The Islamic finance industry is undergoing a big test as defaults and restructurings appear in the sukuk market for the first time.
Last month there was a default on a $650 million Islamic bond launched in 2007 by an offshore vehicle linked to Maan Al Saneas troubled Saudi group, Saad. This came hot on the heels of the first non-payment of an Islamic bond in the Middle East: the $100 million sukuk issued by Kuwaiti firm The Investment Dar in 2005.
These defaults follow last autumns bankruptcy of Texas-based East Cameron Gas Company, which issued a $167 million Islamic securitization in 2006. A court in Louisiana is deciding what rights, if any, the noteholders have. There is uncertainty as to whether the issuer of the notes is bankruptcy remote and whether a true sale of the assets took place.
In the Middle East, other sukuk restructurings are taking place, especially in Dubai. Property developer Nakheel, for example, is trying to restructure its debt, including a $3.5 billion sukuk that matures in December.
Restructuring of Middle Eastern bonds is a relatively untested process even in the conventional market. In the Islamic market, however, things are even more complicated, as western resolutions are less readily transferable. Interest, for example, is banned. In Islamic finance there is not even the concept of a group of creditors, but only of banks and investors.
One of the principles of Islamic finance is that participants must share risks and benefits. Sukuk structures avoid paying interest by paying what is referred to as profit, or a share in profit, for example. The pitfalls of this are becoming apparent.
"Shariah law doesnt even contemplate a default, because you cant default if all youre ever giving is a profit share. If there are no profits, then you arent defaulting. You are just deferring, or sitting around the table to discuss," says a source involved in a sukuk restructuring in the Middle East.
"Unfortunately these instruments were sold to western investors who expected that the profit terms were equivalent to interest, and so a fixed obligation," adds the source.
Still, western-style restructuring methods are beginning to be applied to defaulted sukuk, according to the source. Instead of interest obligations, so-called profit terms are created that are suited to the companies ability to pay. Rather than exchanging debt for common equity, companies must give something akin to a warrant, but called profit participation.
Whatever method is used, Shariah scholars have to approve any change to the structure. This makes the restructuring process even slower. Over the past few years, scholars have become adept at approving or objecting to sukuk issuances. None of them has experienced a default.
As the idea is to share profit and loss, Islamic finance resolutions should be more based on friendly discussion and consensus, taking into account the ability of a firm to repay. Court judgements should rarely be the answer.
But the possibility of a court remedy is more remote in Islamic finance for other reasons too.
As most sukuks were issued by offshore special purpose vehicles governed by English law, a ruling would have to be sought in an English court. This would then need to be enforced in the Middle East, the location of most of the assets of sukuk issuers.
The UAE is a signatory to the New York Convention on Enforcement of Arbitral Law, so in theory this process should be simple in that country. But there is very limited precedent of English judgments being enforced in the Gulf, so the transfer of judgments would be far from mechanical.
In general, consensus-based restructurings might give the chance for a more flexible solution, and might sometimes give investors more. But they would create more uncertainty and less uniformity.
Qudeer Latif is confident about the sukuk market
"Theres a degree of nervousness about defaults in the sukuk market but that is outweighed by the bullishness demonstrated by the new sukuk deals currently being done and those likely to come to the market in the course of this year," says Qudeer Latif, partner at law firm Clifford Chance in Dubai.He points out that the $750 million Bahrain sovereign sukuk last month had an order book of $2 billion, while in February Indonesias $650 million sovereign sukuk had an order book of $3 billion. Even so, one of the bookrunners tells Euromoney that the Middle East, North Africa and Asia accounted for 70% of the buyers of the Bahrain sukuk. In 2007, however, western buyers sometimes accounted for more than 80% of sukuk investors.
The proportion of western investors is far lower now, and it might not be entirely because of the credit crunch. If defaults dissuade western investors from returning to the sukuk market, it will be a big impediment to the development of the industry.