Saying You're Right Isn't Enough: Default Notices and Freehold Leases

Written By April D. Grosse, Russell J. Kruger and Krishna Koul

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. The recent Alberta Court of Queen's Bench decision in 1301905 Alberta Ltd. v. Sword Energy Inc., 2013 ABQB 113 [Sword Energy] confirms that a lessee must challenge a default notice by strictly complying with the provisions of the default clause or be subsequently barred from arguing the substantive merits of the alleged breach.

In Sword Energy, Justice Lee entertained an application for summary judgment brought by a lessor against a lessee for breach of a petroleum and natural gas lease. The decision does not refer to the lease as a CAPL form, but the described clauses appear consistent with the 1991 CAPL P&NG Lease. In January, 2010, the lessor sent the lessee a default notice pursuant to clause 15 of the lease, claiming compensatory offset royalties for an alleged breach of the offset wells clause. 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 omissions [sic] constitute a breach or breaches on the part of the Lessee.

The lessee responded within the required 30 day time period prescribed by the default notice, by stating that it was not in breach of the offset wells clause and thus not required to commence proceedings for a judicial determination of the issue. On the summary judgment application, the lessee submitted that the lessor was not entitled to any offset royalties on the basis of engineering and geological data. On the face of the judgment, it is not clear whether there had been any correspondence between the parties discussing whether an offset notice had been properly issued prior to the issuance of the default notice (and the court file was unavailable for review at the time of posting). If not, it would make the case quite unusual.

Justice Lee canvassed authority concerning limitation periods extinguishing substantive rights. He reasoned that since the lessee failed to commence the required judicial proceeding within the mandated 30 day period, its substantive right to bring a suit defending its position concerning the alleged breach of the offset wells clause was extinguished. In effect, Justice Lee found the lessee had breached the offset wells clause because of its failure to respond as stipulated in the lease. The matter of damages was referred to a referee.

Sword Energy serves as an important reminder that the provisions of a default clause must be strictly adhered to, and that failing to challenge the validity of an alleged breach by commencing proceedings for a judicial determination of the issue within the stipulated time period will result in extinguishing the substantive right to do so at a later date.

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