Defaults to bring sukuk shake-up

Analysis Until the Kuwaiti firm Investment Dar said it had defaulted on a US$100 million Islamic bond, the sukuk market had been largely untested.

Until the Kuwaiti firm Investment Dar said it had defaulted on a US$100 million (Dh367.2m) Islamic bond, the sukuk market had been largely untested. The market has had strong growth over the past seven years, with the value of sukuk issued rising from nothing in 2002 to an estimated $90 billion today. Before the default by Investment Dar, which owns half of Aston Martin Lagonda, no issuer had ever publicly failed to make good on its obligations. But that is changing fast as the financial crisis batters the economies of countries in the Gulf and South East Asia where sukuk have been most popular. Equity and fixed-income markets have tumbled in concert as companies struggle to repay large debts incurred during the boom times, and sukuk have proven just as vulnerable to the downturn as conventional bonds. A $3.5bn sukuk issued by the Dubai property developer Nakheel, for example, saw yields exceed 80 per cent last year as prices plummeted and talk surfaced of a possible restructuring. While Investment Dar's is the first example of an outright sukuk default, industry experts say it is only the beginning of a trend in which issuers of sukuk, burdened by large declines in business activity, will begin to find themselves unable to pay. Already lawyers say they are working on defaults and restructurings of sukuk at a number of companies that have run into trouble. "You're definitely going to see more restructuring," Christopher Walsh, a partner at the UK law firm Clifford Chance, told Bloomberg last week. "We're working with many lead arrangers who are looking into restructuring." It is still too early to tell how many sukuk are likely to go into default or face restructuring, or which markets will be hit hardest, but there appears to be general agreement that more sukuk defaults will emerge this year, posing a major legal and regulatory test for the young market. These developments, lawyers and bankers say, will resolve how courts treat sukuk defaults and eventually change the way they are structured. "Between 2003 until last summer, we had a good run," says Alex Saleh, a partner at DLA Piper in Kuwait who has dealt extensively with sukuk. "There were no defaults. But now we're going into the second cycle where we see companies that are unable to repay. If we could go back and make changes to how they were structured we would, but that's how you learn." Central among the legal concerns is the question of how sukuk certificate holders will be treated when companies go into a general default on all of their loans. Mr Saleh says that with some unsecured sukuk it remained unclear what claims holders might have on a company's assets, or even whether they would have a concrete claim to any assets in the event of a default. Without that clarity, he says, situations may arise where multiple creditors make claims on a company's assets after a default, leaving unanswered the question of who has rights to them. There are also questions about how courts in the Gulf will adjudicate cases where sukuk go into default, and the speed with which certificate holders will be able to claim the assets to which they are entitled. But lawyers say sukuk holders can derive some certainty from the fact that many Islamic bonds have been structured under well-established English laws. "If they are documented properly, they should be no different than conventional bonds," says Anzal Mohammed, a lawyer at Allen and Overy in Dubai. "If it's an unsecured transaction there should be the same legal redress and avenues to be explored as with an issuer of conventional bonds." The market is also looking for clarity. Sukuk have historically commanded higher yields than conventional bonds, partly because they have never been tested by defaults and restructurings. Presumably, if it were clear how sukuk defaults would be treated, investors may not demand such high yields, which would make borrowing cheaper for companies using sukuk to raise money. Jamil Hallak, the head of credit trading in the region at Standard Chartered, says that it was critical for investors to know their "worst-case scenario". Defaults and restructurings, Mr Hallak says, would ultimately be good for the market because once the legal issues are clarified investors will know how they are likely to be treated in this worst case. "The issue is that when you go to your worst-case scenario, it's never clear whether those assets can be transferred or not, and whether the holders of the sukuk can really get their hands on those assets," he says. For now, companies that have run into trouble are working hard with creditors to restructure their debts. Investment Dar's default comes as the company works to retool its entire debt load, not just its sukuk. Many creditors, lawyers say, would rather not go to the extreme of enlisting the help of courts. "In Kuwait the courts are perhaps a little more sophisticated than Qatar and the UAE," Mr Saleh says. "But litigation has not gotten started with sukuk holders. They're working to restructure without litigation." One thing is clear: the upcoming defaults and restructurings will change the way sukuk are structured and marketed. When lawyers and bankers first formulated Islamic bonds seven years ago, they included language about what would happen in the event of default. At the same time, many sukuk were sold as being more secure than conventional bonds because they were backed by assets, although it appears the question of how well backed they are has not been answered. As a result of the defaults, lawyers say demand is likely to shift away from unsecured sukuk to secured ones. "Up until the crisis, a sukuk was treated as a loan based on the balance sheet of the company," Mr Saleh says. "Now the underlying assets are being looked at as closely as the balance sheet. You're going to see the issuance of 'sukuk 2.0', which are going to be completely different." As these changes occur, investors and industry insiders say they do not see demand for Islamic bonds flagging. While issuance has slowed substantially with the financial crisis, from more than $30bn in 2007 to about $15bn last year, there is little doubt that interest among investors and issuers in the Gulf remains strong. Concerns have also been raised over a pronouncement in February by prominent Islamic scholars in Bahrain that most sukuk structures are not Sharia-compliant. This could result in a preference for sukuk with clear backing from scholars, but experts doubt this issue will put a significant dent in the appetite for sukuk. "Demand for sukuk is real and very strong," Mr Hallak says. "There is more and more awareness of Islamic products and people looking to allocate their investment from conventional finance into Islamic." [e-mail]