Middle East Capital Markets Watch: DCM

Key Considerations

Shariah v contractual position   

Over the years, a number of distressed obligors of Sukuk have sought to challenge the enforceability of their contractual obligations on the grounds that the underlying Shariah structure for their Sukuk transaction was at odds with Shariah principles; the most high profile example of this in recent years being Dana Gas. Such challenges have rarely been successful, and the relevant transactions were either redeemed or became the subject of a successful restructuring. These challenges, or the threat of such challenges, are nevertheless a tool which can be used by distressed obligors to improve their bargaining position in the context of restructuring negotiations.

Bearing this in mind, formal or ad hoc committees of Sukukholders (to the extent formed) and their advisers would be well advised to consider the terms of the Shariah structure for the original transaction to formulate well-articulated defences to any potential non-compliance arguments by the obligor. Whilst English courts have been clear in numerous instances that, where Islamic finance documents are expressed to be governed by English law, it is that law which will govern its interpretation in the context of a dispute, it is nevertheless well advised to consider rebuttals to any nuisance-driven claims which may be made. Furthermore, it is important to ensure that Shariah scholars of various anchor Sukukholders are consulted early on in respect of any proposed consensual restructuring of the instrument to ensure that no issues from a Shariah perspective arise in connection with any revisions to the transaction structure. 

Additional steps which may be taken to protect against non-compliance arguments in the future are including a representation from the obligor that it will not challenge the validity of the relevant contracts on the basis that they are not compliant with Shariah principles (which representations have now become market standard), as well as structuring any security to be provided in any consensual deal (e.g. in respect of accounts with cash balances) in jurisdictions which are unlikely to have sympathy with arguments around Shariah compliance. 

Nature of recourse – Asset based v asset backed 

Whilst Sukuk are typically structured such that underlying Shariah compliant assets generate the cash flows to allow payments to Sukukholders to be made, there is often uncertainty among Sukuk investors (particularly conventional institutions) in relation to the precise nature of the recourse available to them; this is the often cited “Asset based v Asset backed” distinction¹. Further, as the exercise of enforcement related rights by Sukukholders is relatively rare, Sukuk investors may not be familiar with the formalities required to exercise their rights under Sukuk documentation.  It is therefore essential, at the outset of any situation relating to a potential distressed Sukuk, to review the terms and conditions and transaction documents that govern the Sukuk to confirm the rights available to the Sukukholders (or the sukuk “Delegate” which, in effect, exercises a role akin to that of a note trustee on a conventional bond).

Value and availability of assets  

While concerns in relation to the availability and valuation of assets are likely to exist in any distressed restructuring where security is required to be taken, there are additional considerations that apply in the context of restructuring Sukuk; this is because the value of the underlying assets for any proposed consensual restructuring of the Sukuk must be sufficient to support the Sukuk deal size and cash flows on a pro forma basis when the restructuring is consummated. For example, if the size of the Sukuk is contemplated to be increased as part of any restructuring, there must be sufficient Shariah compliant and unencumbered assets available to support such an increase in size. Similar considerations apply to the periodic distributions payable under any increased transaction size.  These issues are likely to be particularly relevant in multi-creditor restructurings, where both conventional and Shariah compliant investors are present.  In these circumstances, there may be a conflict between the conventional financiers who wish to take common security over all available assets, while the Sukuk creditors will require their own separate pool of unencumbered assets to support the Sukuk. 

Tradability from a Shariah perspective 

Related to the above, Shariah principles require that, in the context of Sukuk, a certain proportion of the underlying assets for a Sukuk are “tangible” from a Shariah perspective, to allow the Sukuk to be traded in the secondary market at a premium or a discount to its nominal value. This is particularly relevant in the context of the relatively recent introduction of Standard 59 of the AAOIFI Sharia Standards, which regulates the secondary trading of Islamic financing transactions. Whilst many distressed debt investors (including those that invest in distressed Sukuk) are not Shariah compliant institutions (such as conventional hedge funds) and therefore are generally agnostic as to whether a Sukuk is permitted to be traded from a Shariah perspective, it is important to ensure the liquidity of any new Sukuk instrument borne from a restructuring exercise does not alienate the many Sukuk investors that are required to invest in Shariah compliant securities only (including UAE banks which are required to comply with Standard 59 requirements). It is, therefore, important to ensure the Shariah analysis also focuses on tradability of any new instrument early on in restructuring discussions.

Local insolvency and other considerations 

As is the case in the conventional context, it is integral in the context of any distressed situation involving a Sukuk instrument for the obligor(s) involved, the Sukukholders and their respective advisors, to consider local insolvency regimes; that is, the insolvency regime(s) which would be applicable in the event that the relevant obligor became insolvent (either on a voluntary or involuntary basis). Whilst it is often in the interests of all parties to work towards negotiating an out of court, consensual restructuring arrangement, it is crucial to be alive to the insolvency processes and the options available to both debtors and creditors in each such process in the jurisdiction of the obligor(s), so that effective offensive and defensive strategies are employed in any restructuring exercise, often in parallel to consensual restructuring discussions.  

In a similar vein, it is important for all parties to be aware of other restructuring tools which may be available in the legal jurisdiction in which the obligor is incorporated. These will dictate the extent to which structures/tools often used in conventional transactions (e.g. debt to equity swaps, warrants, etc.) can be employed and the parameters which are relevant to their use in the relevant transaction. 

Implementation of any consensual arrangement and/or enforcement 

Once any consensual arrangement is agreed as between the obligor and the relevant Sukukholders (or their relevant committee), or if a deal cannot be reached, the following should be borne in mind:

• Delegate engagement - it is usual for a “Delegate” to be appointed to exercise the rights of the Sukukholders (in similar way to a bond trustee on conventional bond transactions). The Delegate will typically require indemnification and/or pre-funding before agreeing to take any substantive actions in relation to the matter, and so it is important the parties engage with the Delegate as early as possible in the process (noting that the commercial terms of any indemnity and pre-funding between the delegate and the Sukukholders may take some time to agree). In addition, the Delegate will require instructions on how to proceed from a requisite proportion of Sukukholders; the instruction will typically need to be in the form of an extraordinary resolution passed by the requisite threshold of Sukukholders or at the written direction of specified percentage of Sukukholders. The relevant notice periods and quorum and voting thresholds to pass the extraordinary resolution(s) will be prescribed by the Sukuk documentation, and so it is important for these matters to be reviewed early on.
• Consent solicitation v Exchange Offer - Any restructuring of a Sukuk will usually involve a material amendment of the terms and conditions that will require the approval of the Sukuk investors by way of extraordinary resolution(s). As such, the parties will need to consider whether it would be more expedient, based on a number of factors including the requirements of the Sukuk documents, for the consensual restructuring to be implemented by way of a consent solicitation (whereby consents are sought from and provided by Sukukholders in relation to an amendment of the Sukuk) or an exchange offer (whereby the existing Sukuk is exchanged for another Sukuk on the new agreed terms). Any exchange offer will need to comply with the terms of the existing sukuk documents, applicable listing rules (if the Sukuk is listed) and relevant securities law.

Conclusion

The above are only some of the key factors that obligors, Sukuk investors and their respective advisors should be aware of in a distress scenario related to a Sukuk. Others may of course arise in a transaction specific context, and it is important to consider these in the early planning stages of any potential consensual or contentious restructuring transaction.