Scuppered by sukuk

Investors in Islamic debt issued by Nakheel, a Dubai property company, breathed a sigh of relief in December when the government of Abu Dhabi stepped in to provide $10 billion of support to Dubai World, a holding company and parent of Nakheel, via the Dubai Financial Support Fund, a vehicle set up to support government-related entities. Nakheel was in danger of defaulting on its December commitment to repay $4.1 billion on maturing sukuk, and the bail-out meant those investors at least will not end up out of pocket (see box).

But even with the bail-out in place, the possibility of a major sukuk issuer restructuring its obligations – and there is a strong chance future restructurings will take place – raises a number of issues for investors. In particular, legal uncertainty surrounding creditor rights in the event of a sukuk default or restructuring have come to the fore. What rights would investors have over assets in the event of default, and would those rights be legally enforceable? These are the questions investors are scrambling to answer, while also assessing what impact the turmoil could have on the sukuk market.

Sukuk are special types of bonds structured to comply with sharia, which prohibits uncertainty in contracts and the charging of interest. A common template used to structure the transactions – and the kind used by Nakheel for its sukuk – is known as ijara sukuk. This involves the owner of an asset selling it to a special purpose vehicle (SPV), which raises financing to pay for the assets by issuing ijara sukuk to investors for an amount equal to the purchase price. The ijara sukuk represents an undivided beneficial interest in the assets. The SPV then leases the assets out in exchange for periodic lease payments that match the obligations of the SPV. When the deal matures or is dissolved, the SPV sells the obligations back to the seller at a predetermined value equal to any amounts still owed under the terms of the agreement, while the regular payments to the certificate holders can be structured as either fixed or floating rate, depending on the preferences of the buyers and sellers.

As well as ijara sukuk, the transactions can also be structured to give partial ownership in a debt (murabaha sukuk), a project (istisna sukuk) or a business (musharaka sukuk). Although sukuk are structured to replicate the cashflows of conventional bonds, the underlying structures used to create those cashflows look more akin to those in asset-backed securities.

“Sukuk is just a generic name for an instrument where the underlying asset and structure may differ significantly, so what happens in the event of default depends on how the assets have been structured or secured,” says Issam Al-Tawari, Kuwait City-based chief executive of Rasameel Structured Finance Company, which provides risk management and advisory services to institutional investors and finance companies. “In the case of sukuk, the assets are only used as a vehicle to facilitate the transaction, so in most cases it really amounts to a collateralised debt.”

So what does happen to those assets in the event of default and do investors have a direct claim on them? Typically not, says Badlisyah Abdul Ghani, chief executive of CIMB Islamic, a Kuala Lumpur-based Islamic investment bank. “People have to remember that most sukuk are unsecured investment instruments. Even with asset-backing behind it, or a true sale or whatever in the framework, those assets are there to facilitate a financial obligation of the issuers. They are not there to provide security to the investors,” he says.

That means in the event of default, sukuk investors should be treated in a similar fashion to buyers of conventional bonds, with their claims correlated to their seniority as creditors. “If the investor is holding a subordinated sukuk, then they will be treated as a junior creditor. If it is senior lending, then they will be treated as a senior lender,” says Abdul Ghani.

So sukuk should, in theory, follow the same default principles already established in conventional lending markets. But the problem for investors is that while the documentation of the bond may be drawn up based on the laws of a jurisdiction with a robust bankruptcy regime, creditor claims would likely be processed in the country of the issuing company. For example, sukuk originated in the Gulf tend to be structured under English law, but there are no precedents for how such a bankruptcy or restructuring would be treated in Dubai or other Gulf states.

“This has opened people’s eyes to the fact there is no proper tested legal framework in terms of property rights and bankruptcy with these transactions,” says Raymond Hill, head of emerging markets corporate finance for Europe, the Middle East and Africa at Fitch Ratings in London.

What is more, a court in Dubai or elsewhere would have no obligation to recognise the legality of transaction claims that have been made in another jurisdiction. “The immediate concern for investors is enforcement by a foreign court in another jurisdiction, whether it is Dubai or any other country. That has not been tested fully in the past,” says Abdul Ghani. “People know trust law does not exist in the legal framework in Dubai, for instance, so any enforcement of any position of a foreign court on any transaction that involves a trust may be suspect.”

Meanwhile, the sharia-compliant nature of the debt could also cause difficulties. Analysts question whether some sort of official sharia review board would have to be set up to ensure the restructured debt is sharia compliant. If such a board were set up, the edicts could potentially conflict with what investors view as their fair claims, some suggest. Others point out sharia investors might demand such a board be involved in the restructuring to guarantee their new investments do not conflict with their faith.

Warren Edwardes, a London-based Islamic finance consultant, says debt forgiveness and an allowance for late payment are crucial aspects of sharia compliance. “Fees can be charged that have to go to charity in the case of Islamic institutions. Although the bonds are sharia compliant, would conventional institutions have to give the funds to charity? I doubt it,” he says.   

So there remain a number of questions as to how the sharia compliance aspect would be handled. Perhaps the only way to establish certainty would be to actually have some defaults and restructurings take place. In that sense, a restructuring of sukuk could actually be a good thing for the market, as it would at least form a test case for investors, issuers and lawyers to look to. “In the long term, the sukuk market probably needs not just one restructuring but a whole series of them to improve transparency. Then people will know what happens when it goes wrong, and investors will be able to make more informed decisions,” says Hill.

Restructurings

There are signals the market will have to deal with restructurings at some point. On the same day Abu Dhabi provided its $10 billion of support to Dubai World, the Dubai government also announced the introduction of a “comprehensive reorganisation law”. The details of this legal change are yet to be fleshed out, but according to Fitch, the action is “clearly aimed at facilitating easier corporate restructuring”.

“In turn, this has the obvious ancillary benefit of making it simpler for future corporate debt obligations to be addressed through court-based restructurings, rather than through a sovereign bail-out, reducing the pressure on Dubai to continue offering financial support to corporate entities, and on Abu Dhabi to accede to further financial pressures in the neighbouring emirate,” the rating agency says.

The Dubai government also gave details on the composition of a tribunal it is putting together to hear cases against Dubai World. Three judges have been appointed to the tribunal, and all have experience in the English legal system – one of the judges, Anthony Evans, is a former High Court judge and currently chief justice for the Dubai International Financial Centre. The English law bias of the panel suggests Dubai wants future restructurings to be acceptable to international investors, but so far there has been no announcement as to whether there will be a role for Islamic scholars in any proceedings.

When Abu Dhabi’s $10 billion was channelled into Dubai World, the Dubai government was at pains to remind the markets that the standstill it requested in November remains in place with respect to all other obligations, and that restructuring negotiations continue. Since the remaining financial obligations of Nakheel and Dubai World amount to around $22 billion, there is a lot of scope for future restructuring and uncertainty.

So, what does all this mean for the development of the sukuk markets in general, and for Islamic finance overall? Following Dubai’s restructuring announcement in November, spreads on sukuk widened dramatically. “The pricing increased between 100 basis points and 200bp after that announcement,” says Rasameel’s Al-Tawari.

However, these are just short-term market moves – it is the longer-term impact on investor attitudes that matters. Khalid Howlader, a senior credit officer covering Middle East securitisation and sukuk finance at Moody’s Investors Service, says the sukuk investor base could easily be spooked by the Dubai World restructuring. “How the United Arab Emirates handles any restructuring will be crucial for future confidence in the country and Dubai, and its position as a financial centre. When the dust settles, we’ll see if the complexity exposed investors to risks beyond the unsecured corporate credit they were expecting. If so, either they’ll pay an extra premium for compliant sukuk or will prefer simpler, conventional bonds,” he says.

Al-Tawari believes the sukuk market in future could be structured to deliberately give investors greater rights in the event of default. “For any new sukuk, the assets will be ring-fenced and bankruptcy-remote in case of default,” he says.

Another question is whether the legal uncertainty exposed by the Dubai World episode could feed into other areas of Islamic finance. Plenty of effort has gone into developing a sharia-compliant over-the-counter derivatives market, with the International Swaps and Derivatives Association currently working on a sharia master agreement in co-operation with the International Islamic Financial Market. But what if a Dubai-based corporate swap counterparty failed to honour its side of a transaction and had to be pursued in the Dubai courts? Such an arrangement could also fall foul of multiple legal jurisdiction difficulties.

A lot therefore rides on what happens in Dubai in the coming months. If the Dubai government can establish its tribunal successfully and start to deal with Dubai World-related restructurings in an efficient manner and to internationally recognised standards, the outcome could be a big boost to Islamic finance. If, however, the tribunal gets bogged down in scholarly arguments over what is sharia compliant in the context of restructuring, then the message will go out that Islamic instruments are not as legally strong as their conventional equivalents. And if that happens, it could damage Islamic finance in general.

But as well as getting to grips with legal issues in the coming months, the Dubai government will also have to tread carefully when it comes to communicating future developments to the markets. Moody’s Howlader says the confusion surrounding Nakheel has already damaged investor confidence, so Dubai must make improvements in getting news to investors.

“Nakheel is a case study in poor public relations and investor relations. The most important thing in managing debt is communication and feeding timely information to investors,” adds Edwardes.

Despite all these challenges, there is a sense among some Islamic finance experts that events in the coming months will ultimately be a boon for the further development of the market. Abdul Ghani at CIMB Islamic is one of those thinking positively. “There is always a silver lining behind any problems. What is happening now in Dubai is a good litmus test,” he says.

BOX

The Nakheel bailout

On December 14, the Dubai government announced that, with the backing of the Emirate of Dubai, it would provide $10 billion in financing to Dubai World and its subsidiaries via the Dubai Financial Support Fund, an existing mechanism that facilitates funding to state-owned entities. A chunk of that money, $4.1 billion, was used to repay a Nakheel sukuk due that day, while the remainder was used to pay for other contractual arrears the company had accrued. At the same time, the Dubai government announced the standstill it requested on November 25 would remain in place with respect to all other obligations, with restructuring efforts continuing.

Rating agency Fitch said the Abu Dhabi handout, “while constructive in avoiding a near-term default by a high-profile entity with state linkage, is nonetheless tactical in nature as opposed to a reversal of recent rhetoric regarding state support”.

“While this move will help to avoid a default at the Dubai World subsidiary Nakheel, Fitch interprets the move as a tactical step to permit an orderly restructuring of obligations within Dubai to continue,” the rating agency continued.

Fitch had previously placed two state-owned Dubai entities, Dubai Holdings Commercial operations Group (rated BB) and Dubai Electricity and Water Authority (rated BBB–) on negative rating watch following the Dubai government’s initial restructuring announcement in late November, and took no further rating actions following the December announcement.

Rival rating agency Standard & Poor’s (S&P) says it considers December’s developments as a step toward rebuilding confidence in Dubai’s policy-making environment. It said the move to strengthen the laws governing the Dubai World restructuring is an opportunity for the Dubai government to demonstrate the workings of its legal system in dealing with such events. “Moreover, we view the intervention of Abu Dhabi as an indication that it stands ready to safeguard the stability of the United Arab Emirates’ economy and financial system,” said S&P.

However, S&P added that uncertainty remains over the Dubai government’s general ability and willingness to provide “timely extraordinary support” to its government-related entities, as well as the transparency and predictability of such support.