Makhbub Radzhabboev, head of Banking & Finance at TLG The Legal Group, Dubai looks at how project bonds and sukuk structures are being used as debt financing in the Middle East.
As a result of the global economic downturn and deepening Eurozone crisis, international banks reduced their lending in the Gulf market and European banks refocused on their domestic markets partlydue to the effect of the upcoming restrictive Basel III capital and liquidity regulations. The regional governments in the GCC currently face the challenge of raising finance for important infrastructure projects of their government related entities (GREs). To meet this challenge,GREs areconsidering issuing of project bonds as an effective way of raising finance in the existing environment. Recent major project bonds under consideration include the Emirates Aluminium joint venture, Saudi Arabia’s Sadara Chemical – the $20bn petrochemical joint venture between Saudi Aramco and the US’ Dow Chemical considering a riyal-dominated project sukuk. Abu Dhabi National Energy Company (Taqa) and its partners in the Shuweihat S2 independent water and power plant (IWPP) are also planning a project bond to refinance their debt.
These market developments pose interesting questions regarding the choice of the financing method and the investor base. In the Middle East, and particularly in the GCCregion, these questions should be considered in the light of the emergence of a very liquid Islamic Finance market and Islamic investors who demonstrate a huge appetite for Shariah compliant securities, and especially for sukuks.
One of the prominent features of recent sukuk issuesis that they are well oversubscribed when announced and the issuers may choose among the potential investors. So there is a clear economic incentive for originators to structure their deals according to Islamic principles. In turn, if the deal is structured in strict compliance with Sharia principles, then the sukuk holders avail themselves of much better legal protection than conventional bondholders. Therefore, in addition to economic factors,the level of the legal protection should be seriously considered in the choice between the project bond and sukuk.
Project Bonds v. Sukuks
Generally, projects bonds are promoted by entities such as the European Commission in order to stimulate investment in key strategic infrastructure in transport, energy and broadband plus use of the debt capital markets as an additional source of financing for these major projects. The scheme is built on partly guaranteeing the bond issue which is based on a specific project to be implemented by a SPV. The aim is to achieve an investment grade rating so that institutions may invest in these instruments. Unlike conventional bonds, investors here are exposed not to the strength of the borrowing company but rather to the success of the underlying project. So in the event of any problems, recourse can be made only to the assets of this particular project. Normally, international syndicated loans and bonds are unsecured and, in case of the project company’s insolvency, bondholders may find themselves in the queue behind other creditors.
There are a lot of economic similarities between project bonds and recent sukuks as both instruments are intended to finance large infrastructure projects. As reported recently by S&P, the Gulf infrastructure sukuk represented 30% of total sukuk for the year to July 17, 2012, compared with just 7% for the wholeof 2011. This means that sukuks are increasingly used to meet the financing needs of specific infrastructural projects rather than to provide a general debt for the issuer. However, despite economic proximity, sukuks substantially differ from project bonds and conventional bonds in legal terms. Apart from the prohibition to charge interest on the principal, the key feature of sukuk is that it should give its holder the legally executed right of direct ownership in the underlying assets. Although this usually applies to existing and tangible assets, a sukuk giving rights to future assets was also recognized as Shariah compliant. This was the case with the legal structure of the first ever project sukuk issued in 2011 by Saudi Aramco Total Refining and Petrochemical Company (Satorp) where the key asset – the Jubail oil refinery is still being built.
This clear proprietary character of sukuk structures came under the scrutiny of the US courts in the East Cameron Gas Co. bankruptcy case. East Cameron Gas Co.’s $165.67 million investment trust certificates were structured as a Musharaka between an offshore SPV domiciled in the Cayman Islands and the originator, East Cameron Partners. The offshore SPV issued sukuk and contributed the proceeds to the onshore SPV, while the company made an in-kind contribution of the overriding royalty interest (ORRI) in the lease properties. In October 2008, East Cameron Partners (the originator) filed for bankruptcy and this created uncertainty about how the sukuk holders would be treated under U.S. bankruptcy law. Eventually, despite criticism of its legal structure, the US courtsmade an order under which the Sukuk certificate holders were able to get full ownership and possession of the project assets without having to share it with the other creditors.
In another sukuk default case, the Nakheel sukuk issued by a subsidiary of Dubai World, there was a situation where, after the default by the issuer due to the impact of the global financial crisis, the sponsors who initially guaranteed the issue were not in the position to fulfill their obligations and the only way for the investors exit was to gain redress to the property underlying the deal. Even though this case was settled without going through the UAE courts, it highlighted the importance of the proprietary rights of sukukholders in an insolvency scenario.
Based on the above outline, parties who wish to raise debt financing in the Middle East are strongly advised to use sukuk structures for their deals. In the current investment environment, apart from strong economic reasons related to high liquidity of the Islamic Finance market, the use of Sharia compliant instruments gives the investors clear legal advantages. One should not also neglect the behavioral aspect of using Shariah compliant structures where the sponsors and managers of the underlying project have higher moral and legal responsibility to honour their duties because, firstly, they will have not only business but also religious reasons for being diligent and secondly, from the outset they will have a clear understanding that they are dealing with assets belonging to others not themselves.
From a public policy perspective the wide use of Islamic securities will help the GCC countries to develop their domestic capital markets which will be a valuable alternative to normal bank lending.
About the author
Makhbub Radzhabboev is head of Banking & Finance at TLG The Legal Group, Dubai. Before joining the firm he has worked with EBRD, The World Bank and Agroinvestbank and he specializes in Russian, Tajik and international law.
About The Legal Group.
Established in 1998, TLG is a highly reputable Dubai based law firm and is distinguished and renowned for its clear approach, significant accomplishments, international level client service combined with a market leading local presence. TLG is a full service law firm specializing particularly in areas of Real Estate, Corporate, Commercial, Dispute Resolution, Construction and Engineering, Banking & Finance, Employment and Intellectual Property. The firm’s priority is to provide legal advice that is insightful, valuable, cost effective and best serves the interests of its clients.
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2 See EC web site at http://ec.europa.eu/economy_finance/financial_operations/investment/europe_2020/index_en.htm
3 O. Salah, “Islamic Finance: The Impact of the AAOIFI resolution of equity based sukuk structures” (2011) available at: http://ssrn.com/abstract=1799222
4 AAOIFI Shariah Board, Resolutions on Sukuk, February 2008, Bahrain: AAOIFI 2008, available athttp://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf
5 See Mohammed Khnifer, “Lex Islamicus: When Sukuk Default – Asset Priority of Certificate-holders vis a vis Creditors” available at: http://www.opalesque.com/OIFI181/Lex_Islamicus_Sukuk_Default_Asset_Priority81.html
6 O. Salah, “Dubai Debt Crisis: A Legal Analysis of the Nakheel Sukuk” (2010) 4 Berkeley Journal of International Law, Publicist Spring Issue, 19-32