Drilling Down: Alberta Court Finds Production Volume Royalty Can Be an Interest in Land

On June 22, 2018, in Re Manitok Energy Inc., Justice K. Horner of the Alberta Court of Queen’s Bench (Court) confirmed that the creation, grant and sale of a production volume royalty can constitute an interest in land where the parties have an express intention to create such an interest. This decision adopts the reasoning of the Ontario Court of Appeal (ONCA) in Third Eye Capital Corp v. Dianor Resources Inc. (Dianor Resources), and the ONCA’s interpretation of the Supreme Court of Canada’s (SCC) decision in Bank of Montreal v. Dynex Petroleum Ltd. (Dynex). Justice Horner’s decision has provided additional clarity for Alberta’s oil and gas financing industry and may assist parties to creatively finance oil and gas discovery and production.

BACKGROUND

In 2015, Freehold Royalties Partnership (Freehold) and Manitok Energy Inc. (Manitok) entered into a production volume acquisition agreement (Acquisition Agreement) and a production volume royalty agreement (Royalty Agreement) in respect of certain oil and gas properties (Properties). These two Agreements saw Freehold pay Manitok C$25-million in exchange for the grant of a production volume royalty (Producing Royalty). The Agreements specifically and repeatedly referenced the parties’ intention to create an interest in land and provided Freehold with the right to take its Producing Royalty in-kind.

Freehold, Manitok and Manitok’s senior secured creditor (Lender) also entered into an interest clarification and acknowledgment agreement, whereby the Lender confirmed that its security interest did not extend to the Producing Royalty, which was the property of Freehold.

In 2018, Manitok was assigned into bankruptcy and a receiver was appointed to manage its assets (Receiver). The Receiver subsequently reviewed the Agreements and took the position that the Producing Royalty was not an interest in land, which would have reduced Freehold’s claim in the receivership proceedings to merely one for damages. Such a decision would also have allowed the Receiver to seek to convey the Properties to a potential purchaser free and clear of the Producing Royalty.

In response to the Receiver’s actions, Freehold brought an application seeking a declaration that, among other things, the Producing Royalty was an interest in land and the property of Freehold.

COURT’S DECISION

As there were no facts in dispute, the issue before the Court was purely whether the Producing Royalty constituted an interest in land pursuant to the test in Dynex, which requires a clear intention between the parties to create such an interest from an already existing interest in land.

The Receiver and Stream Asset Financial Manitok LP (Stream) opposed Freehold’s application. They argued that the Producing Royalty did not constitute an interest in land because, among other things, the Producing Royalty: (i) did not provide Freehold with an unlimited right to enter the Properties; (ii) could be transferred to other oil producing properties if the Properties were sold (with the consent of Freehold); and (iii) declined with the lifecycle of the Properties.

Justice Horner found that the Producing Royalty constituted an interest in land because Freehold and Manitok clearly stated this to be their intention in both Agreements. For example, both the Acquisition Agreement and Royalty Agreement explicitly defined the Producing Royalty as being an interest in land.

Justice Horner also dismissed the Receiver’s argument that a right of entry is a prerequisite for a royalty to constitute an interest in land, as well as Stream’s argument that the Producing Royalty cannot be an interest in land because it is effectively granted in personal property (i.e., already-produced oil that is severed from the land).

Justice Horner concluded that “a royalty in respect of produced substances, representing a fixed quantity of production per day, may constitute an interest in land if the parties’ intention to make it so is sufficiently clear.” As a result, Justice Horner has confirmed that the legal determination of what constitutes an interest in land must be flexible enough to address the practical realities of Alberta’s oil and gas industry. This approach is consistent with the SCC’s decision in Dynex.

COMMENTARY

Justice Horner’s decision should provide an added degree of comfort to those seeking to finance Alberta’s oil and gas industry through the granting of certain types of royalties. While Dianor and Dynex were useful to potential royalty purchasers by finding that properly constructed gross overriding royalties could constitute and interest in land, Manitok has provided further clarity that the absence of a right of entry and the presence of a fixed payment mechanism are not fatal to the royalty qualifying as an interest in land.

Although Freehold’s Producing Royalty was not the same type of royalty that was at issue in Dynex, Justice Horner’s decision recognized that it was the intention of the parties that was the most significant factor in determining whether an interest in land had been created. Rather than focussing too heavily on rigid legal concepts and indicators, Justice Horner recognized the practical realities faced by Freehold and Manitok at the time they entered into the Agreements.

Blakes successfully represented the Applicant in this matter.

For further information, please contact:

Ryan Zahara                  403-260-9628
Chris Nyberg                 416-863-4252

or any other member of our Restructuring & Insolvency group.

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