Canada: Focus On Energy - May 2009

Last Updated: May 30 2009

Article by Mike Hurst, Miles Pittman, George Antonopoulos and Jenelle Matsalla

Extension of Oil & Gas Operators' Trust Obligations

Where an operator commingles the monies of a joint-operator with its own funds and the account is depleted, a constructive trust may be imposed on the assets (and sale proceeds thereof) of the operator for the benefit of the joint-operator.

Under clause 507 of the 1990 CAPL Operating Procedure, an operator is expressly authorized to commingle its own funds with those of a joint-operator, but it is provided that the joint operator's funds are considered trust monies. In Brookfield Bridge Lending Fund Inc. v. Vanquish Oil & Gas Corporation and King Energy Inc., 2008 ABQB 444, the Alberta Court of Queen's Bench held that, where an operator empties its bank account to pay creditors, a constructive trust may be extended over the other assets of the operator, and the joint-operator will be granted priority over all of the operator's creditors.

Karl Oil and Gas Ltd. ("Karl") and Choice Resources Corporation ("Choice") were 55% and 45% working interest owners, respectively, of a well referred to as the "Simonette property". Karl was originally the operator until it sold its interest to Vanquish Oil & Gas Corporation ("Vanquish"), and Vanquish assumed the role of operator. The well came into production when Vanquish was operator.

The Simonette property was operated subject to the terms of the 1990 CAPL Operating Procedure. Clause 507 specifically allowed the operator to commingle the monies received from or on account of a joint-operator with its own funds, and these monies were deemed trust monies held by the operator as the joint-operator's trustee.

A related dispute not addressed in this specific action was whether Karl or Choice was the owner of the 45% working interest in the Simonette property, which was not previously owned by Vanquish. For the purposes of this case, it was clear that whomever was the owner of that 45% interest was entitled to have been paid by the operator a percentage of the net production revenues. Vanquish, as operator, kept a main operating account where all expenses were paid from and all production revenues were deposited. However, Vanquish did not pay the pro rata net production revenues, estimated to be in the amount of $320,539.00, to the owner of this remaining 45% interest.

Three years after Vanquish became operator, a receiver was appointed on application by Brookfield Bridge Lending Fund Inc. ("Brookfield"), a secured lender of Vanquish. The receiver applied for the sale of Vanquish's assets. From the proceeds of the assets sale, Karl and Choice advanced a claim to obtain the $320,539.00 which should have been remitted to the 45% interest owner for net production revenues.

The issue to be determined then was whether the joint-operator working interest owner in the property had a claim in trust, to the extent of the unpaid net production revenues, on the other assets or sale proceeds of the assets of the operator (ie. those not in the bank account).

Counsel for Brookfield argued that at the date of the receivership, approximately $58,000.00 remained on deposit in the main operating account, and accordingly, that was the maximum amount the joint-operator could claim in the proceedings.

The Court, however, determined that a constructive trust should be imposed on the assets of Vanquish, and not just on the money in the main operating account, on the bases that: 1) clause 507 of the 1990 CAPL Operating Procedure clearly established a valid trust; 2) there was a high probability that the net asset base of Vanquish was unjustly enriched by its breach of trust; 3) the 45% interest owner had a legitimate reason for seeking a remedy against Vanquish's property, rather than simply the money in the account, to ensure that parties like Vanquish would comply with clause 507 of the 1990 CAPL Operating Procedure; and 4) while the imposition of a constructive trust would adversely affect the rights of Vanquish's secured lender, Brookfield, it was not unjust because Brookfield was in a far better position to ensure that Vanquish conducted its business in a manner which complied with the 1990 CAPL Operating Procedure.

Comment:

We are advised that this case has been appealed. This is an interesting decision, as the Court extended a constructive trust to a situation where the trust property, or proceeds of its disposition, may not be able to be directly traced. The effect is that joint-operators, whose revenues were held in trust by the operator, may have a successful claim against the assets of the operator, irrespective of tracing.

The outcome of this case is not favourable from the perspective of the secured creditors of operators, as they will have to ensure that a borrower-operator strictly complies with its CAPL obligations, and be mindful that the claim of the joint-operator is superior to their own claim. Prior to lending, creditors will now face the challenge of determining the extent of a operators' trust obligations, given the impact these obligations will have on potential claim priorities in the future.

We Learn Even More From the Enron Decade

If an express provision in an agreement contains plain language, one party cannot allege that steps contrary to this provision were required to be taken by the other party by virtue of industry practice.

On January 23, 2009, the Alberta Court of Appeal affirmed the Queen's Bench decision that Marathon Canada had lawfully terminated an agreement with Enron Canada. The fact that the termination provision in the agreement was found to have been triggered was fortuitous for Marathon Canada, as it was "out of the money" on the contract.

The dispute in Marathon Canada Ltd. v. Enron Canada Ltd., 2008 ABQB 408; affirmed by 2009 ABCA 31, arose out of a natural gas purchase agreement (the "Agreement"), whereby Marathon Canada Limited ("Marathon") was the seller and Enron Canada Corp. ("Enron Canada") was the buyer (both parties being successors to the original parties to the Agreement).

When the U.S. company Enron Corp., Enron Canada's indirect parent corporation, ran into financial trouble in the fall of 2001, its credit rating was downgraded to a B-, or "junk bond status". Within one hour of learning of this downrating, Marathon faxed a letter to Enron Canada alleging a Triggering Event of a Material Adverse Change, as set out in the Agreement, and terminated the Agreement.

A portion of the definition of Material Adverse Change in the Agreement included, with respect to Enron Canada and Enron Corp., long term debt unsupported by third part credit enhancement rated by Standard and Poors below BBB-. A Triggering Event was defined in the agreement as being the occurrence of a Material Adverse Change, unless the affected party was to establish and maintain a Letter of Credit for the other party (the "notifying party"). While Enron Canada responded to Marathon's letter by insisting that it was solvent and that no Triggering Event had occurred, it did not provide or maintain a Letter of Credit. The Agreement further provided that where a Triggering Event occurred, the notifying party could terminate the Agreement.

The trial judge determined that it was reasonable for Marathon to conclude that a Triggering Event of a Material Adverse Change had occurred in respect of Enron Corp., as set out in the Agreement, which entitled Marathon to terminate the Agreement. Enron Canada argued that it was the industry custom and practice for the notifying party to provide notice requesting the affected party provide performance assurance and allow reasonable time to comply before a right to termination arose. However, the Court concluded that the evidence did not establish such a well-known industry practice that there could be a presumed intent to be bound by it, particularly where the alleged practice was contrary to the plain language in the Agreement, to which the law clearly states that effect must be given.

Furthermore, because Marathon had supplied natural gas under the Agreement in November which Enron Canada had not paid for, the trial judge awarded Marathon damages plus interest for this amount owing. The trial judge also dismissed Enron Canada's counterclaim, concluding that the Agreement contemplated a "one way" arrangement which allowed Marathon, upon lawfully terminating the Agreement, to walk away without having to compensate Enron Canada for incurring the loss of the favourable price for the gas granted under the Agreement. While Enron Canada argued that the one way clause amounted to a penalty such that Enron Canada should be able to seek relief from forfeiture, the trial judge held that this was not a case where the parties had an unequal bargaining power such that it would be fair or equitable to deny enforcement of the one way provision in the Agreement.

Enron Canada appealed this decision. The Court of Appeal held that the trial judge's findings of fact, that a Triggering Event and Material Adverse Change had occurred under the terms of the agreement, and that there was no industry practice or commercial context which demanded that Marathon should have held back on its contractual rights, were reasonable. The Court further held that the trial judge did not misdirect himself on the law when interpreting the Agreement. Because Marathon was within its rights afforded by the Agreement when it terminated the contract, the Court concluded that the trial judge had not erred in finding that Enron had not made out its counterclaim. Thus, the entire appeal was dismissed.

Comment:

This case demonstrates the inclination of courts to determine disputes based on plain language in the contract, as opposed to industry standard, particularly where sophisticated parties are involved and the party seeking to implicitly impose the industry standard on the contract was the drafting party.

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.

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