When Do Royalty Rights Run with the Land?

July 23, 2022

By Mark Mikulasik

A royalty interest in mining claims and leases may be an interest in land, unlike many other contracts affecting the rights of landowners. For historical reasons going back to feudal England, lawmakers have not wanted title to land to be tied up by contractual rights and obligations which may make it difficult for property to be transferred. The law prefers a nice clean title.

This can be very significant, because agreements which do not create an interest in land are not binding on future owners of the property. They are simply contracts between the existing owner and the other contracting party. A property interest also has advantages in insolvency.

Unfortunately, the law is still less easy to apply to new fact situations and wordings of agreements than we would like, and the most recent Ontario Court of Appeal decision is of limited assistance.

THE ISSUE

The Supreme Court of Canada had decided in a 2002 case called Dynex that certain royalty rights in oil and gas properties created an interest in land as that was the intention of the parties who created the royalty interest. This was significant because the owner of the properties had gone bankrupt and if the royalty interests were contractual only, the owners of the royalty interest would be unsecured creditors in the bankruptcy as opposed to retaining a proprietary interest in the land.

Dynex said that because industry practice favoured recognizing the value of royalty interests on an ongoing basis out of the profits of the project, they were an exception to the general common law rules, 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.

This encourages investment in mining projects by improving the likelihood of payment to the investors.

The scope of this exception has remained controversial. Other lenders object to the advantage given to royalty holders in situations of insolvency. They call for more clarity and certainty so that at least they know where they stand. In 2018, the Ontario Court of Appeal tried to clarify that the intent referred to in Dynex required more than merely looking at the plain wording of the agreements. This would not please other lenders.

THE CASE

The Ontario Court of Appeal recently revisited this issue in Prism Resources Inc. v. Detour Gold Corporation. Although it adds some clarity, it is unlikely that it will satisfy the objections, since it requires the precise interpretation of contract wordings in context, in a search for intent, which often is not apparent just by examining the wording of documents.

Prism is not an insolvency case, but the approach it takes to the status of royalty rights does not differentiate and relies on the earlier cases which did involve insolvency.

Prism held a royalty interest, the nature of which had changed over the years through a sequence of options and joint venture agreements. At one point Prism was the 60% owner of the mining rights in the property, with an option to purchase the remaining 40%.  Prism then entered into a joint venture agreement with a corporation called Conquest and eventually transferred its entire interest in the mining rights to Conquest in exchange for a 7.5% “carried interest in the project’s” net profits. Conquest then acquired the remaining 40% of the mining rights and subsequently sold its interests to Detour, which developed a mine. This made the royalty rights valuable. The sales agreement between Conquest and Detour specifically referred to Prism’s rights as a ”permitted encumbrance” on the title being transferred.

Detour did not want to pay Prism, so it claimed Prism’s rights were contractual only. If that was true, Prism would only get paid if Conquest had money. Detour’s purchase did not require that it pay royalties to Conquest, so Conquest was not receiving incoming payments from the revenues of the mine. For Prism, being paid directly from Detour was the best assurance of ongoing payments.

Among Detour’s arguments was the fact that the royalty agreement referred to “carried interest” rather than “property interest.” Their approach would very narrowly apply property rights to royalty agreements.

THE DECISION

The Court of Appeal found in favour of Prism, in a fact-based decision.

The Prism decision emphasizes the factors of commercial reasonable and surrounding circumstances in contract interpretation, at the expense of the plain language of the contract (of no help on the facts).

The Court of Appeal accepted the trial judge’s findings that:

It would not have been commercially reasonable for Prism to agree to give up its property rights and its protected Net Smelter Returns Royalty which appears to be valued at $1 million at that time, in exchange for a mere contractual right against Conquest which could evaporate instantly if Conquest sold the Property. In my view, this would only make sense because the parties knew that Dynex had changed the law and they could create a property interest in a royalty stream.

Again, it makes no commercial sense for Prism to give up its property rights, its Net Smelter Returns Royalties which apparently were valued at $1 million in exchange for being relieved of required payments when it could have simply not paid these costs and still maintained a Royalty Interest which Conquest would have to protect if it ever sold its interest or which Conquest would have to purchase for $1 million. [Emphasis added]

This fact centered approach is technically a good legal test, but not easy to apply as a precedent when looking at just the documents without the context. That need for context may increase the risk and deter other lenders.

Because the decision in Prism relied heavily on the fact that the  contract between Conquest and Detour referred to the royalty rights as a “permitted encumbrance”, this decision may not apply to many royalty contracts, and the clarity it adds is only in very general technical approaches – again, of doubtful commercial value, if we equate certainty and value.

This approach is also consistent with a tendency we have previously commented upon for Ontario courts to base decisions on a search for commercial reasonableness. While avoiding absurd results is commendable, imposing a judge’s view of reasonableness upon the facts, in an industry with its own idiosyncrasies, of which they will inevitably have limited knowledge, may be dangerous, and reduces predictability for future cases.

TAKEAWAYS

If you are negotiating or drafting a royalty agreement, take a few moments to be very clear whether both parties share the same understanding of whether the royalty runs with the land. Once you have that clarity, make sure that the lawyers reflect it correctly and clearly in the agreement, so that future non-lawyers reading the document will not claim confusion or ambiguity when they read the words without context. Though Prism required looking at the context, ambiguity and uncertain is not in anybody’s best interest. It is always best to use tried and true language interpreted in prior cases, but what if your needs are different? Prism tells us that even if you use the same wording, if the context is different, the interpretation may be different.

If you are a lender, borrower, or buyer, know that if the wording of the royalty agreement is less than 100 per cent certain, you will need to investigate surrounding circumstances if you require a higher degree of certainty. Otherwise, you need to know that this approach to interpretation creates risk, and you will need to determine how much risk is commercially reasonable to you.

HOW WEILERS LAW CAN HELP YOU

Weilers Law’s proud tradition in mining law goes back to our roots. Before Biff and Bernie Weiler combined their practices in Fort William (now Thunder Bay) 75 years ago, they got their starts in Red Lake and Hardrock mining camp (Geraldton) respectively. We now combine that tradition with a progressive approach that reflects our extensive work with resource industries, investors, lenders and First Nations. If you have questions about royalty agreements or any other aspect of mining law, we might be the right lawyers for you.