Bank of Montreal v. Dynex Petroleum Ltd., [2002] 1 S.C.R. 146, 2002 SCC 7

Bank of Montreal Appellant

v.

Enchant Resources Ltd. and

D. S. Willness Respondents

Indexed as: Bank of Montreal v. Dynex Petroleum Ltd.

Neutral citation: 2002 SCC 7.

File No.: 27766.

Hearing and judgment: November 9, 2001.

Reasons delivered: January 24, 2002.

Present: McLachlin C.J. and Gonthier, Iacobucci, Major, Bastarache, Binnie and LeBel JJ.

on appeal from the court of appeal for alberta

Commercial law --- Oil and gas industry --- Overriding royalties --- Whether overriding royalties arising from working interest capable of being interest in land.

The appellant Bank was a secured creditor of D, a corporation in liquidation. The trustee in bankruptcy wanted to sell all the oil and gas properties of D. One issue of concern was whether any such sale would be subject to overriding royalties arising out of the working interest held by D. Also, the respondents held overriding royalties and claimed priority over the Bank, as to the assets of D, because their interests, as protected by caveats filed in a land registration office, preceded the Bank’s loans to D and its predecessors. The caveats claimed an interest in D’s working interest as a result of services performed for D and/or its predecessors. The chambers judge granted the Bank’s application for a preliminary determination finding that an overriding royalty interest cannot be an interest in land. The Court of Appeal set aside that decision, holding that overriding royalty interests can, subject to the intention of the parties, be interests in land.

Held: The appeal should be dismissed.

The common law prohibition against the creation of an interest in land from an incorporeal hereditament is inapplicable to the oil and gas industry given its practices and the support found in the law. A royalty which is an interest in land may be created from an incorporeal hereditament such as a working interest or a profit à prendre if that is the intention of the parties.

Cases Cited

Referred to: Berkheiser v. Berkheiser, 1957 CanLII 56 (SCC), [1957] S.C.R. 387; Saskatchewan Minerals v. Keyes, 1971 CanLII 183 (SCC), [1972] S.C.R. 703; Scurry-Rainbow Oil Ltd. v. Galloway Estate (1993), 1993 CanLII 7025 (AB QB), 138 A.R. 321, aff’d (1994), 1994 ABCA 313, 157 A.R. 65; Canco Oil and Gas Ltd. v. Saskatchewan (1991), 1991 CanLII 7788 (SK QB), 89 Sask. R. 37; St. Lawrence Petroleum Ltd. v. Bailey Selburn Oil & Gas Ltd., 1963 CanLII 76 (SCC), [1963] S.C.R. 482; Vanguard Petroleums Ltd. v. Vermont Oil & Gas Ltd., 1977 CanLII 648 (AB SCTD), [1977] 2 W.W.R. 66; Isaac v. Cook (1982), 44 C.B.R. 39; Guaranty Trust Co. v. Hetherington (1987), 1987 CanLII 3332 (AB QB), 50 Alta. L.R. (2d) 193, aff’d in part 1989 ABCA 113, [1989] 5 W.W.R. 340; Vandergrift v. Coseka Resources Ltd. (1989), 1989 CanLII 3163 (AB QB), 67 Alta. L.R. (2d) 17; Nova Scotia Business Capital Corp. v. Coxheath Gold Holdings Ltd. (1993), 1993 CanLII 3450 (NS SC), 128 N.S.R. (2d) 118; Friedmann Equity Developments Inc. v. Final Note Ltd., [2000] 1 S.C.R. 842, 2000 SCC 34.

Authors Cited

Davies, G. J. “The Legal Characterization of Overriding Royalty Interests in Oil and Gas” (1972), 10 Alta. L. Rev. 232.

Dukelow, Daphne A., and Betsy Nuse. The Dictionary of Canadian Law, 2nd ed. Scarborough, Ont.: Carswell, 1995, “corporeal hereditament”, “incorporeal hereditament”.

Ellis, W. H. “Property Status of Royalties in Canadian Oil and Gas Law” (1984), 22 Alta. L. Rev. 1.

Newman, J. Forbes. “Can a Gross Overriding Royalty Be an Interest in Land”, in Insight Educational Services, Oil & Gas Agreements Update. Mississauga, Ont.: Insight Press, 1989.

APPEAL from a judgment of the Alberta Court of Appeal (1999), 74 Alta. L.R. (3d) 219, 255 A.R. 116, 220 W.A.C. 116, 182 D.L.R. (4th) 640, 2 B.L.R. (3d) 58, 15 C.B.R. (4th) 5, 15 P.P.S.A.C. (2d) 175, [2000] 2 W.W.R. 693, [1999] A.J. No. 1463 (QL), 1999 ABCA 363, reversing a judgment of the Court of Queen’s Bench (1995), 1995 CanLII 9262 (AB QB), 39 Alta. L.R. (3d) 66, [1996] 6 W.W.R. 461, 11 P.P.S.A.C. (2d) 291, [1995] A.J. No. 1279 (QL). Appeal dismissed.

Richard B. Jones, for the appellant.

James C. Crawford, Q.C., Frank R. Dearlove and Scott H. D. Bower, for the respondents.

The judgment of the Court was delivered by

//Major J.//

//sc//Major J.//sc// ---

I. Introduction

1 This appeal arises from an application made by the appellant Bank of Montreal before the chambers judge in the Alberta Court of Queen’s Bench for a determination that, as a matter of law, an overriding royalty is incapable of being an interest in land. The application was opposed by several defendants including the respondents in this Court, Enchant Resources Ltd. (“Enchant”) and D. S. Willness (“Willness”), each holders of overriding royalties who claim their interests to be interests in land. The learned chambers judge allowed the Bank’s application which the Alberta Court of Appeal reversed, holding that an overriding royalty is capable of being an interest in land. This appeal to the Supreme Court of Canada was dismissed with reasons to follow.

II. Facts

2 The material filed and submissions of counsel indicated that royalty arrangements are common forms of arranging exploration and production in the oil and gas industry in Alberta. Typically, the owner of minerals in situ will lease to a potential producer the right to extract such minerals. This right is known as a working interest. A royalty is an unencumbered share or fractional interest in the gross production of such working interest. A lessor’s royalty is a royalty granted to (or reserved by) the initial lessor. An overriding royalty or a gross overriding royalty is a royalty granted normally by the owner of a working interest to a third party in exchange for consideration which could include, but is not limited to, money or services (e.g., drilling or geological surveying) (G. J. Davies, “The Legal Characterization of Overriding Royalty Interests in Oil and Gas” (1972), 10 Alta. L. Rev. 232, at p. 233). The rights and obligations of the two types of royalties are identical. The only difference is to whom the royalty was initially granted.

3 The appellant Bank of Montreal was a secured creditor of Dynex Petroleum Ltd. (“Dynex”), a corporation in liquidation. The trustee in bankruptcy wanted to sell all the oil and gas properties of Dynex. One issue was whether any such sale would be subject to overriding royalties arising out of the working interest held by Dynex. Also, there were several competing claims against the appellant, which by the time of this appeal had narrowed to the overriding royalties of the respondents Enchant and Willness, who claimed a preference by way of a caveat filed in the South Alberta Land Registration District, claiming an interest in Dynex’s working interest as a result of services performed for Dynex and/or its predecessors. The respondents claimed their royalty rights comprised interests in land and claimed priority over the appellant because their interests, as protected by caveats, preceded the appellant’s loans to Dynex and its predecessors. The appellant submitted that at common law an interest in land could not arise from an incorporeal hereditament and therefore the respondents’ overriding royalties (which arose from a working interest, an incorporeal hereditament) did not rank higher in priority than the appellant’s security interest.

4 This case pits this ancient common law rule against a common practice in the oil and gas industry. The Court is asked to resolve the apparent conflict.

III. Judicial History

5 The appellant applied to the Court of Queens Bench of Alberta ((1995), 1995 CanLII 9262 (AB QB), 39 Alta. L.R. (3d) 66) for a preliminary determination that the overriding royalty interests do not constitute interests in land. The learned chambers judge, Rooke J. in allowing the application held at para. 3 that:

. . . as a matter of law, a lessee of an oil and gas lease (which is a profit à prendre), which is in itself an interest in land, obtained from a lessor (whether the Crown or freehold), cannot in law pass on an interest in land to a third party.

He also concluded that if an interest in land could issue from a profit à prendre, which he held that it could not, the matter could not be determined summarily as evidence would be necessary to examine the language of the instruments and the intentions of the parties.

6 After a review of policy considerations, industry practice and Canadian and United States case law, the Alberta Court of Appeal ((1999), 1999 ABCA 363, 74 Alta. L.R. (3d) 219) concluded that overriding royalty interests can constitute interests in land if intended by the parties. For substantially the same reasons as the Court of Appeal, I conclude that overriding royalty interests can be interests in land.

IV. Issue

7 Can an overriding royalty issued from a working interest (an incorporeal hereditament) be an interest in land?

V. Analysis

8 At common law, an interest in land could issue from a corporeal hereditament but not from an incorporeal hereditament. “Corporeal hereditament” is defined by The Dictionary of Canadian Law (2nd ed. 1995) as:

1. A material object in contrast to a right. It may include land, buildings, minerals, trees or fixtures. . . .

2. Land. . . .

“Incorporeal hereditament” is defined as:

1. “(A right) . . . in land, which (includes) such things as rent charges, annuities, easements, profits à prendre, and so on.”. . .

2. Property which is not tangible but can be inherited. . .

9 In Berkheiser v. Berkheiser, 1957 CanLII 56 (SCC), [1957] S.C.R. 387, at p. 392, Rand J. held that an oil and gas lease, the interest from which an overriding royalty is created, can be a profit à prendre, an interest in land. A profit à prendre is an incorporeal hereditament. The appellant has submitted that at common law, an interest in land could not issue from an incorporeal hereditament and therefore overriding royalties cannot be interests in land.

10 Canadian case law suggests otherwise. In Saskatchewan Minerals v. Keyes, 1971 CanLII 183 (SCC), [1972] S.C.R. 703, the majority declined to decide whether an overriding royalty could be an interest in land. However, Laskin J. in dissent specifically addressed that issue. He did not find the distinction between corporeal and incorporeal hereditaments to be useful in this context and discussed the difficulty of conforming new commercial concepts to anachronistic categories at p. 722:

The language of “corporeal” and “incorporeal” does not point up the distinction between the legal interest and its subject-matter. On this distinction, all legal interests are “incorporeal”, and it is only the unconfronted force of a long history that makes it necessary in this case to examine certain institutions of property in the common law provinces through an antiquated system of classification and an antiquated terminology. The association of rents and royalties has run through the cases (as in Re Dawson and Bell, supra, the Berkheiser case, supra, and cf. Attorney-General of Ontario v. Mercer, at p. 777) but without the necessity hitherto in this Court to test them against the common law classifications of interests in land or to determine whether those classifications are broad enough to embrace a royalty in gross.

11 Laskin J. referred to Berkheiser, supra, where Rand J. held that a royalty was analogous to rent. While that case involved a lessor’s royalty, Laskin J. found that although theoretically the holder of a lessor’s royalty holds an interest in reversion, whereas the holder of an overriding royalty does not, since in essence the two interests are identical, there should be no distinction between the two royalty interests in their treatment as interests in land. The effect of Laskin J.’s reasons was to render inapplicable, at least insofar as overriding royalties, the common law rule against creating interests in land out of incorporeal interests.

12 Laskin J. concluded that the overriding royalty was an interest in land, analogous to a rent-charge. It is significant that he did not find all overriding royalty interests to be interests in land. He held that the intentions of the parties judged by the language creating the royalty would determine whether the parties intended to create an interest in land or to create contractual rights only.

13 In Scurry-Rainbow Oil Ltd. v. Galloway Estate (1993), 1993 CanLII 7025 (AB QB), 138 A.R. 321 (Q.B.), aff’d (1994), 1994 ABCA 313, 157 A.R. 65 (C.A.), and in Canco Oil and Gas Ltd. v. Saskatchewan (1991), 1991 CanLII 7788 (SK QB), 89 Sask. R. 37 (Q.B.), Hunt J. and Matheson J. respectively relied upon the dissent in Keyes, supra, to find that lessor royalties can be interests in land depending on the intentions of the parties and the language used to create the interest. The Court of Appeal in Scurry-Rainbow did not base its decision on this issue.

14 The appellant referred to cases that held royalty interests not to be interests in land. (See St. Lawrence Petroleum Ltd. v. Bailey Selburn Oil & Gas Ltd., 1963 CanLII 76 (SCC), [1963] S.C.R. 482; Vanguard Petroleums Ltd. v. Vermont Oil & Gas Ltd., 1977 CanLII 648 (AB SCTD), [1977] 2 W.W.R. 66 (Alta. S.C.T.D.); Isaac v. Cook (1982), 44 C.B.R. 39 (N.W.T.S.C.); Guaranty Trust Co. v. Hetherington (1987), 1987 CanLII 3332 (AB QB), 50 Alta. L.R. (2d) 193 (Q.B.), aff’d in part 1989 ABCA 113, [1989] 5 W.W.R. 340 (Alta. C.A.); Vandergrift v. Coseka Resources Ltd. (1989), 1989 CanLII 3163 (AB QB), 67 Alta. L.R. (2d) 17 (Q.B.); Nova Scotia Business Capital Corp. v. Coxheath Gold Holdings Ltd. (1993), 1993 CanLII 3450 (NS SC), 128 N.S.R. (2d) 118 (S.C.).) Although each of these cases held that the royalty therein is not an interest in land, they do not support the proposition that a royalty cannot be an interest in land. In each case the court found that the language used by the parties in creating the interest did not evidence the intention to create an interest in land.

15 That royalties can be interests in land finds support in W. H. Ellis’s “Property Status of Royalties in Canadian Oil and Gas Law” (1984), 22 Alta. L. Rev. 1, at p. 10:

Royalties, as used in the oil and gas industry, make sense only if they are property interests in unproduced minerals. Owners of mineral rights should be able to create them as such if they make clear their intent to do so.

16 In Oil & Gas Agreements Update (1989), J. F. Newman in his article “Can a Gross Overriding Royalty Be an Interest in Land?”concludes that most parties to an overriding royalty interest intend for such interest to be an interest in land. Evidence of this is the common practice of registering caveats in the Land Titles Office of Alberta seeking to protect that interest.

17 The oil and gas industry, which developed largely in the second half of the 20th century and continues to evolve, is governed by a combination of statute and common law. The application of common law concepts to a new or developing industry is useful as it provides the participants in the industry and the courts some framework for the legal structure of the industry. It should come as no surprise that some common law concepts, developed in different social, industrial and legal contexts, are inapplicable in the unique context of the industry and its practices.

18 The appellant 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 other than fidelity to common law principles. Given the custom in the oil and gas industry and the support found in case law, it is proper and reasonable that the law should acknowledge that an overriding royalty interest can, subject to the intention of the parties, be an interest in land.

19 The Alberta Court of Appeal offered compelling insight into the evolution of the law at para. 52:

The principles inherent in the above argument need not be applied to prevent an overriding royalty from being an interest in land for a number of reasons. First, royalties and ORRs need not be classified into a traditional common law property category unsuited to the realities of the oil and gas industry and need not be subject to the arcane strictures of traditional categories. Second, some authorities suggest it is possible to have an incorporeal interest (an overriding royalty) created from an incorporeal interest. Third, even if it is not possible, the rule need not be blindly adhered to because, as stated by Mr. Justice Holmes in “The Path of the Law” (1897) 10 Harv. L. Rev. 457 at p. 469, it is “revolting to have no better reason for a rule of law than that so it was laid down in the time of Henry IV,” and “still more revolting if the grounds upon which it was laid down have vanished long since, and the rule persists from blind imitation of the past.”

20 In Friedmann Equity Developments Inc. v. Final Note Ltd., [2000] 1 S.C.R. 842, 2000 SCC 34, at para. 42, Bastarache J. outlined when changes to the rules of common law are necessary:

(1) to keep the common law in step with the evolution of society,

(2) to clarify a legal principle, or

(3) to resolve an inconsistency.

In addition, the change should be incremental, and its consequences must be capable of assessment.

21 In this appeal, to clarify the status of overriding royalties, the prohibition of the creation of an interest in land from an incorporeal hereditament is inapplicable. A royalty which is an interest in land may be created from an incorporeal hereditament such as a working interest or a profit à prendre, if that is the intention of the parties.

22 Virtue J. in Vandergrift, supra, at p. 26, succinctly stated:

. . . it appears reasonably clear that under Canadian law a “royalty interest” or an “overriding royalty interest” can be an interest in land if:

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.

VI. Conclusion

23 The appeal is dismissed with costs to the respondents.

Appeal dismissed.

Solicitors for the appellant: Jones, Rogers, Toronto.

Solicitors for the respondents: McDonald Crawford; Bennett Jones, Calgary.