Canada: NEP Canada Awarded Damages As Court Finds Liability From Deceitful Disclosure

In NEP Canada ULC v MEC OP LLC, the Alberta Court of Queen's Bench delivered a judgment on a contractual dispute between seller and buyer, which confirmed that a deceitful seller could not rely on contractual limitations on damages in the same contract that the buyer was induced to enter into on the basis of the seller's fraudulent misrepresentations.¹ The NEP decision also serves as a warning that attempts to use vague language to circumvent proper disclosure and mislead the other party will be construed narrowly by the courts in the context of the contract and the transaction.

Background and allegations

The contractual dispute between the Plaintiff, NEP Canada ULC, and the Defendants, MEC Op LLC, MEC Op Transaction I ULC, and Merit Energy Company LLC (collectively, Merit), arose out of a share purchase agreement (SPA) pursuant to which NEP acquired the shares of MEC Operating Company ULC (OpCo), a wholly-owned subsidiary of Merit ULC (Share Transaction). The OpCo's assets critical to the Share Transaction included wells, pipelines and facilities (Transaction Assets) situated across a number of oil fields in Alberta. NEP planned to implement an aggressive drilling program to increase the value of the Transaction Assets and sell the Transaction Assets by 2014.

After closing the Share Transaction, NEP discovered numerous longstanding regulatory non-compliances with the Transaction Assets: approximately 90% of the pipelines were improperly licensed; there was a serious sweet-to-sour problem with the pipelines, and three non-compliant pipelines posed a serious risk to public health and safety, requiring NEP to shut-in production; Merit's facilities were not in compliance with regulations and not fit for sour service; 41 wells had active Surface Casing Vent Flows (SCVFs) requiring monitoring or repair; and 291 wells were not compliant with Directive 13 (D-13) regarding suspension and abandonment.

NEP alleged that Merit misled and deceived NEP in the Share Transaction by not truthfully disclosing the regulatory issues. NEP sued Merit for breach of contract, deceit, conspiracy, and breach of the duty of good faith. The Court held that Merit breached the SPA and its duty of good faith by failing to disclose the regulatory issues with the Transaction Assets, and that Merit's half-truths and misrepresentations amounted to deceit. The Court awarded damages to NEP in the aggregate amount of CA$184,570,200.

Merit's incomplete disclosure in Schedule D

In Schedule D to the SPA, Merit failed to disclose numerous regulatory issues, including the hundreds of wells that were not D-13 compliant, the sweet-to-sour pipeline issues, and the 200 or more pipelines that were improperly licensed as operating. However, these issues were brought to the attention of Merit and its deal team prior to and during the Share Transaction. Employees of OpCo regularly reported regulatory issues up the chain of command. The regulatory issues were discussed at length within Merit, and Merit management and members of the Merit Deal Team understood the magnitude of these issues, including the safety concerns and the work that would be required to achieve compliance. The regulatory issues were also brought front of mind as nearly every issue of regulatory non-compliance was "at one time put forward for express inclusion on Schedule D" as the Merit Deal Team prepared the SPA.²

Merit's evasiveness in due diligence discussions

Merit further evaded disclosure of the regulatory issues in response to NEP's inquiries during the due diligence process. In due diligence discussions that commenced after Merit circulated Schedule D, Merit misled NEP into believing that there were no significant problems with OpCo and the Transaction Assets. During these discussions, NEP asked overtly about "real issues that involve real dollars" and whether there was "any other hidden lurking liability" among the Transaction Assets.³ Merit assured NEP that the items in Schedule D were merely paperwork issues. When NEP later repeated its question about hidden liabilities, Merit responded unequivocally that it had shown NEP everything that Merit knew. NEP continued to ask directly whether there was anything to be added to Schedule D, and Merit responded that there was nothing else.⁴

Breach of contract

The Court held that Merit breached the SPA, as Merit was aware of significant regulatory issues as of the Closing and had the opportunity to disclose these issues but instead "elected to conceal the non-compliances, and obfuscate with half-truths."⁵ The Court held that the "opaque language" used by Merit did not constitute proper disclosure of the regulatory issues under the SPA.⁶

Under Section 4.1 of the SPA, Merit represented and warranted that the Transaction Assets complied with all relevant regulations, and Merit would be liable under the SPA for breaching the warranties unless it accurately and specifically disclosed any regulatory issues in Schedule D. Merit's liability therefore hinged on its disclosure in Schedule D, where Merit had disclosed "potential" instances of non-compliance relating to pipelines, facilities, D-13 and SCVFs. The Court interpreted the word "potential" using its plain and ordinary meaning, examining its use in a commercial context, and finding that the term was not ambiguous. In the context of the SPA and the factual matrix, the Court determined that "potential" instances of non-compliance signified "possible but not yet extant" instances of non-compliance.⁷ The Court held that Merit's use of the word "potential" was deliberately future-facing to shield Merit from providing specific instances of non-compliance.⁸

Merit's purported disclosure in Schedule D breached the SPA because Merit only disclosed "potential" (not yet extant) issues when in fact there were both present and historical regulatory issues, including hundreds of non-compliant wells and more than 40 possible SCVFs. Moreover, Merit's disclosure in Schedule D also contained false representations, such as Merit's statement that "compliance efforts [in relation to pipelines were] largely completed" which was wholly inconsistent with the reality that 90% of OpCo's active pipelines were improperly licensed, OpCo had not applied to the regulator for an amendment, and that the cost of achieving compliance would be significant.⁹

Deceit / fraudulent misrepresentations

Merit's half-truths and positive misrepresentations also amounted to fraudulent misrepresentations and deceit that induced NEP to enter into the Share Transaction. The Court applied the elements from the test in Bruno Appliance and Furniture, Inc v Hryniak as follows:¹⁰ (1) Merit made a number of false representations in respect of the regulatory issues as of the Closing; (2) Merit had some level of awareness of the falsehood of the representations relating to the issues, through a combination of knowledge Bruno Appliance and recklessness by members of the Merit Deal Team; (3) the false representations caused NEP to act to close the Share Transaction; (4) NEP proved that its actions resulted in a loss.¹¹

Limitation of liability clause

The Court held that Merit could not rely on the limitation of liability clause in the SPA once deceit was established, as Merit's deceit raised significant public policy concerns. NEP and Merit agreed to contract out of consequential, indirect, and punitive damages through a limitation of liability clause in the SPA, but the Court declined to enforce the clause. Referring to the tripartite framework in Tercon Contractors v British Columbia (Transportation and Highways),¹² the Court held that the limitation of liability clause applied to the circumstances and was not unconscionable between the two highly sophisticated parties. However, the Court emphasized the public policy concerns raised by Merit's deceit, citing Alberta Ltd v 1284768 Alberta Ltd for the principle that a party who makes fraudulent misrepresentations to induce another party to enter a contract cannot subsequently rely on a limitation of liability clause in the same contract to protect itself from the legal ramifications of its deceit.¹³ Accordingly, the Court held that as Merit knowingly misled NEP by failing to disclose OpCo's regulatory issues, even when asked about those issues directly, it would be contrary to equity to allow Merit to escape liability through the limitation of liability clause in the SPA. The Court declined to enforce the clause and held that Merit was liable to NEP for consequential damages.

Breach of the duty of good faith

The Court held that Merit breached its duty of good faith in failing to properly disclose the regulatory issues to NEP. According to the principles in Bhasin v Hrynew, parties owe a duty to fulfill their contractual obligations in good faith and owe a common law duty to act honestly in contractual performance.¹⁴ The Court emphasized, citing CM Callow Inc v Zollinger, that the requirements of honest performance go beyond precluding outright lies and also preclude half-truths, omissions, and silence.¹⁵ The Merit Deal Team framed the disclosure in Schedule D with half-truths to create a misleading picture of Merit's performance, which constituted a breach of Merit's duty of good faith.

The Court also held that Merit's conduct amounted to lying and actively misleading NEP, as members of the Merit Deal Team had knowledge of issues that were not disclosed on Schedule D. As one example of actively misleading conduct, the Court highlighted D-13 notice that Merit received before the Closing in which the regulator had flagged 67 wells for suspension. Despite having received formal notice, Merit disregarded its regulatory obligations and took no steps to rectify the issues. The Court called Merit's disregard and lack of disclosure "the very conduct that the duty of good faith is meant to address" as the selective disclosure severely misled NEP in the Share Transaction.¹⁶

Damages

The Court awarded CA$184,570,200 in aggregate damages to NEP, comprised of remediation costs, damages for loss of opportunity, shut-in production costs, and borrowing costs. CA$39,937,608 was awarded in remediation costs for pipelines, facilities, SCVFs and D-13 compliance. CA$120,750,000 was awarded for loss of opportunity. The Court accepted that if NEP had been able to follow its business plan, it could have sold the Transaction Assets at fair market value in 2014. Instead, after being misled by Merit, NEP was not able to monetize the Transaction Assets until 2016, when commodity prices had fallen and the oil and gas business environment had changed. Shut-in production costs of CA$3,273,000 were awarded for the value of the oil and gas production that 41 wells would have generated had they not been shut-in. Finally, CA$14,939,592 and CA$5,670,000 were awarded in borrowing costs. NEP sought CA$5,000,000 in punitive damages but the Court determined that Merit's conduct did not warrant punitive damages, particularly in light of the magnitude of the aggregate claims awarded to NEP.

Key takeaways

• Selective disclosure can breach the duty of good faith: Though the duty of good faith should not be conflated with a general duty of disclosure, NEP cautions that if a party elects to make a disclosure, it must make complete and accurate disclosure. Selective disclosure in the form of half-truths, omissions and silence can breach the duty of good faith where the selective disclosure misleads the other party.
• Vague disclosure may be narrowly construed: NEP suggests that where a party uses opaque, misleading language intended to obscure disclosure to the other party, this language may be scrutinized closely by a court with a view to narrowing its construction to prevent the circumvention of negotiated contractual warranties.
• No reliance on contractual limitation of liability in the event of deceit: NEP confirms that a deceitful party cannot evade liability by relying on an exculpatory clause in the same contract that they induced the other party to enter into on the basis of fraudulent misrepresentations.

Footnotes

1. NEP Canada ULC v MEC OP LLC, 2021 ABQB 180 [NEP]. ↩

2. NEP, supra note 1 at para 565.↩

3. NEP, supra note 1 at para 593.↩

4. NEP, supra note 1 at paras 607, 612, 615, 618.↩

5. NEP, supra note 1 at para 748.↩

6. NEP, supra note 1 at para 749.↩

7. NEP, supra note 1 at paras 673, 678.↩

8. NEP, supra note 1 at para 675. ↩

9. NEP, supra note 1 at paras 704, 718.↩

10. Bruno Appliance and Furniture, Inc v Hryniak, 2014 SCC 8.↩

11. NEP, supra note 1 at paras 920-923.↩

12. Tercon Contractors v British Columbia (Transportation and Highways), 2010 SCC 4.↩

13. Alberta Ltd v 1284768 Alberta Ltd, 2010 ABQB 125. ↩

14. Bhasin v Hrynew, 2014 SCC 71. ↩

15. NEP, supra note 1 at para 952; CM Callow Inc v Zollinger, 2020 SCC 45.↩

16. NEP, supra note 1 at paras 970-971. ↩

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