What can Nakheel sukuk holders expect in a default?

The Nakheel sukuk is perhaps the nearest test of the impact of the standstill agreement will play out in Dubai that we have. The sukuk is a complicated financial product and the laws in Dubai do not provide a clear precedent for how the investors in the sukuk will be treated and what recourse they will have provided by the sukuk.

First, a quick look at the structure (excluding the pre-IPO part of the sukuk which is a moot point now). The sukuk was set up as an ijara sukuk based on two properties (and any buildings on the land), which was initially valued at $4.22 billion based on the developments that were to be constructed on it. The two plots were DWF South and Crescent Lands, both in the Dubai Waterfront development. Long leases on these properties were sold to the SPV set up that issued the sukuk. The plots were then leased back to Nakheel for the length of the sukuk for the $3.52 billion amount raised and during the term of the sukuk, Nakheel pays lease payments corresponding to the periodic payment amounts on the sukuk. Half of the lease amount was paid to sukuk holders through the SPV and half was deferred until maturity. At the maturity or in cases of default, the long lease would be repurchased by Nakheel and the deferred lease payments would be made. In the situation that has occurred where there was no public offering, Nakheel was obligated to pay an additional amount to the investors through the SPV.

The sukuk was backed by a few additional guarantees that may provide sukuk investors with some recourse, but this is subject to the ability of investors to receive claim over assets largely located in the UAE, which has no established legal precedent for anything like what has occurred.

The repurchase of the asset (the long-term lease) is guaranteed by Nakheel's parent company Dubai World, which is in no better situation to repay the sukuk than Nakheel. Dubai World is also just a holding company for a number of other companies including DP World, Limitless, the Jebel Ali Free Zone). However, these companies all have their own creditors and their own debts to service and the important thing for Nakheel sukuk holders is that the creditors of Dubai World through the guarantee are subordinated to the creditors of the subsidiaries of Dubai World. The prospectus is pretty clear here:

"Dubai World is a holding company. As such, Dubai World is dependent on the operations of and cash flows generated by its subsidiaries. Therefore any claim that may be made by a creditor on Dubai World will effectively be structurally subordinate to any claims made by creditors directly on Dubai World’s subsidiaries.

As has been mentioned elsewhere, there is no guarantee from the government of Dubai in effect, although there was a general sentiment that Dubai would bail out Dubai World if it ran into trouble, with help from Abu Dhabi if necessary. Now this is shown to be a poor assumption, much as it was by the holders of equity in Fannie Mae and Freddie Mac in the U.S. (although not those companies creditors).

In addition to the guarantee by Dubai World, Nakheel sukuk holders were granted a share pledge of 18.89% of the outstanding equity in Nakheel at the time the sukuk was originated. This is probably worthless if Nakheel cannot restructure or repay the outstanding sukuk due December 14th (and the Nakheel 2 and 3 sukuk that come due in December 2010 and January 2011 for another $2 billion). Sukuk holders were, however, also granted a mortgage over the two properties which formed the basis for the sukuk through a Security Agent. Their recourse is limited by a general lack of precedent in how the laws will be applied. For one, they will need to provide details to the Attorney General of Dubai and enter settlement negotions for two months as described in the prospectus:

"However, the rights of the Trustee and the Security Agent to bring proceedings against Dubai World or the Co-Obligors may be delayed pursuant to Law 10 of 2005, which provides that proceedings may be brought against the Government of Dubai and government entities (which may include Dubai World and the Co-Obligors) before the courts of Dubai provided that the relevant claimant has first given details of such claim to the Attorney General of Dubai and has entered into settlement negotiations for a period of two months. If the parties are unable to reach a mutually acceptable settlement at the end of the two months, the claimant shall be entitled to commence proceedings against the Government of Dubai or the government entity.

Even if they are able to move through this level there are two problems investors may encounter. The first is that they are not able to touch the assets of the government:

"In addition, Law No. 10 of 2005 amending Government Lawsuit Code No. (3) of 1996 (as amended by Law No. 4 of 1997) provides that an establishment of the Government may be sued, but that no debt or obligation of such establishment may be recovered by way of an attachment on its properties or assets.

There is also an issue with the entire structure that could limit investors' ability to enforce the mortgages. The concepts of trust and beneficial interest, on which the entire sukuk is structured (under English law), are not recognized in Dubai. To provide investors, especially foreign financial institutions, with some recourse based on the mortgages used as security, the sukuk used a Security Agent as a domestic agent for investors to enforce the mortgage:

"There is an absence of precedent or authority as how a court would construe Law No. 3 of 2006 and, accordingly, there can be no assurance in respect of Dubai World's or the Co-Obligors' entitlement to immunity in any attachment or enforcement action, whether relating to the Mortgages, the Share Pledge or otherwise. The Dubai Lands Department (the Governmental of Dubai's property registration authority) will register mortgages in favour of UAE licensed banks or persons. Further, the Dubai Lands Department will not register a mortgage, inter alia, if a bank mortgagee is not licensed to operate in the UAE The Security Agent is licensed to operate in the UAE. However, in the absence of clear judicial or legislative guidance or clarification on the arrangement contemplated by the Security Agency Agreement there can be no assurance of the enforceability of the Mortgages by the Security Agent in the manner contemplated by the Security Agency Agreement or any enforcement process or procedure."

This is a new legal concept without precedent so there is great uncertainty about the ability of the Security Agent structure to withstand legal challenge, also described in the prospectus:

"A mortgage granted over real property must be perfected by entering into a mortgage agreement, completing an application form and registering the mortgage agreement in the lands register at the Lands Department. Only the interests of a lender licensed by the central bank may be registered. As such, a non-licensed lender will be prohibited from taking the steps necessary to perfect certain security interests in real property (where registration is required). A possible (but as yet untested before the UAE Courts) way of non-UAE licensed banks or persons deriving the benefit of such mortgage could be to appoint a UAE licensed bank to act as a security agent who would act for all lenders on any enforcement of the security in the UAE."

As one can see, there are a tremendous number of uncertainties about the procedure for investors to enforce upon the various guarantees and collateral provided in the sukuk structures that would appear to give investors a claim on more than just the unsecured pledge of Nakheel and Dubai World, but in all cases, there is a lot of doubt about whether they will end up being legally enforceable.

These factors probably point towards some type of restructuring of the sukuk, rather than an outright default and legal challenge by investors. There would be severe ramifications for Dubai were it to just step back and let the sukuk go into default (not to mention years of embarrassing litigation). Both sides now have an incentive to negotiate some type of settlement (or Abu Dhabi could ride to the rescue as many still seem to believe will be the case). Any restructuring would probably avoid a large mess, but would do nothing to clarify how the legal system would react in a similar situation in the future, which would be unfortunate, but would probably still be preferable to the turmoil that would follow a default.