While real GDP growth in the UAE is projected to rise to 2% in 2018 (up from a meager 0.8% in 2017 but still slower than the 3% recorded in 2016) driven mainly by a revised OPEC+ deal resulting in increased oil production and by a boost in the non-oil sector as well as the government’s economic stimulus plan according to the World Bank, the UAE’s economic outlook for 2019 remains uncertain. VICTORIA MESQUITA WLAZLO explores.
For starters, market volatility continues, in part caused by the geopolitical and energy-related events of 2018, such as Qatar severing ties with other GCC countries and Brent crude hitting a four-year high in October 2018 at US$86 per barrel only to tumble to US$50 per barrel by December 2018. Secondly, the real estate market, which is central to the UAE’s economy, and particularly that of Dubai, continues to decline. Since the last peak in 2014, property prices and rental have fallen 25%–33%, according to Asteco’s 2018 report, and prices could fall a further 10% in 2019.
As a result, we expect a significant amount of debt restructuring to take place in the next two to three years as declining revenues will force corporates to restructure. This article analyzes the key considerations to be taken into account by financiers and companies in the restructuring of each of the main Shariah compliant structures used in the Middle East:
Murabahah
A Murabahah financing is a deferred payment sale used to provide trade, acquisition or even corporate finance. Of all forms of Murabahah financing, the commodity Murabahah structure, whereby financing is provided on the basis of the purchase and on-sale of commodities through two different commodity brokers or a trading platform (such as the Dubai Multi Commodities Centre (DMCC)), has proved to be the most widely used Shariah financing structure. This is because a commodity Murabahah is the closest structure to a conventional loan and does not require the use of an asset by the obligor — it simply uses commodities which are bought and sold from a commodities exchange.
On a simple Murabahah, the financier (as seller) purchases an asset from a supplier at the request of the obligor (the purchaser) and sells it to the obligor on a cost plus mark-up basis, typically payable in installments. In a commodity Murabahah, the seller, at the request of the purchaser, purchases commodities from a commodity broker and sells them to the purchaser on a cost plus mark-up basis. The purchaser will simultaneously appoint the financier to on-sell the same commodities to a second broker, thus receiving a spot payment of the cost price of those commodities.
This structure can also be replicated directly on the DMCC, without the need to involve brokers, although an agent registered with the DMCC will be required to execute the sale and purchase of commodities unless the obligor is a registered entity. The mark-up can be fixed or floating (based on a benchmark figure such as LIBOR or EIBOR, plus a margin) and will be equivalent to the interest the financier has agreed with the obligor. The seller must disclose the cost price to the purchaser who must agree to the relevant mark-up at the outset of the transaction.
One risk to the financiers derived from this structure is that the legal title to the goods or commodities must pass to the financier before they are on-sold to the obligor. While in practice the goods or commodities will be sold to the obligor within seconds of being acquired by the financier, if the purchaser were to go insolvent upon the financier purchasing the good or commodities requested by the purchaser and the purchaser would repudiate its promise to purchase the goods or commodities from the financier, the Islamic financier would be left with the ownership of those goods or commodities. This risk is very much mitigated under the DMCC commodity Murabahah as, in effect, the exchange acts as a purchaser of last resort and would immediately buy the commodities from the financier if the purchaser is unable or unwilling to.
However, it is worth noting that under English law, where the financier is unable to on-sell the goods or commodities to the purchaser, that would normally leave it with a claim for damages equal to the difference between the price paid by it for the goods or commodities and the market price of the goods or commodities (provided that there is an available market for those goods or commodities). This is a much more complex claim than that of a lender in a conventional financing who would have a claim for a liquidated debt. In contrast, a claim for damages requires proof of a loss and is subject to the legal principles of legal causation, remoteness, mitigation and contributory negligence.
Moreover, due to the Shariah prohibition on Riba, trading of participations in debt-based Islamic structures such as Murabahah can only be made at par. This can be a substantial obstacle to Islamic financiers looking to dispose of their participations in a Murabahah financing on the outset of an insolvency of the purchaser. Financiers normally want to have the option to dispose of their distressed debt holdings on the secondary market to distressed debt funds or other funds or institutions with a greater appetite for risk. Clearly, any potential buyer of distressed debt would only be willing to buy such debt at a discount. If participations in a commodity Murabahah cannot be sold at a discount, other structured solutions will need to be pursued to allow a financier to offload its exposure to the troubled obligor — however, any alternative solutions in this respect will carry their own risks and will usually not increase the liquidity of the Murabahah debt.
A similar issue faced by financiers attempting to restructure Murabahah facilities is the lack of flexibility for the capitalization of interest that has already accrued. The profit amount calculated at the outset of each Murabahah transaction will be due at maturity and any waiver and capitalization of accrued interest will typically require the entry into of a new Murabahah transaction, thus complicating the documentation required on a restructuring of the obligor’s Shariah compliant obligations.
Ijarah
Similarly, in other Shariah structures requiring the sale of an asset solely for purposes of Shariah compliance (such as where the company is not requesting that an asset be purchased on its behalf on financing terms but rather when the company uses its own assets to create a Shariah structure), there is the question of the validity of the transfer of assets. For example, in an Ijarah financing, the obligor typically sells off its assets, usually real estate, to the Islamic financier. The latter will then lease it back to the obligor in exchange for rental payments which will be the equivalent of amortization payments and interest. Because the sale of the asset is made purely for purposes of the Shariah structure, and to avoid real estate transfer fees, the sale of real estate assets in Ijarah structures is typically not registered with the relevant land department.
Under Article 7 of Dubai Law No (7) of 2006, a transfer of real estate will not be valid unless recorded with the Dubai Land Department. As such, there is an argument that if in an Ijarah transaction the initial transfer of real estate from the obligor to the Islamic financier is not registered with the Dubai Land Department, then that initial sale is void and therefore the Islamic financier would not have a right to claim rental payments from the obligor as the lessee under the Ijarah agreement. In insolvency, the liquidator could make this argument leaving the Islamic financier with a restitutionary claim rather than a liquidated debt claim.
In relation to the transfer of assets other than real estate, the position is less clear. For the transfer of assets which do not require registration, in theory, a sale under the relevant asset purchase agreement should be valid in accordance with its terms. In the event of an insolvency of the obligor, the Islamic financier may claim ownership of the relevant Ijarah assets. The question will then arise as to whether the financier must apply the value of those assets toward the satisfaction of its claim against the obligor under the Ijarah finance documents or whether the financier may keep the assets as their rightful owner. Alternatively, the financier might enforce its rights against the obligor under the relevant purchase undertaking for the ‘put’ of such assets at a price which should be equal to the principal, plus accrued but unpaid profit.
Istisnah
Insolvencies can be particularly complicated in an Istisnah financing (essentially, an order to manufacture), especially if the onset of the insolvency takes place before the delivery of the relevant Istisnah assets. Under an Istisnah, the Islamic financier makes scheduled payments of the contract price to finance the manufacture, development or construction of an asset in accordance with agreed specifications. The scheduled payments by the Islamic financier will usually follow the schedule of payments required under the relevant underlying construction agreement, such as an engineering, procurement and construction contract. Because an order to manufacture will only provide for payments to the obligor to manufacture the goods or assets ordered by the financier, an Istisnah is typically coupled with a forward lease agreement to allow for the payment of interest or ‘rental’. Such rental payments will be made by the obligor as advance rental payments during the construction period, and as rental payments during the operational period.
The Istisnah structure has the advantage that it does not require an asset existing as at the date of the financing, as the asset will be constructed and delivered once it is completed. Once the asset is delivered, the title will vest on the Islamic financier who will lease it back to the obligor against rental equal to the amortizing principal plus profit. In an insolvency post-delivery of the asset, the analysis will be the same as that of an Ijarah structure and the Islamic financier will be able to exercise its rights under the relevant purchase undertaking giving rise to a liquidated debt equal to the principal plus accrued profit and costs. However, in the event of an insolvency occurring before the asset is delivered, the principal will be returned to the Islamic financier in the form of a refund of the stage payments made for the development of the Istisnah asset. However, accrued interest (including that paid under the forward lease agreement) can only be recovered by way of indemnity, which again will require proof of loss (although conclusive evidence clauses mitigate this risk under English law-governed contracts — the position is not so clear under UAE law contracts).
Equity-based structures: Musharakah, Mudarabah and Wakalah
The calculation of the ‘exercise price’ under a purchase undertaking in equity-based Shariah structures (Musharakah, Mudarabah and Wakalah) may not be as straightforward. Since late 2008, further to Sheikh Taqi Usmani’s declaration that 80% of all Sukuk outstanding at that time do not comply with Shariah, purchase undertakings under equity-based structures may not have a fixed face value. Instead, the exercise price must be determined by reference to the relevant market price of the assets being ‘put’ to the obligor at that time, which, in the case of insolvency and depending on the specific asset, may not be worth much.
In addition, the obligor generally has an obligation to pay a pre-agreed periodic profit amount (equivalent to interest in a conventional financing) but only to the extent actually accrued — that is, the profit amount cannot be a fixed claim by the financiers. There are risk-mitigating techniques which are often used in order to mitigate the risk of the obligor refusing to pay the profit amount on the basis that it has not gained such profits (for example during a downturn or if its operating costs increase) such as forcing the obligor to deposit all of its profits in a ledger account as a reserve for any periodic distribution period where the obligor claims to have insufficient profits to pay the relevant profit amount. However, on a restructuring scenario, the obligor is unlikely to have sufficient operating profits which would be set aside (contractually, not necessarily physically in a separate account) for purposes of topping up any missed profit payments.
Conclusion
Amid volatility and uncertainty, there is an expectation that 2019 will see a flurry of restructurings in the Middle Eastern market. Given the abundance of Shariah compliant financings in this region, it is worth considering likely issues that may arise in restructurings of issuers of Shariah compliant debt. When looking at troubled companies under Shariah compliant financings, it is necessary to assess risks which are inherent to each Shariah compliant structure. Islamic finance is said to be ‘asset-based’ because it invariably requires the use of an asset as the basis of its structure, whether as a sale and leaseback, an installment sale or an investment — such use of assets for purposes of the Shariah structure is not risk-free. In addition, the overreliance of Shariah documentation on indemnities as a way of recovering profits and costs which cannot be otherwise recovered in a Shariah compliant way generally entails additional enforcement risk in the requirements of causation, remoteness, mitigation and proof of loss.
This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.
Victoria Mesquita Wlazlo is a partner at law firm Morgan Lewis in Dubai. She can be contacted at [email protected].