Global Edge, Cerulli Associates, February 2010
In December, world markets reacted strongly to the news that an expected default on a US$3.52 billion sukuk issue from Dubai’s Nakheel Developments would not now take place, following a US$10 billion bailout by the Abu Dhabi government. For creditors in the Nakheel sukuk – the Islamic equivalent of a bond – the news was clearly good: only weeks earlier they had been told that Dubai World, the state-owned holding company that includes Nakheel, was entering a debt standstill and that they would have to wait indefinitely to get any of their money back. But one can also argue that Nakheel’s step back from the brink is a lost opportunity.
How so? Well, the Nakheel/Dubai World standstill represented something that has to happen at some stage, but hasn’t yet: a default in an international sukuk. Without it, uncertainty hangs over the whole sector and impedes its maturity. That, in turn, hinders its development as an asset class for fund managers.
The sukuk industry is youthful and most of its activity has taken place in the last decade. Zawya, a research group in the United Arab Emirates, calculates US$106.6 billion was raised through 747 sukuk issues between December 1996 and September 30 2009, the majority of it since 2002, and that more than 90% of that total is still outstanding, with only US$12.6 billion having matured so far. At a local level, defaults have happened and been worked out in Malaysia’s sophisticated ringgit sukuk industry, but in the more complicated global, cross-border deals, they remain an unknown quantity. Two have happened in the last 18 months – Kuwait’s Investment Dar, and the US-based oil firm East Cameron Partners, which is under Chapter 11 bankruptcy protection in the US and has a sukuk outstanding that will be impacted by that filing. But neither has yet made it to court so not much can be learned from either.
A Nakheel default – on the biggest sukuk ever launched – might have answered a lot of questions about how the sukuk market works when, as must inevitably happen from time to time, things go wrong. That would have helped to create a path for the future which, in turn, would give investors a clearer idea about the level of risk they are entering into when they buy a sukuk.
A sukuk behaves broadly like a conventional bond, in that it pays out a predictable and regular amount over a pre-agreed period of time. Its key difference from conventional finance stems from the fact that in Islam, riba, or interest, is prohibited. So sukuk use the cashflows of an underlying asset, usually a property, to pay out a regular income stream. While this may sound like just semantics, the point is that money isn’t just turning into more money without doing something else – which is what happens with interest on a bond – but is instead a sharing of the profits being created by a tangible asset. In Nakheel’s case, this was a 50-year leasehold on two plots of land in the Dubai waterfront.
So the first question many people have is: if things go wrong, what are the rights of the creditor to the underlying asset? Some investors believe that, had Nakheel defaulted, they ought to have had rights to those underlying plots of land (or at least the leasehold on them). Others believe that, unless it’s specifically stated in the documentation, the creditor’s rights are instead to the obligor’s balance sheet – and that the underlying asset is only there to make the whole thing Shariah-compliant, not to serve as collateral. This latter is the norm in Malaysia, where these issues have been successfully tested by the courts. We don’t now know what the answer would have been for Nakheel.
Things are much more complicated in an international than a domestic deal. A Moody’s analyst, studying the sukuk, says that in the case of Nakheel, different parts of the structure fall under different legal codes. 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 share pledge, amongst other things, are under UAE laws – which are Islamic. That would have a big bearing on the enforcement of rights in a default. And, even those areas that are governed by familiar and commercially-savvy English law are not clear cut, because any English judgment would need to be enforced locally.
And for that, consider the position of the creditor, going after Nakheel assets – owned, ultimately, by Sheikh Mohammed bin Rashid Al Maktoum, Dubai’s emir. Who’s going to go into a court (in which there is a symbol of the ruler behind the judge) and say: “Give me that land. It’s mine”?
In practice, for this reason and the general reluctance of creditors to head to the courts in the Gulf, Nakheel would almost certainly never have made it to court but instead been hammered out in a behind-the-scenes restructuring – but this, too, would have been instructive. A Nakheel default would have told potential buyers in any global sukuk just what they should expect – what they really own, where they would rank in bankruptcy restructurings, what their recourse is to assets in different jurisdictions and under different laws.
One good thing that does appear to have come out of the confusion is the promise of a new bankruptcy law. One of the things creditors, and market-watchers generally, had been so concerned about as Nakheel approached default was the lack of clarity about bankruptcy and the whole process of pursuing a debt. This, too, is an area of difference with Malaysia, where the bankruptcy legislation is clear and tested. When Dubai announced the Abu Dhabi bailout in December (in a statement from the chairman of Dubai’s Supreme Fiscal Committee), it announced a new bankruptcy law in the same release, saying: “The law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations.”
That, at least, does represent some of the dispute resolution maturity that the industry needs to grow further. And this matters considerably to portfolio managers in the region. So far, sukuk-only funds are reasonably rare: examples are from Dubai’s Algebra Capital, in which Franklin Templeton owns a stake, and some newer Saudi Arabian asset managers such as Jadwa Investment Co. But, although it’s difficult to track, sukuk are much more widely held than that, and not just in the Middle East. In recent years the yield pick-up offered by sukuk over some conventional bonds, coupled with the supposed security of being underpinned by real assets, have seen sukuk move into portfolios run by conventional asset managers worldwide too. Prominent holders of the Nakheel sukuk are understood to include BlackRock, Ashmore and the New York hedge fund QVT Financial.
The sukuk market faces other challenges too. One is that, again notwithstanding Malaysia’s domestic market, they just don’t trade: there is hopelessly thin secondary market liquidity because supply is still exceeded by demand and people who buy them don’t want to sell. Also, there are a number of different structures used for sukuk, and the most commonplace was recently denounced by one of the world’s leading Shariah scholars, Pakistan’s Sheikh Taqi Usmani, in a speech that appeared to suggest that 85% of non-ijarah sukuks were not Shariah compliant at all (ijarah is a type of structure that is increasingly commonly used for sukuk in the Middle East, but less so in Asia). This raises another issue: standards on Shariah compliance vary between the Middle East and southeast Asia, and even within Gulf jurisdictions, which impedes cross-border sales and trading of sukuk.
Nevertheless, the fact that this youthful market faces challenges does not suggest it lacks a vibrant future; these are necessary teething troubles from which the sector has the potential to emerge stronger. More sukuk mutual funds are bound to follow in due course, while the presence of individual sukuk in global conventional debt portfolios is here to stay. It’s just that, for true acceptance globally, there has to be clarity on what happens when things go wrong – because sooner or later, they always do.