Canada: Fully Secured @ Gowlings: September 26, 2013 - Volume 4, Number 3

Edited by Richard Dusome

In this issue:

• Oil and Gas Leases – An Intangible Form of Personal Property in Alberta
• Demanding Repayment for Non-Payment Defaults
• When Can a Second Mortgagee Sell a Property in Ontario?
• Security Enforceable Despite Technical Errors in the Documents
• A Banker Asked Us: Renewing Bank Act Security

OIL AND GAS LEASES – AN INTANGIBLE FORM OF PERSONAL PROPERTY IN ALBERTA

By: Gillian Scarlett (Calgary)

In a recent decision of the Alberta Court of Queen's Bench, Kasten Energy Inc. v. Shamrock Oil & Gas Ltd.¹, an oil and gas lease was characterized as a form of personal property subject to the Alberta PPSA.² The case appears to broaden the scope of assets that are characterized as personal property, and therefore may be secured by a typical general security agreement ("GSA").

The Alberta Court of Queen's Bench (the "Court") considered an application by Kasten Energy Inc. ("Kasten") to appoint a receiver and manager pursuant to the Judicature Act³ over all of the assets of Shamrock Oil & Gas Ltd. ("Shamrock"). Shamrock held a Crown petroleum and natural gas lease (the "Lease") for the development of an oil well in Alberta. Shamrock executed a GSA in favour of Kasten's predecessor which granted a security interest in all of Shamrock's present and after acquired personal property. The GSA was subsequently assigned to Kasten.

In considering Kasten's application for the appointment of a receiver and manager, the Court summarized the applicable test for the appointment of a receiver, namely, whether the appointment is "just or convenient"⁴. The Court concluded that the appointment of a receiver was just, convenient and appropriate in the circumstances.

What is remarkable about this case is the Court's consideration of the question of whether the Lease was covered by Kasten's GSA. Shamrock contended that the Lease is a profit à prendre (ie. the right to enter someone else's land and work and remove a valuable resource), which is an interest in land excluded from "personal property" pursuant to the Alberta PPSA. Kasten acknowledged that the GSA is not enforceable against the oil and gas in the ground, but argued that once the oil and gas is extracted from the ground by Shamrock, it becomes intangible personal property subject to the GSA. The Court relied on the reasoning of the Supreme Court of Canada in Saulnier⁵, where the term "property" was considered in the context of a commercial fishing licence under the Bankruptcy and Insolvency Act⁶ and the Nova Scotia PPSA.⁷ In that case, the Supreme Court found that the subject matter of the licence (ie. the right to participate in a fishery that is exclusive to licence holders) coupled with a proprietary interest in the fish caught "bears a reasonable analogy to rights traditionally considered at common law to be proprietary in nature".⁸ Therefore, the Court in Kasten Energy held that an oil and gas lease is analogical to a commercial fishing licence, since the leaseholder has a beneficial interest in the earnings generated by its oil and gas lease during the leasehold term. The Court concluded that, "within the purposive contemplation of Alberta's [PPSA]" the Lease is an intangible form of personal property subject to both the GSA and the PPSA and fell within the power and authority of a court-appointed Receiver.

Some commentators have suggested that the Court found it necessary to shoehorn the Lease, Shamrock's principal asset, into the category of personal property in order to reach the conclusion that it had the authority to appoint the receiver, although there is no such requirement under the Judicature Act.

The Court's judgment in Kasten Energy appears to be contrary to previous authority indicating that a Crown oil and gas lease is not a form of personal property.⁹ Prior to this decision, it was generally understood that an oil and gas lease is an interest in land, and security interests in an individual oil and gas lease were perfected by registration either at the Alberta Land Titles Office (for freehold leases) or at Alberta Energy (for Crown leases). This case may cause confusion for lenders, as it suggests a security interest in an oil and gas lease can also be perfected at the Personal Property Registry ("PPR"). Kasten Energy may also lead to uncertain priority disputes between parties who have registered in the PPR and those who have registered at the Land Titles Office or Alberta Energy. Further, transferees of such leases may need to obtain "no interest" letters from creditors with registered GSAs to ensure the lease, as intangible personal property, is not encumbered.

It remains to be seen whether Kasten Energy will be followed, distinguished or ignored.

DEMANDING REPAYMENT FOR NON-PAYMENT DEFAULTS

By: Sean Morrison (Hamilton)

Determining when to demand repayment of a loan is often difficult for a lender in any situation. This decision becomes exponentially more complicated in circumstances where the borrower has not defaulted on any payments. Lenders have to weigh the fact that a loan is being repaid as required against the risk to their security arising from the other defaults. In addition, many lenders and borrowers are under the impression that a demand for repayment that is based upon defaults unrelated to payment may be unsustainable and may be disallowed by the Courts. A recent decision of the Ontario Superior Court of Justice has shed some light on this issue and demonstrated that the Courts are reluctant to interfere in those situations where demand is made in the absence of a payment default provided that the demand is not either capricious or impermissible in law.

In Ocean Sands¹⁰, the Bank of China (the "Bank") brought a motion for summary judgment for repayment in relation to funds advanced to Ocean Sands Developments Ltd. ("Ocean"). Ocean opposed the motion on the basis that it was up-to-date on all loan payments and, as a result, the demand was unreasonable and unsustainable.

The loan in this case was evidenced by a promissory note which specifically stated that it was payable on demand and was governed by a facility letter containing a number of covenants. In addition, both the mortgage and guarantee securing the loan indicated that they were payable on demand.¹¹ Given the demand language in the loan documents, the Bank took the position that it was within its rights to simply require repayment at any time, and that there did not need to be a breach of any term of the loan commitment in order for it to do so. In the event that a justification for the demand was required, the Bank argued that the following triggering events entitled it to make a demand:

1. Ocean sold the mortgaged premises without the Bank's consent in breach of the negative covenants in the facility letter;
2. There were misrepresentations made in two sworn statutory declarations from the principal of Ocean which constituted events of default under the facility letter;
3. Ocean failed to provide financial statements in the time frame required under the facility letter;
4. Ocean failed to maintain the minimum debt service ratio required under the facility letter;
5. Ocean failed to pay realty taxes as due in breach of the positive covenants in the facility letter; and
6. Ocean failed to inform the Bank of an unregistered mortgage on the mortgaged premises.

The Bank took the position that its security had been considerably weakened as a result of the actions of Ocean, that it had lost trust in Ocean due to the misrepresentations, and that it was unwilling to continue to do business with Ocean as a result.¹² The Bank argued that in these circumstances it was entitled to demand repayment of its loan in full and that it would be improper for the court to force it to do business with someone that it did not want to, particularly in circumstances where it justifiably had lost confidence in the borrower.¹³

Ocean took the position that the defaults were either unsustainable or had been rectified by the time the motion was heard, and that there was no basis for the Bank's demand given that it had made all of the required payments on the advance.¹⁴ The Borrower also argued, among other things, that the fact that the loan could not be prepaid without penalty was evidence of an intention of the parties to have a specific arrangement for a fixed term. Ocean suggested that the parties had in fact contractually agreed to a five year term for the loan, and the Bank should not be able to now demand repayment prior to the end of that fixed term.¹⁵ However, no text from the facility letter was quoted as evidence of that five year term in order to counteract the demand language.

The Court rejected the arguments of Ocean and granted summary judgment.¹⁶ It held that the loan documents clearly stated that the loan was payable on demand and rejected Ocean's claim that the parties had intended for a fixed term, concluding: (i) that the wording of the specific security prevails over any conflict in wording that may be found in the facility letter; and (ii) that the specific security documents did not restrict the Bank from making a demand prior to the conclusion of the five year term of the loan.¹⁷

The Court further held that if it was wrong in its initial determination and that a triggering event is required for a proper demand to be made, the following was sufficient to justify the demand by the Bank¹⁸:

1. There was clear evidence of a transfer of the property without the Bank's consent and the existence of an unregistered vendor take-back mortgage;
2. The statutory declarations were inaccurate;
3. Ocean was in breach of the debt service ratio;
4. Ocean's principal admitted under cross-examination that the promissory note and mortgage security were payable on demand without any limitation and that the loan was structured on the basis that Ocean was to be both the legal and beneficial owner of the interest under the leases on the mortgaged property; and
5. Ocean's principal admitted that the financial statements were late.

The Court rejected the argument put forth by Ocean that there needed to be something more than a simple demand made by the Bank in these circumstances, stating that it is "reasonable not to constrain commercial lenders to lend to borrowers whom they no longer trust or with whom they no longer wish to do business ... so long as the Bank has not made a demand which is either capricious or impermissible."¹⁹ The demand made by the Bank in this case was supported by: (i) the loan and security documents which stipulated clearly that they were payable on demand; (ii) the confirmation of the validity of those documents by Ocean; and (iii) the fact that that the non-financial breaches of the facility letter by Ocean were concerning, real and created an understandable breakdown of the parties' business relationship. As a result, the Court concluded that the Bank should not be prevented from making a demand and ending its relationship with Ocean.

While the facts of the Ocean Sands case are fairly unique, it does demonstrate an acceptance by the Courts of the importance of the role of factors beyond simply whether or not payments are being made in the relationship between a lender and a borrower and the reluctance of the Courts to interfere with the legitimate business decisions of lenders. This decision should also provide some comfort to lenders that they may, in the right circumstances, demand repayment of loans where non-payment defaults have led to a breakdown in the relationship with the borrower without fear that the Courts will look solely at whether or not payments have been made when determining whether or not a demand is reasonable. It should be noted however that the Court did not comment on the amount of time needed to be given to a borrower after making demand to arrange for alternative financing in order for the demand to be reasonable. Ocean Sands also shows the importance, wherever elements of a demand loan are blended with certain features of a term loan in a facility letter, of making it abundantly clear that the demand nature of the loan takes precedence over the term features.

WHEN CAN A SECOND MORTGAGEE SELL A PROPERTY IN ONTARIO?

By: Rosa Lupo (Waterloo Region)

A recent decision by the Ontario Court of Appeal in Business Development Bank of Canada v. Pine Tree Resorts Inc.²⁰ illustrates the extent of exposure which a second mortgagee could potentially face when it attempts to enforce its second mortgage.

In Pine Tree, the mortgagor defaulted on a first mortgage in favour of Business Development Bank of Canada ("BDC") and also defaulted on a second mortgage in favour of Romspen Investment Corporation ("Romspen") with respect to an inn located in Honey Harbour, Ontario. At the time of enforcement, BDC was owed approximately $2.6 million. Romspen was owed approximately $4.3 million.

In addition to amounts owing to BDC, the mortgagor was also in arrears of approximately $250,000 for HST. Non-payment of HST was a breach of a covenant under the BDC security.

To enforce payment, BDC applied for and was granted the appointment of a court-ordered receiver over the mortgagor's assets as it was contractually entitled to do under its security documents. In contrast, Romspen attempted to initiate power of sale proceedings over the property but the proceedings were halted by BDC's appointment of a receiver.

Romspen, together with the mortgagor, then sought leave to appeal the application judge's order appointing the receiver, arguing that Romspen had the right as a subsequent mortgagee to put BDC in good standing per Section 22 of the Mortgages Act²¹, and thus take over the sale of the property by resuming the power of sale proceedings.

Section 22 of the Mortgages Act entitles a mortgagor, where default has occurred, to perform such covenant or pay the amount due under the mortgage and thereupon relieves a mortgagor of the consequence of any default.

Romspen proposed to do so by "[putting] the [first] mortgage in good standing by paying all arrears of principal and interest, together with all of BDC's costs, expenses and outstanding realty taxes."²² However, Romspen did not propose to repay the approximately $250,000 in remaining HST arrears.

Romspen and the mortgagor submitted that it was not necessary for them to comply with the HST covenant in order to be able to take advantage of their subsequent mortgagee's rights under Section 22, as the HST arrears formed a subsequent encumbrance and did not jeopardize BDC's security in any way.

In response, BDC submitted that bringing the prior mortgage in good standing required "paying the amount due under the mortgage and – where there are unperformed covenants – performing those covenants as well."²³

The Court did not accept Romspen's argument and instead found:

"Romspen relies upon the jurisprudence of this Court establishing that a mortgagor – and therefore, a subsequent mortgagee – is entitled as of right, upon tendering the arrears or performing the covenant in default, to be relieved of the consequence of default. The problem is that Romspen has not offered to put the BDC mortgage in good standing, but has only offered to do so partially. It proposes to leave unperformed a $250,000 covenant – payment of the outstanding HST arrears.

For Romspen to succeed on appeal would require a very creative interpretation of Section 22 of the Mortgages Act, and one would potentially create an undesirable element of uncertainty in the field of mortgage enforcement, because no one would know which covenants could be left unperformed and which could not, without litigating the issue in each case."²⁴

As a result of the decision in Pine Tree, second mortgagees may find themselves facing much more significant costs before they can be in a position to enforce their second position mortgage and may be more reluctant to enforce their security ahead of a first mortgage.

SECURITY ENFORCEABLE DESPITE TECHNICAL ERRORS IN THE DOCUMENTS

By: Richard Dusome (Toronto)

Loan and security documents frequently contain a series of defined terms and acronyms to simplify references to the parties and to facilitate the drafting of the operative covenants. There is obviously a great potential for inadvertent errors to occur in the use of some of those defined terms and acronyms.

Fortunately, in the recent case of Great Eagle Resources²⁵, the British Columbia Supreme Court rejected several very technical defences raised by a borrower to the enforcement of certain security documents supporting a legitimate loan transaction, and raised by a related secured creditor seeking to avoid a postponement it had granted. The borrower and the postponing creditor party had attempted to have the documents declared invalid solely by reason of technical errors contained in them.

The Great Eagle Resources case involved the financing of mining claims and other related mining operation assets of Great Eagle Resources Ltd. ("Great Eagle") by a non-institutional lender ("5240"). The loan was documented with a formal loan agreement and supported by a general security agreement. 5240 also arranged for a prior registered secured creditor ("MortonCo") of the borrower to execute a postponement agreement in favour of 5240. The development of the mine did not proceed as well as the parties had intended, and Great Eagle stopped providing the required financial reports. When 5240 learned that Great Eagle had attempted to transfer the mining claims to another related party, 5240 made demand on its loan and proceeded to enforce its security.

The loan agreement formally created the defined term of "Borrower" to describe Great Eagle. However, in some sections of the loan agreement including the paragraph requiring the delivery of the general security agreement, the undefined term "Company" was also used where "Borrower" should technically have been used. Great Eagle suggested that the agreement was imprecise and failed to adequately identify a contracting party.²⁶ Mr Justice Greyell took a very practical approach in dismissing that technical argument. He found that notwithstanding the error, in a bilateral agreement between 5240 and Great Eagle, the use of the term "Company" obviously referred to Great Eagle and that there was no further company or general security agreement contemplated by the parties.²⁷

The postponement agreement provided by MortonCo had been prepared for signature with the corporate name shown on the personal property register as the party holding the prior registered secured claim. However, MortonCo had changed its name prior to signing the postponement agreement, and had not bothered to reflect its new name on the PPR. It also did not advise 5240 of the name change at the time it executed and delivered the postponement agreement. MortonCo argued that it was not bound by the postponement, as it referred to a non-existent corporation. Mr Justice Greyell refused to allow this technical error to defeat the clear intentions of the parties, and ordered a rectification of the postponement so that it referred to the current legal name of MortonCo. In reaching his decision, Mr. Justice Greyell expressly applied the fundamental principle of contract law that courts should avoid an interpretation of a contract that produces a result that is unreasonable.²⁸

Great Eagle also argued that the general security agreement was not valid as 5240 had not actually paid to Great Eagle the $10.00 consideration referenced in its introductory paragraph. The Court held that the $10.00 consideration was a symbolic amount, which was not intended by the parties to be paid. The agreement did not fail for a lack of consideration as each party derived substantive benefits under the terms of the contract.²⁹ A similar finding was made in respect of the postponement agreement which also contained a reference to the $10.00 consideration.

In the end result, the Court held that the loan and security documents were enforceable by 5240 against Great Eagle and MortonCo as the parties had intended. It is encouraging to have a case like Great Eagle Resources where the Court recognized the clear intent of the contracting parties, applied a common sense interpretation to the applicable contracts, and refused to entertain frivolous defences advanced by the borrower and related parties.³⁰

A BANKER ASKED US:RENEWING BANK ACT SECURITY

By: Richard Dusome (Toronto)

Footnotes

1. 2013 ABQB 63 [Kasten Energy].

2. Personal Property Security Act, RSA 2000, c P-7 [Alberta PPSA].

3. Judicature Act, RSA 2000, c J-2.

4. Judicature Act, s 13(2).

5. Saulnier v. Royal Bank of Canada, 2008 SCC 58 [Saulnier].

6. RSC 1985, c B-3, as amended.

7. Personal Property Security Act, SNS 1995-96, c 13.

8. Saulnier, at para. 34.

9. For example, see R v Industrial Coal and Minerals, [1997] 4 WWR 35, rev'd on other grounds, [1979] 5 WWR 103 (Alta App Div).

10. Bank of China (Canada) v Ocean Sands Developments Ltd, 2013 ONSC 1413 [Ocean Sands]

11. The specific text of the facility letter was not disclosed in great detail in the judgment. From those excerpts of the facility letter that were referenced in the judgment, it appears to have contemplated events of default even though the promissory note, mortgage and guarantee were all payable upon demand.

12. Ocean Sands, at para. 15.

13. Ocean Sands, at para. 11.

14. Ocean Sands, at para. 19.

15. Ocean Sands, at para. 23.

16. In a subsequent costs ruling, the Court also awarded the Bank its costs on a partial indemnity basis. Bank of China (Canada) v Ocean Sands Developments Ltd, 2013 ONSC 1828.

17. Ocean Sands, at para. 30(a).

18. Ocean Sands, at para. 30(b).

19. Ocean Sands, at para. 33.

20 Business Development Bank of Canada v Pine Tree Resorts Inc, 2013 ONCA 282 [Pine Tree]

21 RSO 1990, c M.40

22 Pine Tree, at para. 9

23 Pine Tree, at para. 11

24 Pine Tree, at paras. 39 and 40.

25. 5240 Investments Ltd v Great Eagle Resources Ltd, 2013 BCSC 35 [Great Eagle Resources].

26. Great Eagle Resources, at para. 114.

27. Great Eagle Resources, at para. 119.

28. Great Eagle Resources, at paras. 159 and 160.

29. Great Eagle Resources, at paras. 104 and 112.

30. The Court also granted a subsequent application by 5240 for special costs against those related parties based upon their frivolous defences and their conduct in participating in certain fraudulent conveyances of secured assets in 5240 Investments Ltd v Great Eagle Resources Ltd, 2013 BCSC 778.

31. Bank Act SC 1991, c 46, as amended [Bank Act]

32. The three year period is referenced in Section 427(4)(a) of the Bank Act, and is frequently mistaken as being the registration period of a Notice of Intention. However, that subsection actually provides that the rights of the bank under Section 427 are not effective unless the Notice of Intention is filed not more than three years immediately before the security was given.

33. Registration of Bank Special Security Regulations, SOR/92-301, as amended [The Regulations]

34. The Regulations, s 7(1).

35. The Regulations, s 7(2).

36. The Regulations, s 7(3).

37. The Regulations, ss 2 and 8(2).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.