Written By Vivek T.A. Warrier, Alexis E. Teasdale, Robert W. Staley, Jane C. Helmstadter, Kevin J. Zych, Sander A.J.R. Grieve and Isabel Langlois

In a decision of critical interest to the holders of overriding royalties in the mining and oil and gas sectors, the Ontario Court of Appeal has clarified the test used to determine when a royalty interest constitutes an interest in land. The Court of Appeal's recent decision in Third Eye Capital Corporation v Dianor Resources Inc., 2018 ONCA 253, both reaffirms the test established in the 2002 landmark decision Bank of Montreal v Dynex Resources Ltd., 2002 SCC 7, and implements a practical approach to the application of this test, sensitive to the underlying business realities. Notably, the Court of Appeal determined that to create a valid interest in land, it is not necessary for the royalty holder to be granted the right to enter the land to explore and extract minerals—an element that was introduced into the legal test for determining the nature of royalty interests by courts in Québec and Ontario.

Test Established in Dynex

In Dynex, the Supreme Court of Canada confirmed that a gross overriding royalty carved out of a working interest is capable of being an "interest in land" if the parties so intended. The Supreme Court held that a royalty interest can create an interest in land when:

1. 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
2. the interest, out of which the royalty is carved, is itself an interest in land.

The characterization of a royalty interest as an interest in land is important because an interest in land "runs" with the land and will bind a third-party purchaser of the land. In addition, interests in land have typically been characterized as indefeasible in an insolvency context. Conversely, if a royalty interest is characterized as a mere contractual right to share in the profits derived from the sale of the extracted minerals, the royalty interest will not "run" with the land and can be enforced only against the grantor of the royalty.

Dianor

Dianor Resources Ltd. was engaged in the exploration and development of mining properties and held various mining claims in Québec and Ontario. In August 2015, on application by a secured lender, the court appointed a receiver over Dianor's assets. The receiver sought court approval of the sale of Dianor's Ontario mining claims, which were subject to gross overriding royalties, to a third party. The proposed terms of sale included a condition that the royalty interests be terminated or significantly reduced, and contemplated that a cash payment of $250,000 would be made to the royalty holder as compensation (based on expert valuation of the royalties).

The royalty holder did not oppose the sale but argued that the mining claims had to be transferred to the purchaser subject to the royalty interests. The royalty holder argued that the relevant agreements granting the gross overriding royalties evinced a clear intention that the royalty interests were interests in land and would "run" with the lands—providing, in relevant part:

4.1 It is the intent of the parties hereto that the GOR shall constitute a covenant and an interest in land running with the Property and the Mining Claims and all successions thereof or leases or other tenures which may replace them, whether created privately or through governmental action, and including, without limitation, any leasehold interest…

Applying the principles set out in Dynex, Justice Newbould of the Ontario Superior Court of Justice held that the royalty interests were not interests in land. Justice Newbould determined that neither the parties' expressed intentions (as reflected in the contractual language providing that the royalty "shall constitute a covenant and interest in land"), nor the registration of the royalty interests, was sufficient to convey an interest in land. He found that the royalty interest, as expressed in each of the royalty agreements, was only a right to share in revenues produced from the extracted minerals. Notably, Justice Newbould stated that in order to qualify as an interest in land, the royalty agreements had to give the royalty holder the right to enter the property to explore and extract minerals.

Based on this conclusion, Justice Newbould granted a vesting order, which authorized the sale of the Ontario mining claims free from the royalty interests on the condition that $250,000 of the proceeds of sale be paid to the royalty holder as compensation. Interestingly, Justice Newbould went on to state, albeit in obiter dicta, that the Court would have the authority to grant the vesting order free of the royalty rights "whether the royalty rights were or were not an interest in land."

On appeal, Justice Lauwers, writing for the unanimous panel of the Court of Appeal, concluded that the royalty interests were in fact interests in land. In rendering the decision, Justice Lauwers found that the motion judge had made three errors in applying Dynex:

1. First, the motion judge failed to examine the parties' intention from the royalty agreements as a whole, along with the surrounding circumstances. Justice Lauwers held that the plain language of the royalty agreements, when examined as a whole, and the fact that the royalty holder registered the interests on title was sufficient to evidence the parties' intention to create interests in land.
2. Second, the motion judge erred in holding that in order to qualify as an interest in land, the royalty agreements had to give the royalty holder the right to enter and work the land. Justice Lauwers held that the Dynex test does not require a royalty holder to have the right to enter the property to explore and extract minerals to qualify the royalty interest as an interest in land. Justice Lauwers recognized that royalty interests are fundamentally passive interests carved out from the mineral estate, reiterating the acknowledgement of the Supreme Court in Dynex that royalty rights are virtually always "non-operating interests".
3. Third, Justice Lauwers held that the fact that the royalty interests were calculated based on production did not defeat the clear intention of the parties that the royalty interests were interests in land. According to Justice Lauwers, the motion judge erred in holding that the royalty interest was only a right to share in revenues produced from the extracted minerals.

Having concluded that the royalty interests were interests in land, Justice Lauwers invited further submissions on the issue of whether the motion judge had jurisdiction to issue a vesting order that extinguished the royalty interests.

Implications

The decision of the Ontario Court of Appeal in Dianor clarifies the principles established in Dynex and reduces some of the uncertainty created by Justice Newbould’s interpretation of Dynex in finding that it is not necessary for the royalty holder to be granted the right to enter the land to explore and extract minerals, and in confirming that the calculation of a royalty based on production does not defeat the clear intention of the parties that it constitutes an interest in land.

Dianor also serves as a reminder of the importance of properly drafting a royalty agreement if the parties' intention is to have the royalty interest run with the land and bind a third-party purchaser. This intention can be expressed by the use of words such as "grant", "assign", and "convey". It is important to note, however, that in determining when a royalty interest constitutes an interest in land, the courts will examine the parties' intention from the agreement as a whole, along with the surrounding circumstances, as opposed to searching for specific "magic words". If the royalty agreement is not drafted to convey the parties' intention that the royalty be an interest in land, the royalty interest will be construed as a mere contractual right enforceable only against the grantor of the royalty.

Prudent royalty holders should also consider, where possible, registering a caveat on title to the relevant surface and/or mining rights to protect their interests in land. It should be noted, however, that it is not possible to register a caveat or caution against Crown mineral leases in Alberta for a royalty interest. Dianor demonstrates that the registration of the royalty interest is an indicium of the parties' intention to create an interest in land.

The next phase of the appeal will consider the powers of the court in insolvency proceedings to vest assets free and clear of royalty interests that constitute interests in land. Justice Newbould's comment, albeit in obiter dicta, suggests that interests in land can be made subject to vesting orders. The Court of Appeal's ruling on this issue is highly anticipated, as Justice Newbould’s decision was contrary to the generally held expectation that interests in land that "run" with the land cannot be extinguished through a vesting order. To date, a court's jurisdiction to extinguish a proprietary interest belonging to a third party by way of a vesting order has been limited to a very narrow set of circumstances. A decision affirming Justice Newbould's finding would be a concerning development for owners of royalty interest portfolios.

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