Overriding Royalties: Walter Energy, Dianor Resources And The Importance Of Negotiating For An Interest In Land

The downturn in Canada's natural resources sector over the past few years has caused industry and insolvency professionals to consider the complicated area of royalties in the context of insolvency proceedings. Two recent cases indicate the potential adverse effects of insolvencies on royalty owners whose interests do not meet the test for an "interest in land".

Nature of Overriding Royalties

Legal deliberation on the nature of oil and gas royalties traces back to the early 1930s. Cases discussing whether a particular royalty was an interest in land, or whether royalties by their character even could be found to be an interest in land, culminated in the Supreme Court of Canada (SCC) decision in Bank of Montreal v Dynex Petroleum Ltd.1 (Dynex). A stumbling block in earlier decisions was the common law doctrine that an interest in land cannot issue from an incorporeal hereditament (such as a profit à prendre or working interest). In Dynex, the SCC held that the parties "could not offer any convincing policy reasons for maintaining the common law prohibition on the creation of an interest in land from an incorporeal hereditament".2 Therefore, the customs of the oil and gas industry warranted a shift in the law to recognize overriding royalties as an interest in land, subject to the intentions of the parties.

Dynex set out a two-part test. An overriding royalty interest can be an interest in land if:

the language used in describing the interest is 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 substances recovered from the land; and the interest, out of which the royalty is carved, is itself an interest in land.3 Why is an "interest in land" Important?

An "interest in land" is a legal term denoting an interest that "runs" with the land.4 An interest in land allows the holder to register a caveat on the subject land title to give notice to potential purchasers and protect its interest against third parties. In contrast, a contractual interest governs a relationship between the royalty owner and royalty payor and does not attach to the lands. As a result, if the original royalty payor sells its interest to a third party purchaser without specific assignment and novation of the royalty agreement, the royalty owner cannot compel the new purchaser to comply with the royalty obligations.

The Decision in Walter Energy

The value of overriding royalties as interests in land is nothing new to the oil and gas industry, but as demonstrated in the recent British Columbia Supreme Court decision Re: Walter Energy Canada Holdings, Inc5 (Walter Energy), it is of paramount importance in the current climate of the industry. Walter Energy involved an application...