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Home > Regulation Best Practice > Bankruptcy Resolution and Investor Protection in Sukuk Markets

Regulation Best Practice

Bankruptcy Resolution and Investor Protection in Sukuk Markets

by Kamal Abdelkarim Hassan and Muhamad Kholid

Case Study: Nakheel Sukuk—A Lesson for Islamic Finance

Background

Nakheel sukuk is chosen as a case study despite the fact that this sukuk never defaulted. Nevertheless, this near-default of the sukuk has left an indelible mark on the Islamic financial market, ushering in the Dubai Debt Crisis. On November 25, 2009, the financial world was shocked when Dubai World requested a restructuring of US$26 billion in debts. The main concern was the delay in the repayment of the US$4 billion sukuk, or Islamic bond, of Dubai World’s developer Nakheel, which was especially known for construction of the Dubai Palm Islands.

The massive implication of the Nakheel sukuk default scenario to the financial world, particularly Islamic finance, has created a broad discussion among experts on the course of events and how to provide better protection to investors against bankruptcy in sukuk investment in the future.

Nakheel sukuk were originated by Nakheel Holdings 1 LLC, one of three Nakheel World LLC subsidiaries (along with Nakheel Holdings 2 LLC and Nakheel Holding 3 LLC, these three companies together acting as co-guarantor of the sukuk) which are 100% owned by Dubai World, a 100% stated-owned company under the Government of Dubai. All three Nakheel Holdings companies had a subsidiary, Nakheel PJSC, which was operating in the real estate sector in Dubai. Below is the company ownership structure and the interlinking, to give a better background of the case.

The Transaction Structure—Issuance

Nakheel sukuk was set up as an ijarah sukuk based on two properties (and any buildings on the land), DWF South and Crescent Lands, both in the Dubai Waterfront development. This parcel of properties was initially valued at US$4.22 billion, based on the developments that were to be constructed on it. The sukuk was issued by SPV, Nakheel Development Limited (Nakheel SPV), a newly incorporated free-zone company with limited liability in the Jebel Ali Free Zone. Nakheel SPV acted as agent and trustee for and on behalf of the sukuk-holders, in accordance with an agency declaration and a declaration of trust.

The originator, Nakheel Holding 1 LLC, sold the leasehold right on the properties of 50 years to the SPV, which in turn issued sukuk to finance the transaction. The funds raised of US$3.52 billion were used to pay the leasehold right from Nakheel Holding 1 LLC. The amount was injected into Nakheel Co. PJSC. Next, Nakheel SPV, as lessor, leased the sukuk assets to Nakheel Holdings 2 LLC, as lessee, for a period of three years to end on December 14, 2009, in concurrence with the maturity of the sukuk. The lease comprised six consecutive periods of six months each. The rental payments of the lease periods matched the periodic distribution payments on the sukuk. Half of the lease amount was paid to sukuk-holders through the SPV and half was deferred until maturity.

On December 14, 2009, the lessee had to purchase the sukuk assets from the lessor in accordance with a purchase undertaking at a certain exercise price. This is when the deferred lease payment would be made. This exercise price was equal to the redemption amount of the sukuk and would be used to pay back the principal amount to the sukuk-holders. In this way the sukuk were redeemed.

The Issues over Nakheel Sukuk

The issues over Nakheel sukuk comprise two sources—the sukuk structure and the legal concern. The sukuk in itself is a complicated financial product, and the laws of Dubai do not provide a clear precedent as to how investors in the sukuk will be treated and what recourse is provided. The sukuk was structured under a sale and leaseback transaction, which from an Islamic perspective is referred to as an ijarah structure. The sale and leaseback structure in ijarah sukuk does not provide for a real transfer of assets from the originator to a SPV; it merely provides a leasehold interest over the tangible underlying asset for a period of, in this case, 50 years. The issue is that leasehold right is not seen as a real right or property right under UAE law as applicable in Dubai, which limits investors’ claims and law enforcement.

Nevertheless, the Nakheel sukuk was backed by a few additional guarantees that may provide sukuk investors with some recourse. As such, these guarantees gave investors the confidence to invest in the sukuk. A guarantee from the state-owned parent company, which implicitly provides a government guarantee for the sukuk (despite the fact that the prospectus clearly stated otherwise), had reassured investors. This misplaced assumption misled investors in their risk–return decision on the investment. A similar scenario occurred for the holders of equity in Fannie Mae and Freddie Mac in the United States. The issue, however, does not end there; the complications worsened when the parent company that acted as guarantor found itself in a situation that made it no better placed than Nakheel to repay the sukuk. Dubai World is also just a holding company for a number of other companies beside Nakheel Holding 1 LLC. However, all of Dubai World’s subsidiaries have their own creditors and their own debts to service, and the important thing for Nakheel sukuk-holders is that the creditors of Dubai World, through the guarantee, are subordinated to the creditors of the subsidiaries of Dubai World.

The sukuk-holders were also granted a mortgage over the two properties that formed the basis for the sukuk through a security agent. Nevertheless, this is subject to the ability of investors to pursue claims on assets that are mainly located in the UAE, as there is a general lack of precedent in how the laws will be applied. Investors are not able to touch government assets, pursuant to Law no. 10 of 2005 amending Government Lawsuit Code no. 3 of 1996 (as amended by Law no. 4 of 1997), which provides that a government establishment may be sued, but that no debt or obligation of such establishment may be recovered by way of an attachment on its properties or assets. In addition, the structure of the sukuk transaction (the issuance) itself could limit investors’ ability to enforce the mortgage. The sukuk is structured under English law in which the concept of trust and beneficial interest is applied. These concepts are not recognized in Dubai.

In addition to the guarantee above, Nakheel sukuk-holders were granted a share pledge of 18.89% of the outstanding equity in Nakheel at the time the sukuk was originated. The aggregate value of the share pledge was capped at 25% of the sukuk issue amount (US$3.52 billion). However, this guarantee would probably be worthless should Nakheel be unable to restructure or repay the outstanding sukuk due on December 14 (and the Nakheel 2 and 3 sukuk that also become due on December 2010 and January 2011 for another US$2 billion).

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Further reading

Books:

  • Adam, Nathif J., and Abdulkader Thomas. Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. London: Euromoney Books, 2005.
  • Mahmoud A. El-Gamal (trans). Financial Transactions in Islamic Law. Syria: Dar Al Fikr, 2003. (Translation of: al-Zahayli, Wahbah. Al-Fiqh Al-Islami wa ’Adillatuh. 4th ed. Volume 5. 1997).

Articles:

  • Fidler, Stephen. “Defaults pose latest snag in Islamic-bond market.” Wall Street Journal (June 16, 2009). Online at: online.wsj.com/article/SB124510859262816907.html
  • Howladar, Khalid. “The future of sukuk: Substance over form?” Moody’s Investors Service, May 6, 2009.

Report:

  • Accounting and Auditing Organization for Islamic Financial Institutions. “Investment sukuk.” Shari’a standard no. 17. 2004.

Websites:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI): www.aaoifi.com
  • Association of Islamic Banking Institutions Malaysia (AIBIM): www.aibim.com
  • International Islamic Financial Markets (IIFM): www.iifm.net
  • Islamic Financial Services Board (IFSB): www.ifsb.org
  • Islamic Research and Training Institute (IRTI; a member of the Islamic Development Bank): www.irti.org

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