The near-default of Dubai developer Nakheel's Islamic bond will trigger calls for better bankruptcy rules in the Gulf as investors wake up to legal and financial risks now that the boom years are over.
Sukuk are fixed income products that behave like conventional bonds but don't pay interest - which is banned by sharia law - and roughly offer the same protection as an ordinary unsecured corporate bond in case of a default.
A large number of Islamic bonds are construed under English law, but investors will often need to go before a local court even if a UK judge rules in their favour, because few Gulf countries have enforcement treaties with the West. That can greatly complicate matters. "Each Gulf country has a bankruptcy code and in many cases that bankruptcy code is antiquated compared to countries like the UK or the US that had 200 years to develop," said a source at a large law firm in the Gulf region, asking not to be named because of client sensitivities.
Problems may arise from rules that cap payable interest, through the lack of binding precedent and through a lack of knowledge of the local system and how it works. Dubai narrowly averted becoming the stage for the highest-profile sukuk collapse to date when its neighbour Abu Dhabi threw it a $10 billion lifeline, enabling the $3.5 billion sukuk to be repaid.
Dubai, seeking a wider standstill on its $26 billion debt pile, hastened to say it would implement insolvency law modelled on international practices, and set up a tribunal to deal with Dubai World's debt restructuring. "Anything that brings in first-world legislation, and I mean Western concepts, is going to be a step forward because this is a complex area and you need modern legislation," said the source at the law firm.
Originally set up to give devout Muslims access to state-of-the-art financial engineering, Islamic finance in its heyday quickly became a means for Western investors to earn high yields and for banks to rake in fat fees. It was at the height of the credit boom in end-2006 that Nakheel issued its sukuk, following hot on the heels of a similar $3.5-billion deal for Dubai's Ports, Customs and Free Zone Corporation (PCFC).
Barclays Capital and Dubai Islamic Bank were the banks selling these sukuks, which were both convertible into equity ahead of a mooted flotation. They were very large compared to other Islamic or equity-linked products. "In 2006/7, a lot of so-called Islamic money was only there for the yield," said an emerging markets debt official at a bank not involved with either of these two bonds.
Western banks, whose business overwhelmingly relies on precisely the interest income that sharia forbids, were the main issuers of sharia-compliant products. Investors often seem to have glossed over the legal and financial risks in such products, bankers and lawyers working in the sector say, despite the fact that the documentation is clear and lists all of them.
"There are all sorts of things you have to think about when you buy these products and when you look in the offer documents you'll see there are significant risk events," said Roger Wedderburn-Day, a partner at Allen and Overy. "But it never seems to have stopped anyone, and people have been happy to invest in these things notwithstanding the reasonable enforcement risk," he said. Part of the confusion may have stemmed from the way sukuk is engineered to provide fixed payments that aren't interest. Typically, this involves paying rent for an underlying asset, such as land or real estate.
But investors have no security over the asset if the issuer gets into trouble, unlike in structured finance products such as mortgage-based securities. Sukuk may be asset-based, that does not mean they are asset-backed. "A sukuk is a fixed-income instrument which mimics the characteristics and the risk profile of an unsecured corporate bond and that is it. There's nothing more," the first source who works a large law firm said.
"People have different views but they're wrong." The Nakheel deal was of the Ijara variety, the most common type, where a special purpose vehicle sells the sukuk to investors. The SPV bought assets from Nakheel, which then leased them back, providing the SPV with periodic payments.
Had Nakheel defaulted, the SPV would have merely become an unsecured creditor. The upshot is that sukuk are roughly as risky as any emerging market unsecured bond, Islamic or not. The legal risk is bigger than a cross-border deal in the West, but not because they are Islamic finance products. And even the legal risk may not be so insurmountable as it looks. Paying rent is a common thing anywhere in the world, so local courts might well enforce Ijara. Moreover, most sukuk contracts offer a way out of court through arbitration. That again, is no different from any other restructuring of a default: Islamic or non-Islamic, emerging market or developed market.
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