IIFM-ISDA Shari'ah-compliant hedging agreement, KFH investment in US real estate

Shari'ah-compliant hedging

The International Islamic Financial Market (IIFM) held a meeting of Shari'ah scholars in Dubai to discuss the Tahawwut (Hedging) Master Agreement. The Tahawwut Master Agreement, developed in partnership with the International Swaps and Derivatives Association (ISDA), has not been described in significant detail, in particular what types of hedging activities it would cover. There are certainly areas where hedging could be useful in the Islamic finance industry, and a standardized agreement could provide some standardization and a starting point for more discussions about the place of Shari'ah-compliant hedging products in the industry.

The difficulty with many hedging products in Islamic finance is that there are so few and each hedging transaction must have a counterparty to assume the hedged risk. For example, if an Islamic bank hedges against its foreign exchange or interest rate risk, there must be a counterparty that is essentially unhedged, which would probably be characterized as speculation. There could be a central counterparty that enters into enough transactions to be able to be relatively hedged itself, but this is not yet the case. Alternatively, a conventional bank could step in and act as the counterparty in the transaction. In this case, that bank would then go into the conventional swaps/derivatives markets to hedge its own risk.

This raises the question of whether the Shari'ah-compliant hedge was beneficial to anyone except the counterparty. If an Islamic bank hedges its risks with a conventional bank, which then hedges itself against the same risk, who benefits except for the conventional bank which inserts itself into the middle and presumably collects fees?

To some degree this problem occurs in other Islamic finance transactions. However, the nature of derivatives as opposed to other investment products, highlights this problem. In the best case, the IIFM-ISDA Tahawwut Master Agreement will provide a transparent and simple way for hedging transactions to be structured that will lead to the development of a common counterparty that only acts in Islamic derivatives. There are similar institutions in emerging market currency hedging. The scope of the problem would be large enough to probably require some assistance from a multi-lateral institution like the Islamic Development Bank.

KFH real estate investment in the U.S.

Kuwait Finance House made a $242 million investment in a real estate project in Chicago, Illinois which is currently under construction and is expected to be completed in 2011. The building will be a 40-storey Ritz-Carlton Residences, a condominium tower and $137.5 million of the project will be debt financed from German landesbanks Helaba.

Helaba recently arranged its first Shari'ah-compliant real estate deal in the U.K. with Gatehouse Bank, so the debt for the Chicago project may be Shari'ah-compliant. If it is not, it is likely to be separated from the equity using an ijara-istisna'a structure which has been used internationally over the past decade.

Other News

• Saudi Hollandi Bank issued a $193 million subordinated, callable sukuk.
  
• The Islamic Development Bank saw its AAA rating affirmed by Standard & Poor's.
  
• Bursa Malaysia may allow individual investors to invest in sukuk. Following Dubai World's debt crisis and the multitude of questions asked regarding the ability of investors to have recourse to the underlying assets, it would seem that opening sukuk secondary markets up to individual investors could create the potential for problems down the road.
  

Pipeline of sukuk grows, despite uncertainty about bankruptcy laws; GFH buys back sukuk

There has been reports that the pipeline of 'planned sukuk' is quite high with past estimates of $45 billion which has been increased to $50 billion by Standard & Poor's as reported in the DIFC Sukuk Guide. However, as the new issuance seized up again following the Dubai World standstill request, these estimates may not necessarily turn into actual new issues in the foreseeable future. With the myriad of issues about the legal enforceability by investors raised by the Dubai World and Nakheel crisis, many potential issuers may delay or cancel planned issuances. To take an optimistic perspective, the well reported confusion over bankruptcy laws may move some of the new issuance to other countries outside of the Gulf and may also lead to the development of new bankruptcy laws.

Gulf Finance House announced it was going to repurchase $9 million of its $200 million sukuk. This is in contrast to other sukuk issuers which had a chance to repurchase their issued sukuk at distressed levels, some of whom have subsequently defaulted on their sukuk. It is an interesting idea for issuers to take advantage of distressed prices in secondary markets known for its illiquidity. However, in many cases, distressed prices, despite the illiquidity, do reflect the prospects of a default.

Other News

• The DIFC Sukuk Guide (pdf), which was released recently, reports that the total issuance of sukuk in the GCC between 2000 and 2008 was $26.8 billion.
  
• The Investment Dar, the Kuwaiti financial institution which defaulted on $100 million in sukuk, has reached agreement with enough creditors to approve its restructuring plan. Details of the plan have not yet been released. Most reports of the plan say that The Investment Dar will sell most of its assets in order to repay creditors.
  
• The bill to provide tax breaks to put sukuk on a level playing field with conventional bonds in South Korea has been held up in the National Assembly.
  
• Italian insurance company Generali is considering a joint-venture with Qatar Islamic Bank to launch a takaful company in the GCC with possible expansion across Europe in Asia.
  

Dubai World restructuring talks to begin on Monday

The first talks in the Dubai World restructuring will occur on Monday with 90 banks and other creditors sitting down with representatives of Dubai World including its chief restructuring officer Aiden Birkett. According to reporting from Bloomberg, it is unlikely that Dubai World will present a formal standstill request and proposal at this meeting due to the complexity of the restructuring. As The National reports in an article, the restructuring process is likely to take a long time and be expensive to all parties involved.

From the perspective of the Islamic finance industry, the most interesting aspects of the restructuring negotiations--the impact of the Shari'ah-compliance of any restructuring of the sukuk owed by Nakheel and the bank debt owed by Limitless--is unlikely to be discussed immediately. The sukuk are governed by English law, which has in the past dismissed requests for Shari'ah-compliance concerns to be used to challenge enforcement actions by debtors. However, given the attention placed on Islamic finance due to the Nakheel sukuk repayment and the entire Dubai World debt crisis, it will be imperative that this issue be addressed publicly. On the one hand, it will likely be impossible for Dubai World to treat creditors through conventional debt differently from those who invested in sukuk. On the other hand, there could be fallout from any restructuring that is not accepted as Shari'ah-compliant by the Shari'ah boards of any Islamic banks or other Shari'ah-sensitive investors.

This could hurt those institutions relative to conventional financial institutions that invested in the same sukuk. If the restructuring that is approved by the creditors committee were viewed as non-Shari'ah-compliant, it could force Islamic banks holding the sukuk to liquidate their holdings, which would probably be done at a price less than they would get if they held them until a complete resolution of the sukuk. This could create a transmission mechanism for the problems of Dubai World to affect unrelated Islamic banks through the losses they recognize on selling the sukuk holdings. It will indeed be interesting to watch as the negotiations continue and see the impact of some debt being Shari'ah-compliant.

Other News

• Singapore will see its first listed Shari'ah-compliant REIT in the second half of 2010.
  
• With all the negative attention in the news about Dubai, I found it very interesting to see a travel article about the rest of the UAE that was published by the Guardian.
  
• Gulf Finance House appointed a new deputy CEO for investment banking, Ted Petty. The new group CEO was formerly an Executive Director at Macquarie Capital. Marquarie recently purchased a $100 million convertible murabaha from Gulf Finance House.
  
• Iran is issuing sovereign, euro-denominated Islamic bonds and the "government of Iran guarantees the bonds' interest". Not to be a bit flippant about it, but it is not a typical practice to describe the periodic payments on Islamic bonds as 'interest'.
  
• An article on Islamic finance provides a brief overview with all of the misstatements that have been common in much of the reporting on Islamic finance. The article describes that Islamic finance does not allow leveraged investments. In reality, there are many ways for leverage to be used within Islamic finance either through the natural leverage that accompanies Islamic banks' use of debt financing through sukuk and increasing the size of their balance sheet through customer deposits (which provides leverage over the banks' capital). There is also frequent use of leverage in real estate development where equity investments are made into a development company that builds a property with additional Shari'ah-compliant debt financing but separates the equity and debt components through a lease.
  
  The article also provides a description of the prohibition of riba: "Following the Quranic verse: 'Allah made legal commerce, and illegal interest,' Islamic law prohibits usury, known as riba." This description, while common in many articles about Islamic finance, does a poor job of explaining the implications of the prohibition. I have read countless articles that provide a similarly unhelpful overview, so I do not want to place too much of this criticism on this specific article. However, it does perpetuate a misunderstanding that Islamic finance is solely concerned with 'interest-free' financing, without explaining how Islamic finance actually works in practice. Perhaps it is too much to expect that a short, introductory article could provide the nuances and actual workings of the industry.
  

World Bank, ThomsonReuters to provide assistance for standardization and improving data in the Islamic finance industry

The World Bank says it is committed to helping the Islamic finance industry turn its voluntary standards into binding standards. I would imagine that this assistance would be focused primarily on accounting and auditing standards that have been issued by AAOIFI and the IFSB, rather than Shari’ah standards. The former is an admirable goal to ensure that Islamic financial institutions incorporate global accounting standards within the guidelines of the Shari’ah. The latter, however, is a mixed bag. There are areas where some standardization of Shari’ah rulings could benefit the growth of the Islamic financial industry, but too much, especially pushed to quickly, could limit beneficial innovation that will eventually reduce the reliance on controversial products like tawarruq/commodity murabaha. It is also a little curious that the World Bank and not the International Monetary Fund would be taking the lead on this standardization. The World Bank is primarily focused on development, while the IMF has a mandate that focuses more on financial market and exchange rate stability.

Thomson Reuters is launching an Islamic finance portal in 2010 that will provide one source of data on the Islamic finance industry. I think this is essential for the Islamic finance industry to grow, particularly to expand into Western markets and attract more interest from the global financial industry. While this could be a mixed blessing if it reinforces the reliance on conventional financial product replication, However, it should also provide some transparency that is necessary for the industry to mature, as well as providing the needed data for debate within the industry.

I would recommend heading over to Opalesque and downloading the latest Islamic Finance Intelligence (registration required). They offer a (free) monthly newsletter that is always of very high quality.

The Islamic Development Bank is planning another $850 million sukuk issue in 2010. This follows a similar size issue in 2009 and could signal a continued dominance of sovereign, multilateral and high-grade corporate (e.g. GE Capital) issuers in the next year. I have been critical recently about the lack of seeming promise for a wider diversity of issuer quality, but there could be a benefit to these types of issuers dominating the market following the Nakheel debacle. The area where these highly rated issuers can contribute most to the market is by testing the longer maturity issues. Most sukuk are now issued with five to ten year maturities, although the number of issues are clumped more towards the five year maturities. If Islamic finance is going to grow sustainably and if there is a chance for the industry to move away from LIBOR as a pricing through the development of a Shari’ah-compliant yield curve, then two things will have to happen. First, the maturity profile of new sukuk issues will need to expand into the longer maturity sukuk and second, we will need to see a return of lower rated issuers.

The Indian state of Kerala is planning to issue sukuk next year, the country’s first.

The Bank of Kuwait and the Middle East will transform itself into an Islamic bank in the second quarter of next year.

Could the bailout of Dubai that started with the bailout of the Nakheel sukuk lead to Abu Dhabi running out of liquidity? I would lean towards doubting it because Abu Dhabi has made it clear that the funds it has already provided to Dubai are not the sign of an open checkbook by requiring a standstill agreement and pressuring Dubai into taking credible steps to achieving a successful restructuring. However, with little transparency about how much of the Abu Dhabi sovereign wealth fund is in illiquid investments, the question should still be asked and it would be foolish to assume that Abu Dhabi has infinite liquidity to support the other emirates. However, even if investors react positively to the new law in Dubai surrounding the restructuring being judged under DIFC law, there is a long road ahead.

Dubai World - The Issue of Shari'ah-compliance in the restructuring

There has been a lot written about the Dubai World repayment of the Nakheel sukuk in the last 24 hours, with assistance from Abu Dhabi. Undoubtedly, much of the discussion has been on the negative side about the lack of clear communications from Dubai World and the government of Dubai about what would happen to the Nakheel sukuk in the weeks since Dubai World requested a ‘standstill agreement’.

One analyst at UniCredit SpA, whose comments from a note were quoted in a Bloomberg article, described:

“The whole story leaves a bitter taste […]The reputational damage for Dubai World is enormous as its failed timely communication of its fiscal problems will alienate investors. Negative surprises like Dubai World’s debt restructuring announcement, which let the value of Nakheel’s bond plunge by 50% within two days, is definitely something investors do not appreciate.”

The investors certainly have reason to complain about the incredible lack of certainty provided by Dubai World and the government of Dubai surrounding the sukuk repayment.

However, there is a positive development that I think has received far too little attention: Dubai appointed a three judge tribunal to review any disputes in the restructuring of the remainder of Dubai World’s debts. The panel was established so that it is based on the laws of the Dubai International Financial Center (DIFC).

“The Government decided to base the law of the Decree on the insolvency laws, rules and regulations of the DIFC because it determined that such such laws, rules and regulations were comprehensive and reflected international standards. In addition, such laws, rules and regulations were in English rather than Arabic, which the Government determined would facilitate a complex financial reorganization involving investors and professionals from all over the world.”

The three judges appointed to the tribunal are all judges with experience in the English legal system (two are former English judges and one is a Singaporean judge and the legal system in Singapore is largely based on English law).

The main thing that this tribunal accomplishes is it provides a forum where the legal rights of creditors can be heard in a setting that may be more neutral than if the restructuring were accomplished based on negotiations with the various creditor groups of Dubai World’s subsidiaries. Although there is likely to be government involvement with the restructuring, the tribunal may provide for a forum that is viewed as more impartial. It also provides for a test case of how government-related entities in Dubai will react to a restructuring of debts.

However, the tribunal should also provide clarity on how well the creditors of Islamic financial products will be treated in a restructuring. Although the large Nakheel sukuk was repaid, there are two smaller sukuk maturing in 2010 and 2011, as well as $1.2 billion in Shari’ah-compliant bank financing provided to Dubai World’s international property development company Limitless. These will certainly be a part of the restructuring. Less clear is whether the DP World sukuk that financed the company’s acquisition of P&O Ports will be restructured. It is almost as large ($3.5 billion) as the Nakheel sukuk which was paid by Abu Dhabi.

There remain many uncertainties about how Dubai World will restructure its debts, particularly its Shari’ah-compliant ones. There will (or probably should be) a role for a Shari’ah review board to approve any restructuring of the Shari’ah-compliant debts of Nakheel, Limitless (and DP World if it is included). There is not much precedent for this to occur and it could affect whether the restructuring is accepted by Shari’ah-sensitive investors in the sukuk of Dubai World’s subsidiaries.

There are some nascent steps being taken to provide a forum for arbitration in Islamic finance that is based in Dubai (the International Islamic Centre for Reconciliation and Arbitration) although this is still a new effort and would probably not have the capacity or legal ability to become involved with the Dubai World restructuring. However, if issues do begin to arise surrounding the Shari’ah-compliance of any restructuring of sukuk or other Islamic financing, it will highlight the need for there to be an alternate dispute resolution mechanism to provide a forum where the unique features of Islamic finance with its reference to the Shari’ah can be applied before the dispute is escalated to a (secular) court that is unlikely to consider anything but the governing law—usually English—of the contract.

This type of dispute was heard by the English courts in a case between Shamil Bank of Bahrain and Beximo Pharmaceuticals whether the court found that it could not adjudicate based on Shari’ah because it was not the law of a country. The decision of an appeals court in England describes the logic used in reaching this conclusion.:

”The wording of Article 1.1 of the Rome Convention ("the rules of this Convention shall apply to contractual obligations in any situation involving a choice between the laws of different countries.") is not on the face of it applicable to a choice between the law of a country and a non-national system of law, such as the lex mercatoria, or "general principles of law", or as in this case, the law of Sharia. Nevertheless, that wording, taken with Article 3.1 ("a contract shall be governed by the law chosen by the parties") and the reference to choice of a "foreign law" in Article 3.3, make it clear that the Convention as a whole only contemplates and sanctions the choice of the law of a country.”

If there does arise issues in the Shari'ah-compliance of a restructuring (for example, if sukuk creditors can receive partial payment with the remainder paid by issuing new debt), it could throw the entire restructuring into turmoil if some creditors believe that the Shari'ah-compliance of certain debts is providing an advantageous position for those creditors. In this case, the situation could turn back into a stand-off between Dubai and its creditors, which would benefit no one. It would only serve to highlight the need for greater clarity in Islamic financial products about what the role is of the Shari'ah-compliance in terms of enforcing the contracts.

Nakheel sukuk bailed out by Abu Dhabi

Zawya Dow Jones is reporting that Abu Dhabi has provided $10 billion in financing to the Dubai Financial Support Fund and that $4.1 billion of this will be used to repay the sukuk issued by Nakheel, guaranteed by Dubai World, maturing today. The article stated that:

Dubai's government Monday said it received $10 billion in financing from Abu Dhabi, which will pay part of the debt held by conglomerate Dubai World and its property unit Nakheel.

"As a first action for the new fund, the Government of Dubai has authorized $4.1 billion to be used to pay the sukuk obligations that are due today," the Dubai government said in an emailed statement.

This is a stark reversal from the recent statements by Dubai’s government following the request for a standstill on all Dubai World debts, including Nakheel. The government had stepped away from the debts saying that there was a difference between government-owned companies and government-backed companies. The request for standstill agreement had turned into a crisis for other Dubai and UAE companies with ties to the government, most concretely DEWA, which had $2 billion in debts that were backed by the government that would have been subject to an accelerated payment schedule. The statement also indicated support for the working capital needs of Nakheel through the end of April, contingent upon it negotiating a standstill agreement with other creditors.

However, the repayment of the Nakheel sukuk and a limited support for Nakheel only kicks the can down the road for the other sukuk due from Nakheel as well as a large Shari’ah-compliant loan due in March by Limitless, the international property subsidiary of Dubai World. There are also two more sukuk totaling over $1.5 billion that come due between now and 2011 in addition to a pile of debts of other Dubai World companies.

The Nakheel sukuk was repaid with essentially a bail out from Abu Dhabi, which should lead to some questions about whether Abu Dhabi will also come to the aid of other Dubai World companies as well as whether Abu Dhabi will expect to receive other assets from Dubai in exchange for the bailout.

While this repayment certainly takes the heat off of the Islamic finance industry and the sukuk market in particular for the moment, the questions that had become common points of discussion about whether creditors would have recourse to the assets underlying unsecured sukuk will remain. This is still a thorny time for Islamic finance with the attention now being paid to these issues and it will probably not be resolved quickly. Dubai World will be the spark that should ignite introspection on the limits of innovation and particularly innovation that replicates ever more complicated conventional products.

Articles on Islamic finance and the Dubai effect

As the maturity date (December 14) looms for the Nakheel sukuk, there have been two avenues of media attention to the Islamic finance industry. One of these is trying to read the tea leaves and predict the outcome of the Nakheel situation. The other is to look at the overall impact of the recent Dubai debt crisis on the entire Islamic finance industry. Here is a sampling of some of what is being written along these two tracks, with a few comments along the way on what I think about the arguments.

Oxford Analytica wrote an article titled, "Islamic Finance Still Profitable", which goes to admirable length to differentiate between the areas of Islamic finance that are experiencing difficulties like property and those areas that are still growing.

"Although Islamic capital market activity was negatively affected by the global financial crisis, the impact on Islamic banks has been limited, largely because most are focused on retail business"

"Real estate has been the most troublesome, with mortgage lending reduced. In many instances, the value of property has fallen below the amount of credit outstanding. [...] As Islamic banks in the GCC had more conservative housing finance policies than their conventional competitors, they have been less affected by the fall in real estate prices."

The article concludes with a positive outlook for the Islamic finance industry:

"Most sukuk issuance is concentrated in Malaysia, which is not likely to be directly affected by the Dubai crisis. Moreover, if the Dubai case is tested in the courts, this could clarify the legal position of sukuk investors with regard to their rights to the underlying assets backing the issuance. Although this may be painful for Dubai World subsidiary Nakheel in the short run, a court ruling in favor of investors would increase confidence in sukuk in the longer term. Overall, the global Islamic finance industry seems well positioned for recovery in the longer term with further sukuk issuance, a widening of products to include takaful and the continuing buoyancy of Islamic retail banking."

I think this conclusion is right. There will be significant short-term pain for Nakheel, but it might also extend to other GCC-based Islamic financial institutions, but the resolution of Dubai World's subsidiaries' overindebtedness will clarify as of yet untested structured including sukuk. It should also remind issuers that they need to be mindful of the level of debt (whether conventional or Islamic) that they take on to finance their businesses.

The second article focusing on the future of the Islamic finance industry is a white paper released by the Dubai International Financial Centre Authority on the potential for Islamic finance to be involved in infrastructure finance in the GCC. While it is clear that the white paper was largely completed before the debt crisis hit, the white paper is still relevant. Most of the infrastructure projects would be long-term investments and the Dubai crisis should return the focus from building luxury or statement projects like the undersea hotel, Burj Al-Arab, Burj Dubai and return to the more needed projects like infrastructure across the region. There are only so many people who can afford and desire luxury apartments and hotels in Dubai, but there are far more--within the GCC and outside the region--with large infrastructure needs. A growing focus on infrastructure projects would be more beneficial to more people, although they may not seem as sexy as the luxury projects.

This leads into another article, which focuses on the lessons from Dubai written by Dr. Lin See-Yan. He argues that there is a light at the end of the tunnel, but not without significant changes in Dubai and across the GCC region:

"As it now stands, the Gulf markets are soft and under continuing pressure. To be fair, the structural underpinnings of these markets need to be viewed in perspective over the longer term."

"Lest it’s forgotten, Dubai’s hydrocarbon-rich neighbours – Saudi Arabia, Kuwait, Qatar and Abu Dhabi – command two thirds of the world’s oil and 45% of gas reserves."

"Debt levels are very low and high oil prices have enabled them to accumulate more than US$1 trillion in reserves. A few key elements set the stage."

"These Gulf nations need some US$2 trillion in infrastructure spending to diversify from oil."
[...]
"But these oil-rich nations are known to be basically conservative. No doubt the Dubai excesses present lessons to be learnt. Throughout history, nations have defaulted and live to fight again, and succeed, even prosper."

"To regain confidence, a number of things need fixing: call for fiscal transparency, opaque family business groups need to heed the lessons of Korean chaebols, and clarity on the road-map to government prudence over the longer term. This includes a credible plan on debt management once global recovery becomes sustainable."

"Dubai teaches an important lesson. Unpredictable, unsustainable, unclear and uncertain policies are a no-no."

Dr. Lin's analysis is correct and looks to whether the future growth will come from. However, to paraphrase J.M. Keynes, "In the long run, we're all dead". A blog post from The National highlights the impact in the short term from the ripples that the Nakheel and Dubai World debt crisis sends through the UAE via credit ratings agencies. The post focuses on how the impact of Dubai World is transmitted to other companies through reviews by the ratings agencies who have downgraded other companies across the UAE and in some cases, this may produce financial difficulties for those companies that would not have existed had Nakheel's sukuk been paid on time without a standstill request. The author, Wayne Arnold, does describe a way for the government to help clear up some of the uncertainty that has affected the ratings of other (mostly) state-owned or government-related companies:

"Last month's announcement, therefore, has prompted all three agencies to scale back their assumptions once again, this time eliminating from their ratings any assumption that Government-owned companies enjoy implicit guarantees of any kind. Obviously, the Government could still move to back some companies considered too big to fail, and not all companies may ever need such a bailout."

"But the onus is now on the Government to do what the US Government did with Fannie and Freddie -- make the implicit explicit and clear up just which companies enjoy guarantees and which will have to stand on their own."

Until now, the Dubai Department of Finance has refused request to meet with the credit ratings agencies and so the uncertainty continues, which casts a long shadow over many other companies in the UAE, some of whom would be judged to be fine if the ratings agencies were given clarity about their status vis-a-vis the government (or they would be downgraded based on the information provided). Either way, it could speed up the necessary process of separating good companies from bad and as long as the uncertainty persists, the good will be dragged down by the bad.

Returning to the specifics of sukuk rather than the entire Dubai debt crisis, Oliver Agha and Claire Grainger write a thought-provoking article about whether the inclusion of clauses to provide bond-like protections for sukuk holders in sukuk can or should be enforceable. They criticize the structures created, rather than than Islamic finance itself, because the documentation does not involve risk-sharing but instead incorporates risk transfer:

"Blaming Islamic finance for sukuk defaults is both simplistic and misinformed. The ‘defaults’ occurring in instruments today would not necessarily qualify as genuine Islamic defaults because such provisions effect the kind of risk-transfer that is inimical to Islamic finance."

They then review the difficulty of structuring sukuk to include legally enforceable requirements that the sukuk not violate Shari'ah and point to the Beximo Pharmaceuticals case in the U.K. which English law was ruled to be the only governing law because "Shari'ah was not a governing body of law but merely embodied the religious principles to which Shamil Bank held itself as doing business".

They conclude by suggesting that:

"In short, purchasers of sukuk and other Islamic instruments need to be aware these products may be subjected to scrutiny at enforcement and certain non-conforming provisions may be excised or disregarded. While sukuk holders share in the rewards, they would take the risk of a depreciation of their capital in adverse business circumstances provided there was no negligence on the issuer’s or manager’s part."

"Islamic finance is a permissive field and, apart from the fundamental prohibitions, a multitude of structures can be developed to serve varying commercial needs. However, referring to sukuk as Islamic bonds is like jamming a square peg into a round hole and then wondering why it does not fit."

While this article highlights much of what the Islamic finance industry should focus on in the future, it does not provide much help to the sukuk holders trying to enforce their claims on Dubai World. An article in the Times speaks with several lawyers involved in Islamic finance who reiterate the point that should have been clear to investors. The Nakheel sukuk and any other debt issued by or guaranteed by Dubai World or its subsidiaries is not sovereign debt. Investors had no explicit guarantee of that debt by the government of Dubai, the UAE or any other Emirate. This misunderstanding and the equally important misunderstanding that all sukuk are backed by and give investors recourse to a tangible asset should make the article by Agha and Grainger even more important to consider as the Islamic finance industry tries to move on from the Dubai World debt crisis.

Finally, the National provides an update on the range of possible outcomes of the Nakheel maturity and suggest that the most likely outcome is a restructuring that pays 70 percent in cash and the remaining 30 percent in new debt (nothing mentioned about the Shari'ah-complaince of such a restructuring). A top Dubai government official told Gulf News that there will not be a Dubai default, which doesn't necessarily apply to Nakheel's maturing sukuk which is not government-backed, but may be another signal that Dubai will pay in full the DEWA bond, which may be facing accelerated payment. An article from Bloomberg provides other updates on the Nakheel sukuk maturity.

Finally, John Foster provides another article critical of the Islamic finance industry which includes accusations (supported by quotes from an anonymous investment banker in Dubai working for a "major Western financial organization") of fatwa shopping.

A brief summary of the GE Capital sukuk

Before the Dubai debt crisis hit the region and focused all of the attention towards that aspect of the Islamic finance industry, there was a very significant new issue from GE Capital (prospectus available from NASDAQ Dubai) that in other situations would have received much more attention than it did. The sukuk for $500 million, which yields 3.875%, was a first for GE Capital, although not the last according to the company: “’We intend to be regular issuers in the sukuk market and are heartened by the support we have seen in this first transaction,’ GE's senior vice president and treasurer, Kathy Cassidy, said.”

The structure of the sukuk is somewhat unique from many other ijara sukuk and has a number of interesting components that differ from what has been the norm for an aircraft-based ijara sukuk. The proceeds of the sukuk are not used to directly finance a new aircraft purchase. Instead, the funds are used to purchase a portfolio of existing leases from two subsidiaries of a wholly-owned subsidiary of GE Capital. The direct subsidiary, Delaware-domiciled Sukuk Aircraft Leasing Inc. (SAL), owns the two subsidiaries, SAL Investments 1 LLC and SAL Investment 2 LLC, which have portfolios of leases for aircrafts.

The transaction involves the two SAL Investment companies selling the leases to the SPV, GE Capital Sukuk Ltd. (Bermuda-domiciled), that pays for the purchase using the proceeds of a sukuk issued to investors with a return of 3.875%, payable semi-annually in May and November for five years (due in 2014). The SPV then enters into an Agency Services Agreement with the parent company of the two SAL Investment companies to service the leases. Not all of the proceeds of the sukuk are used to purchase the leases; $50 million is set aside in reserve account for the use by SAL due on maturity or early termination of the sukuk to cover any expenses, is called the Funded Reserve Account. There are other reserve accounts established for airplane replacement and substitution.

The unique aspect of the Agency Services Agreement is that it takes leases which are not Shari’ah-compliant and strips out the non-compliant aspects of it so that none of the returns to the investors come from interest, penalties. The sukuk prospectus describes that SAL must “ensure that any Lease Revenues received by it which comprise Non-Qualifying Revenues are segregated and paid to buildOn, Inc. or any other Sharia compliant charity as determined by SAL”. Any Non-Qualifying Revenues are donated to buildOn, Inc., a charity in the US which describes it’s activities as:

”a non-profit organization that empowers primarily urban U.S. high school students through in-class and intensive after-school programs. In addition to tremendous contributions of community service in their own cities and neighborhoods, buildOn youth actually build schools and bring literacy to children and adults in developing countries around the world. buildOn programs are designed to build confidence and real-world capabilities in American youth while also empowering communities world-wide to overcome the crippling cycle of illiteracy, poverty and low expectations by opening the door to education.”

During the term of the sukuk, the leases generate revenue, the non-Shari’ah-complaint parts are stripped out and donated to charity, and the lease payments are passed to the SPV, which then makes the periodic payments to the sukuk certificateholders. In this way, the returns provided by the sukuk are equivalent to an unsecured debt.

The unsecured status (both of the payments and any guarantee from GE Capital should the lease payments not be sufficient to cover payments), which is made explicit:

“The payment obligations of SAL under the Purchase Undertaking will be direct, unconditional, unsecured and general obligations of SAL and shall rank at least pari passu with all other unsecured, unsubordinated and general obligations of SAL, other than those mandatorily preferred by law.”

“The Guarantee is unsecured and ranks equally with all other unsecured and unsubordinated obligations of the Guarantor.”

At maturity, the SAL Investment companies will repurchase the aircraft (and the future stream of lease payments) from the SPV to provide funds to redeem the sukuk.

In addition to the basic structure described above of converting non-Sharia’h-compliant leases into Shari’ah-compliant ijara cashflows, there are a couple additional features that provide sukuk certificateholders with additional security: 1) an insurance undertaking; and 2) a reverse commodity murabaha using the funds in the reserve accounts. I will start describing the latter.

The reserve accounts (Funded, Unfunded, and Replacement Airplane Accounts) use the funds between each periodic payment date or aircraft substitution date to fund commodity murabaha transactions with the Servicing Agent, SAL, at the same rate as the underlying sukuk, 3.875%. This ensures that there is sufficient funds to pay the 3.875% rate on the entire principal amount, not just the amount used to purchase the airplane leases ($450 million). However, it also may not provide the same return as if it were credited on the remaining $50 million because of the expenses the Funded Reserve Account pays to the Servicing Agent to service the leases.

The prospectus describes:

“The Master Murabaha Agreement will be entered into on the Closing Date between the Trustee and SAL, acting in a personal capacity and on a voluntary basis, and will be governed by English Law. The terms and conditions on which each Murabaha Contract will be entered into will be set out in the Master Murabaha Agreement, including provision for (i) each Murabaha Contract to be entered into on the Closing Date and, thereafter, on each Periodic Distribution Date, in the case of amounts credited to the Funded Reserve Account and on each Aircraft Substitution Date and Aircraft Loss Settlement Date, in the case of amounts credited to the Replacement Aircraft Account, (ii) the date of the deferred payment of the purchase price for the relevant commodities to be the next succeeding Periodic Distribution Date, as the case may be (iii) the profit payment in respect of such deferred payment to be determined by reference to a rate of 3.875 per cent per annum and (iv) the Deferred Payment Price to become immediately due and payable on the occurrence of a Termination Event or a Total Loss Settlement Date and to be paid without the need for any notice or demand on the relevant Termination Date or the Total Loss Settlement Date, as the case may be.”

The other feature is a form of insurance against loss of the aircraft being leased. In the absence of a way to refigure the insurance on the airplanes being leased to conform with Shari’ah requirements, the sukuk structure provides a way for the sukuk certificateholders to be compensated from the insurance payouts without entering in any non-Shari’ah-compliant transactions. The prospectus describes:

”Pursuant to the Insurance Undertaking SAL shall undertake that: (i) following the occurrence of an Aircraft Loss Event, it shall, on the relevant Aircraft Loss Settlement Date, pay any Aircraft Loss Shortfall into the Replacement Aircraft Account; and (ii) if, following the occurrence of a Total Loss Event, the sum of the insurance proceeds paid into the Transaction Account by the Servicing Agent on or before the Total Loss Settlement Date in accordance with the Servicing Agency Agreement as described above and any other amounts standing to the credit of the Transaction Account on the Total Loss Settlement Date is less than the Total Loss Amount (the difference between the amounts standing to the credit of the Transaction Account on the Total Loss Settlement Date and the Total Loss Amount being the Total Loss Shortfall, it shall pay the Total Loss Shortfall into the Transaction Account on the Total Loss Settlement Date.”

The GE Capital sukuk is an interesting adaptation of a typical ijara structure to incorporate non-Shari’ah-compliant leases without violating the Shari’ah restrictions around the payments on cash balances in reserve accounts, non-Shari’ah-compliant payments from a lease agreement and the applicability of non-compliant insurance for sukuk certificateholders. It incorporates these features into an unsecured sukuk, guaranteed by GE Capital. This demonstrates the flexibility of Islamic finance, but the innovative features of the sukuk—as well as its unsecured nature and guaranteed status—are reminders that there remain questions about whether innovation is always beneficial. For example, is the use of non-Shari’ah-compliant lease contracts that have their non-compliant cashflows stripped out and donated to charity simply a new frontier of transforming conventional financial instruments into Shari’ah-complaint instruments by wrapping (or unwrapping in this case) a conventional financial product?

If anything comes out of the attention paid to the Nakheel sukuk and the questions about its ability to meet the obligations to sukuk certificateholders, it should be a close examination of how new Islamic financial products are structured and what the ‘innovations’ mean for the industry’s future as a whole.

Nakheel semi-annual report as of June 30, 2009

I put together a couple of interesting quotes from the Nakheel financial statements, which are available from NASDAQ Dubai. See the full financial statement for additional details. The numbers included are from various financial statements presented in the semi-annual report.

“In light of the challenging market environment Nakheel has reviewed the carrying value of all its assets to ensure that they are reflected in the financial statements at a prudent estimate of their future recoverable amount. This resulted in impairment and termination charges of AED 13.21 billion in the period. The impairment charge primarily relates to the write-down in the value of land to current fair market levels and the write-down of certain properties under construction relating to projects that have been delayed or scaled back”

“Total liabilities increased by AED4.90 billion in the six months to June 2009 mainly due to increases in accounts payable and accruals which include funds received from a related party”

“Debt maturities occurring in the coming 12 months are being addressed in conjunction with support from Nakhweel’s parent Dubai World”.

Ernst & Young noted that “As discussed in note 2 to the financial statements under “Impact of the Global Crisis on Funding”, the ultimate parent of the Group intends to enter into discussions with its providers of financing on restructuring of the Group’s debt facilities. The outcome of any such discussions cannot be determined at this stage”

Assets include “Loans to a related party” of AED9.769bn as of 6/30/09 compared to AED9.286bn on 12/31/08.

Loans to a related party were AED482.7m in six months to 6/30/09 compared to AED5.93bn in six months to 6/30/08. The balance was AED2.485 billion on 1/1/08, AED 9.286bn on 12/31/08 and AED 9.769bn on 6/30/09 and bore interest at an effective rate of 3% in 2008 and 2.38% in 2009.

Funding received from a related party was AED3.014bn in six months to 6/30/09 compared to AED0 in six months to 6/30/08. The funding received was from Dubai World.

“The Group has received significant funds from Dubai World in the current period and subsequent to the period-end. Furthermore, on 25 November 2009, the Government of Dubai issued a statement that the ultimate parent of the Group [Dubai World] intends to request all providers of financing to the Group for a ‘standstill’ and extension of the maturities of such facilities until at least 30 May 2010. Whilst the management and shareholders remain optimistic, the outcome of such a request cannot currently be determined”

Should Islamic finance move away from unsecured debt?

One of the areas that has preoccupied me when thinking about the Nakheel sukuk and the lessons it presents for the rest of the Islamic finance industry is whether the idea of an unsecured sukuk even makes sense. In many ways, it is an easy uncomplicated change to the typical ijara (for example) sukuk structure. An asset is sold to an SPV (essentially being securitized in the process) that has issued sukuk certificates to raise the purchase price. It is then leased to the issuer over the maturity of the sukuk. However, at maturity (or in a default), the issuer must repurchase the asset under a ‘purchase undertaking’.

This raises several questions for me, especially with respects to the Nakheel sukuk. However, first returning to sukuk in general, AAOIFI ruled in March 2008 that repurchase at par is not acceptable in mudaraba and musharaka where the issuer ‘buys out’ the investor from the partnership at a predetermined level equal to the redemption value of the certificates. However, they also upheld the use of repurchase agreements at the redemption value for ijara. The AAOIFI ruling (pdf)states that “It is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to undertake to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase”. However, “It is permissible for a lessee in a Sukuk al-Ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he [lessee] is not also a partner, Mudarib or investment agent.”

I do not claim to make an argument on this point based on what is and is not permissible or Shari’ah-compliant. I have no basis to argue that the structure used in an unsecured sukuk is or is not Shari’ah-compliant. The issue for me is that seems logical for the investors in a mudaraba sukuk or musharaka sukuk to be forced to share in a profit shortfall. However, it also seems that the same logic should apply to an ijara sukuk. If the value of the asset sold to the SPV declines significantly (like DWF South and Crescent Lands, the two properties backing the Nakheel sukuk), then the repurchase agreement should not be fixed at par if the company defaults on the sukuk.

Granted, if this were the case, there would be far fewer investors (particularly those looking for alternative investments that closely resemble bonds) interested in sukuk and the growth (or regrowth) in the sukuk market would be significantly stunted. However, it would provide at least a format for how a resolution of a default would occur. There would be some discount to the repurchase agreement (a haircut) reflecting the diminished market value of the asset backing the sukuk. This could be any number that is agreed upon in a default. In the event that there was no default and the asset remained at relatively the same valuation as it started, there would be little or no change to the price at which the asset were repurchased.

Returning to the case of a default, the SPV (on behalf of the investors in the sukuk) should have the right to take possession of the asset backing the sukuk and either hold onto it or liquidate it to recover some of the initial investment (it should be secured rather than unsecured). The expected recovery value from taking possession of the assets and selling them (likely into a distressed market environment or at a fire sale price) would provide a floor for the negotiation of the haircut that investors would take. It would also provide a way for the creditors to be secured against total loss (like what may happen to investors in the Saad Group’s Golden Belt 1 sukuk). It would also provide a way for a default to be resolved that does not place the entire liability upon the issuer if the assets turned out to be less than what they were initially worth.

In the case of the Nakheel sukuk, the asset was valued at $4.2 billion based on the development plan for the land that backed the sukuk and also on assumptions about the timeframe for that development (there was a discount rate used for future value to bring it back to a present value). The land itself was not worth $4.2 billion had there not been plans to develop it into the Dubai Waterfront. Perhaps in this case, the ijara structure may not have been appropriate because there was not a physical asset that was worth the price it was sold for at the issue of the sukuk.

It may have been more appropriately structured as a musharaka with contributions of cash from investors and contribution from the land by Nakheel. Then the profits that flowed to the investors could have been based upon the actual realization of profit. However, it would not have been that simple. The sukuk, if it were a musharaka sukuk, would probably have been structured so that the musharaka SPV (owned jointly by the investor SPV and Nakheel) would lease parcels of the contributed land to sub-developers who would then pay lease payments sufficient to make regular payments to the investors and then, upon completion, the developed properties would be sold by the musharaka SPV to redeem investors.

That is just one somewhat hastily constructed example of an alternate structure that could avoid the unsecured nature of the Nakheel sukuk and provide a different risk-return profile for investors who would be joint owners in the land. It would have done nothing to clear up the big problems facing investors, which is the enforceability of contracts and claims to the underlying land (through English and Dubai courts) in Dubai.

That caveat in mind, the lesson that I think should come out of the Nakheel sukuk in particular but unsecured sukuk in general, is that the use of an asset to structure a sukuk with a purchase undertaking to make it into an unsecured obligation of the issuer contains an element of cognitive dissonance . What is the point in using an asset in a structure if it does not actually come into play if events don’t happen as intended.

This question raises more intriguing questions about other more common Islamic finance products that have attracted criticisms of their own , specifically commodity murabaha and tawarruq. These have come under fire from some scholars and critics within the industry because the use of an underlying asset never enters into any real economic activity. One does not enter into a commodity murabaha with platinum with the intention of taking physical possession of the platinum. It is used as a non-currency commodity to structure what amounts to an unsecured loan.

I don’t have an answer; both commodity murabaha and unsecured sukuk are a significant part of the Islamic financial industry and will probably continue to be significant. However, as the industry takes the lessons from the recent defaults, this would be one area where there should be a significant amount of consideration in whether the Islamic finance industry continues its current trajectory or shifts towards a combination of secured debt and quasi-equity products that would match the rhetoric used by the industry better than the current slate of products that relies heavily on structuring unsecured debts.

Dubai Monday news

The creditors of the Nakheel sukuk may try and claim the land underlying the project which was valued at over $4.2 billion by Jones Lang LaSalle in 2006 based on the value of the development plan. This is pretty much the only recourse sukuk holders have if Dubai World cannot make good on the guarantee of the sukuk. Remember, the Dubai World guarantee is granted by a non-sovereign holding company and unless it decides to sell its stakes in the companies it owns, including DP World. Dubai World has announced that it may sell some assets, although it had earlier disclaimed any intention to sell assets which include a stake in Standard Chartered Bank, P&O Ports (a part of DP World, the purchase of which led to controversy because of P&O's U.S.-based port holdings which were divested), luxury retailer Barney's and Limitless.

Any claims on the underlying land would be difficult to enforce, particularly for non-UAE creditors because they may not be able to get a judgment to enforce the mortgages in courts in Dubai or register the land in their names. The sukuk prospectus (as I have described in an earlier post) provides some caution about the legal durability of the structure that was set up using a security agent:

"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."
[...]
"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."

The chances of a positive outcome through legal means, particularly for the international firms talking about pursuing this route are slim and expensive and the land they would get if they prevail is of dubious value (it is more or less empty desert with a few low structures). A lawyer speaking to the Financial Times cautioned: "It’s expensive, time-consuming and unpredictable, and any creditor thinking of taking legal action in this part of the world must understand that from the outset". Another UAE-based lawyer added, "If you are taking action against the government in the courts – good luck to you".

It is possible that the threat of legal action is nothing more than a pressure tactic, based on the negative image problems that Dubai would receive from international investors with a drawn-out legal case. The international creditors led by QVT, an activist distressed debt fund, may be hoping that the bond repayment is eventually made by asset sales of other Dubai World assets. The last week before the maturity next Monday of the Nakheel sukuk will probably feature continued back and forth statements from Dubai World and the creditors. Dubai World is currently in talks with its six largest bank creditors.

After the immediate crisis with Nakheel passes, it will be expensive for Dubai World to refinance its other debts with a across-the-board sovereign bailout having already been ruled out.

Other News

• Gatehouse bank is planning to launch a Shari'ah-compliance trade finance fund.
  
• Prime Rate Capital is launching a Shari'ah-compliant liquidity fund to provide GBP, USD and EUR overnight, call and short-term cash management options.
  

Dubai Saturday Update

The jockeying between Dubai World, Nakheel and the sukuk certificateholders has begun in earnest, following a meeting of the certificateholders amongst themselves on Friday. According to the Financial Times

"Lawyers representing holders of sukuk bonds from Nakheel, the real estate unit of Dubai World, are expected to reject any attempt by the government-owned holding company to call a standstill on its debts."
[...]
"One bondholder said: "We are not going to give the government the luxury of a standstill that avoids default. We expect full repayment, so we are keeping the pressure as high as possible."
[...]
"The move was made as Dubai World seeks to encourage holders of the sukuk to negotiate, placing repayment within a broader restructuring of the conglomerate and its real estate units, Nakheel and Limitless

"As the government pushes for a wholesale restructuring of Dubai World, it may inject cash into these flagging property companies if creditors are willing to compromise, according to a person close to the situation.

"Nakheel groaning under $8bn in debt, is seeking ways to recapitalise its balance sheet to match its short-term liabilities with long-term real estate development plans. The company has had to put on indefinite hold many projects as cash flow and financing dried up.

"Options could include paying out the sukuk at a certain percentage on the dollar, as well as rolling over the sukuk into new debt or possibly granting equity.

"Dubai World did not call a meeting of bondholders 21 days in advance of the December 14 maturity date, a step necessary to approve any standstill request. That raises the prospect of a default if the company does not pay the bonds before the two-week period of grace expires on December 28.

"The government is thought to believe enforcement remains a poor option for bondholders, as Nakheel's assets are located almost entirely in Dubai."

Dubai World has until December 28 to make full repayment on the sukuk to avoid a default, which would then shift the attention onto the ability of the courts in Dubai to judge any claims brought there. These courts would also likely be called upon to enforce any judgments the certificateholders receive in English (or other) courts.

This would be a large challenge to the legal system in Dubai, which is lacking in precedent for anything like the resolution of a default by a government-related entity on its debts and could be further complicated by the complex structure used to ensure the sukuk was Shari'ah-compliance. At this point, the certificateholders could be applying pressure on Dubai World in the hopes of getting better terms from Dubai World and may not necessarily be signaling that they will unequivocally reject either a standstill agreement or a haircut on their debts. However, this will not be settled probably until near the end of the grace period (December 28).

In positive news for Dubai, the FT reports that "On Friday the Dubai government confirmed that it would step in to avoid any default on bonds issued by Dubai Electricity and Water Authority, guaranteed by the government." Unlike the Nakheel sukuk, any default by DEWA would be a sovereign default because of the irrevocable guarantee of the debts, including the Thor Asset Purchase (Cayman) Ltd. notes, that has been accelerated to December 14, 2009 and downgraded to junk (BB- from A-).

What can we learn from sukuk defaults?

Although Nakheel is still technically not in default for its ‘09 sukuk and may repay the full amount due, it is a good time to consider what works and what doesn’t in the world of sukuk. I have alluded to some of what I am thinking in other blog posts, as have others, but I think it should be made explicit what worked and what didn’t. It may still be early for introspection on the future of sukuk and the conclusions may change as defaults are resolved, and with those caveats, I am going to take a stab at it.

What went wrong (Reuters Timeline)

• (Musharaka sukuk) East Cameron Partners $165.67 million, 11.25%. Issued in 2006, due 2019. Company entered Chapter 11 bankruptcy in October 2009
  
• (Musharaka sukuk) The Investment Dar $100 million, LIBOR + 2%. Issued in 2006, due 2011. Company missed regular payment in May 2009.
  
• (Manfa’a sukuk) Saad Group (Golden Belt 1 Sukuk), $650 million, LIBOR+0.85%. Issued in 2007, due 2012. Company missed periodic payment in November 2009 after questions arose in June 2009.
  
• (Ijara sukuk) Nakheel, $3.52 billion, 6.345%. Issued in 2006 due December 14, 2009. Company may be judged in default based on request for standstill agreement.
  

The list above describes some of the sukuk that have run into trouble during the past 13 months. They include companies in Saudi Arabia, Kuwait, the UAE and the US with several different structures for the sukuk they issued. However, there are some differences between the sukuk that I think presents an instructive case for how sukuk could be structured in the future to provide the investors with more protection than they have now, or at least to give guidance on the yield investors will demand for different structures.

The main thing that I think is instructive is the divide between the East Cameron on the one hand and the other three on the other. The East Cameron—the first to run into trouble—was structured as a musharaka where the investors through an SPV entered into a joint venture with East Cameron and the contribution from East Cameron was an overriding royalty interest in 2 leased properties off the coast of Louisiana (which is considered real property under Louisiana law). The ORRI gave the investors the right to a certain quantity of gas over the life of the sukuk. When there was a shortfall in the amount of production and the issuer filed for bankruptcy, sukuk certificate holders filed claim in the bankruptcy case.

The certificateholders claimed that the terms of the sukuk gave them legal claim on the ORRI because it was sold to the SPV as a part of the transaction. The company asserted that it had not in fact been a ‘true sale’ because it was done to create a financing transaction, and was not a ‘true sale’. The company remains in bankruptcy still, but the judge ruled that the sale of the ORRI to the SPV was in fact a ‘true sale’ (there was a legal opinion denoting it as such in the original documentation. This means that the sukuk was in fact asset-backed. For the specific transaction, the property needs to remain registered as being leased by a U.S. Minerals Management Service authorized lessee. As a part of the bankruptcy process, the sukuk certificateholders have extended DIP financing that keeps the lease and finances production.

In contrast to the East Cameron sukuk, the other 3 were all in one form or another asset-based sukuk. That is, they did not give the investors legal claim on any assets. The one partial exception is the Nakheel sukuk, which did provide investors with a share pledge of 18.89% of Nakheel as well as two fully-perfected mortgages over the underlying properties DWF South and Crescent Lands. However, as a Reuters article today describes, the legal environment in Dubai and the UAE is, to put it mildly, not as predictable as in the U.S. where the East Cameron bankruptcy proceedings were held.

” Creditors, including the likes of Standard Chartered, HSBC and Lloyds, have chosen lawyers and auditors to represent them and have yet to respond to the request for restructuring.

Rejection would tip the Islamic bond, or sukuk, into default, opening the door for legal proceedings.

Creditors could sue in English courts as well as in the United Arab Emirates, a seven-member federation that includes Dubai.

But even if they win and a court orders assets to be seized, the sukuk agreement and the UAE's foreign ownership laws cast doubt on whether such a verdict could be enforced, lawyers say.”

The point with this is that the Nakheel, Investment Dar and Saad Group (Golden Belt) sukuk are all in essence asset-based sukuk and therefore investors’ claims are backed only by the full faith and credit of the issuers, not the assets on which the sukuk are based. This is convenient for the issuers and comfortable for the bankers that structured the products, but hardly do much for the investors who may have (wrongly) believed that they had recourse to an underlying asset.

However, that argument should not be construed as an attempt to discredit the use of asset-based sukuk. They are—like conventional unsecured bonds—a useful way for companies to raise financing that may be more attractive than secured debt or equity for the issuers. However, it should be more clear now that an asset-based sukuk is equivalent for investors if there is a default to an unsecured bond. No recourse can be expected against any of the assets used in the sukuk. This may make asset-based sukuk more expensive, but that is how it should be.

On the other hand, asset-backed sukuk may become more widely used if investors are concerned about the ability of an issuer to pay periodic payments and the final redemption amount. If that happens, they will have the ability (in theory at least) to take possession of the asset backing the sukuk and will be more likely to have a higher recovery value than investors in asset-based sukuk. Of course, if anything can be learned from the Nakheel sukuk debacle, it is that there is a wide gap between having a mortgage over property and being able to legally enforce the claim to an asset and take possession. However, it should still be seen as more secure than an asset-based sukuk.

Finally, there should be new recognition that sukuk based on or backed by tangible assets has some limitations in the diversification that investors can create across regions and industries. Many people complain that the replication of conventional finance is the cause of the problem and, while I don’t agree with that perspective, there was an overconcentration in some sectors like property and energy by sukuk investors and when those sectors ran into hard times, there was a general panic about the whole Islamic financial industry.

New forms or applications of sukuk that go beyond the most common forms like ijara could provide financing for a broader scope of projects and industries, which would provide diversification. This diversification, as well as more awareness of the difference between asset-based and asset-backed sukuk can provide for new growth in Islamic finance as well as hopefully some additional stability.

The land backing the Nakheel sukuk

The FT has a great article on the Dubai Waterfront (the site of the collateral for the Nakheel sukuk and the overlapping nature of English and UAE laws and the impact of the Shari'ah-compliant structure of the sukuk. The land backing the Nakheel sukuk is subject to a 50-year lease holding that was transferred to the SPV and is supposed to be repurchased by Nakheel to redeem the sukuk. The investors were granted a fully-perfected mortgage over the land, but the ability to enforce this mortgage under UAE law is uncertain.

Sakoui, Anousha and Robin Wigglesworth. "Sukuk restructuring crunch-point looms" Financial Times, December 3, 2009.

The open desert near Dubai’s Jebel Ali industrial area was supposed to be the site of Nakheel’s grandest vision – the Dubai Waterfront.

Here, the property developer wanted to build a city twice the size of the Hong Kong island, with skyscrapers for 1.5m residents, all ringed by a 75km canal.

But Dubai and Nakheel’s financial crisis has stalled the project, perhaps permanently, making it another multi-billion dollar casualty of the emirate’s crisis.

Unfortunately for Nakheel’s many creditors, the barren, dusty land of the proposed Dubai Waterfront is also the security behind the developer’s $3.52bn (£2.1bn, €2.3bn) Islamic bond, which is due in less than two weeks.
[...]
One of the uncertainties is that many of these financings have been structured to comply with Islamic law, but created under English law. Bondholders in one of the Nakheel bonds, which needs to be repaid with about $4bn on December 14, have the benefit of a guarantee from Dubai World which some investors believe would be enforceable under English law.

Some bondholders are currently in the process of forming a group that would represent in excess of 25 per cent of the outstanding issue, which under English law would be enough to block a restructuring.

Dubai: news & thoughts about the crisis

The National Day in the UAE has quieted the flow of news on the Dubai World debt crisis, which is on its way to becoming more of a Nakheel debt crisis (although there are certainly other companies within Dubai World like Limitless with debt issues). A press statement (pdf) released by Dubai World on December 1 clarified what will and will not be included in the restructuring:

”The proposed restructuring process will only relate to Dubai World and certain of its subsidiaries including; Nakheel World and Limitless World. The process will not include Infinity World Holding, Istithmar World and Ports & Free Zone World (which includes DP World, Economic Zones World, P&O Ferries and Jebel Ali Free Zone), all of which are on a stable financial footing. The total value of debt carried by the companies subject to the restructuring process amounts to approximately US$26 billion, of which approximately US$6 billion relates to the Nakheel sukuk.”

The restructuring process is described in several phases:

”It is envisaged the restructuring process will be carried out in an equitable way for the overall benefit of all stakeholders and will comprise several phases including: long term plans and commitment of stakeholders; determination of maintainable profit and cash generation; assessment of deleveraging options, including asset sales; assessment of funding requirements and the formulation of restructuring proposals to financial creditors and their implementation.”

In short, this sounds like they are going to assess the willingness of creditors to delay repayment for quite a while, then determine whether the businesses have a chance of being profitable and capable of making a profit over that period of time. From there, they will dispose of whatever assets fall outside the profitable parts of the businesses to reduce the debt load on the companies.

While that sounds like a good idea (find out how you can make a profit to pay debtholders), I think it comes down to finding out whether there is any way that the businesses included in the restructuring can repay the debts either through asset sales or through future profitability and then adjust the expectations of the creditors with that reality, which will likely lead to a sharp haircut. The terms of the restructuring that will happen will probably be somewhat negotiated through the media if the investors think they are getting a bad deal. The negotiations are just getting under way

The other event that happened today is a general revaluation of the risks of the other Dubai-linked companies. S&P downgraded six GREs (DIFC Investments, DP World, Dubai Holding Commercial Operations Group, Dubai Multi Commodities Centre Authority, Emaar Properties and Jebel Ali Free Zone to high-yield from investment grade (with the exception of DMCCA which was previously rated BB). In their note, they state that under their ratings criteria “a standstill is a default”. Additionally, “Standard & Poor’s is of the opinion that, as evidenced in the case of Dubai World and Nakheel, the Dubai government is either unable or unwilling, or both, to provide extraordinary government support”.

This last note is the reason for the downgrade and for a lot of the frustration by investors who believed that the government would support the government-related entities, even though they were not legally obliged too. Reuters has a good description:

“‘Companies such as Dubai World can no longer be seen as having the protection of their respective governments. This is true all over the region and not just in Dubai," said Anshuman Jaswal, an analyst with Celent, a Boston-based financial research and consulting firm.

Foreign banks had lent to Dubai government-linked firms on the implicit understanding that they were backed by the UAE -- the world's third largest oil exporter flush with cash from a six-year boom in oil prices.

‘Something that has irritated international investors is that the government distanced itself from Dubai World, which legally speaking is true, but morally speaking, they had gone out of their way before to make that tie,’ one investor said.”

In contrast to that view, Prince Alwaleed says that investors made poor assumptions about the government backing for the GREs, “These banks are very mature banks, and they have to differentiate between a corporate loan and a sovereign loan”.

The Dubai crisis still has a way to go before it is resolved and the impact of the restructuring (of Nakheel more than any other sukuk) will see a return of the uncertainty that plagued the sukuk markets after the AAOIFI ruling and the Saad & Algosaibi, East Cameron Partners and The Investment Dar sukuk defaults. The sukuk market was just returning to a ‘new normal’ with slower growth and smaller sukuk from higher quality issuers than before the crisis, but there were sovereign sukuk from the Islamic Development Bank, Dubai, Indonesia and quasi-sovereign sukuk from the World Bank’s IFC and high-grade sukuk issued by Petronas and GE Capital. This will continue although there will probably be higher yields on non-sovereign government-related corporate to compensate for the “Dubai World” risk that the government might step away in a default.

The Dubai crisis has done one thing; it has empowered the critics of the Islamic finance industry. In the cases where the suggestions are positive this is a great thing. The industry has not done everything perfectly and still has many gaps where a second-best alternative has been adopted (e.g. commodity murabaha/tawarruq for liquidity management). There are also some over-engineered products that do not serve the benefit of anyone but the people who put them together. Critiques of these areas is justified, particularly when sukuk like the Nakheel sukuk which is in essence a relatively simple, uncontroversial structure (with a couple bells & whistles like the pre-IPO rights feature), can lead to such great confusion on the part of investors.

However, other critics argue that Islamic finance should have emerged unscathed from the credit crisis had it not created financial products that mimicked those used in conventional finance. This is false and the longer the recession has continued, the more apparent this has become. Islamic finance is no panacea. It is vulnerable to the economy’s booms and busts and we are definitely facing the latter on a worldwide scale. To deny that an industry that bills itself as being more connected to the real economy than conventional finance could be susceptible to a recession in the real economy, especially this deep into the recession, seems to me to be denying reality.

It has been clear to me that the credit crisis would have an impact on the Islamic finance industry, although not by the same transmission mechanisms as conventional finance. The impact would be secondary. As I wrote in February 2008, “In my opinion, however, the credit crisis does not pose much of a threat to the industry; not because it is fundamentally insulated from the conventional financial industry but because oil prices are still high. The stability of the Islamic financial industry will face its greatest test if oil prices drop significantly, something not particularly likely unless the credit crunch produces a significant fall in demand across the world.”

I underestimated the impact of the credit crisis at that point, but as the recession deepened and oil prices began to fell, I reevauated the impact of the recession on Islamic finance. In October 2008, I focused on the impact of the property bubble that was starting to burst: “Islamic financial institutions are realizing that they're exposed to the credit crisis through their investments in the GCC real estate market which has begun to slow.” Now, the property market collapse in Dubai is spreading into the sukuk market. Fortunately, the UAE Central Bank has stepped in to minimize any transmission from the sukuk markets to the banking institutions, including Islamic banks. If the systemic risk from the Nakheel sukuk is limited, then—amid the writedowns by investors—the Islamic finance industry will have passed another test and should come out stronger on the other side.