Canada: Seismic Shift For Lenders To The Resource Sector: Supreme Court Of Canada Rules That A Company's Environmental Liability Can Rank In Priority To Secured Debt

Summary

A recent Supreme Court of Canada decision commonly referred to as Redwater marks a seismic shift in Canadian insolvency law. The case is causing uncertainty throughout Canada's secured lending community, which now faces new and unexpected risks.

In Orphan Well Association v Grant Thornton Limited, 2019 SCC 5 (Redwater), a majority of the Supreme Court of Canada ruled that provincial legislation governing the abandonment and remediation of oil and gas assets and associated sites was effective in spite of federal bankruptcy and insolvency legislation governing trustees' rights and duties in relation to environmentally-impacted property. The decision also dealt with the priority of repayment to creditors out of a bankrupt estate.

Based upon the Supreme Court's decision, an insolvent company's environmental liabilities, which may engulf the realizable value of the insolvent estate, can have priority over any distributions to secured creditors. The decision has raised the spectre of zero-recovery insolvencies, even for senior secured lenders.

While the Redwater decision was made in the context of oil and gas remediation, the decision will have significant implications in a variety of industries where environmental regulation is a significant issue, including mining and manufacturing.

Background

The legislation

The Oil and Gas Conservation Act and Pipeline Act form part of the regulatory scheme that governs Alberta's oil and gas sector. Under that legislation, industry participants must be licenced to begin operation. Those licences are issued by the Alberta Energy Regulator (the Regulator). One of the objectives of the licensing scheme is the management of environmental risks. Attaching to each licence are various "end-of-life" obligations that require licence holders to remediate properties once they have reached the end of their useful lives or been abandoned.

To ensure that these obligations are met, the Regulator imposes strict limitations on the transfer of licences. In particular, the Regulator will not permit a transfer where the effect of that transfer would be to reduce one of the parties' asset value to environmental liabilities ratio to less than two (2.0).

The Bankruptcy and Insolvency Act (BIA) is one of Canada's primary insolvency statutes. The BIA prescribes a "waterfall" of repayment obligations, the effect of which is to rank various kinds of debt and pay out according to the priority scheme set out in section 136 of the BIA.

Facts

The oil and gas assets in this case were formerly owned and operated by Redwater, a publicly traded corporation with operations in central Alberta. Prior to its bankruptcy, Redwater possessed 84 wells, 7 facilities and 36 pipelines, each of which was subject to a licence. Redwater was also party to a secured loan agreement, under which it owed approximately $5.1 million. In mid- 2014, Redwater encountered financial difficulties and eventually became bankrupt, at which time Grant Thornton Limited (GTL) was appointed trustee in bankruptcy and initiated a liquidation sales process.

On learning of Redwater's insolvency, the Regulator sent a letter reminding GTL of Redwater's outstanding environmental obligations. The Regulator advised that, under Alberta legislation, the trustee in bankruptcy was a deemed licensee, and therefore subject to the same end-of-life obligations as had been the bankrupt licensee—in this case, Redwater. The Energy Regulator further advised that, per its licence transfer policy, it would deny any application to transfer the valuable licences pending satisfaction of the end-of-life obligations or the posting of security in the full amount of such obligations, as Redwater's asset to liability ratio was currently less than one. Denial of license transfers would render Redwater's assets effectively unsaleable, as the assets can only be exploited lawfully with the regulatory licenses in place.

GTL responded that it was under no such obligation. Specifically, it asserted that it was entitled under the BIA to disclaim assets with negative realizable value, and advised that it had done so in respect of 107 of Redwater's licensed properties. GTL argued that it had no responsibility with respect to Redwater's former environmental obligations, and that any attempt by the Regulator to block the transfer of the licences for assets that had positive net realizable value would be a violation of the BIA.

At trial, the Alberta Court of Queen's Bench agreed with GTL's argument and concluded that the Alberta legislation was inoperative to the extent that it conflicted with GTL's rights under federal bankruptcy law. A majority agreed at the Court of Appeal of Alberta. The Regulator and the Orphan Well Association appealed.

Decision

At the Supreme Court of Canada, a 5-2 majority overruled the Court of Appeal's decision. Specifically, the Court held that Redwater's and GTL's obligations arising under the Alberta legislation remained effective and were not affected by the provisions of federal bankruptcy legislation.

Under Canadian law, where provincial legislation conflicts with federal legislation, the provincial legislation will be deemed inoperative to the extent of the conflict. In applying this doctrine to the facts of the case, the Court considered two primary questions:

  1. Do the provisions of federal bankruptcy legislation permit trustees in bankruptcy to disclaim environmental obligations of the kind imposed under the Alberta Legislation?
  2. In obliging trustees in bankruptcy to satisfy outstanding environmental obligations prior to transferring oil and gas licences, does the Alberta legislation (and the Regulator's actions thereunder) interfere with secured creditors' priority rights under federal bankruptcy law?

Subsection 14.06 and the power to disclaim

On the first question, GTL argued that federal bankruptcy legislation allows the trustee in bankruptcy to reject or "disclaim" any asset of the bankrupt estate, along with any environmental liabilities that might attach to that asset. 

The Court rejected this argument. In reaching this conclusion, the Court relied on specific language in the BIA—which makes no reference to absolving the bankrupt's estate from liability—and parliamentary evidence from the time of the subsection's enactment. The section of the BIA in issue was interpreted as apply only to the personal liability of trustees.

Interference with the BIA priority scheme

On the second question, the Court  again found for the Regulator. Here the central question was whether the Regulator's actions had the effect of creating an unsecured "claim provable  in bankruptcy."

Where an unsecured claim provable in bankruptcy exists, it will be subject to the distribution scheme set out in section 136 of the BIA, and unless otherwise indicated, will be subordinated to the interests of secured creditors. In seeking to enforce the end-of-life obligations ahead of the senior secured debt, GTL argued that the Energy Regulator was effectively seeking to enforce a claim against the estate, thereby interfering with the priority scheme set out in the BIA.

The Court took the opportunity to provide clarification and elaboration with respect to the three-part test from Newfoundland and Labrador v AbitibiBowater Inc., 2012 SCC 67, [2012] 3 S.C.R. 443 (Abitibi), which is used to determine whether a regulator is asserting a claim provable in bankruptcy.

The test from Abitibi can be summarized as follows. For an environmental obligation owing to a regulator to meet the definition of a "claim provable in bankruptcy":

  1. There must be a debt, a liability or an obligation to a creditor;
  2. The debt, liability or obligation must be incurred before the debtor becomes bankrupt; and
  3. It must be possible to attach a monetary value to the debt, liability or obligation.

In reaching its conclusion, the Supreme Court's majority clarified parts one and three of the Abitibi test. With respect to step one, the Court explained that a regulatory body does not become a creditor simply by demanding satisfaction of an environmental obligation. Rather, it must be determined whether the body is acting in a bona fide regulatory capacity, or whether it is simply seeking to collect an amount owing. In this case, the Court held that it was clear that the Regulator was acting in a bona fide regulatory capacity to enforce a pre-existing regulatory scheme. This was not a debt collection, the Court held, but an effort to ensure the satisfaction of a "public duty". As such, the Regulator's enforcement of the end-of-life obligations could not render it a creditor under part one of the test.

The Court went on to hold that the third prong of the Abitibi test was likewise unmet. The Court found that it could not attach a monetary value to the obligation imposed by the Regulator. The Court emphasized that the relevant question was whether it was "sufficiently certain" that the Energy Regulator would complete the work, and that a corresponding debt to the Regulator for doing so would "come to pass." The Court found that it was not the Regulator who might perform the work, but an independent not-for-profit organization: the Orphan Well Association. Further, the Court found that it was not sufficiently certain when, if at all, the work would be completed, given the rapidly rising rate of orphan wells, and the limited capacity of the Orphan Well Association.

Having determined that the Regulator's orders did not constitute claims  provable in bankruptcy, those orders were unaffected by federal bankruptcy legislation or any claims of  secured creditors.

In the result, the Supreme Court directed that funds held in trust by GTL from sale proceeds of Redwater assets be used to address the outstanding environmental obligations, as opposed to being distributed to the company's first secured creditor.

The path forward

The practical implications posed by Redwater are far-reaching for lenders, energy industry participants, and regulators. Secured lenders are left with significant uncertainty about what environmental obligations, if any, will have to be paid before any proceeds of realizations can be used to repay the ranking creditors.

Energy industry financing will, no doubt, face growing pains as the industry adapts to the new legal framework that would enforce a "polluter's creditors" pay model, as opposed to the "polluter-pay" approach to environmental harm that was more typically associated with Canadian resource extraction.

In particular, lenders will no doubt adjust their lending practices to account for end-of-life obligations that, until now, were thought to be subordinate to secured debt. Under the common law, end-of-life obligations attaching to oil and gas licences are effectively super-prioritized in the bankruptcy context. Accordingly, lenders are likely to be more hesitant in extending financing to small-to-medium-size energy industry participants or will require bonding or other forms of up-front commitments to satisfy the prospective end of life obligations. Certainly any new financing is likely to have just become more costly as a result of Redwater. Secured lenders may also wish to modify the loan terms to which they earlier bound themselves to protect against this new risk. Lenders are also likely to reserve greater rights for themselves to prevent borrowers from acquiring marginally-producing assets.

Another implication of the decision concerns the utilization of the bankruptcy process. In particular, with respect to loans extended in the pre-Redwater world, lenders may elect not to commence formal bankruptcy proceedings where the end-of-life obligations attaching to oil and gas properties outweigh the potential value of the associated assets. Similarly, trustees in bankruptcy or receivers may be unwilling to accept mandates where their efforts will not be able to provide value to the estates over which they are appointed (let alone when their own fees may not be first-secured given the Supreme Court's ruling). Insofar as these possibilities exist, so too does the possibility that the Redwater decision will ultimately lead to, perversely, an increase in the number of orphan wells, as insolvent companies leave behind both their spent properties that have high remediation costs relative to their value and their valuable properties due to the inability to sell the valuable properties separate from the spent properties.

Another potential outcome is that that the Regulator will adjust its licence transfer policy to demand a higher asset to liability ratio before permitting transfers. While this change will not be directly attributable to the Redwater decision, the Regulator may now have a greater impetus to limit instances such as the one considered in Redwater. Moreover, in the long-term, while financing for regulated industries in the extractive sector may be stymied, the decision may afford regulators with greater flexibility and a greater ability to address environmental concerns in the context of insolvent companies whose insolvency leaves behind untended environmental hazards. Indeed, on the day the Redwater decision was released, the Regulator press released its intention to build a new regulatory "framework."

The case also poses implications for regulated industries in Canada beyond oil and gas; the Supreme Court's ruling bears upon any industry in which environmental remediation is a regulated and obligatory activity. Redwater suggests that the obligation to remediate not only survives a formal insolvency but must be addressed ahead of the claims of secured creditors, including lenders, municipalities, and lien claimants.


We would like to thank Daniel Mills, an articling student in our Calgary office, for his assistance in writing this article.


About Norton Rose Fulbright Canada LLP

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