Cecilia Valente & Frederik Richter

Focus on Due Diligence For Islamic Bonds as Defaults Rock Market

London. Defaults on Islamic bonds and the debt delay requested by Dubai World will transform the market, as investors demand more transparency and subject new issues to forensic due diligence.

Investors in state-run Dubai World’s main real estate developer, Nakheel, were stunned following the announcement the company and its parent would delay by at least six months repayment on billions of dollars in debt.

Nakheel had a $3.5 billion Islamic bond, the largest ever issued, maturing on Dec. 14, an obligation the market widely expected to be honored.

“If there are lessons to be learned here, it is that due diligence is all important. Compliance to Shariah in its structuring does not ensure the success of a sukuk [Shariah bond] or of any product or business,” said Yusuf Talal DeLorenzo, chief Shariah officer at fund management company Shariah Capital.

The sukuk market was already jittery before the news from Dubai. Prominent Saudi business group Saad said this month it would miss the payment of the second coupon on its $650 million Golden Belt 1 Shariah bond domiciled in Bahrain.

In May, Kuwait’s Investment Dar said it defaulted on a $100 million Shariah bond.

In its simplest form, a Shariah bond is a certificate proving ownership of an asset, but unlike bond holders, investors in sukuk do not receive interest but rather returns generated by the underlying assets pooled under special purpose vehicles. The events have shaken the reputation of sukuk as safer and more transparent than their conventional counterparts — just as the market was recovering from a slump in 2008, with issuance up 40 percent in the first 10 months of the year.

They show that sukuk do not necessarily grant ownership of the underlying assets, which would in theory make investors safe in case of default.

“Clarity on the structure is essential. The Islamic finance industry must do all it can to avoid accusations of mis-selling products,” said one senior industry figure.

The nature of the sukuk plays a role in where Islamic debt is ranked in debt-restructuring processes, such as the ongoing ones at Saad and Investment Dar.

Even when investors fully understand the structure of the sukuk, it is not certain their ownership rights will be reinforced, said an Islamic finance expert who declined to be named.

“The reality is that Middle Eastern property law is so weak that even with asset-backed, people have little confidence in the success of that claim,” the expert said, adding most investors did know the risks involved.

“All the rating agencies have never rated Middle Eastern sukuk in reference to the assets, they only ever rated them in reference to the credit rating of the sponsoring entity. They were rated as unsecured liability,” he said.

A dramatic sell-off, although possible, looks improbable, according to Indraj Mangat, a partner at law company Eversheds’ Islamic Finance Group.

“The defaults in the Gulf sukuk markets are more a reflection of the broader economic difficulties in the Gulf than an indictment of sukuk per se. It is possible that investors may judge sukuk on the defaults, but that is like throwing the baby out with the bath water,” he said.

Investors however will become more discerning.

“Lending in the Gulf has often been based on the perceived value of the family name of the borrower or its backers. The current announcement sees that position being eroded,” said Amjad Hussain, head of banking and Islamic finance, Middle East at law company Eversheds.

“The defaults in the Gulf will now act as a catalyst for lenders to encourage them to adopt a more impartial and diligence-led process. This is good for the long-term development of the Gulf economies, including on corporate governance-type issues,” Mangat said.

Reuters

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