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The Orphan Well Decision: Implications for the Banking Sector

The Orphan Well Decision: Implications for the Banking Sector

A case comment by Nikita Gush, Articled Student & Dennis Ryan, Partner and Head of the Natural Resources Group at Doak Shirreff Lawyers LLP, Kelowna BC © 2019

The Supreme Court of Canada (“SCC”) recently held that a trustee of a bankrupt company must attend to the bankrupt’s environmental remediation obligations in priority of satisfying the claims of secured creditors. Reverberations of the Supreme Court of Canada decision, Orphan Well Association and Alberta Energy Regulator v Grant Thornton Ltd, 2019 SCC 5 are likely to be felt by financial lending institutions in provinces across Canada.

Background Information: The Oil and Gas Regulatory System in Alberta

In Alberta, oil and gas companies are issued licenses by a provincial regulator called the ‘Alberta Energy Regulator’ (“AER”) who is responsible for permitting oil and gas extraction, processing, and transportation. The AER also has authority over a financially independent entity that operates as a non-profit organization to clean up abandoned wells, called the Orphan Well Association (“OWA”).

Prior to issuance of a license, the AER must determine whether the applicant will be able to fulfill its inevitable end-of-life obligations, including, plugging and capping oil wells to prevent leaks, dismantling surface structures, and restoring the surface to its previous condition. These end-of-life obligations are known as “abandonment” and “reclamation”. The Licensee Liability Rating Program is one means that the AER seeks to ensure that the end-of-life obligations will be satisfied by licensees. As part of this program, the AER will assign a ‘Liability Management Rating’ (“LMR”), which is a ratio of the oil and gas company’s value in licensed assets; and, the liability exposure associated with the eventual cost of abandoning and reclaiming those assets. A licensee’s LMR is calculated on a monthly basis and, where it dips below the prescribed ratio, the licensee is required to bring its LMR back up to the prescribed level by paying a security deposit, performing end-of-life obligations, or transferring licences with the AER’s approval.

The Facts of the Case

The facts of the Orphan Well case begin with a small oil and gas company called, “Redwater”. Redwater had 127 oil and gas assets, including “wells, pipelines, facilities, and their corresponding licenses.” The majority of those assets were abandoned, and their reclamation liabilities exceeded their actual value. In need of financing, Redwater obtained a facility from ATB Financial in exchange for security interests in Redwater’s present and after-acquired property. The next year, Redwater sought protection under the federal bankruptcy laws. Grant Thornton Ltd (“GTL”) was appointed as its receiver. At the time of its bankruptcy, Redwater owed ATB Financial approximately $5.1 million. Prior to its insolvency, Redwater’s LMR did not drop below the prescribed ratio, which meant that it was able to circumvent the requirement of paying a security deposit to the AER/OWA, which would have gone towards the costs associated with cleaning up its abandoned oil wells and reclamation.

The Issues

A dispute arose between GTL in its capacity as receiver of Redwater’s estate, and the AER as the provincial regulator. The dispute began when the AER informed GTL that it was legally obligated to fulfill abandonment obligations for all licensed assets before it distributed funds to creditors—in this case, ATB Financial. GTL asserted that it had no obligations to fulfill any provincial regulatory requirements because:

(1) it did not possess the same obligations as the ‘licensee’ (i.e., Redwater); and
(2) the Bankruptcy and Insolvency Act (“BIA”) had a priority scheme in place for distribution of a bankrupt’s assets that did not include priority ranking for environmental clean-up.

GTL’s position was that the AER was an unsecured creditor and, therefore, should be paid only after all the secured creditors were paid in full, and only if there were sufficient funds remaining for distribution. The case went to the Alberta Court of Queen’s Bench, which supported GTL’s position, and then to the Alberta Court of Appeal, which upheld the lower court’s decision. The AER appealed the decision of the Alberta courts to the SCC— Canada’s highest court, which allowed the appeal and decided in favor of the AER.

1 Orphan Well Association and Alberta Energy Regulator v Grant Thornton Ltd, 2019 SCC 5, para 2 [Orphan Well].
2 Ibid, para 5.

The Arguments

GTL argued at the SCC that there was a conflict between the BIA, which is a federal law, and the Environmental Protection and Enhancement Act (“EPEA”), which is the Alberta legislation regulating the environmental duties of oil and gas companies operating in that province. GTL argued that the federal BIA took priority over provincial legislation, where conflicts arose.

The Decision

The majority of the SCC judges applied a three-part legal test from Newfoundland and Labrador v AbitibiBowater Inc, 2012 SCC 67, which identifies whether a regulatory obligation (i.e., in this case the environmental clean-up obligations under the EPEA for an oil and gas company) amounts to a claim provable in bankruptcy. The test requires:

(1) there to be a debt, liability, or obligation to a creditor;
(2) that is incurred before the debtor becomes bankrupt; and
(3) it must be possible to attach a monetary value to the debt.]

In applying this test, the SCC determined that the AER did not have a claim provable in bankruptcy, because it was not a creditor. The SCC supported its assertion that the AER was not a creditor since it was, “exercising a power to enforce a public duty,” and “the public is the beneficiary of the environmental obligations; [so] the province does not stand to gain financially from them.” Moreover, the SCC explained that since the AER is not a creditor, it has the ability to place a first charge on the real property of the bankrupt oil and gas company in priority to the secured lenders of the bankrupt estate. This decision, therefore, was premised on the basis that the AER was not a creditor and that it was exercising a power to enforce a public duty.

3 Orphan Well, para 47; See also Newfoundland and Labrador v AbitibiBowater Inc, 2012 SCC 67.

The Outcome

At its core, this case prioritizes the responsibilities for environmental remediation obligations of bankrupt resource companies. The result is in line with the ‘polluter pays’ principle. This principle dictates that the party responsible for producing the pollution is responsible for cleaning it up. When an oil and gas company does not pay a security deposit to the regulatory body, and the company becomes bankrupt, this decision obligates the trustee in bankruptcy to undertake environmental decommissioning and clean-up. The consequences of this decision may result in the bankrupt’s estate being left with insufficient funds to pay out its creditors.

One aspect of this case that all of the parties can agree upon is that the provincial legislation governing the regulation of the oil and gas industry is “not a model of clarity.” The laws regulating the oil and gas industry in British Columbia are largely the same to those in Alberta, which means that the Orphan Well decision will bind lenders in British Columbia. This is not only a problem for financial lending institutions, but also for smaller to medium-sized resource companies, because the industry is very credit-reliant.

What does this mean for financial institutions that lend to resource companies in Canada?

Before legislation is enacted by the provinces to effectively deal with abandonment and reclamation end-of-life obligations, banks will be reluctant to lend money to smaller to medium-sized resource companies unless they have a very strong balance sheet. The Orphan Well decision will require financial institutions to heighten their due diligence efforts as a condition to financing resource companies. Unless the loan applicant has a strong balance sheet, banks may now require resource companies to obtain insurance as a form of security, such that if the oil and gas company becomes insolvent, that its environmental clean-up obligations would be covered by an insurer.

4 Ibid, para 122.
5 Ibid, para 72.

How does this case impact the resource industry in British Columbia?

The system regulating the oil and gas industry in BC is largely similar to that of Alberta. There is an equivalent energy regulator in BC is known as the BC Oil and Gas Commission (“BC OGC”). Up until April 1, 2019 the BC OGC required oil and gas companies to pay a tax (at a rate of $0.06 per cubic metre of oil production; and $0.03 per 1,000 cubic metres of marketable gas) “aimed at covering the cost of abandonment and restoration of orphan wells, test holes, production facilities, and pipelines.” In an article written by Jeremy Hainsworth, BC OGC spokesperson Graham Currie was quoted explaining that in spring 2019 this current tax scheme will be eliminated, and a liability levy will be phased in over the next three years. The amount of the liability levy for each oil and gas company is going to be determined using an equation that takes into account the projected liability of the specific permit holder (i.e., the oil and gas company) divided by the total amount that needs to be raised by the levy. Currie states that, “The 2019-20 fiscal year will see 50% of the orphan funding from the new liability levy, increasing by 25% in each subsequent year,” and that, “by 2021-22, the liability levy will provide the entire estimated $15 million per year required to sustain the orphan fund.” Furthermore, this new system, which was implemented in BC starting on April 1, 2019, will assist with the reclamation of the over 300 abandoned ‘orphan’ oil wells existing in BC presently.

6 Jeremy Hainsworth, “BC Energy Regulator Faces Possible $90 million Tab for Orphan Wells”, Business in Vancouver (22 February 2019): online: <https://biv.com/article/2019/02/bc-energy-regulator-faces-possible-90-million-tab-orphan-wells>.
7 Ibid.

Concluding Remarks

Orphan well reclamation is an equally important issue in BC as it is in Alberta. For example, the Calgary-based ‘Ranch Energy Corporation’ that has been operating in British Columbia, is now in receivership, leaving 300 to 500 wells facing designation as ‘orphan’ or ‘abandoned’. As well, the BC Auditor General has announced that oil and gas clean-up costs in BC are rising, and presently, the BC OGC is facing up to $3 billion in clean-up costs in our province. While the 2019 to 2020 fiscal year in British Columbia will see 50% of orphan funding coming from the new liability levy, insufficient funds are currently budgeted to address Ranch Energy Corporation’s additional 300 orphan wells that the BC OCG may have responsibility to remediate.

Provinces throughout Canada need to undertake studies to determine the most effective means of either implementing existing security regimes appurtenant to Crown licensing of resource tenures; or, enact effective legislation to ensure that sufficient security, insurance and/or funds are available for the proper abandonment and reclamation of orphan natural resource sites, be it in the oil and gas industry, the pipeline industry, the mining industry or the forest products industry. Without such legislation being implemented, or an insurance or security fund that will be sufficient to address prospective liabilities, the tax-payer will be liable for the clean-up of abandoned sites. Absent effective legislation, lenders will need to consider the risks of lending money to smaller and medium sized natural resource companies that do not have a strong balance sheet and an excellent track record of loan repayment. Conversely, the impact to the economy will certainly be an indirect consequence of decreased funding in these industries.

8 Andrew Kurjata, “Oil and Gas Cleanup Costs in BC are $3B and Rising, Auditor General Finds”, CBC News (14 March 2019), online: <https://www.cbc.ca/news/canada/british-columbia/orphan-wells-british-columbia-oil-gas-auditor-general-1.5056633>.