The recent debt restructuring of Dubai World and the last minute rescue of property subsidiary Nakheel, which issued one of the largest Islamic bonds three years ago, has shaken the confidence in Islamic finance owing to growing controversy about the interaction of Shariah compliance and principles of investor protection in times of distress. As creditors are about to sign their settlement agreements at the time of writing, there remains general concern about whether Shariah compliance might hamper an orderly dispute resolution under conventional law and about the legal enforceability of asset claims under the current Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) recommendations on sukuk structures.
Overview and Legal Enforceability
The Nakheel case was about to test the legal enforceability of asset claims on Shariah-compliant financial instruments if the instrument were to dissolve prior to maturity [and investors were not fully paid at maturity]. The US$3.5bn Nakheel structure, explicitly guaranteed by Dubai World (but not by the Government of Dubai), was a commercial leasehold interest-based sukuk al-ijara (lease-based) with assets of mostly Dubai waterfront properties (Figure 1).1 While the issuance of sukuk certificates in this transaction was governed by English law, the issuing special-purpose vehicle (SPV) itself was incorporated in the Jabel Ali Free Zone, subjecting the sale or lease of the collateral assets to Shariah-based United Arab Emirates (UAE) law as applied by Dubai courts. However, this arrangement raised questions whether Shariah compliance would uphold legal enforceability of investor claims, and possibly encroach upon dispute resolution under conventional law.
Source: Dubai World, Offering Circular of Nakheel (13 December 2006)
Repayment of Asset Value – Restitution Interest in Asset-linkage?
While Islamic jurisprudence would most certainly have rejected the permissibility of principal protection of sukuk investors, scholarly opinion would have permitted repayment of the original asset value at the time of issuance (which was lower than the nominal amount). According to Shariah principles, in general issuers cannot guarantee principal through re-purchase of underlying assets for a fixed nominal value or offer a credit guarantee. Any re-purchase can only occur at net value or fair market value. However, since the Nakheel transaction involved commercial leasehold properties, the legal action consistent with current AAOIFI recommendations on ijara sukuk would have permitted repayments up to the amount of remaining lease payments or original asset value (which would have resulted in a forbearance on interest).
Shariah courts would have likely ruled favourably on the substantive non-consolidation of collateral assets (‘bankruptcy remoteness’), opening the door for investor recourse. Although Shariah law requires payoffs from state- or time-contingent profit/loss sharing arrangements, this principle is tied to contractual certainty associated with direct ownership. Regrettably, the original terms and conditions of the Nakheel sukuk ruled out such direct asset linkage. Investor claims arising from the sukuk were considered only pari passu asset-based (and not secured asset-backed) handing investors ownership of the cash flows but not of the assets themselves. Relegating investors to nominal holders of securities (rather than actual legal owners of the underlying assets), however, contradicts recommendations of AAOIFI’s Shariah board on sukuk and Shariah principles at large. Since Shariah law would likely to have been applied as a matter of form in the case of Nakheel, the opinion of Dubai courts could have overridden commercial legal concepts stipulated in the transaction prospectus, and quite possibly, requalified the legal nature of the transaction.2 Thus, creditors of Nakheel should have reasonably expected the severity of a likely haircut to be mitigated by some asset recourse if Shariah law had been deemed the forum of dispute resolution and courts enforced direct ownership rights held by creditors (barring extension of sovereign immunity to Dubai World,3 Nakheel’s parent company and ultimate guarantor).4
Consequences from the Nakheel Fallout
What are the wider implications for the sukuk market in the Middle East and elsewhere? Investor sentiment for sukuk issuances has been severely damaged from the Nakheel initial debt standstill and might halt the strong rebound of the sukuk market this year in the wake of continued uncertainty about investor protection. Prior to recent events, developments have been very positive. In 2008, overall sukuk volume dropped to US$17.2bn from US$36.2bn while issuance in the second quarter of 2009 alone already exceeded total issuance in 2008 (see Figure 2). According to the Islamic Finance Information Service (IFIS), US$53bn of the overall US$127bn sukuk market is either sovereign or quasi-sovereign paper. More than 40% (US$23bn) of outstanding sukuk (sovereign and private) is attributable to entities in UAE, of which US$14.8bn was issued by Dubai-based companies, US$6.95bn by Dubai World companies, and US$5.25bn by their subsidiary, Nakheel.
Source: Dealogic, Bloomberg, Islamic Finance Information Service (IFIS)
Focus on Governance and Transparency
In general, the Nakheel case underscores many governance issues that have beset financial innovation in Islamic finance. Considerable heterogeneity of scholastic opinion continues to hamper the creation of a consistent regulatory framework and corporate governance principles. Islamic jurisprudence is neither definite nor bound by precedent in absence of unified principles on which Shariah scholars decide on compliance of new products. Fragmented opinions of Shariah boards have inhibited universal recognition and enforceability of rulings, which has raised the spectre of ‘Shariah risk’ in cases when sukuk are governed by conventional law while the underlying cash flow generating assets are located in countries subject to Shariah law.
At the same time, recent legal charges brought against arrangers of Islamic capital market transactions have further deepened scepticism by confounding the delineation between conventional and Shariah law. In the recent UK court case, the Kuwaiti asset management firm Investment Dar is wrangling over the repayment of a separate type of debt to Bank Blom, a Lebanese bank, on the grounds that the purported wakala (principal-agent) agreement between both firms was not consistent with Shariah law. The English court ruled that the Investment Dar was only liable for the principal and not the profit share. It remains to be seen what the full repercussions are for Islamic finance but there is a danger that the court ruling could set a precedent for other similar cases.
Going forward, the current controversy will raise expectations of enhanced transparency of sukuk structures as recent defaults5 have served as a poignant reminder of many risks that investors had not priced in before. As the differentiation between a private sector-issued sukuk and an issue with implicit government backing has become increasingly blurred over the years, investors will probably like to see explicit guarantees if issuers are seen as quasi-sovereign. Overall, the Nakheel bond issue was the first real test case for Shariah-compliant bonds, and this episode highlighted some areas that will hopefully induce investors to call for a more robust sukuk infrastructure and more clarity on the legal enforceability of claims, including the degree of bankruptcy-remoteness of reference assets, which have historically remained on the originator’s balance sheet. Thus, with new asset-backed structures still rare, greater investor caution paired with fragmented supply will likely make the issuance of sukuk more costly over the short term.
The views expressed in this article are those of the authors and should not be attributed to the IMF, its executive board, or its management. Any errors are the responsibility of the authors.
1 Despite the disclaimer in the Nakheel prospectus that “the Government of Dubai does not guarantee any indebtedness or any other liability of Dubai World” investors perceived the sukuk to be implicitly guaranteed by the government.
2 In general, this relates to the question whether Islamic law governs sukuk by substance or form. If Shariah compliance is treated (only) as a matter of substance and upholds in spirit what was created in form, such as perfected security interest (or agency agreements) as defined by commercial law, then the violation of the Shariah would temper investor interest but not preclude legal enforceability of investor claims. If treated as matter of form, then the opinion of Shariah courts could potentially override the opinion of commercial courts.
3 Under UAE law, no attachment orders can be imposed on other state-owned assets.
4 In the case of the Nakheel sukuk, the land for the Dubai Waterfront is the reference asset behind the Islamic bond, and according to reporting by the Financial Times (3 December 2009), creditors might have attempted to lay claims on some international assets of Dubai World if repayment of the Nakheel sukuk had not occurred.
5 East Cameron Partners, a US oil and gas producer, Investment Dar, a Kuwaiti investment firm, and Saad Group, a Saudi conglomerate, are three issuers that recently defaulted on their issued sukuk.
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