as a debtor in possession under the CCAA by the Court in December, 2015.

The proposed sale included the Wolverine Mine, to which the applicant Kevin James objected. James was the owner of a 1% gross overriding royalty on coal produced from the Wolverine coal mine (the GORR) pursuant to a royalty sharing agreement (the Royalty Agreement) between James and the debtor's predecessor in interest (WCC). The asset sale agreement listed the Royalty Agreement as an "excluded contract", that would not be assumed by the purchaser. As a result, James opposed the proposed sale on the grounds that his GORR was an interest in land and therefore the Wolverine coal licences could only vest in the purchaser subject to the GORR.

The decision in Walter Energy turned directly on whether the GORR was an interest in land that ran with the Wolverine coal licences or merely a contractual royalty. The Court examined the jurisprudence, analyzing the text of the Royalty Agreement against numerous indicia indicating an interest in land. One clause in the Royalty Agreement provided that the GORR was based on the price bracket of the product produced from the coal properties, strongly factored against characterizing the GORR as an interest in land. The payment of a royalty on substances produced indicates an obligation to pay money, in contrast with a royalty in all the minerals within, under or upon the lands which indicates conveyance of an interest in the minerals in situ. This clause also lacked any granting or conveyancing language. The Court highlighted the fact that, as a director, James controlled WCC at the time it entered into the Royalty Agreement. If it had been the intention of the parties, James could have easily incorporated clear language indicating that the GORR ran with the land. Further, the Royalty Agreement could have been drafted to grant a security interest to James and to restrict the sale of the properties subject to the purchaser assuming the GORR obligations.

The Court concluded that James' GORR was a mere contractual royalty. As a result, the nature of the Royalty Agreement was executory — where performance is ongoing or not yet completed.6 This characterization granted the debtor in possession the ability to terminate the executory Royalty Agreement to enhance the prospects of restructuring7.

The Implications of Walter Energy

In non-distressed circumstances, if a particular royalty obligation was excluded from a sale and the corresponding royalty agreement was not assigned to the purchaser, the vendor/royalty payor would be in a difficult position, burdened with royalty obligations after selling its interest. The insolvency context shifts the risk and puts a contractual royalty owner in a far more precarious position. The Court's recognition of the potential future disclaimer of the Royalty Agreement sets a precedent for future debtors to attempt to disclaim royalty payor obligations where the agreement does not clearly establish an interest in land. If a debtor company is successful, the holder of the contractual royalty interest assumes the position of an unsecured creditor with recourse only through the formal claims process.

The Decision in Dianor Resources

In a recent Ontario case, a receiver was appointed over the assets of Dianor Resources Inc. (Dianor) which included mining interests. The receiver brought an application for an approval of the sale of the Ontario assets to Third Eye Capital Corporation. The sale contained a condition that a 15.4% GORR on diamonds and a 1.5% GORR on metals and other minerals be either terminated or reduced and included a cash payment of $250,000 to be paid as "fair and reasonable compensation" for the GORRs. 2350614 Ontario Inc. (the Royalty Owner) argued that the approval order needed to vest the assets in the purchaser subject to the two GORRs. The resulting decision in Third Eye Capital Corp. v Dianor Resources Inc.8 (Dianor) has raised some alarm bells for royalty holders due to a statement of the Court made in passing after deciding the central issue of the case — whether the diamond and mineral GORRs were interests in land. On the interest in land question, the Court applied the test from Dynex and held that despite the clear statement that the interests were intended to be interests in land, the lack of granting or conveying language and the royalty being paid on the products once recovered from the properties, meant the GORRs did not run with the lands.9

Concerning Statements in Dianor Resources

In a standard approval and vesting order application, a debtor in possession or monitor (under CCAA) or a receiver or trustee (under the Bankruptcy and Insolvency Act) seeks the court's approval of an asset transaction. The standard form order allows for the discharge of all encumbrances and claims from the assets except for any permitted encumbrances, and vest the assets in the purchaser. Those encumbrances and claims that are "vested off" title to the purchased assets then attach to the purchase proceeds, which stand in place of the sold assets. The order contemplates encumbrances such as personal property security interests and other financial or monetary claims whether or not registered or perfected against the sale assets. In Dianor, the purchaser argued that the GORRs could be vested off by the Court whether or not they were interests in land, so long as fair value was paid to the Royalty Holder.

In finding that this claim did not have to be considered, given the finding that the GORRs did not amount to an interest in land, the Court nonetheless went on to state as follows: "I see no reason in logic however why the jurisdiction would not be the same whether the royalty rights were or were not an interest in land".10 While this statement is troubling, the authors suggest that its relevance is questionable given the established judicial treatment of interests in land and the fact that the statement was not part of the Court's finding. This would render it "obiter dicta" or non-binding on other courts. Under a receivership order, a receiver takes possession of a particular debtor's property; however, royalties that are interests in land are separate property interests outside the scope of such an order. Further, converting an interest in land to an unsecured claim is, in effect, expropriation of the royalty owner's property interest for the benefit of the debtor's creditors. Selling the debtor's property free and clear of a royalty interest running with the land is effectively disclaimer, which is limited to executory contracts.

No Formula for Determining an Interest in Land

It is essential that parties signal their intent to create an interest in land, rather than merely a contractual obligation owed by the royalty payor to the royalty owner. Unfortunately there is no "magical incantation" required to create an interest in land; however, the language used in an agreement will aid the court in assessing the parties' intentions.11 Each case will depend on the particular agreement and circumstances and no particular indicia will be determinative of the outcome.12

Protecting Your Interest in Land

Royalties that are an interest in land can be protected through registration of a caveat which gives notice to the world of the interest claimed. Registrations in respect of royalties granted on freehold mineral interests are governed by the Land Titles Act [LTA] and registered at the Alberta Land Titles Office. The LTA awards priority to the first party to register its interest.

The current law in Alberta is unclear as to the proper forum for registration in circumstances where the overriding royalty interest is granted by the lessee of Crown-owned mines and minerals. Section 202(a) of the LTA prohibits registration of a caveat or encumbrance affecting Crown mineral interests. The Mines and Minerals Act [MMA] provides for a limited exception applicable generally only to financial institutions. Per section 4(g), security interests registered under the Alberta Personal Property Security Act cannot be used to protect an interest in land. What is clear is that overriding royalty interests in Crown mineral tenure do not obviously fit within the standard legislative schemes in place to aid in protection of an interest by registration.

It is possible that the definition of a "charge on land" under the Law of Property Act encompasses this type of interest. Land charges are defined as interests in the real property of a corporation to secure payment or performance of an obligation and are registered in the Alberta Personal Property Registry. Land charges are often used by financial institutions to register floating charges against corporate debtors until taking steps to register against specific interests in a situation of default. While a royalty owner would not be able to register against specific interests under the MMA, registration of a land charge will, at minimum, provide notice to third parties and potential creditors of the royalty payor (and, if applicable, subsequently appointed insolvency professionals) that the royalty owner has an interest.

Footnotes

1  2002 SCC 7 [Dynex].

2 Dynex, at para 18.

Dynex, at para 22, citing Virtue J. in Vandergrift v Coseka Resources Ltd. (1989), 67 Alta LR (2d) 17, 95 AR 372 (Alta QB) at para 26.

4  Strathcona (County) v Half Moon Lake Resort Ltd, 2013 ABQB 236 at para 61.

5  2016 BCSC 1746 [Walter Energy].

6 Barron's Canadian Law Dictionary, 6th ed, sub verbo "executory" (QL).

7  Section 32 of the CCAA.

8  Third Eye Capital Corp. v Dianor Resources Inc., 2016 ONSC 6086 [Dianor].

9  Dianor, at paras 22-30.

10  Dianor, at para 40.

11  Walter Energy, at para 100.

12  James H Meek Trust v San Juan Resources Inc, 2003 ABQB 1053, at para 37.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.