Canada: Gross Overriding Royalty Interests Not Interest In Land Absent Clear Language

Two recent decisions of Canadian courts have reiterated the critical requirement of clear language in contracts creating royalties where parties intend such royalties to be "interest in land," that is, real property. The Supreme Court of Canada had established in Bank of Montreal v. Dynex Petroleum Ltd. 2002 SCC 7 (Dynex) that gross overriding royalty interests (GORR) could constitute interest in land provided the parties so intended and that intention was sufficiently evidenced in an agreement. Based on Dynex, the status of GORR must be determined on a case-to-case basis. Both Walter Energy Canada Holdings Inc, (Re), 2016 BCSC 1746 (Walter Energy) and Third Eye Capital Corporation v Dianor Resources Inc, 2016 ONSC 6086 (Dianor), provide recent examples of how courts approach the exercise of determining whether a specific GORR constitutes an interest in land. The British Columbia Supreme Court and Ontario Superior Court of Justice considered the types of provisions that will fail court scrutiny, and emphasized the importance of including, in royalty agreements and agreements creating royalty interests, language which expressly creates and conveys an interest in land. Dianor also addresses a court's ability in insolvency proceedings to convey and vest assets free and clear of royalty interests.

Walter Energy

In 2000, three individuals (the royalty owners) assisted Western Canadian Coal Corporation (WCC) in acquiring and maintaining certain coal licenses pertaining to the Wolverine mine (the Licenses), and conveyed the mine and Licenses to WCC in exchange for 1% royalty (the Wolverine Royalties) pursuant to a royalty sharing agreement (RSA). Walter Energy Canada Holdings Inc. (WEC), following an acquisition, was the successor in interest of the Licenses. WEC subsequently was involved in insolvency proceedings under the Companies' Creditors Arrangement Act, RSC 1985, c C-36 (CCAA) and sought court approval of the transfer of its mining properties including the Licenses to Conuma Coal Resources (CCR). The proposed asset purchase agreement (APA) contemplated that the Wolverine Royalties would be excluded. One of the royalty owners challenged this exclusion, arguing that the RSA created an interest in land which encumbered the properties.

The British Columbia Supreme Court had to determine "whether, on a proper interpretation of the RSA, it can be said that the parties intended the royalty owner to have an interest in land, as opposed to a contractual right to the royalty stream from production under the Wolverine coal licenses." The RSA contemplated that WCC would pay a royalty of "one percent (1%) for all product tonnes produced from the ....Wolverine coal properties". The RSA also contemplated that WCC would be the beneficial owner of all of the coal licenses comprising the Properties, including the Wolverine Licenses, "...free and clear of all liens, charges and claims of others." The RSA contained the provision that it would "enure to the benefit of and be binding upon the parties and their respective successors, heirs, executors, administrators and permitted assigns."

The Court held that the RSA was not intended to create an interest in the land, rather it simply represented a contractual right to payment as the consideration for which the royalty owner transferred his rights in the properties. The court found that the language creating the Wolverine Royalties in the RSA did not meet the Dynex requirements. To reach this conclusion, the Court found as follows:

• WEC was stated to have "acquired" the Licenses and be the beneficial owner of them free of "any claims of others;"
• The assignors had relinquished their direct rights to the Licenses, including any further aspect of control;
• Neither the RSA nor the APA contained formal conveyancing language such as "grant, assign, transfer or convey" any right in the substances beneath the relevant properties;
• The APA did not contain the language what the Wolverine Royalties would "run with the land" and the RSA did not contain restrictions on the ability of WEC to sell the Licences or contain a requirement of a purchase to assume obligations under the RSA; and
• Reference to the payment of the Wolverine Royalties was to what was "produced" from – importantly, not a royalty "in" – the relevant properties.

Dianor

Dianor Resources Inc. (DRI), was an insolvent company with interests in mining assets in Ontario (the Ontario Assets) and Quebec. DRI's receiver applied for an Order approving the sale of the Ontario Assets in which 2350614 Ontario Inc. (235Co) held GORRs. 235Co was controlled by Mr. John Leadbetter, and did not oppose the sale but argued that the Ontario Assets would be conveyed subject to 235Co's GORRs. While the GORRs were created under a Crown Land Agreement and Patented Land Agreement (the Agreements) by which DRI acquired the Ontario Assets from 3814793 Ontario Inc., another entity controlled by Mr. Leadbetter, it was unclear from the records how 235Co acquired the GORR. However, this fact was immaterial to the Court's findings.

The winning offer by Third Eye Capital Corporation (TECC) was conditional on the GORRs being terminated or significantly reduced. TECC's offer contemplated a payout of the GORRs in the amount of $250,000 which 235Co refused. TECC argued that the Court had jurisdiction to cancel the GORRs under a vesting order if fair compensation was paid for those rights. The central issue was whether 235Co'S GORRs constituted interest in land.

Ultimately, the Court approved the sale to TECC. As in Walter Energy, the Court applied Dynex to determine whether the Agreements created the GORRs in the Ontario Assets. The Agreements provided that once DRI became the owner of a 100% interest in the mining claims, the optionors (235Co) would "retain a [20% GORR] for diamonds and a [1.5% GORR] for all other metals and minerals" which was calculated on an appraised value of the contemplated substances in accordance with other provisions of the Agreements. The appraised value for diamonds was calculated after they had been recovered or produced, cleaned and sorted. The non-diamond GORR was payable on the basis of gross revenue derived from all product sold by Dianor.

The Court held that the GORRs are not interests in land, although the Agreements clearly set out the parties intentions as follows:

The Court noted that while this clause stated the intention of the parties it failed to convey an interest in land. The ultimate issue is whether that intent is carried out in the contract. The Court emphasized the importance of the parties creating provisions which have the effect of granting a right in real property. Without specific wording, such an agreement will only create a right to the percentage of minerals or petroleum substances derived from the extracted minerals, instead of conveying such a right. It is not sufficient to state the intentions of the parties.

The Court noted other instances where the words "covenants and agrees to pay" and "produced" have been interpreted, and the distinction drawn between the "granting" of royalties attached to or in the land or minerals in situ, and the "payment" of royalties derived from attaching to the minerals or revenues "produced" or "removed" from the land. The latter creates only contractual rights. Other relevant factors the Court considered include whether an owner is in control of the lands and if the royalty holder retains a right to enter upon the lands to explore for and extract minerals. In this case, the Court found that 235Co had no right to enter the property to explore and extract diamonds or minerals, and the GORR was calculated on post-production substances. Applying Dynex, the Court concluded that 235Co's GORR was not an interest in land.

The Court also addressed and confirmed the powers of courts to cancel the GORRs under a vesting order. The jurisdiction of the Courts to grant vesting orders derives from the common law, the Bankruptcy and Insolvency Act, RSC 1985, c B-3 (BIA) and the Ontario Courts of Justice Act (CJA). Further, the BIA and CJA give the Court jurisdiction to order the property be sold and on what terms. The Court found that TECC was entitled to be the purchaser of the assets as the successful bidder under the authorized bid process, and that the Court had the jurisdiction to grant a vesting order of the Ontario Assets to TECC on terms considered just. TECC was able to purchase the Ontario Assets free and clear of 235Co's GORRs upon payment of the $250,000 offered, which was considered a reasonable amount for 235Co's royalty rights. The court didn't decide TECC's argument that even if the royalty rights were an interest in land, a vesting order could be made vesting clear title in the assets being sold on the proviso that fair value be paid to the holder of the royalty rights. However, the Court saw no reason why its jurisdiction would not be the same whether the royalty rights were or were not an interest in land.

Implications

The status of royalty interests continues to spawn extensive litigation in Canadian courts. This determination impacts asset conveyance and whether a purchaser will acquire assets encumbered with or free of the royalty. This is particularly so with pre-Dynex royalty agreements that did not clearly specify the parties' intentions. However, Dianor and Walter Energy have confirmed that even specifying the parties' intention to create an interest in land by itself is not enough. The parties must carry that intention through in the agreement by creating the interest in land, using specific wording consonant with conveying real property interests.

The problem is compounded when profitable assets encumbered by royalties are being sold through court-supervised sales processes in insolvency proceedings. Insolvency statutes are paramount, give the courts broad powers and create different priorities over properties. As shown in Dianor, having royalty interest in land may not be a guarantee to retaining royalty assets in insolvency proceedings.

These cases provide a measure of certainty as to the requirements for making royalty interests real property. Real property rank higher in priority than personal property and in that sense, other than by vesting orders, should provide some form of security to royalty owners. Similarly, the guidance in determining which royalty interest is real property and the power of the courts to grant vesting orders provide monitors, receivers and insolvency professionals with additional tools in insolvency proceedings and sales processes.

About BLG

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.