Sunday, February 17, 2013

The GCC embarks on the journey of developing a bankruptcy regime

The financial crisis of 2007 -2009 did not spare the GCC region or Islamic finance as many real estate-related companies, and some financial institutions with exposure to this sector, either failed or were forced to restructure their debt.  A number of these companies had Shari’ah-compliant financing that was involved.  One of the most well known is Nahkeel Development Company whose $3.52 billion sukuk led to the Dubai debt crisis.  

Kuwait Finance Centre (Markaz) released an interesting report in January 2013 (PDF) detailing how much development the GCC needs to implement bankruptcy legislation that meets international standards.  There have been some efforts—some more successful than others—like the Dubai World Tribunal (established by Decree No. 57 of 2009) and Kuwait’s Financial Stability Law which was passed in March 2009. 

The primary resolution in the GCC for corporate defaults is either liquidation of the company or a consensual restructuring of the debt obligations.  There is no established process for distressed companies to enter a court-led process that aims first for the restructuring of debts and the reorganization of the business so that it can become viable, as there is elsewhere (e.g. the Chapter 11 reorganization process in the United States).  Markaz described: “A closer look reveals that the Bankruptcy laws in GCC are primarily liquidation laws and are insufficient to help an ailing company to restructure its debt so that it can continue in business.” (emphasis in original). 
Markaz further comments that:

“There is a stigma associated with bankruptcy in the GCC, which makes filing for bankruptcy protection almost unheard of in the region. This is both due to the cultural stigma attached in addition to the inadequacy of regional bankruptcy laws where they exist.  The lacking regulation and legal framework came into focus with the financial crisis whereby many firms in the GCC encountered debt and insolvency issues with very little in the way of legal recourse for resolution.

The primary outcome of the financial crisis-related defaults by GCC corporates, including the government-related enterprises like Nakheel was that creditors were forced into some form of restructuring through an ad hoc arrangement outside of any established legal process and where an emergency legal process was imposed, it was subject to either significant uncertainties (e.g. Kuwait’s Financial Stability Law) or was limited in scope (the Dubai World Tribunal established by Decree No. 57).  It should not be surprising—nor is leveling too much criticism in hindsight particularly valuable—since many countries even where there were established bankruptcy laws resorted to one-off or otherwise unusual resolution processes for the financial sector following the financial crisis. 

However, the recent experiences do highlight many areas where improvements can be made so that future defaults can be better managed without leaving the restructuring to be done outside of an established process.  Because, while some restructuring outside of periods of financial crisis may proceed relatively smoothly (e.g. the restructuring of the $1bn Dana Gas sukuk) with minimum market disruption, it relies too much on the hope that there will not come a time when a voluntary restructuring agreement cannot be reached. 

A stopgap measure for some companies will be to use the bankruptcy law of another country, like Arcapita did with its Chapter 11 filing in the United States (PDF), which has led to a proposed reorganization plan that will allow the company to leave Chapter 11 and conduct an orderly exit from its investments with a formalized process for splitting up whatever value remains for the secured and unsecured creditors.  But, not all companies are eligible to file for Chapter 11 bankruptcy (which requires some assets in the US, where Arcapita had an office and many of its investments).  As an article on cross-border insolvencies by Howard Seife, a lawyer at Chadbourne & Parke LLP (PDF) explained:

“Section 109(a) of the U.S. Bankruptcy Code permits a Chapter 11 filing in a U.S. bankruptcy court by a person (defined in Section 101(41) as including a corporation) ‘that resides or has a domicile, a place of business, or property in the United States.’  Cases that have considered the ‘property’ requirement with respect to foreign corporations have found it satisfied by even a minimal amount of property located in the U.S.”

For example, the Dana Gas sukuk, where assets were located in the UAE, Egypt and Iraq would probably not be able to take advantage of the Chapter 11 process if it had failed to restructure its sukuk.  It could, instead, let creditors take Dana Gas to an English court (which was the law chosen for most of the dispute resolution for the sukuk), but as the prospectus notes: “in respect of foreign court judgements, the UAE courts are unlikely to enforce an English judgment without re-examining the merits of the claim and may not observe the choice by the parties of English law as the governing law of the transaction.”

The UAE is addressing one aspect of the problem with a new bankruptcy law that was expected to be enacted by the end of 2012, but it has since been pushed back to late 2013.  A managing director at Deloitte Corporate Finance explained the purpose of the new law as “provid[ing] a method by which stressed and distressed companies can either come to a place where they are able to resume trading profitably and to the advantage of all parties, or be wound up and liquidated in a controlled manner.”

Reuters reported that the draft law is likely to be based on the French bankruptcy laws, which is debtor friendly (the US’ Chapter 11 process is also viewed as being debtor friendly). 

The development of a bankruptcy resolution process is positive, and even with a delayed development of a bankruptcy law in the UAE will help attract investors.  If it is based on the French or US bankruptcy law, as indicated, it could allow for either reorganization (where the company remains in business with a modified capital structure where, for example, some debt is converted to equity) or liquidation, depending on whether the business is seen as viable.  However, as the Markaz report highlights (specifically in the table below), there are other factors that are important besides just the reorganization laws.

Islamic finance and sukuk in particular, the first three rows in the table are of particular importance.  Many sukuk issued by GCC corporates and governments are not rated and while ratings agencies have taken significant criticism following the financial crisis for the high ratings they gave to what turned out to be low quality securities, they can still provide information to investors.  Currently there is no requirement for new sukuk to be rated (e.g. in order to be listed), whereas Malaysia requires a rating for any sukuk that are offered to the retail market.

The second and third rows are all important as well in developing the ability of sukuk holders to take possession of the underlying collateral in asset-backed sukuk.  Currently, sukuk holders can enforce on some collateral because the sukuk are based on English law (mostly), but they are limited in enforcing on collateral within the GCC region.   

If more sukuk are issued using an asset-backed structure, which is often suggested as being preferable compared with the asset-based sukuk that mimic unsecured bonds through a purchase undertaking by the issuer, there will need to be the ability of sukuk holders to take possession of the asset to sell it to recover some of their investment if a sukuk defaults.  That will probably not happen in the near-term, but in the context of thinking about the role of a bankruptcy process in the GCC, it should not be ignored either.  

In the end, there is not a well-developed process for bankruptcy in the GCC and, particularly in the wake of restructurings necessitated by the financial crisis, might have held back the sukuk market (although from the growth in new issuance, it has not had a dramatic effect).  It is good to see the problem acknowledged and first steps made to fix the problem, but it is just the beginning of the process since even when laws are enacted it will take a while for enough cases that use the bankruptcy process to create certainty for investors about what they can expect if the issuer of the sukuk they buy needs to use it.  

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