Vesting out a royalty?

AlphaBow Energy Ltd. (Re), 2024 ABKB 652
Can a royalty be vested out in a CCAA proceeding?

Summary: In this case, a CCAA debtor seeking a sale approval and vesting order applied for a declaration that a gross overriding royalty agreement entered into prior to the company’s insolvency did not create an interest in land. The counterparty to the agreement opposed the relief, arguing that the royalty was “much more” than a fixed monetary interest that attached to the property. The Court examined the agreement as a whole, along with the surrounding circumstances, and concluded that the parties did not intend to create an interest in land. In any event, the Court stated that it would have vested the interest off under section 11 of the CCAA had it found that the agreement created an interest in land.

AlphaBow Energy Ltd. (“AlphaBow”), a privately-owned company in the business of acquisition, development, and production of oil and natural gas in Alberta, sought and obtained an initial order, inter alia, continuing its previous Bankruptcy and Insolvency Act proposal proceedings under the Companies’ Creditors Arrangement Act. In November 2024, AlphaBow applied for a sale approval and vesting order for its proposed sales transaction to Resistance Energy Ltd. pending the resolution of AlphaBow’s application for a declaration that certain royalty agreements between AlphaBow and Advance Drilling Ltd. (“Advance”) did not create an interest in land and could be vested off to facilitate the sale of AlphaBow’s assets.

In November 2018, AlphaBow and Advance had entered into a Master Drilling and Completion Contract (“MDCC”) to govern the execution of AlphaBow’s multi-year drilling and completion plan and to confirm the obligations and liabilities of each party. AlphaBow and Advance also entered into a Gross Overriding Royalty Agreement (the “2018 GORR Agreement”) for the reservation and grant of an Overriding Royalty (the “2018 GORR”) to satisfy unpaid amounts, including those under the MDCC. Despite the presence of the standard intention-of-the-parties-to-create-an-interest-in-land clause, the parties agreed that the 2018 GORR created a security interest and not an interest in land.

Following persisting defaults of AlphaBow’s payment obligations under the MDCC, on November 12, 2020, Advance invoked its right under the 2018 GORR Agreement to receive the 2018 GORR, though it proposed certain payment terms. AlphaBow failed to make the first payment, and Advance demanded payment of all amounts due, including those under the MDCC and the 2018 GORR Agreement.

In June 2021, Advance commenced an action seeking relief against AlphaBow, including judgment in the amount of $14,523,038. In September 2021, AlphaBow applied for partial summary judgment, which culminated in a Consent Judgment dated October 29, 2021, a Royalty Agreement made as of October 28, 2021 (the “2021 GORR Agreement”) and a Settlement Agreement and Release made effective as of November 12, 2021 (the “Settlement Agreement”).

Under the 2021 GORR Agreement, AlphaBow granted a gross overriding royalty (the “2021 GORR”) to Advance but, unlike the comprehensive, stand-alone 2018 GORR Agreement, the 2021 GORR Agreement was modeled on the more prevalent Canadian Association of Petroleum Landmen (CAPL) Overriding Royalty Procedure. The 2021 GORR Agreement incorporated by reference the CAPL Overriding Royalty Procedure, including section 2.01, which states that “the Overriding Royalty is an interest in land.”

The legal test for determining whether a royalty is an interest in land is often referred to as the two-part Dynex test, in reference to the Supreme Court of Canada’s decision in Bank of Montreal v Dynex Petroleum Ltd., 2002 SCC 7:

1. Is the language used in describing the interest sufficiently precise to show that the parties intended the royalty to be a grant of an interest in land, rather than a contractual right to a portion of the oil and gas substance recovered from the land; and

2. Is the interest, out of which the royalty is carved, itself an interest in land.

Determining the parties’ intentions requires examining the agreement as a whole, along with the surrounding circumstances, instead of searching for some magic words. The decision-maker’s role is to ascertain the interpretation of the royalty agreement that promotes or advances the parties' true intentions at the time of contracting on an objective basis, focusing on what a reasonable person would infer from the terms of the agreement, consistent with the surrounding circumstances known to the parties at the time of formation. The assessment of the surrounding circumstances includes the genesis, aim or purpose of the agreement, the nature of the relationship created by the agreement, and the nature or custom of the particular industry. Lastly, royalty agreements must be interpreted according to sound commercial principles and business sense to avoid results that are unrealistic, absurd, or unreasonable with respect to the commercial realities of the industry.

In opposing AlphaBow’s application, Advance argued that the 2018 GORR would likely not have been considered an interest in land, and would not have protected Advance’s interests in the event of AlphaBow’s insolvency. Accordingly, Advance had to make a choice: take what Advance, as an unsecured creditor, could get in an AlphaBow receivership or agree to a payment plan whereby Advance might recover the totality of AlphaBow’s indebtedness, albeit over a significantly long period, provided AlphaBow remained solvent. Advance needed to be induced to take that risk with additional consideration in the form of a GORR interest that would amount to an interest in land, which would be preserved in the event of AlphaBow’s insolvency. Essentially, Advance wanted a backup plan to recover AlphaBow’s indebtedness in the event of its demise.

The Court found that Advance believed that using the CAPL standard form of agreement would suffice to achieve their goal of creating an interest in land because, unlike the 2018 GORR Agreement, payments under the 2021 GORR Agreement did not require an event of default by AlphaBow and the standard form also did not specify a termination date. The circumstances surrounding the 2021 GORR Agreement revealed that Advance’s true and only intention in entering the 2021 GORR Agreement was to give itself a backup collection tool if AlphaBow became insolvent. From AlphaBow’s perspective, the Court found that it unlikely that a rational commercial party would commit itself, subject to the eventual depletion of the resources, to paying $4.2 to $8.4 MM per year in exchange for a creditor forbearing enforcement of a $15MM debt. Accordingly, the Court concluded that the parties to the 2021 GORR Agreement did not intend to create an interest in land, and granted AlphaBow’s application for a declaration that the 2021 GORR Agreement did not create an interest in land.

Had the Court found that the 2021 GORR Agreement created an interest in land, it would have vested it off pursuant to the broad discretionary authority granted to the Court by section 11 of the CCAA. The Court did not accept the submission that the 2021 GORR was “much more” than a fixed monetary interest that attaches to the property. A GORR resembles a fixed monetary interest more closely than a fee simple. A GORR is a future right that may or may not come into existence because the GORR holder only becomes entitled to anything of value if the leaseholder or working interest holder chooses to extract substances from the land. A 17.5% GORR would very likely detract producers from acquiring these assets. Further, while Advance was unlikely to consent to vesting off if the 2021 GORR were an interest in land, the Court gave little weight to that factor in determining whether vesting it off would be appropriate given the circumstances in which they obtained it. Obtaining the 2021 GORR was nothing more than an attempt by Advance to improve its debt's status to others' detriment.

Judge: Honourable Justice M.H. Bourque

Counsel: Keely Cameron and Sarah Aaron of Bennett Jones for AlphaBow; Afshan Naveed and Changhai Zhu of Dentons for Advance Drilling; Jeffrey Oliver of Cassels for KSV as monitor; Richard Jones, KC and Sarah Rhydderch of Brownlee for Flagstaff County et al.; Michael Swanberg of Reynolds Mirth Richards & Farmer for Red Deer County et al.; Molly McIntosh of MLT Aikins for the Orphan Well Association; Ryan Algar of Burnet, Duckworth & Palmer for North 40 Resources Ltd.; Marianne Panenka for Indian Oil and Gas Canada