closing the books on the Dubai World debt restructuring

At a time when investors around the globe seem to be in panic mode, it’s nice to know that at least one mini-crisis has been resolved.

the Dubai World crisis

Last week, with little fanfare, Dubai World and its creditors reached an agreement on restructuring the company’s finances.  As you probably recall, the crisis was touched off by Dubai World’s unilateral announcement, issued on the eve of religious and secular holidays that would keep many of the parties involved away from their desks until the following week, that it would be unable to pay at least some of its obligations on time.   It therefore wanted to restructure everything–about $25 billion.

Complicating the issue was the fact that these obligations were a mixture of western-style bank debt and publicly traded sukuk, a  form of sharia-compliant Islamic finance.  In the case of the latter, some parties seemed to think that a dispute over failure to repay was an issue for English courts, others that it was one for sharia compliance boards–an ambiguity brushed under the rug in the bull-market enthusiasm to get the instruments sold.  Given that we have only been seeing over the past couple of years the first high-profile cases of sukuk “default,” there were no precedents to say what sharia authority would decide the case or administratively how it would proceed.

On top of all that, creditors believed that the obligations were guaranteed by the Dubai government, although as far as I can tell none of the documents for the bank loans or sukuk issues specified this.  Investors also took the Dubai World announcement as a signal that the entire $100 billion+ that emirate entities owe would eventually need to be restructured as well.

What a mess!

the outcome

Abu Dhabi lent Dubai $10 billion, which Dubai then relent to Dubai World.  DW used these funds to pay off maturing sukuk. Dubai subsequently converted the loan into equity.

Last week, bank creditors agreed to convert their existing $14 billion in loans into new 5-8 year (i.e., longer) maturity obligations at lower interest rates.  The new loans also carry an explicit sovereign guarantee.  Although the present value of these loans is likely substantially less than that of the previous ones, the form of the agreement is in harmony with sharia guidelines on risk-sharing and repayment of the nominal amount of the original obligation.

After a bad start last November, the Dubai World saga seems to have worked out as well as could have been expected–and certainly far better than pessimists had feared.

The Dubai World debt restructuring

The restructuring’s terms

Last week Dubai World revealed the general terms of the $24 billion debt restructuring it said it was seeking last November.  They are:

1.  trade creditors. Small trade creditors will be paid in full.  Larger creditors will get 40% of the money they are owed in cash and the rest in a sukuk where ownership will be transferable–i.e., public trading will be allowed.

2.  secured creditors. Sukuk holders will be paid in full and on time.

3.  unsecured lenders. The nominal amount of the non sharia-compliant, unsecured loans from international banks will be paid in full.   But maturities will be extended and interest rates lowered.  Also, it sounds as if interest payments may be “in kind” rather than in cash.  In other words, creditors may get periodic IOUs redeemable in cash at the final bond maturity.  The modified bonds will now have an explicit sovereign guarantee.  Dubai’s intention is to get the money to redeem them from asset sales.  The guarantee appears to be a pledge that the government will make up the difference if sales don’t fetch hoped-for prices.

4.  the Dubai government. First of all, there’s the guarantee.  Dubai will also  convert its $8.9 billion in loans to Dubai World into equity and will inject another $1.5 billion in cash, as needed.

Is the restructuring “pragmatic”?

Western commentators have so far concentrated on the “pragmatic” nature of the restructuring.  They suggest that the better treatment of sukuk holders vs. the banks comes from the fact that many of the former are British or American hedge funds who were threatening to delay the restructuring through litigation in the UK.  Therefore, they, not the banks, had to be appeased.

It has also been remarked that trade creditors had to be repaid so that construction work could be restarted.  Partial payment in a tradable sukuk would have been an exercise in futility if Dubai had, at the same time, acted in a way that devalued sukuks in general.

I think this is true as far as it goes, but may miss the main point.

… or is it sharia-compliant?

Dubai is not an oil-rich country.  It has decided that its future lies in being a cultural and commercial interface between the Middle East and the rest of the world, a neutral site that caters to the needs of all sides and creates an atmosphere where ideas can be discussed and business deals arranged.  This is the same role that Hong Kong continues to play with regard to China.

Dubai has just experienced a tremendous property crash, much like Hong Kong did in 1994.  For Hong Kong, the rules of the game were very clear.   Beijing was happy that Western financial principles would apply.  That’s not so clear in Dubai’s case.

Two issues.

–Dubai has a mix of Islamic and non-Islamic, sharia-compliant and non sharia-compliant, Middle Eastern and rest-of-the-world creditors.  It has to satisfy both.

–In addition, as the first mega-blowup of sharia-compliant finance, and one closely associated with Dubai government policy,  the way Dubai handles this situation would doubtless act as a precedent for future resolution of sharia-compliant investment problems. And it could easily make or break Dubai’s reputation as a place to conduct business for sharia-compliant investors.

If the Dubai World case is to be a blueprint for future sharia-compliant debt restructurings, what are its salient features?

salient features

contrast a Chapter 11 filing…

Let’s start by considering what would have happened in a Dubai World Chapter 11 bankruptcy proceeding in the US.

–trade creditors would receive nothing

–equity holders would receive nothing

–bondholders and bank lenders would receive some portion, but not 100%, of what they were owed.  Who got what would be a subject for negotiation among the parties involved.  In the cases of GM and Chrysler, the federal government pressured bondholders to relinquish some of their legal rights in favor of employee pension and healthcare claims.

…with what Dubai is doing

In contrast, in the Dubai World case,

–everyone, except possibly the Dubai government, gets their principal back in full

–sharia gives no clear precedent for extending the maturity of a sukuk, other than that a creditor should give a debtor extra time to settle his debts, if needed.  Dubai presumably didn’t want to establish one by trying to change its sukuks’ terms.  The effect on Islamic banks holding Dubai sukuks of doing so, and the reaction of those banks–and their countries’ governments– would also be unpredictable.

–(secured) sukuk holders are getting better treatment than (unsecured) bank lenders.  One could argue that the collateral backing, or lack of it, was the deciding factor.  One could just as easily argue (and I think this is the right way to look at it) that sukuk holders got sharia-compliant treatment, bank lenders got Western-style treatment.

–trade creditors are in a much stronger position than they would be in Chapter 11.


I’m not sure that in the rush to provide financing to Dubai a few years ago, any creditor gave a lot of serious thought to the possibility of a restructuring.  The absence of a dispute resolution mechanism for sharia-compliant finance is one lesson that jumps out.

Another is that Dubai World, either by accident or design, built an important safety value into its financial structure by including relatively more flexible Western bank loans in the mix.   Their terms can be changed without violating any ethical norms.  I imagine that future large project financings in the Middle East will try to imitate this mixed structure.  One difference, though–Western banks, having seen this once, will want to charge more for their services.

Sharia-compliant investing: wakala woes

Growth in sharia-compliant investing

International investors have become more aware of, and involved in, sharia-compliant financings over the past ten years or so.  This development is, in principle, good both for financial market participants whose actions are guided by the Koran and those whose actions aren’t necessarily sharia compliant.  The former gain access to a wider pool of potential investment capital, and very likely a lower cost of funds.  Institutional investors among the latter get greater diversification, plus the chance at differentiating their performance from that of peers unwilling/contractually unable to hold sharia-compliant securities.

Veteran investors know that you don’t really get to know the securities you own, or how well-crafted your portfolio is, until a time of trouble arises.  This has certainly proved true recently in the case of Islamic finance.

first sukuk…

In late November of last year, on the eve of a series of religious and secular holidays that would leave it incommunicado for the better part of a week, Dubai World made a surprise announcement that it wanted to restructure its debts.  These included a large sukuk issued by its real estate subsidiary Nakheel that was slated to mature three weeks later.  (See my series of posts on the Dubai World restructuring.)

As the situation unfolded, sukuk holders discovered to their dismay that there had been so few prior sukuk defaults that there was no history to use to make a judgment about what the possible outcomes of a restructuring might be.   This meant both the holders and the sharia compliance boards that would have to approve any settlement were going to have to break new ground.

The sukuk issuers also discovered an unanticipated vulnerability in their position.  Opportunistic hedge funds (reportedly mostly US- and UK-based) had bought the soon-to-mature Nakheel sukuk at a steep discount in the secondary market.  They announced that they would bring suit in the UK to force Dubai World into a western-style bankruptcy.   They could do this, they said, because the sukuk documents had been drawn up under UK law.

Again, there was no precedent to use in judging whether this action would be successful.  On a deeper level, however, the threatened lawsuit could potentially lead to a finding that the sukuk was really a Western-style interest-bearing debt instrument and not the equity-like sharing of profits and losses that the Koran requires.  What a mess!!

…now wakala

Sukuk is long-term financing.

The traditional equivalent of a CD is murabaha. This is an asset-based repurchase agreement (repo).  In the murabaha contract, one buys a certain amount of a commodity at an agreed-upon price and simultaneously commits to sell it for a higher price at a later date.

Wakala is a simpler alternative to murabaha.  It isn’t backed by a specific physical asset that the holder buys and sells.  Instead, it is backed by a general pool of assets that the issuer certifies to be sharia compliant.  So easier to handle logistically.  But it’s more like a mutual fund share than a repo.

Blom Development Bank v. TID

Here again, though, a conflict has arisen between the rules of English law, under which the documents are written and which presumably gives comfort to the non-Islamic parties to a deal, and the requirements of sharia.  The case in question, reported by the Financial Times, involves the Islamic finance subsidiary of the Blom Bank of Lebanon and the troubled The Investment Dar (TID) of Kuwait.

Blom gave TID $10 million to invest under a wakala agreement.  TID defaulted in 2009 and Blom sued in English court–this despite the fact both entities are sharia-compiant investors.  Where did the sharia compliance boards go?  Did the pair approach a sharia court, only to be rebuffed?

How could that be?  See below.

TID’s defense

TID had an ingenious (shameless might be a better word) defense.

Simplifying a bit, the parties in a sharia-compliant agreement are supposed to share in profits and losses.  Nevertheless, as a practical matter, a wakala commonly has a clause in it guaranteeing a minimum rate of return to the holder.  This makes it more like a Western CD than a true wakala. This one did, too.  And it presumably got the seal of approval not only from Blom but also from TID’s in-house sharia compliance board, or else the wakala would never have been issued.

TID argued that the contract should be declared null and void and that as a result it owed nothing to Blom.  Why?  –because the profit guarantee clause rendered the agreement out of compliance with sharia.  Since TID’s charter only permitted it to engage in sharia-compliant financing, it could never have entered into the contract in question.  Therefore, no contract–and no liability–existed.  (You can find more details here, in the interesting blog.)

Yes, TID lost.  But it didn’t get laughed out of court, as one might have expected.  Instead, although the judge said TID was unlikely to prevail on appeal, he conceded that the company had an arguable case.  He ordered TID to pay the original $10 million to Blom and left the profit element to be decided later.

So it turns out that maybe not in this case but potentially in some other, the “security blanket” of a wakala drawn up under English law with a guaranteed return may not act as expected.  Also, potential recourse to English courts may be a “secret weapon,”  but will it work for the issuer or the holder?  With a different judge or with a slightly different set of facts, the wakala might be declared null and void.

More troubling, if so what’s to stop a bank in difficulty from declaring after the fact that it had “discovered” its contract wasn’t sharia compliant after all?

What this means

You could make a persuasive (to me, anyway) argument that up until now that a lot of “Islamic finance” has been for most non-Muslims a bull market phenomenon, sort of like “hybrid bonds.”  That is, a half-baked idea that sounds good when uninvested funds are burning a hole in your pocket but where potential consequences haven’t been well thought through.

Unlike hybrid bonds, which I see as a contrivance by commercial banks and bond fund managers to allow them to exceed the limits of their investment mandates, and which therefore won’t resurface, I expect sharia-compliant investing to increase in importance as time goes on.  But the Dubai World restructuring and this, admittedly minor, wakala lawsuit have both exposed cultural and legal questions that buyers and sellers alike papered over in their zeal to get new issues of securities completed over the last few years.

These are teething pains.  Sellers of future sharia-compliant instruments will doubtless be compelled to be more transparent in disclosing the uses for the funds they want.  Buyers will have to do more due diligence on projects and become more involved in understanding the intricacies of sharia compliance.  And both sides will have to agree on a dispute resolution mechanism that doesn’t allow the parties to make the rules up on the fly.  This doesn’t necessarily help anyone involved in a sharia-related restructuring now.  But now that these issues are on the table, I’m sure they’ll all be addressed in the creation of future sharia-compliant securities.

Dubai World update: Abu Dhabi to the rescue

Abu Dhabi bailout

The government of Abu Dhabi announced on Monday that it is giving US$10 billion to the government of Dubai.  Dubai, in turn, will give the money to 100%-owned Dubai World.  DW will forward about US$4 billion of that to its property development subsidiary, Nakheel, to repay a large sukuk that came due on the 14th.  DW will use the rest of the money for debt payments and working capital while it tries to restructure itself.  (See my earlier posts for more background on the Dubai World debt problems.)

The Nakheel sukuk was suspended from official trading after the standstill request made late in November.  But gray market transactions were reportedly done at just above fifty cents on the dollar.  Courageous buyers will have doubled their money in less than a month.

I think it’s reasonable to conclude that three weeks elapsed between the time Dubai requested a debt standstill and yesterday’s bailout announcement because Dubai didn’t have the funds to bail DW out.  It had to get them from Abu Dhabi.  We don’t know if any strings were attached to the $10 billion gift, or if more money will be forthcoming, if needed–and it probably will be.  My guess is that the answer to both questions is “yes.”  (I’m not alone in thinking this.  See Bloomberg’s comments.)

Why a bailout?

Why not default?  I think there are four reasons:

1.  the possibility of cascading defaults. We know that a lot of DW debt was held within the United Arab Emirates.  If Nakheel defaulted and this triggered a disorderly process of unwinding of more of the DW group’s debt, the negative impact on UAE banks could have been severe.

2.  the sharia supervisory board. All sukuk activities, including presumably liquidation, are overseen by a group of scholars who ensure that they are sharia-compliant.  Because there have been virtually no prior sukuk defaults, it would be impossible to predict what actions the supervisory board would recommend.  Suppose it decided that because of negligent management by DW (or some other reason), sukuk holders could make claims against all the assets of DW, not just Nahkeel’s?  A ruling in this case might also set a precedent for other sharia boards in Dubai to follow.

3.  some holders apparently didn’t want to negotiate. Nahkeel sukuk was originally sold to few if any Americans.  But as Nahkeel’s problems emerged, it appears that some US and UK hedge funds accumulated positions at lower prices in the secondary market.  Armed with credit default swaps that would pay off in the event of a default, these owners had different interests from the rest.  For them, the worst outcome would be a protracted negotiation that resulted in a decline in sukuk value but no default.

4.  reputational damage. Despite the facts that the Nahkeel sukuk was issued by a Dubai entity and that the prospectus clearly said the government assumed no obligation to guarantee repayment, possible default was giving the entire UAE a black eye.  I’d bet that Abu Dhabi was less concerned that foreigners thought the sukuk had a sovereign guarantee that buyers in the UAE thought it did, too.

One odd consequence of the DW troubles is that the rating agencies have begun to focus more carefully on the financial problems of Greece. Greece is a short step away from having its government bonds downgraded to a level where the EU will no longer accept them as collateral for borrowings by the Greek central bank, thus shutting off credit from the rest of the EU.  This is an issue, but it has nothing to do with Dubai.  Go figure.

What we’ve learned about Dubai World since Nov 27th

The facts about the imminent restructuring of Dubai World are gradually becoming clearer.  Over the past several days , we’ve learned:

1.  The amount of debt that Dubai World proposes to restructure is about US$26 billion, less than half what was originally thought.  The borrowings are centered around DW’s property subsidiary, Nakheel, and Nakheel’s international property development arm, Limitless World.  According to DW, its other activities are on sound financial footing.

2.  It appears that about half of DW’s overall obligations are to entities within Dubai.  It’s a reasonable working assumption that the same ratio would hold with the debt requiring restructuring.  If so, foreigners’ exposure would be $13 billion or so, plus whatever credit default risk they might have taken on through derivatives.

3.   The UAE central bank pledged support on Sunday for the federation’s banks through a new liquidity facility, again suggesting that a lot of the direct financial exposure is held internally.

4.  The actual restructuring has been underway since at least November 20th, when Dubai fired the head of its International Financial Center, as well as three members of the Investment Corporation of Dubai–including Sultan Ahmed bin Sulayem, the chairman of Dubai World.

5.  Yesterday, according to Bloomberg, Dubai’s finance minister, Abdulrahman al-Saleh, clarified the relationship between the government and DW.  He said in a TV interview that when DW was set up the government decided that DW’s debt should be secured by its investment projects, not a government guarantee.  Further, the government stated in a sukuk prospectus in October that it assumed no obligation to support strategic state-owned enterprises (like DW) financially, although it reserved the right to do so if it chose.

6.  Despite the government’s statements, it appears most investors thought that this was similar to what the US government said about Fannie Mae and Freddie Mac–that in the end, despite its protestations, the government would bail DW out.  Unlike the US case, this expectation has proved false.  It would be doubly interesting if, again unlike the case in the US, a corruption investigation follows.

So the DW debt problems are looking more and more like a tempest in a teapot.  Yes, there may be domestic repercussions and emerging markets debt investors may look more askance at countries like Greece, but further fallout appears unlikely.

To me, by no means an expert on sharia-compliant finance, one big surprise is that investors should have so unreflectively assumed that they would be bailed out by the Dubai government.

In a country like the US, where the banking paradigm accepts that the interest of creditors and equity holders are somewhat opposed–that the equity holder is allowed to financially leverage his returns in return for the debt holder being partially insulated from the full consequences of business failure, debt holders would not expect to be fully sheltered from the failure of the debtor’s business.  Under a banking paradigm like Dubai’s, however, that, in contrast, brings debt and equity holders together as common participants in the fruits of business success or failure, it’s hard to imagine how a bailout of debt holders could be, even in principle, justified.  Go figure.

Also see my original comment from November 29th.