Dubai ducks default – a relief but an opportunity missed

Asiamoney, December 2009

Dubai went to the brink – and it’s still there. Abu Dhabi’s decision in December to supply Dubai with $10 billion for debt repayment allowed it to forestall, at the very last moment, a default on the world’s largest ever sukuk – the $3.52 billion Nakheel Developments issue which matured on December 14. But it doesn’t repair Dubai’s tarnished reputation as a financial centre and issuer, or give any reason to suggest investors will rush back to help Dubai refinance the $100.6 billion of outstanding debt Moody’s believes Dubai Inc owes, $12.5 billion of it due next year. And it leaves significant questions unanswered about the credibility of the sukuk industry that has become a bedrock of global Islamic finance.

It is in some sense a shame that Nakheel didn’t enter formal default. While that sounds absurd, professionals across the Middle East and the Islamic finance industry globally had become increasingly sanguine about a potential Nakheel default, believing it would have answered vital questions about just what happens when a sukuk turns bad.

These, after all, have never been answered or tested satisfactorily. The sukuk market has grown with mercurial haste in the last 13 years: The UAE-based research group Zawya says there were $106.6 billion of sukuk raised in 747 issues between December 1996 and September 30 2009, most of it since 2002. But such is the sector’s youth, well over 90% of that total is still outstanding: to date only $12.6 billion has matured. Consequently, outside of Malaysia’s more mature domestic sukuk industry, there has been hardly any experience of default. Two did fall in the global financial crisis – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which has a sukuk outstanding but has filed for Chapter 11 bankruptcy protection – but since they have yet to make it to court (and may never do so), it is hard to learn much from them yet.

There is a feeling, therefore, that this had to happen sooner or later, to answer that nagging question: what if? What happens when something goes wrong? For this reason, after the initial shock when Dubai announced a debt standstill and a $26 billion restructuring including the Dubai World state-owned holding company and its Nakheel Development subsidiary, market practitioners had started to look forward to a little clarity.

“In a sense, defaults in a type of transaction reveal the actual rights held by investors in that type of transaction,” says Ayman Adel Khaleq, partner at Vinson & Elkins in Dubai. “Pure economics aside, the defaults facing various sukuk in the current market are therefore not entirely negative occurrences.”

The same sentiment was echoed all over the world in the weeks up to Abu Dhabi’s intervention. “The sukuk market is growing up,” said Dino Kronfol, managing director at Algebra Capital in Dubai, one of the few Gulf asset managers to run a mutual fund investing exclusively in sukuk. “Nakheel will be an opportunity to set some important precedents. First and foremost, we are going to have a better understanding of what the path is going to be like post-default.” Three thousand miles east in Malaysia, Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, said: “There’s always a silver lining. What is happening now will make the market even stronger in future because it will cause people to build the necessary framework and infrastructure to make sure these things do not happen again.” Well, maybe now they won’t.

So what’s at issue here? Part of the uncertainty is structural. The principle of a sukuk is that it replicates the mechanics of a conventional bond in a Shariah-compliant way. In Islam, riba, or interest, is prohibited: money can’t just turn into more money without doing something else. So instead, sukuk use the cashflows of an underlying asset – typically a property – which pay out an income stream. In Nakheel’s case (there are actually three separate sukuk worth $5.25 billion maturing between December 2009 and January 2011), that’s a 50-year leasehold interest in two plots of land within Dubai Waterfront. In a sukuk, the return is a share of profits among the creditors.

But if it goes wrong, it’s not clear what the rights are of creditors to the underlying assets. Unless it’s specifically stated in the documentation, a creditor’s right is not typically to that cash-generating asset – which is there chiefly to ensure Shariah compliance – but to the obligor’s balance sheet, which can be a very different proposition. Also, the ethical stance of a sukuk is an equal sharing of profit and risk. Well, if it all goes sour, doesn’t this principle of equal sharing alleviate any obligation the issuer has to continue to pay out if it feels it can no longer do so?

Nobody is entirely sure. “Until recently the growth of the sukuk market has been driven more by an abundance of financial resources than by, for example, regulatory or legal considerations,” says Khaleq. “In conventional finance and investment markets, the post-default path is well worn.” Consequently when you structure and document a new conventional bond, you take into account a worst case scenario like a default or insolvency, based on what you’ve seen happen before. “Precedents indicating what such a scenario may entail are readily accessible. The same cannot yet be said for Islamic transactions, particularly in debt capital markets.”

Abdul Ghani says in Malaysia, through experience, these things are understood and therefore practised. “The majority of sukuk are unsecured paper, and there is no expectation whatsoever on the part of the creditors for using the underlying asset to get back their money,” he says. “That asset is just there in a transaction to make it Shariah compliant, it is never intended to be collateral.” Instead, creditors can seek a liquidation of a sukuk, in a process well established over the years in Malaysia’s courts. And this, really, is the difference: experience. “One of the major things that is missing in the Gulf is the bankruptcy law,” he says. “That’s not fully tested.”

One other area Nakheel could have shed some light is the issue of multiple jurisdictions. There are major challenges with different bits of a sukuk being covered by different laws and codes. Khalid Howladar, an analyst specialising in sukuk for Moody’s, says that the declaration of trust, the transaction administration deed, agency agreement, certificates, co-obligor guarantee and the Dubai World guarantee are governed by English law. The purchase agreement, lease, mortgages and the share pledge, among other things, are under UAE laws – which are Islamic. “This complicates issues such as enforcement of rights,” he says. “Ultimately, even an English judgment will need to be enforced locally, and given the conflict of government ownership of the entities involved, as well as the immaturity of the legal environment, it’s not clear how transparent or fair local courts would be.”

In truth, nobody in their right mind would have taken Nakheel’s backers – ultimately, Sheikh Mohammed bin Rashid Al Maktoum, emir of Dubai – to court in the United Arab Emirates. “It’s a brave person who stands up in court and says to him: ‘that’s mine, not yours’,” says one banker. “When you go to court in Dubai, there’s a symbol of the ruler behind the judge. Are you going to go into that court and ask for the ruler’s assets?”

Kronfol also doubts the point of going to court. “It’s never helpful. And even if you got the court to give you access to the asset, why would you? It will be complicated – you won’t own the land, you’ll own a lease, and that land is just desert with a fence around it. You’re much better off with a planned restructuring.”

The sukuk market has a host of other challenges to deal with besides: a lack of secondary market liquidity anywhere outside Malaysia; the damning remarks recently by leading scholar Sheikh Taqi Usmani from Pakistan, who said 85% of non-ijarah sukuk issues were not in compliance with Shariah law, undermining the credibility of the entire industry; and divergent standards on compliance between the Middle East and southeast Asia. Issuance more than halved between 2007 and 2008, to $15.4 billion, although it did rebound to $16.2 billion in the first three quarters of 2009; issuance is driven by southeast Asia rather than the Middle East, with the Gulf nations accounting for only 16% of issuance in the first half of 2009.

But despite this continuing lack of clarity about rights and processes, the market itself will no doubt persevere. In particular, few in Malaysia – whose US$66 billion of outstanding public and private sukuk at the end of June 2009 accounted for 62% of the total outstanding sukuk globally, according to Bank Negara Malaysia – feared much contagion even when a default was on the cards. “The Malaysian ringgit sukuk market will be isolated from this incident,” says Abdul Ghani. “It’s a domestic market with its own framework, its own infrastructure, its own investor base. It’s the most mature sukuk market and its activities have been tested in court, in restructurings and reschedulings since 1990.” He did, though, expect dollar sukuk issued from Malaysia to struggle to tap Gulf investors “as most of them have been affected by Nakheel.” For its part, Bank Negara Malaysia told Asiamoney a default, if it came, would be “a credit issue on a particular issuer” with “no systemic impact on the Islamic capital market” and “no adverse impact on the overall sukuk market in the long run.”

That said, the market will evolve. Ernst & Young expects more sovereign issuance, including European and Asian issuers such as the UK and South Korea; others say investors are likely to show a preference for those from wealthy companies with assets to back them – such as oil for Abu Dhabi, and gas for Qatar. Efforts are likely to increase to build secondary market trading in sukuk – Saudi Arabia is already trying this by introducing sukuk trading on the Tadawul stock exchange, and the Islamic Development Bank proposes to launch an investment bank to create an Islamic interbank market. And, more than anything, even if Nakheel’s survival has deprived the market of a chance to learn more about creditor rights, the future must involve an evolution of structures that makes these things more clear. “There is going to be an increased push for transparency and better governance,” says Kronfol.

But today, the whole market looks tarnished. As Asiamoney went to press, the great and the good of the Islamic finance industry were meeting in Bahrain for the landmark annual World Islamic Banking Conference. “We were expecting to be able to celebrate the triumph of Islamic finance over conventional,” says one person in attendance. “In the last year most Islamic bankers have been saying: ‘look at us, if people had worked with us they wouldn’t have lost any money’. Well, nobody is saying that right now.”

BOX: Dubai

Sheikh Ahmad Bin Saeed Al Maktoum, the chairman of the Dubai Supreme Fiscal Committee and uncle of Dubai’s ruler, had some soothing words to say when he announced the $10 billion bailout of Dubai World on December 14. There was talk of “our strong commitment as a global financial leader to transparency, good governance, and market principles.” He wanted to “reassure investors, financial and trade creditors, employees and our citizens that are government will act at all times in accordance with market principles”. And he promised: “Our best days are yet to come.”

It is to be hoped so, because the two weeks prior to his statement are never going to appear in any précis of Dubai’s best days. Credit and stock markets worldwide were delighted at the news, but that doesn’t mean are going to forgive Dubai’s conduct in a hurry. That’s going to matter when Dubai comes to refinance its other debt.

One of the biggest complaints that came after the announcement of the standstill was that people felt misled: that they had assumed the state would stand behind its subsidiary companies. Nakheel – “where vision inspires humanity”, as its tagline continues to trumpet – is the backer of the vast palm-shaped property developments that are sprouting into the Gulf, among the most iconic projects in this most ambitious of cities. Nakheel, in ownership and symbolism, is Dubai.

In fact, the 237 page prospectus for the sukuk itself contains no mention of state backing, which has led some to question the wisdom of investors and rating agencies in their approach to assets like the Nakheel issue. “As there were various risk factors listed in the Nakheel sukuk prospectus, a clear statement that Dubai World depends on its subsidiaries, and none actually giving any indication that the Emirate of Dubai would pay for Nakheel in case of insolvency, the original rating based on implicit sovereign support seems to be exaggerated, and not really wise,” says Michael Salah Gassner, a banker and founder of the website islamicfinance.de.

On paper, that’s clearly true, but what muddied the waters was the apparent statement of support from Dubai’s leadership – right up to Sheikh Mohammed – in the weeks and months before the standstill announcement. “A few weeks ago Sheikh Mohammed publicly said the Dubai economy was in good shape and he didn’t expect any more problems for it,” says Douglas Hansen-Luke, CEO for the Middle East at Robeco in Bahrain. “I am sure there are no records anywhere of him explicitly guaranteeing the debt of companies in which he is the largest shareholder. But at the same time there are no explicit statements until these last two weeks that he would not stand by them. And it would certainly be true to say that the vast majority of the investment community thought they were almost pari passu.” And, in the end, it appears it was.

Hansen-Luke stresses there is another side to the coin. “The ruler in Dubai has got the opportunity to show two things – one, that Dubai is a normal economy, where companies that invest soundly and are in the right markets will do well, and companies that don’t will become smaller, restructure or close – that’s the nature of capitalism. It’s good for people to see this is a capitalist economy and nothing is too big to fail: that is a positive message. The other is that Sheikh Mohammed will not tolerate corruption or wrong-doing. That’s also very positive for the long term future of Dubai. But to get that right in the near term, a third element is needed, which is transparency.” And this is really where the greatest hand-wringing is taking place: the sense of being surprised, of being in the dark.

This is only the first stage of Dubai World’s restructuring so there is much to be worked out. “This really is a key moment in Dubai’s evolution,” says Khalid Howladar at Moody’s. “If it hopes to retain and improve its position as a financial centre it needs to show fairness and transparency in its restructuring.”

One thing in particular infuriates foreign investors: that the standstill was announced immediately before a four-day public holiday, letting uncertainty and rumour drive world markets until Dubai got back to work. And the bailout, when it came, was a matter of hours before the sukuk would have entered technical default. Investors don’t like a white knuckle ride like that, particularly on what they thought was state-backed paper; many will doubtless think twice before rushing back to Dubai.

“The direct impact of the standstill and the relatively small amount of money involved,” says Hansen-Luke, “is much less important than the impact on perception and credibility.”