Canada: Cansearch: Lessons For Operators In Limiting Counterparty Risk

Introduction

The Court of Queen's Bench of Alberta ("Court") recently decided in Cansearch Resources Ltd v Regent Resources Ltd, 2017 ABQB 535 that an unregistered operator's lien is subordinate to the registered interest of a secured lender under applicable provisions of the Personal Property Security Act (Alberta) ("PPSA"), notwithstanding an agreement's language to the contrary. The decision provides caution to operators in the oil and gas industry to take the required steps under the PPSA to protect contractual liens. The decision has further implications for operators who have failed to register an operator's lien in the Personal Property Registry and attempt to assert priority based on possession of equipment at a facility or rig.

Background

The decision arose from the receivership of Regent Resources Ltd. ("Regent"). Cansearch Resources Ltd. ("Cansearch") was the operator of an oil and gas facility jointly owned by Regent. Regent was petitioned into receivership and Ernst & Young Inc. was appointed as its receiver (the "Receiver"). Through the receivership proceedings, the Receiver sold Regent's assets, including the jointly owned facility. Cansearch applied for a declaration that it had a first priority claim to the proceeds realized from the sale of Regent's interest in the facility and for an order directing that such proceeds be distributed to Cansearch.

Cansearch and Regent were partners in the Joffre Gas Battery and Compression Facility (the "Facility"). The partnership between Cansearch and Regent in the Joffre Facility was governed by a 2008 agreement between Regent and Cansearch (the "Operating Agreement") incorporating the 1999 Petroleum Joint Venture Association Operating Procedure (the "Operating Procedure") and the 1996 PASC Accounting Procedure (the "Accounting Procedure"). Cansearch was the operator of the Facility, responsible for managing and conducting the day-to-day operations at the Facility for the benefit of both parties.

During 2015, Regent stopped paying its share of the operating expenses of the Facility. Regent owed Cansearch a total of $91,683.64 for the pre-receivership period ending November 30, 2016 (the "Unpaid Expenses"), which was not disputed. In Regent's receivership, Cansearch attempted to assert that it had a priority claim to proceeds from the sale of Regent's interest in the Facility (the "Facility Proceeds") arising from the Unpaid Expenses because of Cansearch's operator's lien. During the course of the court proceedings, Cansearch's legal basis for priority shifted from an operator's lien arising under the Operating Agreement to an asserted possessory lien under the Possessory Liens Act (Alberta) (the "PLA"). Cansearch was ultimately unsuccessful in obtaining a priority to the Facility Proceeds as a result of either alternative lien. The Court's reasoning provides guidance and instructions to operators to properly protect their interests under operating agreements.

The Operator's Lien

The validity of the Operator's Lien was unchallenged by the Receiver and Alberta Treasury Branches ("ATB"), Regent's first secured creditor pursuant to a general security agreement ("GSA"). The Operating Procedure provided Cansearch with the Operator's Lien for any unpaid expenses relating to Regent's interest in the Facility pursuant to the following clause:

602(a) Operator's Lien and Remedies: Effective from the Effective Date, Operator shall have a lien and charge, which is first and prior to any other lien, charge, mortgage or other security interest with respect to the Function Unit Participations of each Owner in the Facility and such Owner's share of Facility Products, to secure payment of such Owner's proportionate share of the costs and expenses incurred by Operator for the Joint Account.

Cansearch notified the Receiver that its Operator's Lien gave it first priority to the Facility Proceeds, ahead of ATB's GSA. The Receiver investigated the matter but ultimately determined that ATB's GSA, which had been duly registered in the Alberta Personal Property Registry ("PPR") gave it first priority.

Cansearch subsequently conceded that its unregistered Operator's Lien was subordinate to ATB's registered GSA. Notwithstanding this, the Court provided reasons behind this determination.  The Court's reasons provide a clear lesson to operators: operators must register their interests under the PPSA to benefit from language granting them an operator's lien. In particular, the Court noted that:

  • Registration of an operator's lien is both possible and advisable.1
  • An operator's lien is a consensual and contractual interest. As such, it qualifies as a security interest under the PPSA.2 The PPSA governs priority vis-à-vis other security interests.3
  • An operator's lien extends to the ownership interest in an operating facility and the ownership interest itself comprises a separate component of the Facility.4
  • An operator's lien can apply potentially to both freehold and Crown real property interests (both as to surface and mineral rights), and a number of different types of tangible and intangible personal property.5
  • Priority of the operator's lien is dependent upon which section of the PPSA governs it. For example, the PPSA provides that certain non-consensual liens have priority over other perfected security interests6 Contractual liens are not afforded priority as non-consensual liens under applicable provisions of the PPSA. Operator's liens are governed under the usual "first in time" rules of the PPSA, where priority is dependent upon if, and when, the security interest was perfected by either registration or possession.

As the Operator's Lien was unregistered, Cansearch accordingly did not have priority based on registration. As such, Cansearch could only claim priority under the PPSA by virtue of possession, which perfects a security interest if a secured party holds the collateral for the purposes of securing payment. A secured party must establish that it holds collateral for the purpose of securing payment. Mere physical handling or custody is insufficient; the property must be shown to be held as collateral. In addition, the possession must be sufficient to indicate to third parties that the debtor has given a security interest in collateral in order for perfection by possession to be established for the purposes of the PPSA.7

Cansearch was not able to adduce any evidence which indicated that it was holding any interest of Regent as collateral. The Court agreed with the parties, that the Operator's Lien is an unperfected security interest for the purposes of the PPSA, and was subordinate to ATB's GSA. Had Cansearch registered its interest, the outcome could have been different.

The Possessory Lien

After abandoning its position based on the Operator's Lien, Cansearch attempted to claim priority based on a possessory lien under the PLA against equipment at the Facility (the "Possessory Lien"), which lien would constitute the type of non-consensual lien afforded priority pursuant to section 32 of the PPSA. In order to establish entitlement to a Possessory Lien, Cansearch was required to show that it expended money, labour, or skill over a particular chattel and that it had maintained actual or constructive possession of that chattel.

Cansearch argued that it had a Possessory Lien over certain equipment comprising the various components of the Facility. It argued that all of the Unpaid Expenses were incurred to enhance the value of the equipment at the Facility and that it maintained continuous possession of the equipment due to its undivided ownership interest in the Facility.

The Court found that Cansearch provided only a preliminary description of equipment, which the Operator's Lien was intended to cover, coupled with generalized invoices from the Facilities' operations, and that such evidence did not provide enough specificity required to establish the claimed Possessory Lien.

The Court inferred such lack of information stemmed from Cansearch's erroneous belief that the Possessory Lien could be conflated with the Operator's Lien vis-à-vis the Unpaid Expenses. There are important differences due to the nature and application of each type of lien. These differences were fatal in establishing that the Possessory Lien gave Cansearch priority. In this respect, the Court made three important points:

  1. Cansearch did not establish that the Possessory Lien covered the entirety, or even part of Regent's ownership interest in the Facility. The PLA is clear that a possessory lien only covers chattels (i.e. specific tangible personal property such as equipment). This was contrary to the Operating Agreement, which defined Regent's ownership interest in the Facility as including both real and personal property. Importantly, Cansearch could not claim a possessory lien over any part of Regent's interest without first identifying the specific chattels that such a lien would cover.
  2. Cansearch did not properly identify which chattels would be covered by its Possessory Lien. Cansearch only introduced the Operating Procedure's definition of what equipment would have been on site at the Facility, which was only at the time of its construction. There was no evidence as to what equipment was situated at the Facility at the time Regent's debt arose, or evidence as to the money or services expended on specific equipment giving rise to Regent's debt.
  3. There was insufficient evidence as to whether the described equipment at the Facility remained a chattel or became a fixture or improvement to the real property on which the Facility was situated.
  4. Most importantly, Cansearch's Possessory Lien argument failed to recognize that such a lien would not cover all of the Unpaid Expenses. The PLA is clear that the Possessory Lien cannot extend over a general balance owed by an owner of chattels. Cansearch would therefore be required to identify the work it had done or money spent to enhance (or maintain) the specific chattel and the cost. As evidence was only introduced to support the Unpaid Expenses, there was insufficient evidence in that regard. The Court found that the descriptions permitted by the Accounting Procedure were vague and imprecise, and did not allow the court to adequately determine what money or services were expended by Cansearch to enhance the value of specific site equipment. Additionally a portion of the Unpaid Expenses – as permitted by the Accounting Procedure, were for the acquisition of subsurface rights and related bonus cost, lease, license or permit deposits, rentals, renewal or extension fees and royalties.

The important distinction for a Possessory Lien is between services related to general operational activities and those specifically related to performing work to enhance the value of chattels. The Court concluded that many of the Unpaid Expenses were relating to general operational activities and not specifically to performing work to enhance the value of chattels. Cansearch's generalized expenses were not enough to establish an entitlement to a Possessory Lien as there was insufficient evidence to substantiate that the Unpaid Expenses represented money or services provided to enhance the value of specific identified chattels.

Conclusions and Implications

The key takeaways from the Cansearch decision for industry participants are:

1. The priorities as between parties' contractual agreements and security interests will be determined by the PPSA. An unregistered operator's lien will not have priority over registered security interests pursuant to the PPSA.

2. An operator cannot establish entitlement to a possessory lien against a facility on account of a general balance owing by a working interest participant. Further, it remains difficult, if not impossible, for an operator to establish entitlement to a possessory lien against a party's general interest in a facility, as such liens are only valid as against specified chattels to the extent a party has expended money, labour or skill to improve those chattels.

The unfortunate reality of this situation is that often times a party will not register an operator's lien as this may interfere with its partner's financing arrangements. For example, it is a common provision in oil and gas loan agreements that an event of default occurs where security interests are registered against the borrower. Additionally, the practical reality of accounting practices in the oil and gas industry make it difficult for parties to properly document expenditures with reference to specified equipment. Given these issues and the increasing number of oil and gas insolvencies in Alberta, operators may want to consider revising their accounting procedures to allow the majority of operating expenses to be collected from the working interest participants upfront based upon an estimate of the previous month's expenses. While not an ideal solution or a solution which can be implemented over night, it may nevertheless be an issue for industry to consider.

Footnotes

1 Cansearch at para 37.
2  Cansearch at para 39.
3 Cansearch at para 39 citing Direct Energy Marketing Ltd v Kalta Energy Corp [2002] AJ No 463 (QB) and Re Blue Range Resources Corp, 2000 ABQB 4.
4 Cansearch at para 38.
5 Cansearch at para 38.
6 Cansearch at para 40.
7 Cansearch at para 44 citing Re Blue Range Resources Corp, [1999] AJ No 1665

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