Friday, December 4, 2009

Nakheel and the sukuk legal spook

This is Caravan I Ltd. — a sukuk set up in Saudi Arabia in 2004:

Caravan I sukuk structure - IMF working paper

Does it look familiar?

It’s the same type of sukuk — al-ijarah — as the $3.5bn Nakheel bond.

It’s a sort of asset-based sale-and-leaseback structure where investors receive rental payments instead of interest, which is prohibited under sharia law. In this particular example, a deal aimed at securitising Saudi Arabian car fleet inventory, a Special Purpose Vehicle is created (often in Jersey or some other tax haven), which holds legal title for the assets, which are then leased back to the originator in return for those rental payments. The originator uses the rental payments to service its obligations on the sukuks.

In the particular deal outlined above, a Special Purpose Company is also created — since under Saudi law offshore SPVs are prohibited from buying or leasing vehicles, while a locally domiciled SPV is (supposedly) not bankruptcy remote and cannot issue securities. The SPC and SPV have a funding agreement, which includes periodic funding repayments and the transfer of profits from SPC to the SPV.

Only the sukuk structure is a veritable minefield of unknown legal questions and obligations.

Here’s a summary from an IMF working paper on the economics of Islamic finance and securitisation:

While deferrals are possible, in the default event, investors have recourse to the underlying assets and can force the sale of the cash-flow-generating assets. Although the transaction structure implies business risk from identified and direct investor participation in the asset performance of permissible real economic activity without payment or receipt of interest consistent with shariah law, legal risk from Islamic jurisprudence continues to impinge on the legal enforceability of investor interests. Saudi courts and other adjudicatory authorities might apply different interpretations of shariah principles to the transaction. Since shariah law remains the governing law of the transaction, legal uncertainty might compromise the ability of the Jersey-based SPV to enforce investor interests. Moreover, the integrity of the funding agreement in this dual-SPV structure of Caravan 1 Limited hinges on the capacity of the SPV to oblige the SPC to make pre-specified and contingent payments from lease revenues to repay sukuk investors—a guarantee whose enforcement runs against the condition of investment risk under the basic tenets of shariah law. All of these aspects taken together have precluded an official rating of the transaction.

Which gives you an idea of the kind of legal difficulty we are about to see from the Nakheel sukuk. Though that structure is based on the sale and leaseback of two Dubai Waterfront development properties and United Arab Emirates-based rather than Saudi Arabia — it shares the basic features with the Caravan sukuk.

Leases on the properties were sold to the SPV which issued the sukuk, with the plots then leased back to Nakheel. Nakheel paid rental to the sukuk holders — with half of the lease amount to be paid to sukuk holders through the SPV and half deferred until maturity. At maturity, or in cases of default, the long lease would be repurchased by Nakheel and that deferred rental payment would be made.

But with the standstill request from Nakheel-parent Dubai World’s debt, the payments look more than a little in doubt. The Guardian reports this morning that creditors of Dubai World are expected to reject the proposed standstill agreement — in which case we are in for a trigger of default, and a long and complicated legal battle as owners of the sukuk seek to reclaim as much of Dubai World’s assets as legally possible.

The idea that the sukuk investors have any legal recourse to those assets, however, is by no means clear. Not least because it’s uncertain whether Western law, which typically allows for recourse, is more relevant/enforceable than sharia law in the UAE, which implies a degree of burden-sharing for creditors.

And disregarding the tension between Western and Islamic law for a moment, you still have the discrepancies within sharia law alone — so that even if the Western-Islamic legal debate is settled, internal tussles over the appropriate future and principles for the Nakheel sukuk within sharia law also loom.

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