Dec 23 2009
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Confusion over Gulf sukuk bankruptcy rules
The recent near-default of Nakheel 's Islamic bond has triggered calls for better bankruptcy rules in the Gulf as investors wake up to legal and financial risks now that the boom years are over.
Sukuks are fixed income prod-ucts that behave like conven-tional bonds but don't pay interest - banned by Sharia law - and roughly offer the same protection as an ordin-ary unsecured corporate bond in case of a default.
Bankruptcy rules when it co-mes to sukuk however, are difficult to fathom as they can vary throughout the Middle East region.
Problems may arise from rules that cap payable interest, thro-ugh the lack of binding prec-edent and through a lack of knowledge of the local system and how it works.
Barclays Capital and Dubai Islamic Bank were the banks selling these sukuks, which were both convertible into equity ahead of a mooted flot-ation. They were very large compared to other Islamic or equity-linked products.
Investors often seem to have glossed over the legal and fina-ncial 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 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 Wedd-erburn-Day, a partner at law firm 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.
Some of the confusion may have stemmed from the way sukuks are engineered to prov-ide fixed payments that aren't interest. Typically, this involves paying rent for an underlying asset, like land or real estate.
But investors have no security over the asset if the issuer gets into trouble, unlike in struc-tured finance products.
Sukuks are asset-based, that does not mean 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.
The-re's nothing more," the first source who works a large law firm said."People have differ-ent views but they're wrong."
The Nakheel deal was of the Ijara variety, the most comm-on type, where a special purp-ose vehicle (SPV) sells the sukuk to investors. The SPV bought assets from Nakheel , which then leased them back, providing the SPV with perio-dic payments.
Had Nakheel defaulted, the SPV would have merely beco-me an unsecured creditor.
The upshot is sukuks 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 common any-where in the world, so local courts might enforce Ijara.
Moreover, most sukuk cont-racts offer a way out of court through arbitration. That is no different from any other restructuring of a default: Isl-amic or non Islamic, emerg-ing or developed market.
"Most rational creditors realise you get more back on a restru-cturing than a winding up, which is the logical outcome of successful litigation," said Wedderburn-Day.
© 7Days 2009
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