Restructuring or reorganising
After much talk about the resilience of the GCC market in these tough economic times, the recession has finally bitten. The increasing number of corporate defaults, real estate devaluation, credit contraction, et cetera has all contributed to market woes. By Furquan Kidwai.
The increasing number of corporate defaults, real estate devaluation, credit contraction, et cetera have all contributed to market woes in the GCC. Some of the previously overlooked legal opinions are being referred to and insolvency and bankruptcy laws are being deliberated upon. However, it is not just a busy time for lawyers and restructuring bankers, regulators and government officials are conjured on the possibility of losing credibility for future foreign investment should the decisions be anything but equitable and legal.
Questions are also being raised about some of the structures used in Islamic finance. As per Sharia law, there is no concept of fixed obligation; it is only "profit" that matters. Looking from the investors' perspective, they need some certainty on the return – be they Islamic or conventional. This quagmire between the Sharia law and investors is further accentuated by the financial crisis as more of these Islamic instruments face stresses similar to those faced by their conventional counterparts, raising questions on their value proposition over the conventional form of finance.
The financial distress in Middle Eastern economies is having a considerable impact on the Sharia-compliant bonds market. As a significant portion of global sukuk issuance has been GCC based, stress has also started to appear in some sukuk deals – exacerbating the anxieties of investors in these Islamic securities.
These upheavals need not be taken as the curious case of Islamic finance. It is about time market participants took a bottom-up approach, by considering principle differences in sukuk structuring. This is not only consequential in reforming the market and making it more attractive but also plays a part in analysing the implications of restructuring. Whereas the asset-based and asset-backed nature of sukuk has always been a discussion point among practitioners and to some extent contentious among scholars, it is likely to impact many restructuring issues in the market.
As asset-based sukuk are essentially exposing investors to the credit risk of the originator, the restructuring process is aligned with that of unsecured instruments. This makes the process more complicated due to the involvement of other creditors that might rank senior or pari passu to sukuk investors. As one lawyer puts it: "There is no difference between corporate bond and asset-based sukuk restructuring."
Complications arise due to the presence of an undertaking by the originator to purchase the asset at maturity. So far so good, but in case the originator defaults or experiences financial difficulties, this becomes tricky. Questions on issues such as the creditor's ability to enforce, its priority ranking, and court rulings arise. And the current situation in the Middle East is mirroring these particular dilemmas, as an increasing number of borrowers are now unable to meet their obligations.
From a legal perspective, this undertaking can have manifold interpretations, depending on the jurisdiction. Conversely, lawyers can also argue widely for or against it. For creditors the ideal scenario – in case of sale and lease-back agreements or if they have asset ownership – is to enforce their security. Practically, the jurisdiction plays a role in allowing the enforcement of such securities – which is yet to be seen.
On the contrary, plain vanilla asset-backed sukuk are predominantly exposing investors to asset performance risk. In case of sukuk default, they are more likely to dissolve, at least theoretically, in favour of investors. This is in line with the investors' lien over secured assets. Such a dissolution process is more attuned to that of securitisation deals, albeit the jurisdiction risk remains.
However, if we take the example of Dubai's relatively more developed jurisdiction, even there exist major concerns over its untested nature. As more bankruptcies and default situations arise, the legal structure is expected to become more transparent to the market. On the other hand, technical glitches such as the lack of recognition for a floating charge over assets and provision for an out-of-court settlement, make it unlikely for the creditor to enforce any contractual right to appoint a receiver in case of debtor bankruptcy.
Such legal impedances are equally detrimental to both asset-based and asset-backed sukuk markets, making them no more or no less preferable over the other. Coming back to the current situation, sukuk issuance so far has predominantly been asset-based, with only a handful of asset-backed issues, so the uncertainties in the market are more to do with issues such as purchase undertakings.
Moving on, there is a silver lining for the sukuk market and its future. An evolution from the present situation will be a rejoinder to market players; making risk pricing more scientific than speculative, providing comfort to creditors in terms of their rights, and identifying investor-friendly legal regimes. Although a sign of hope for the sukuk industry, any tweaking or opaque decision-making process is equally likely to disserve the Islamic finance industry. Some of the sukuk default cases include:
* Bahrain – The ongoing controversy with Saad and AH Algosaibi groups has also embroiled the sukuk market. The US$650m Golden Belt sukuk holders are negotiating dissolution proceedings with their trustee. Despite the pessimistic outlook of some bankers for any resolution in favour of creditors, one would hope for a priority treatment of sukuk holders given their ownership of leased assets. However, as discussed above, the purchase undertaking element is likely to lead to sukuk holders being treated pari passu with unsecured lenders. Taking a more optimistic view, Sharia-compliant creditors will take real estate risk, at best, in case they are able to take ownership of the underlying asset.
* Kuwait – Kuwait's economic worries are further testing the sukuk market. Investment Dar's restructuring exercise had led to a coupon payment default on its US$100m sukuk. According to the offering circular, the trustee is within its rights – due to the purchase undertaking – to dissolve and sell trust assets back to the issuer. The current negotiations between Investment Dar and its creditors will determine the enforcement priority of sukuk holders. The market expects sukuk to be treated on a par with unsecured debt.
* UAE – Despite the relative quietness in the UAE sukuk market, all eyes are on the coming redemption of the Nakheel sukuk. Investors, being exposed to the real estate sector, have genuine fears. On the other hand, it is reasonable to expect the Dubai government to prevent Nakheel's default as it could potentially hamper Dubai's investment prospects. However, discounting the support of government, the liquidity position of Nakheel is unlikely to be sturdy enough to repay about US$3.5bn to its creditors. The situation is worsened by the declining asset values in Dubai's real estate market, giving little respite to sukuk holders if they are to enforce their rights – if any – on the assets.
A possibility, nevertheless, could be a government-backed refinancing package from local lenders. Although one could argue against banks increasing their exposure to the Dubai real estate market, as one banker puts it, "it is too tempting for local banks to turn their backs on some lucrative distressed real estate opportunities with implicit government support".
The decline in real estate valuations in the GCC has had a significant impact on the sukuk market. This impact, however, is more indirect due to the predominance of asset-based sukuk. As discussed above, devaluation only affects the default rate if it impedes a company's financial performance rather than for the sole reason of sukuk being backed by a real estate asset. To repeat and put it mildly, asset-based sukuk returns are not determined by asset performance.
Having said that, it is imperative to see the sector of the borrower as it is more likely for an asset-based sukuk issued by a real estate firm to default following a real estate crash. Similarly, sukuk issued by banks in the GCC are vulnerable to real estate risk due to the high exposure of the banks to the sector. According to a report by Fitch, UAE banks have real estate exposure of more than 20% of deposits (the UAE central bank's cap).
At the sector level, GCC banks have also been paying for the unpropitious news from the market. According to a report by Standard & Poor’s, at least 30 banks in the GCC have exposure to either the Saad or Algosaibi group, translating into potential losses of at least US$9.6bn. Given the opaque and discreet nature of local economies, there is a likelihood of these figures rising significantly once the exposure of foreign banks is realised – market whispers are of circa US$22bn exposure.
Debt repayment challenges have also surfaced at corporates in the GCC. Leverage build-up during the boom years is now being reversed with the decline in margins, replenishing cash reserves, falling commodity prices, and tightened credit conditions. However, it is not very likely for the big-name groups to have any difficulty in being able to restructure their repayment schedules; first, due to their names and second, their deep-rooted banking relationships. Capital market transactions are also likely to increase as these stricken companies try mending their balance sheets utilising other instruments such as rights issues.
From our market sources, it is becoming clearer that there is a move towards preventive restructuring by firms that are in a healthy situation. Many of them are renegotiating their terms and covenants, while others are restructuring their obligations into Sharia-compliant debt. We see this as an alternative measure to tackle liquidity concerns in the conventional market by tapping excess liquidity from investors that only invest in Islamic instruments.
Similarly, as long-term financing for projects sets with the sun, many new projects are being developed as Sharia-compliant structures. However, it should not be assumed that Islamic investors are not in tune with returns in the conventional market. All renegotiated loans are more likely to provide yield pick-up and significantly improved terms and conditions to lenders. The outcome of these restructuring exercises and developments is yet to be seen. But one thing is certain and that is their ability to reform the Islamic finance industry. For better or worse? The onus is on its players.