Default Notices and Freehold Leases: Take Two

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There may be a sign that last year’s dire consequences for a freehold oil and gas lessee who does not quickly respond to a default notice by commencing legal proceedings may be moderating somewhat, at least in certain circumstances, given the Alberta Court of Queen’s Bench recent decision in Laird v Sword Energy Inc., 2014 ABQB 13 [Sword #2].

As discussed in an earlier post, most freehold oil and gas leases in Canada require the lessor to provide the lessee with notice of an alleged default. The lessee then has a certain amount of time to remedy the default or commence proceedings for a judicial determination of whether there was, in fact, a breach of the lease. The Alberta Court of Queen’s Bench in 1301905 Alberta Ltd. v Sword Energy Inc., 2013 ABQB 113 [Sword #1] ruled somewhat controversially last year that a lessee must strictly comply with the provisions of the default clause or be subsequently barred from arguing the substantive merits of the alleged breach. That means prudent counsel who wish to contest the existence of a breach have to move fast to commence a lawsuit, typically within 30 days of the default notice. In Sword #2, a similar claim was brought by the same counsel against the same defendant by different freehold lessors. The lessors applied for summary judgment, claiming compensatory royalties for an alleged breach of an offset wells clause. Notwithstanding that the lessee had drilled a well (the “1-5 well”) on the lessors’ lands into the same formation as the relevant offset wells were producing from, and the 1-5 well was determined by the lessee to not be capable of commercial production, the lessors sent a default notice pursuant to clause 15 of the lease creatively claiming that the lessee had the “obligation to make every reasonable endeavour to produce [the 1-5 well] rateably” with the offsetting wells. Clause 15 of the lease stated:

(a) If, before or after the expiry of the primary term, the Lessor considers that the Lessee has not complied with any provision or obligation of this Lease … the Lessor shall notify the Lessee in writing, describing in reasonable detail the alleged breach or breaches. The Lessee shall have 30 days after receipt of such notice to:
i) remedy or commence to remedy the breach or breaches alleged by the Lessor, and thereafter diligently continue to remedy the same; or
ii) commence and diligently pursue proceedings for a judicial determination as to whether the alleged acts or ommisions [sic] constitute a breach or breaches on the part of the Lessee.

The lessee maintained it responded within the 30-day period by advising that each of the leases would be allowed to expire on their own terms (within that same 30-day period). Under clauses 8 and 13 of the lease, the lessee had the option of surrendering the lease in certain circumstances. On the summary judgment application, the lessors argued that the lessee had neither sought to remedy the alleged breaches nor commenced judicial proceedings as required by clause 15. The Court, however, found that the threshold for summary judgment had not been met.

First, the Court determined that there were sufficient disputed facts, relating to (amongst other things) the lessee’s claim to have responded to the default within the 30-day period. Turning next to issues of law intertwined with the facts, in response to the lessee’s argument that it elected to exercise its option under clause 15(a)(i) by surrendering the leases, the Court found that there were triable issues relating to: whether the lessors were substantively denying receipt of the lessee’s response of surrender; whether the lessee’s response sufficiently satisfied the requirement under this clause; and the necessity for the lessee to respond to a technically defective default notice (as the notice referred to a non-existent clause in the lease). In addition, the Court was concerned with the alleged underlying default in the context of clause 15. That is, in a situation where affidavit evidence was led that a well on the leased lands existed and was not capable of production, was the lessee obligated to remedy or commence to remedy anything, given that the lease permitted the lessee to “surrender all or any portion of the said lands”? The Court distinguished its holding from the result in Sword #1, where summary judgment was granted, on the basis that the lessee in that case admitted it was in “breach” of the default clause, but simply relied on the absence of an underlying breach of the lease for failure to commence judicial proceedings (without attempting to remedy the alleged breach). The tenor of the Court’s decision in Sword #2, however, was that it seemed somewhat uncomfortable with embracing the full implications of Sword #1 in barring the lessee from contesting the substance of the default notice, at least in the particular circumstances of the case.

Sword #2, like Sword #1, thus serves as another reminder of the importance of complying with the provisions of a default clause. Unlike Sword #1, though, it also illustrates that where a lessee relies on the provision that allows the alleged breach to be remedied within the 30-day period, the nature of the underlying obligation may bear on the determination of whether such remediation has actually taken place.