Thursday, December 03, 2009

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.

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