The untested waters of default in Islamic finance

Dennis Ryan and Fawaz Elmalki, Associates with Conyers Dill & Pearman, Dubai office report on this highly topical subject in this first of a two part series.

The Cayman Islands has developed a reputation as a jurisdiction of choice for Islamic finance structures, including sukuk. However, such structures are largely untested and have been drawing attention in the Cayman Islands following recent announcements from Dubai World relating to negotiations with creditors for a standstill on the repayment of certain debt obligations including a sukuk issued by its subsidiary, Dubai property developer Nakheel. These announcements follow the controversial ongoing bankruptcy proceedings involving East Cameron Partners’ sukuk (involving a Cayman issuer), and a recent sukuk default by an entity in the Saudi Arabian Saad Group. These events raise issues relating to the functionality of sukuk structures in the event of a default or a restructuring.
Islamic law, or Shariah, principles must be applied when structuring Shariah-compliant financial products, including sukuk. These principles include the avoidance of riba (interest), gharar (uncertainty or speculation in contracts), unjust enrichment and prohibited activities or investments (such as gambling and alcohol related investments). Undoubtedly the Islamic finance term most commonly referred to in the financial newspapers of Western countries is “sukuk”. Sometimes known as Islamic bonds, sukuk are better described as trust certificates or participation securities created pursuant to a declaration of trust that grant the investor a share of assets along with the cash flows and risk commensurate with such ownership. Each certificate represents an undivided beneficial ownership in the assets held in trust by the issuer, and ranks pari passu with other certificates. In most sukuk, certificate holders have no recourse against the issuer for the payment of any outstanding amount in respect of the certificates and typically do not have security or any preferential claim over any of the assets held in trust. 
The most common type of sukuk structures are sukuk ijara (a lease structure), sukuk musharaka (a partnership structure) and sukuk mudaraba (a management and profit sharing structure). The majority of recent sukuk structures have been sukuk ijara where the originator (or borrower) seeking financing transfers certain of its assets to a special purpose vehicle.SPVs formed as issuers of sukuk ijara are frequently incorporated in an offshore jurisdiction. The SPV is typically owned by a charitable or a purpose trust (such as a Cayman STAR trust). The SPV will issue sukuk or trust certificates and invest the proceeds in assets. Trust arrangements typically are governed by English law. The issuer of the sukuk holds the assets in trust for the benefit of the sukuk holders pursuant to a declaration of trust, using the income from the assets to make payments to the sukuk holders. The rights of sukuk holders in the event of default will vary depending on whether the sukuk structure is an “asset-based” or an “asset-backed” structure.
In an asset-based sukuk, the investors are not granted legal title in the underlying assets, rather they must depend on the creditworthiness of the originator of the sukuk or the borrower. Investors must rely on an undertaking by the originator to purchase the sukuk assets in the event of a default or upon maturity of the sukuk. 
Alternatively, in an “asset-backed” sukuk, legal title to the underlying assets will typically pass to the issuer SPV and on default by the borrower, sukuk holders are able to exercise certain rights of ownership and control over such assets.  The elements of true sale, fundamental to a securitization, must be present in an “asset-backed” sukuk. An asset-backed sukuk is similar to a securitization in that it is a non-recourse obligation and credit risk performance is determined solely by the underlying asset.
Though the Nakheel sukuk is an exception, to date many sukuk issuers have been established as Cayman exempted companies. As a result, issues may well arise under Cayman Islands law as to how investors in a sukuk will be treated and what recourse they may have in the event of a default or in the course of a restructuring. The difficulty in this regard stems from the fact that investors and the courts may well struggle to make legal sense of finance structures that are designed primarily to comply with Shariah.  Moreover, the questions of governing law, jurisdiction and enforcement authority may be entangled. As mentioned above, although a sukuk issuer is often incorporated as a Cayman Islands exempted company, the transaction documents, including the declaration of trust, are typically governed by English law and the courts of England will normally have exclusive jurisdiction to settle disputes under such documents. Since the underlying sukuk assets may be located outside of the Cayman Islands or the United Kingdom (in the Middle East for example), conflict of laws issues arise. Some foreign courts, for example, tend to guard their jurisdiction over a matter jealously and view the retention of jurisdiction as a matter of public policy. As a result, clauses purporting to grant exclusive jurisdiction to a Cayman Islands or United Kingdom court may be deemed to be contrary to public policy and not upheld. Furthermore, where there are no bilateral treaties for reciprocal enforcement of judgments between the Cayman Islands or the United Kingdom and foreign jurisdictions where the assets are located, even if judgment is obtained in the Cayman Islands or the United Kingdom against the borrower, there may be additional hurdles to be overcome to have those judgments enforced in those foreign jurisdictions.
The East Cameron Partners’ sukuk was the first US originated sukuk. In October 2008, East Cameron Gas. Co. filed for bankruptcy protection under Chapter 11 in the U.S. Bankruptcy Court for the Western District of Louisiana after its offshore Louisiana oil and gas wells failed to yield the expected returns, partly because of hurricane damage. The ultimate question facing the court in the East Cameron case is whether the sukuk holders actually own a portion of the company’s oil and gas royalties. The company argued that there had been no transfer of ownership of royalties into the Cayman SPV formed to issue the sukuk.  They submitted that the transaction was really a loan secured on those royalties suggesting that sukuk holders would have to share the royalties with other creditors in the event of liquidation. At this stage in the East Cameron proceedings, the bankruptcy court appears to have rejected East Cameron’s secured loan argument when it said that “holders invested in the sukuk certificates in reliance on the characterisation of the transfer of the royalty interest as a true sale.” If East Cameron cannot advance additional arguments favourable in support of its case, the sukuk holders’ rights will obviously be strengthened and they may be entitled to the stream of royalties.

This article is not intended to be a substitute for legal advice or a legal opinion. It deals in broad terms only and is intended to merely provide a brief overview and give general information.