Bankruptcy is not a licence to ignore rules

Calgary – For more than 70 years, the energy industry has been one of Alberta's primary economic engines. It is no secret, however, that large scale oil and natural gas development can have a detrimental impact on the environment if it is not properly managed. This interplay between risk and benefit creates complicated policy and regulatory tensions as exploration and production (E&P) companies become financially distressed. Most stakeholders benefit from responsible resource development, but their interests diverge when a company becomes insolvent. The public's priority lies in the safe abandonment of a defunct company's orphaned assets and the company's lenders want to limit their loss on investment. But with limited funds in an insolvent estate, it is impossible to satisfy both interests.

Until very recently, it was unclear where the balance between these competing interests lay. The Alberta Energy Regulator (the AER or the Regulator) administers a provincial regulatory regime designed to prioritize the interests of the public; the federal bankruptcy and insolvency regime prioritizes the interests of lenders and creditors. Given the constitutional doctrine of federal paramountcy, the interests of creditors tended to supersede those of the public where the two schemes conflicted. But on January 31, 2019, the Supreme Court of Canada delivered its long-awaited decision in Orphan Well Association et al v Redwater Energy Corporation, with a 5-2 majority holding that the estates of insolvent and bankrupt companies remain responsible for their abandonment obligations (ARO) and that such responsibilities exist prior to the engagement of the priority scheme in the Bankruptcy and Insolvency Act (the BIA). Though it is inaccurate to describe this as a regulatory "super-priority," the effect is similar: the funds that a receiver or trustee generates through any sales process that it conducts must first satisfy the bankrupt's ARO before it can satisfy the claims of its creditors.

The legal dispute that led to this decision was complex and evolved in an unusual way that, given the changes Redwater ushers in, is unlikely to repeat. It is therefore unclear how the Supreme Court's decision will apply moving forward. As we discuss, Redwater may have the unintended consequence of compounding, rather than resolving, the orphan asset problem. In this article, we discuss the decision, its potential impacts, and possible ways the AER can reduce the uncertainty that is now permeating Alberta's energy industry and lending climate.

Background

On May 12, 2015, Redwater Energy Corporation (Redwater), a publicly traded junior oil and gas company, was petitioned into receivership by its primary secured creditor, ATB. ATB appointed Grant Thornton Limited (GTL) to act as Receiver. At the time of the receivership, Redwater owed ATB approximately $5.1 million and was the licensee of 84 wells, seven facilities, and 36 pipelines. Of the 91 wells and facilities, only 19 were producing. Not only did Redwater owe a substantial amount of money to its creditors, it was also responsible for contingent AROs associated with the unproductive assets that its productive base could not support.

The notion that AROs are contingent is important to both understanding the issues the Courts grappled with in Redwater, as well as the challenges the Redwater decision poses. Through the 1980s, the number of inactive wells in Alberta increased dramatically and it was unclear how the associated ARO would be managed if the licensed company became insolvent or bankrupt. More challenging still, the precise quantum of the ARO is impossible to determine until it has actually been dealt with. Further complicating this uncertainty is the fact that the decision to abandon a well, pipeline, or facility is frequently commercial, and the commercial viability of an asset is in part determined by technology and market conditions. Not only is it impossible to determine the precise value of the future liability but it is also impossible to predict when the liability will crystallize. To remedy this, the Energy Resources Conservation Board (a predecessor to the AER) established an industry supported Abandonment Fund (the predecessor to the Orphan Well Fund) to fund the operations necessary to abandon orphan wells.

Despite the creation of the Abandonment Fund, the backlog of orphaned wells continued to grow. In October 2000, the Alberta Energy and Utilities Board (another predecessor to the AER) introduced the Licensee Liability Rating Program, which, rather than safeguarding ARO with a front-end security deposit or sinking fund, operated as a risk management program, seeking to reduce the risk that wells, pipelines, and facilities would become orphans in the first place. As it currently operates, a licensee cannot receive or dispose of assets if such a transfer would result in its having an insufficient Liability Management Ratio (LMR), which is a crude measure of the licensee's financial fitness. Where the deemed value of a licensee's assets exceeds the deemed value of its asset-related liabilities, the licensee will have an LMR greater than 1.0. When Redwater became insolvent, the AER's practice was to only approve a licence transfer if, immediately following the transfer, both the transferor and the transferee would have LMRs above 1.0. In any other circumstance, the AER could refuse to transfer the licenses until the deficient licensee either posted a security deposit or conducted abandonment operations to reduce the extent of their liability.

Given that many licensees in financial distress are likely to have LMRs close to or under 1.0, this approach to risk management poses unique challenges to receivers and trustees seeking to monetize value in a bankrupt's estate. This is the precise issue that gave rise to Redwater. Upon being advised of Redwater's Receivership Order, the AER notified GTL that, by virtue of the Oil and Gas Conservation Act (OGCA) and the Pipeline Act, receivers and trustees of bankrupt or insolvent licensees are themselves licensees subject to the regulatory regime. Accordingly, Redwater and, by extension, GTL were still required to comply with all regulatory requirements associated with the licenses, including the fulfilment of all suspension and abandonment obligations and continued compliance with the LMR Program. Thus, if GTL's attempts to sell Redwater's assets resulted in its LMR dropping below 1.0, the AER could refuse to transfer the associated licenses until GTL, on Redwater's behalf, either conducted abandonment operations or posted security sufficient to maintain an LMR of 1.0.

Following its appointment as Receiver, GTL assessed the economic marketability of Redwater's assets and determined that the liabilities associated with the non-producing assets far exceeded their value. Given the AER's position, however, GTL could not administer the estate for the benefit of the creditors. Any time it sold a valuable asset, Redwater's LMR would drop. But paying a deposit or funding abandonment operations can diminish the value of the estate such that creditors will not realize any value from the insolvency process. Moreover, the extent of the liabilities was such that it would be unlikely any buyers would have been willing to acquire a deal packaging the valuable assets with the non-productive assets.

As noted, the OGCA, the Pipeline Act, and the Environmental Protection and Enhancement Act (EPEA) "all contemplate that a licensee's regulatory obligations will continue to be fulfilled when it is subject to insolvency proceedings." In the ordinary course, the AER can issue an abandonment or environmental protection order against a solvent licensee or operator, and it would be obliged to comply with the terms of the order. This does not change when the licensee comes under the administration of a receiver or trustee. But the wording of the OGCA and Pipeline Act suggests that the AER can, in fact, hold a receiver or trustee personally responsible for unfulfilled abandonment orders. Only the EPEA limits their liability to the value of the bankrupt estate.

While the AER can arguably enforce an abandonment order against a receiver or trustee personally, it has never done so. Before the Redwater litigation, receivers and trustees worked to package debtors' uneconomic and economic assets together for sale. Where a security deposit was required, the purchase price was often reduced or a portion of the sales proceeds would be diverted to meet the LMR deposit obligations. The parties often engaged the AER to negotiate the terms of license transfers and security deposit amounts on a case-by-case basis. Following this process, the receiver or trustee would distribute the sales proceeds to creditors and whatever assets were left in the estate would go to the Orphan Well Fund. Where the receiver or trustee could not reach a deal with the AER, all of the assets would become orphans.

It is important to keep in mind that the aim of the provincial regulatory scheme and the LMR Program is not to maximize returns to the creditors of bankrupt companies — it is to protect the public interest and limit the volume of orphaned assets that the Orphan Fund has to assume control over. But this policy aim is undermined where the LMR Program requirements form an insurmountable hurdle to the conduct of a sales process, resulting in otherwise saleable assets ending up in the Orphan Well Association (the OWA) inventory.

On June 25, 2015, the AER advised GTL that it would require confirmation GTL had taken possession and control of all of Redwater's assets before it would consider any proposed process. The AER's more stringent position in the Redwater case was consistent with its regulatory role, but GTL was concerned that: i) Redwater's estate could not fund the entirety of its ARO; ii) the AER would prevent it from administering the estate for the benefit of Redwater's creditors; and iii) due to the shortfall, the AER would hold GTL, as "licensee", personally responsible for the balance of the ARO.

To protect itself, GTL sought to shelter under section 14.06 of the BIA, which provides that a trustee will not be personally liable for a failure to comply with any regulatory order that has the effect of requiring the trustee to remedy any environmental damage on behalf of the bankrupt if the trustee disclaims its interest in the subject property. In other words, section 14.06(4) permits a trustee to avoid personal liability for environmental damage if it renounces its interest in the damaged property. This ability to avoid personal liability appears to conflict with the Regulator's ability to issue an abandonment order against a receiver or trustee, in their capacity as "licensees."

Relying on section 14.06 and the terms of the Receivership Order, GTL notified the AER that it would only take control of Redwater's 17 most productive wells, three associated facilities, and 12 associated pipelines (the Retained Assets). It would then renounce its interest in the remaining assets (the Renounced Assets). The AER responded by issuing a number of abandonment orders related to the Renounced Assets. In late September 2015, the AER and the OWA responded with an application to the Court challenging GTL's renunciation of the Renounced Assets; GTL filed a cross-application seeking the approval of a sales process that excluded the Renounced Assets. On October 28, 2015, ATB petitioned Redwater into bankruptcy and GTL's role became that of both Receiver and Trustee. On November 2, 2015, GTL formally disclaimed the Renounced Assets in its capacity as Trustee and took the position that it would not comply with the abandonment orders.

Left to right: Brendan Downey and Natasha Wood are associates at Burnet, Duckworth & Palmer LLP (BD&P) in Calgary.

Judicial history

In disposing of the applications, Chief Justice Wittmann of the Alberta Court of Queen's Bench concluded that:

• Section 14.06 of the BIA was "designed to permit trustees to disclaim property where this was a rational economic decision" and that the spectre of personal liability was not a condition precedent to the trustee's power to disclaim.
• An operational conflict arose from the definition of "licensee" found in the OGCA and the Pipeline Act. The BIA permitted a trustee to renounce assets and their associated environmental liabilities, but the structure of the OGCA and the Pipeline Act prevented the trustee from doing so.
• The AER's abandonment orders were neither liquidated nor certain, nor was it clear that either the AER or the OWA would carry out the abandonment operations on Redwater's behalf. However, the AER was a creditor as its claims against Redwater and GTL were "intrinsically financial".
• Requiring a trustee to comply with abandonment orders before it could distribute proceeds to creditors therefore favoured the Regulator, as a creditor, in a manner at odds with the purposes and scheme of the BIA.

In the result, Chief Justice Wittmann approved GTL's proposed sale procedure and declared the OGCA and the Pipeline Act inoperative to the extent that they conflicted with the BIA. He further declared that the AER could not consider the Renounced Assets in determining Redwater's LMR or whether it would approve of a license transfer.

A 2-1 majority of the Alberta Court of Appeal subsequently upheld Chief Justice Wittmann's decision for substantially similar reasons. Justice Martin (now of the Supreme Court of Canada), however, dissented, arguing that the Regulator was not, in fact, a creditor and the abandonment orders it issued did not disturb the distribution scheme — the obligation to conduct abandonment operations and remain in compliance with the LMR Program existed separate from and prior to the engagement of the BIA's distribution scheme. The AER and OWA appealed to the Supreme Court, and then brought an application to stay the precedential effect of the appellate decision while its appeal was pending. The Court denied the stay application.

While GTL was permitted to disclaim the Renounced Assets and market the Retained Assets following its successful application, there was sufficient uncertainty as to the true legal entitlement of the sales proceeds, so it reached an agreement with the AER to hold all proceeds in trust pending final resolution at the Supreme Court. However, other trustees and receivers that were acting during this interim period were under no such obligations, and many adopted GTL's strategy of disclaiming unproductive assets to better administer the bankrupt estate.

The Supreme Court of Canada

On January 31, 2019, Chief Justice Wagner, writing for a 5-2 majority, found that neither the OGCA, the Pipeline Act nor the AER's use of its statutory powers created a conflict with the BIA sufficient to trigger the doctrine of federal paramountcy. The majority held that the purpose of section 14.06 was to shelter trustees from personal liability for failure to comply with environmental orders. As a matter of statutory interpretation, the majority limited its interpretive exercise solely to the specific subsections at issue. In doing so, it identified a distinction between the liability of the trustee, the liability of the estate, and the purpose and availability of the disclaimer power.

Section 14.06 protects the trustee from personal liability, but it does not eliminate the continued liability of the estate for failure to comply with environmental regulatory orders, nor does it protect the interests of the estate's creditors. Accordingly, Redwater remained liable to the AER for its ARO, and its licenses remained subject to the LMR Program. Because the AER did not try to hold GTL personally liable, there was no need for it to rely on s. 14.06(4). No conflict arose.

On the question of whether the abandonment orders interfered with the priority scheme set out in the BIA, the majority agreed with Justice Martin that the Regulator was not a creditor of Redwater. To begin, the AER's claim concerned a regulatory order, not a claim provable in bankruptcy. Indeed, the abandonment orders concerned contingent liabilities and were therefore not sufficiently certain in respect of a monetary value. Further, neither the AER nor the Alberta government stood to benefit financially from the enforcement of the abandonment orders; instead, the AER was acting in the public interest. The implications of this latter holding are profound. To support its conclusion, the majority relied on the "polluter-pays principle", the principle of cooperative federalism, and further cited two academic commentators, Fenner Stewart and Anna Lund for the following principles:

• "there remains a distinction between a regulatory body that is a creditor because it is enforcing a debt, and a regulatory body that is not a creditor because it is enforcing the law"; and
• a court should "consider the importance of the public interests protected by the regulatory obligation when deciding whether the debtor owes a debt, liability or obligation to a creditor."

In the result, the Court granted "the Regulator's request for an order that the proceeds from the sale of Redwater's assets [held in trust] be used to address Redwater's end-of-life obligations". It bears mentioning that this remedy does not require GTL to pay the funds to the AER and it remains uncertain exactly what the nature of Redwater's liability and GTL's responsibility will look like. Moreover, the decision is somewhat artificial: the Court could only grant this order because GTL had previously agreed to hold the sales proceeds in trust.

It is arguable that this sort of remedy is impossible in the ordinary course. Absent a sales process, trustees will be unable to monetize assets to either fund the abandonment operations or post security, but unless the trustee conducts such abandonment operations or posts security to comply with the LMR Program, it won't be able to conduct the sales process. If the trustee bears no personal liability (and it shouldn't), the funds required to comply with the regulatory regime must come from somewhere. Unfortunately, the practical implications of the post-Redwater application of the regulatory regime on the prospective returns to creditors makes it impossible to raise these funds — especially if creditors are no longer willing to fund a receivership in the first place. While the dissent flagged this issue, the majority appears to have not given it much consideration and it remains unclear how this decision will impact present and future receiverships.

Potential practical implications

It goes without saying that the consequences of the Redwater decision extend to many different stakeholders in the energy sector, as well as the greater public interest. While the decision brings certainty to the priority of ARO, it gives rise to significant uncertainty for an already beleaguered industry and its participants, including E&P companies, lenders, insolvency professionals, equity investors, regulators and government. Even a few months after the decision, there appear to be more questions than answers.

The decision may result in the amendment of credit facilities to include increased reporting or financial LMR covenants as lenders consider methods of calculating AROs and the effect on lending values. With the annual renewal season upon us, the fallout of the Redwater decision may include lower lending values and increased pricing for borrowers in a climate where many are teetering on the edge of insolvency. Formal insolvency proceedings require the engagement of professionals, including licensed insolvency professionals, legal counsel, sales agents and other advisors. The priority ranking of ARO ahead of recovery for lenders means that lenders will be hesitant or perhaps completely unwilling to fund formal insolvency proceedings.

Without the engagement of a trustee or receiver to run a sales process, all of a company's assets (both economic and not) will end up in the Orphan inventory after lenders recoup what they can by exhausting other enforcement remedies available to them. In an unprecedented move in March 2017, the AER put Lexin Resources Ltd. in receivership and engaged GTL as receiver to market and sell its 1,600 wells. However, the AER is not in the business of funding receiverships. It is in the business of ensuring the safe, efficient, orderly, and environmentally responsible development of energy resources. Further, the explicit finding in Redwatert hat the AER is not a creditor in respect of enforcing the law in the public interest has likely closed off the possibility of AER receiverships becoming the norm.

While Canada's highest court ruled that AROs must be satisfied in full before the priority schemes under insolvency legislation are engaged, that outcome is not workable from a practical perspective. Facing the irony that more assets will likely fall to the care of the OWA than before the court's decision, it is incumbent upon the AER to work with industry and lenders to find an acceptable compromise. We have seen glimpses of this already — the AER has engaged with the trustees and receivers of ongoing formal insolvency files that span various chapters of the Redwater litigation. Many of the trustees and receivers of these insolvent estates have taken control of the assets, worked with sales agents and advisors, operated the assets while undertaking a sales process, completed sales and disclaimed unsaleable assets. Absent a compromise between industry and the AER, the benefit of the proceeds realized from creditor-funded sales processes might go directly towards the remaining AROs or, more likely, be the subject of further litigation. Resolving the complex issues of each pre-existing file on a case-by-case basis will provide answers to the specific stakeholders, but the industry will be no further ahead in terms of clarity on the go-forward rules of engagement.

The Redwater decision will likely trigger a number of unintended consequences and a new status quo. As the 'winners' at Canada's highest court, the ball is in the court of government and the AER to work with industry to build a framework that improves upon the regime that generated the Redwater litigation. Industry participants should prepare for regulatory change. But given the recent election and a plethora of pressing issues facing a new government, it is unclear just how soon those changes will come.

Brendan Downey and Natasha Wood are associates at Burnet, Duckworth & Palmer LLP (BD&P) in Calgary. Photo by Zbynek Burival on Unsplash.