CHAPTER 8 PRIVATE ROYALTY ISSUES: A CANADIAN VIEWPOINT

• Jurisdiction: United States

PRIVATE OIL & GAS ROYALTIES
(Sept 2003)
CHAPTER 8
PRIVATE ROYALTY ISSUES: A CANADIAN VIEWPOINT
Nigel D. Bankes
Faculty of Law The University of Calgary
Calgary, Alberta, Canada

ndbankes@ucalgary.ca

February 2003

1.0 PURPOSE OF THE PAPER AND AN OUTLINE

This paper discusses some of the key private royalty issues that have engaged the Canadian courts over the last number of years. Some of these issues will no doubt seem parochial to an American audience. It may appear in some cases that Canadian oil and gas lawyers are captured in a time- warp from which our American colleagues escaped decades ago. Others of these issues will doubtless resonate with American readers more directly.

The first matter for discussion is the legal characterization of the royalty. The principal issue here is whether or not the royalty in question may be characterized as an interest in land that will bind subsequent purchasers of the property. This continues to be an important issue in Canada because of the restrictive rules that we have for the running of covenants and especially the burden of positive promises.¹ The second matter for discussion deals with the approach of the Canadian courts to the question of the implied duties that the working interest owner may owe to the royalty payee, whether that payee is the holder of a lessor's royalty or the holder of a GOR. Third, I shall deal with the case law pertaining to the measures that royalty owners may take to protect their interests through the negotiation of reassignment and surrender clauses and the like. Fourth, the paper looks at a range of interpretive questions that have drawn the attention of Canadian courts. Key among these are those cases that deal with the deductions that the royalty payor is entitled to make for post- production charges such as transportation, compression and processing but I shall also consider a range of other miscellaneous interpretive matters as well. The paper closes with some conclusions.

The paper does not deal with Crown royalties and neither does it deal with some of the interesting litigation that has been occurring over the last number of years in the context of Indian oil and gas leases.² One of the surprises that one encounters in surveying the Canadian case law is that there is really no case law relating to the private lease and gross overriding royalties that deals with the valuation of production for royalty purposes. Thus, while we have case law on the legitimacy of

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deductions for processing and transportation none of that private case law deals with the meaning of market price. While the absence of such litigation during the period of regulated pricing in Canada from the mid-1970s to the mid-1980s should be anticipated, the fact that we have not seen such litigation emerge since then, except in the context of Indian oil and gas leases is more surprising.³

Before taking up the issues identified above individually it seems useful to begin with some remarks of a more general nature on the Canadian law of royalties.

1.1 The Classification of Royalties in Canadian Oil and Gas Law

Canadian case law recognizes three principal categories of royalties: a lessor's royalty, a royalty created by the owner of a corporeal estate in fee simple, and a gross overriding royalty (GOR). The lessor's royalty is a royalty that is reserved or granted as a term of an oil and gas lease. It would ordinarily terminate upon the termination of the lease. The second form of royalty is characterized by the fact that it is granted by the owner of the corporeal estate and is not incident to a reversionary interest of the grantor.⁴ It might be granted for a term of years or in perpetuity. Perhaps surprisingly we do not have a particular name for this form of royalty in Canadian law. In American law it is generally known as a perpetual non-participating royalty. The gross overriding royalty is a royalty created by the holder of a working interest in the property. Since it is carved out of the working interest it too will terminate when the working interest terminates.⁵

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There is at least one additional category of royalty interest that is something of a hybrid of the first two types of royalty; this is the gross royalty trust agreement (GRTA). A GRTA is an arrangement whereby the owner of the corporeal estate⁶ settles a royalty interest in the petroleum and natural gas on a trustee.⁷ Under the terms of the transfer and trust deed, the trustee creates units in the royalty, each evidenced by a certificate, which units the trustee distributes on the instructions of the settlor. The unit holders have an entitlement to a share of the royalties. Thus far, the GRTA has all the hallmarks of the second form of royalty described above, but most of these GRTAs were actually created when the lands in question were already subject to a lease. Thus, one possible characterization of the arrangement was that it was simply an assignment of a lessor's royalty. GRTAs were very common during the 1950s and 1960s. They permitted lessors to market their royalty entitlements and allowed them to share the risks of production or non-production by trading royalty certificates with neighbours. We have seen extensive litigation on these GRTAs during the last decade and I canvass some of that case law in section 2.2 of the paper.

While the above distinctions remain useful, and while some of the attributes of the different forms of royalty will always differ (e.g. attributes relating to duration), the recent trend of Canadian courts has been away from emphasising the distinctive characteristics of the forms of royalty. Instead, the courts have chose to emphasise, for example, that the rules pertaining to both the creation and the interpretation of royalty clauses should be the same.

1.2 The Case Law and the Literature: Use of American Authority

There is not a large body of Canadian case law on private royalties and the same may be said of the academic commentary.⁸ This has led both counsel and the courts to resort to US case law and

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commentary, especially when considering any question that has not already been subject to consideration by Canadian courts. That said, it is rare for such considerations to be conclusive if only because there seems to be such a varied range of opinion in state courts on most issues of oil and gas law. But royalty cases in particular seem to encourage broad research and the marshaling of relevant US authority. Here are some examples:

• In Vanguard v. Vermont⁹ Justice Moore of the Alberta Supreme Court referred generally to US authority for the somewhat commonplace proposition that, after many years debate on the meaning of the word royalty, "The American courts have held that it is necessary to examine the language under particular sets of circumstances to determine the nature of a royalty."

• In Telstar Resources v. Coseka Resources¹⁰ the Alberta Court of Appeal, while emphasising that it was the wording of each agreement that would, if clear, "govern at all times", relied on US authority to support the proposition that a GOR is carved out of the lessee's working interest.

• In Resman Holdings Ltd v. Huntex¹¹ the Alberta Court of Queen's Bench relied upon US authority (an academic article and a decision of the Fifth US Circuit Court of Appeals) for the proposition that the calculation of value at the wellhead for royalty purposes implies that one can deduct processing charges on a proportionate basis from the point of sale back to the wellhead.

• In Mesa Operating Agreement Ltd. v. Amoco Canada Resources Ltd¹² Justice Shannon of the Alberta Court of Queen's Bench relied on a US decision for the proposition that a working interest owner would only breach its duty to the royalty owner in the event that it allowed the lands to surrender, if there were evidence of fraud or collusion between the lessor and the working interest owner.

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• In Prudential Trust Company Limited v. National Trust Company Limited¹³ the court used US authority to show that the problems of apportioning royalties were universal.

• In Western Oil Consultants Limited v. Bankeno Resources¹⁴ the court relied on US commentary and case law for the proposition that reassignment clauses were developed to protect the royalty owner because of the clear understanding that the payor of the royalty owed no duty to the GOR holder, except possibly a duty of good faith, and has no fiduciary relationship with the GOR holder.

• In Scurry-Rainbow Oil Ltd v. Galloway Estate¹⁵ (hereafter the GRTA Test Cases), a case on the characterization of the royalty, Justice Hunt urged that while US decisions may be of assistance "they must be used cautiously because of the fact that different American jurisdictions have adopted varied approaches to basic concepts of oil and gas law...." Her comments were approved by the Court of Appeal but that court added the qualifications that "it would be ... erroneous to rely to heavily on U.S. decisions" and that "American cases are persuasive when not in conflict with authoritative Canadian decisions."¹⁶

With the exception of the case law on the GRTA, the bulk of Canadian case law deals with GORs rather than with the lessor's royalty. This should not be taken as a reflection of the fact that all is well with the lessor's royalty interest but rather a reflection of the fact that in Canada we do not have a tradition of freehold owners organizing to vindicate their rights.¹⁷ An individual freehold lessor will ordinarily lack the legal, technical and financial resources to challenge, for example, the lessee's view of deductions.

2.0 THE CHARACTERIZATION OF THE ROYALTY

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The most significant doctrinal issue to come before the Canadian courts in the royalty context has been the capacity of the royalty entitlement to bind third parties, that is to say, an assignee of the property out of which the...