Sharia Law Will Likely Be A Creditor Disaster In The Dubai Restructuring

December 2009

At the end of November, Dubai announced that it would seek a six-month postponement of debt repayments, the earliest of which is due on December 14. The announcement came as a shock. This situation is interesting because it (i) provides insights regarding Islamic finance, and (ii) shines a spotlight on how economic bubbles are not just a Western phenomenon. Although not reported in the press, creditors holding much of this Dubai debt are going to face massive losses.

Dubai is over its head with aggressive real estate development

Dubai is one of the seven emirates of the United Arab Emirates (UAE). The UAE is located south of the Persian Gulf on the Arabian Peninsula. Dubai and Abu Dhabi are the most powerful of the seven highly autonomous states that make up the UAE, but they are sharply different. Abu Dhabi has much more expansive oil resources. Abu Dhabi is the seat of the UAE's federal government, and is more conservative, both religiously and financially. In comparison, Dubai is relatively oil poor. To make up for its lack of oil, Dubai aggressively spent borrowed funds over the last decade to develop itself as a financial, trading and tourist center.

Dubai World is a government-owned conglomerate with interests in a variety of assets, but most substantially in ports and real estate. According to Dubai World last August, Dubai World and its subsidiaries has roughly $60 billion of obligations. Other more recent estimates put the amount at $80 billion. Dubai World’s most well-known companies are (i) DP World, one of the largest owners of ports in the world, and (ii) Nakheel, the subsidiary used for property development that is now in financial difficulty. DP World (the ports operation) is still profitable; it is protected from the just-announced real estate financial difficulties and related restructuring.

Nakheel has spent massive amounts on extravagant and speculative real estate construction. Completion of this construction is financially justifiable only if Dubai could continue its recent significant growth for at least another decade. The construction includes the following:

1. Three “palm islands” - Each of these are land-recovery peninsulas shaped in the form of palm trees. These new land creations are constructed from sand dredged from the bottom of the Persian Gulf. Residences on the second of the palm islands were planned to be completed in 2020, and would then house 1.7 million people. The third of the palm islands was to be eight times larger than the first island and five times larger than second. Construction of the third palm island has been halted, and the construction equipment removed.
2. Dubai Waterfront - The second of the palm islands is planned to be encircled by an enormous land reclamation project with related canals, called the Dubai Waterfront. The Waterfront would be the largest man-made development in the world, and would be twice as large as Hong Kong. It will add approximately 44 miles to Dubai's coastline, and will encompass an area of 1.4 billion square feet of water and land developments. It is expected to house an estimated population of 1.5 million people.
3. Burj Dubai or "Dubai Tower" – This is a 206 story skyscraper, surrounded by a large downtown area. The skyscraper is the tallest man-made structure ever built, at 2,684 ft (just over a half mile high). The skyscraper construction began in September 2004, and is expected to be completed in early 2010. The building is part of the approximate 0.8 square mile development called Downtown Burj Dubai. The budget for the Burj Dubai skyscraper is $4.1 billion, and $20 billion for the entire downtown. The downtown (as planned) includes 30,000 homes, at least 19 residential towers, nine hotels, the world’s largest shopping mall based on land occupied, 7.4 acres of parks, and a 30-acre man-made lake.

Because of a lack of demand to pay for these expensive projects, real estate prices are reported to have dropped from 40 to 50 percent since the peak values. Regardless of whether Islamic or Western law is involved, a creditor disaster will occur with the combination of incomplete real estate projects occurring at the same time as the underlying real estate values are decreasing significantly.

A sukuk (see below for description) with a face value of US$ 3.52 billion is coming due on December 14, 2009 but it is only the beginning. Dubai World is obliged to repay a total of $9 billion of debt over the next four months.

Sharia law makes matters worse for creditors

Most casual observers assume that Dubai's oil resources can dig it out of its oversized ambitious developments. Here, the casual observer (or creditor) would have a rude awakening. As noted already, Dubai should not be confused with its oil-rich UAE neighbors.

Recent Dubai press announcements already indicate that the Dubai government has no intention of bailing out the creditors. This is substantiated by the prospectus for the first of the borrowings that will go into default. The prospectus states:

“Dubai World is a public corporation established pursuant to Law No. 3 of 2006 issued by His Highness Sheikh Mohammed Bin Rashid Al-Maktoum as Ruler of Dubai. Investors should note, however, that the Government of Dubai does not guarantee any indebtedness or any other liability of Dubai World.”

Islamic law, or sharia (also spelled shariah) forbids interest and other financial products that allow investors to "make money off of money". Because sharia forbids interest as compensation for lending money, “lenders” are instead granted a share of the assets. In the case where debt-like arrangements are desired, the property developer issues a sukuk. The issuer of the sukuk typically pays “rent” until the loan is refunded on maturity. Investopedia defines a sukuk as follows:

“An Islamic financial certificate, similar to a bond in Western finance, that complies with Sharia, Islamic religious law. Because the traditional Western interest paying bond structure is not permissible, the issuer of a sukuk sells an investor group the certificate, who then rents it back to the issuer for a predetermined rental fee. The issuer also makes a contractual promise to buy back the bonds at a future date at par value.”

While this arrangement ordinarily provides an economic result similar to what would occur with a Western bond, the remedies in a bankruptcy could be quite different. A reader of the 237-page prospectus for the US$ 3.5 billion of sukuks that are in the most immediate risk of default will not confuse these instruments for a simple Western-style bond.

With this background in mind, a second reason for large creditor losses involves the use of Islamic or sharia law, which in turn causes the traditional lending relationship to be turned upside down. The sukuks are supported only by specific assets contained within Dubai, where enforcement actions would most likely be controlled by Dubai law. The prospectus states:

“The Certificates are not debt obligations of the Issuer. In particular, the Certificates do not represent bonds or notes issued by the Issuer. The Certificates attached represent entitlements solely to the Trust Assets. Recourse to the Issuer is limited to the Trust Assets and proceeds of the Trust Assets are the sole source of payments on the Certificates. Upon occurrence of a Dissolution Event, the only remedy available to Certificate holders will be to require the Issuer to serve an Exercise Notice and exercise the option under the Purchase Undertaking to require the Purchase Undertaking Obligor to purchase the Sukuk Assets at the Exercise Price and to take steps to enforce the Share Pledge, the Mortgages, the Co-Obligor Guarantee and the Dubai World Guarantee if the Purchase Undertaking Obligor fails to pay amounts due following service of an Exercise Notice. Certificate holders will otherwise have no recourse to any assets of the Issuer, the Trustee, Dubai World or the Co-Obligor Group (in each of its respective capacities under the Transaction Documents), the Transaction Administrator, the Managers or the Agents or any affiliate of any of the foregoing entities in respect of any shortfall in any amounts realised from the Trust Assets

The investors were warned of these additional risks brought by sharia. This same prospectus includes the following description of controlling law:

UAE Bankruptcy Law

In the event of Dubai World’s, a Co-Obligor’s or the Issuer’s insolvency, UAE bankruptcy law may … adversely affect Dubai World’s, the Co-Obligors’ and/or the Issuer’s ability to perform their respective obligations under the Transaction Documents. There is little precedent to predict how claims by or on behalf of the Certificate holders would be resolved, and therefore there can be no assurance that Certificate holders will receive repayment of their claims in full or at all.”

Enforcing foreign judgments in Dubai

Under current Dubai law, the courts are unlikely to enforce an English judgment without reexamining the merits of the claim and may not observe the choice by the parties of English law as the governing law of the transaction.”

Judicial precedents in Dubai have no binding effect on subsequent decisions. In addition, court decisions in Dubai are generally not recorded. These factors create greater judicial uncertainty. Under applicable Dubai law, no debt or obligation owing from the Ruler or the Government of Dubai may be recovered by laying hold, attachment, sale in auction, or taking possession in any other legal action of the Ruler’s or the Government’s properties and assets whether or not a final judgment is issued in respect of such debt or obligation. References in the law to the Government of Dubai include its departments and any other establishment or public authority and so would include Dubai World and each Co-Obligor and may include the Issuer.”

These various challenges will combine to give investors in Dubai World “debt” some unfortunate surprises.

Fulcrum Inquiry performs bankruptcy consulting and related forensic accounting.