UK government faces uphill struggle to be Islamic finance hub

The UK government established an Islamic Finance Task Force to try again to find its place as an “Islamic finance hub” which it never fully attained before the financial crisis.  The government’s decision not to pursue a sovereign sukuk as recently as 2011 set London back in its ambition to challenge financial centers in the Middle East and Southeast Asia for preeminence.  The stated reason for not issuing the sovereign sukuk was that it did not ‘provide value for money’, which if true strictly on the basis of cost  could turn out to be a shortsighted mistake.  

The London Stock Exchange remains a formidable challenger for any exchange seeking sukuk listings, but the rest of the UK Islamic finance industry is underwhelming at best.  The opportunity cost from not issuing a sovereign sukuk after so many years of market expectation could be a significant headwind that an Islamic Finance Task Force will struggle to overcome.  If the UK hopes to attract capital through sukuk as a result of the task force—something it has struggled with to date—it will need to build credibility that the UK government is not just opportunistically looking to Islamic finance and that may be the hardest thing to do with the shelving of the sovereign sukuk.

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An Islamic covered bond?

Gatehouse Bank issued a 5-year covered bond in December that has quarterly redemption rights for investors. While broadening the available types of sukuk to include the possibility for covered bonds that better align incentives for investors is beneficial, it will likely attract interest primarily from issuers of secured sukuk (and their investors). It is unlikely to attract much interest from unsecured sukuk issuers—who make up the bulk of the market—and are either unable to or unwilling to shift from a sukuk based on an asset to one explicitly backed by an asset. Gatehouse’s granting investors the option for quarterly redemption raises some troubling questions about liquidity management for Islamic financial institutions that offer longer-term sukuk with frequent redemption options.

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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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More Information

• Markaz. 2013. Dealing with Bankruptcy in the GCC: A Key Missing Block in the Reform Agenda.  Available from http://www.markaz.com/DesktopModules/CRD/Attachments/BankruptcyintheGCC-MarkazResearch.pdf
  
• Seife, Howard. 2004. “Bankruptcy for Bankers,” Banking Law Journal, 121(4), April, pp. 341-349.  Available from http://www.chadbourne.com/files/Publication/57a21544-1309-4974-acab-99c9cc612831/Presentation/PublicationAttachment/dcf5e197-7e13-4f70-99e9-9dd7ecfb6fef/BLJ-0404.pdf
• Financier Worldwide. 2012. “10Questions: The United Arab Emirates’ New Insolvency Law,” August. Available from: http://www.financierworldwide.com/article.php?id=9540&page=1
• Reuters. 2012. “UAE new law draft may be delayed until end-2013 –Lawyer,” Available from: http://www.reuters.com/article/2012/12/05/emirates-bankruptcy-idUSL5E8N54WC20121205

On balance, arbitration including Shari'ah experts is positive for Islamic finance

The Kuala Lumpur Regional Centre for Arbitration (LKRCA) announced new rules for arbitration that would allow for the arbitration panel to "outsource Shariah issues to a specialist council or expert agreed by the parties".  This is an important move for Islamic finance because it will provide a process for dispute resolution that incorporates a process for deciding differences of opinion between parties on the Shari'ah-compliance of contractual arrangements.

There will also be a significant ability to enforce arbitration decisions as well since, as the director of KLRCA Sundra Rajoo described in an article (pdf), "Awards under the i-arbitration rules will be enforceable in the 146 countries that are signatories to the New York Convention."  These countries include most of the countries with significant Islamic finance industry presence, including all 6 GCC countries.

In the past, Islamic finance contracts have been subject to either English or New York law, which has little room to incorporate disputes about Shari'ah-compliance.  One of the most widely cited cases was one between Shamil Bank of Bahrain and Beximo Pharmaceuticals, which received financing through a murabaha that included language that "Subject to the principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with the laws of England."

The English courts declined to decide on the Shari'ah-compliance of the transaction saying that only one law could be selected, and that Shari'ah was "merely intended to reflect the Islamic religious principles according to which the Bank held itself out as doing business[, and] not a system of law designed to trump the application of English law as the governing law." (see a description here as a PDF). 

In another case between The Investment Dar and Blom Bank, TID claimed that it was not obligated to repay a wakala facility because the contract was not Shari'ah-compliant (here was my summary).  The courts again declined to hear arguments about whether the contract was void because of Shari'ah-compliance concerns (TID was at the time in financial distress), and the Investment Dar's Shari'ah board, which had approved the transaction when it was signed requested that TID stop pursuing its claims that the transaction was not Shari'ah-compliant.

In July, I was predicting that it might be a long time for something like the KLCRA arbitration to develop the credibility needed to see much movement away from using English or New York law, and there remain some hurdles to be overcome before Islamic finance companies will adopt binding arbitration through the KLCRA rather than litigation in English and New York courts. 

Besides the difficulty of convincing large banks with Islamic windows that they will preserve their rights equally through an arbitration proceeding, I think there will be resistance within the banks based in regions like the GCC to using the KLRCA.  The biggest source of resistance will be the choice of what Shari'ah boards to use to decide on the Shari'ah-compliance of products.  The article linked above as a pdf describes:

"Parties who adopt the i-arbitration rules can opt for one of the two Malaysian councils, as named by the KLRCA – either the council of Bank Negara Malaysia, established by the Central Bank Act 2009 or the council established by the Securities Commission under the Securities Commission Act 1993."

The composition of the Bank Negara Shari'ah Board is overwhelmingly composed of Malaysian Shari'ah scholars, and while several of them are widely regarded and work globally, there is likely to be concern that the BNM Shari'ah Board will adopt Shari'ah standards used in Malaysia which are not all accepted by GCC-based Shari'ah scholars. 

For example, what would happen if a GCC-based Islamic bank with a Malaysian subsidiary was taken to arbitration by a counterparty in Malaysia, and the arbitration panel found that the GCC-based bank had to pay compensation to the counterparty that the GCC-based Shari'ah board said would fall afoul of Shari'ah.  It would not be possible (as it would be if the two parties were in reverse position in the arbitration) for the GCC-based bank to purify the settlement by donating the proceeds to charity since in this case it is being required to make a payment.  Likely it would be regarded as a de minimis item and allowed as a one-off occurrence.

But, if that happened, the Shari'ah board and boards of other Islamic financial institutions outside of Malaysia might make a push to require that future arbitration clauses specify that the Shari'ah board not be the BNM Shari'ah board, which would require additional arbitration centers in different regions.  This could limit the adoption of the KLRCA standards from then on.  It is likely that this will be the end result regardless, and the development of the KLRCA as an arbitration center will hasten this process, so it might be a good long-term development even if it could cause angst in the short-run. 

The development of an arbitration process for Islamic finance is on balance good, in my opinion, for the industry's long-term development and it is not surprising that it originates in Malaysia, where there is a national Shari'ah board.  In order for other arbitration panels to develop, I think there will have to be some standardization of Shari'ah opinion, whether on a national or regional basis.

The one concern that could arise is that arbitration (which would include an ex post review of the Shari'ah-compliance of a transaction) could lead to "Shari'ah risk".  Generally speaking, Shari'ah risk is the risk that a transaction that is approved by a Shari'ah board today could be ruled later as non-Shari'ah-compliant.  With the exception of the unsuccessful challenges by Beximo and The Investment Dar, there has been a general trend that a transaction that was approved by the Shari'ah board will not be challenged later on Shari'ah-compliance grounds.  Incorporating Shari'ah review into arbitration processes would change that and increase Shari'ah risk, which could slow the growth of Islamic finance, or increase costs. 

TheCityUK report on Islamic finance

TheCityUK, the trade group for London's financial services industry released its annual report on the Islamic finance industry, showing the growth of the industry to $1,130 billion in assets at the end of 2010 with an estimated growth in 2011 to $1,289 billion. This report is useful because at this point there are several years of report to look for trends, in part to identify areas where the data are more or less likely to reflect reality.  The Islamic finance industry is notoriously opaque, so hard data, even data on the aggregate size of the industry, are unreliable. 

For example, on of the areas that I am skeptical of the data is the inclusion of the Iranian financial institutions.  The reason why I am skeptical of the Iranian data is that, despite accounting for 36% of total assets and facing tight international sanctions, there has been no spillover to the rest of the Islamic finance industry in terms of growth.  Viewed a different way, as of the end of 2006, Iranian Islamic financial institutions had $154.9 billion in total assets as of the 2008 version of this same report.  By 2010, this had increased to $388.0 billion, an annualized growth rate of 26%.  The Iranian economy was growing during this period (pdf, page 5), but with international sanctions tightening, and limited financial market development and integration with other markets for Islamic finance, it is unlikely, in my opinion, that the Iranian Islamic finance industry grew at a more rapid pace than the Islamic finance industry in the rest of the world.  Another factor that casts doubt on the rapid growth is that the banks that would represent much of this growth are specifically targeted by sanctions, and are also large banks (it is much harder for a big bank to achieve and sustain such a high growth rate). 

However, the rest of the report is worth reading because there are few other sources of data on the industry as a whole.  For example, a new table this year (I think) shows a data series of the average management fee of Islamic funds.  The interesting thing in the table is that the average management fee has been declining from 2006 to 2011Q1, from over 1.5% to just above 1.0%.  This is a positive development for Islamic investors, but may hamper the entry of new fund managers.  However, one area where growth is due is in fixed income funds, which only make up 6.8% of total assets under management in Islamic funds.  The demand for Islamic fixed income funds is likely to be strong, since there are few offerings and it is difficult for all but the largest investors to invest directly in a portfolio of sukuk.  The upside from the fee perspective is that most conventional fixed income funds charge lower management fees than equity funds, so prospective entrants will be less concerned with the dropping average management fee in the Islamic fund space.