Restructuring challenges in Islamic financing
November 2010 | TALKINGPOINT | BANKING & FINANCE
FW moderates a discussion between Hani Bishara at Ernst & Young and Christopher W. Langdon at Latham & Watkins LLP, on the restructuring challenges surrounding Islamic finance.
FW: How would you describe the state of the local bank debt finance market and the outlook for Q3 2010 into 2011?
Bishara: Many companies in the region continue to face challenges in obtaining new – or even extending existing – credit facilities. Lenders are increasingly becoming more demanding of their corporate clients, expecting more transparency and more diligence into the affairs of businesses. The existence of multiple bilateral lenders for individual corporations has exasperated this issue as lenders face concerns of at least perception of inequity between lenders. This generally translates to increasing pressures on debtors and demands for payment, equity injection or increased security. The imbalance on many regional balance sheets with short-term financing utilised for long-term and now devalued (and illiquid) investments also adds to the complex situation as repayment is seemingly always pushed into the future with mounting accumulated interest expense providing no source of relief on businesses cash-flows already affected by lower volumes. This environment will continue to put pressure on liquidity for many corporates well into 2011, as many companies will look to reschedule their debts and seek sources of refinancing in a region with relatively few options.
Langdon: On the heels of the 2008 global financial crisis, Saudi Arabian (and GCC) credit growth fell sharply in 2009 as liquidity tightened and banks became increasingly risk averse in the face of rising non-performing loans and deflated asset prices. A number of restructurings and workouts are still playing out in the Kingdom which were precipitated in late 2008 and early to mid 2009 due to the tightening of credit markets and many borrowers’ cash flows being affected by a reduction of commodity prices. In 2010, dollar new money deals have remained sluggish, but Saudi Riyal new money deals, along with refinancings, seem to be enjoying greater liquidity and activity. Many banks have now provisioned and put the worst of the last 18 months behind them, and are well capitalised to provide a sound basis for growth into 2011.
FW: In the context of a default by a debtor, what typical enforcement options would a creditor have?
Langdon: As an Islamic state, it must always be kept in mind that the law of the Kingdom of Saudi Arabia is based on the Shariah, with the Quaran and Sunnah as principle sources of law. Given that interest is ‘riba’ or forbidden under Islamic law, for example, there are obvious tensions between the basic Saudi Arabian legal environment and the interests of typical bank creditors. Nonetheless, creditors do have a number of enforcement options. Firstly, a creditor may make application to the Negotiable Instruments Committee under the Ministry of Commerce and Industry for recourse in respect of promissory notes or the like, provided such notes are in the appropriate form. Another route is the Banking Disputes Settlement Committee, or SAMA Committee, formed under the Saudi Arabian Monetary Agency, which has jurisdiction over all disputes involving banks and their customers, excluding negotiable instruments. Often colloquially referred to as a ‘court’, in fact the SAMA Committee has jurisdiction to orchestrate a ‘settlement’ between parties. Any process before the SAMA Committee may take up to two years or more and there is currently some debate in the Kingdom as to whether settlements can be appealed to the Board of Grievances. If the SAMA Committee cannot or does not take jurisdiction, or if creditors are seeking to enforce security, the dispute will fall to Board of Grievances’ jurisdiction. The timing in this regard is very open ended – a case may take up to several years to hear. And, given that the judges sitting at the Board of Grievances are also Shariah court judges, there is an element of uncertainty in results, including a stricter application of Shariah principles, meaning that interest is almost certainly not recoverable and any interest paid to date may be deducted from outstanding principle.
Bishara: While there are a range of technical enforcement options, they still remain fairly untested and therefore not desirable due to the lack of certainty on outcome. Many regional lenders still rely heavily on guarantees provided by either large sponsors or key shareholders.
FW: Is the local bankruptcy and insolvency regime in your region a viable solution for creditors?
Langdon: The Kingdom has a Bankruptcy Code and a number of pieces of legislation that provide a framework for bankruptcy and insolvency. The Bankruptcy Code is fairly archaic, though, and was originally drafted to apply to individuals. It is largely untested in respect of large or complex corporate bankruptcies and the Board of Grievances, which has jurisdiction, has limited experience in applying it to companies. Basic principles seen in Western legislation is evident in the Code, including hardening periods, ranking of creditors and schemes of arrangement – and these principles are helpful in having a base line position at law – but in our experience creditors are quite hesitant to commence bankruptcy proceedings since they may take several years to play out. It’s worth noting that Saudi legislation includes bankruptcy avoidance regimes – ‘amicable conciliation’ sought by a debtor from its creditors under supervision of a committee formed by the Ministry of Commerce to avoid bankruptcy. Debtors may also apply to the Board of Grievances to convene ‘settlement procedures’ with creditors to avoid bankruptcy. However, again, given the uncertainty of results, creditors are hesitant to pursue these avenues.
Bishara: Currently most insolvency regimes in the Middle East remain largely untested and therefore do not necessarily provide the intended relief an established and robust process would offer.
FW: Given the local legal environment, what can creditors do with distressed credit? What challenges exists in terms of standstill, settlement and enforcement issues?
Bishara: Creditors must work more closely with distressed debtors to gain a proper understanding of their financial position and be prepared to accept longer term repayments and haircuts. There is continued resistance for lenders and creditors to accept anything less than full recovery when it is clear that in some situations that is not a viable option. Once this notion is more accepted, restructuring transactions stand a greater likelihood of success. Enforcement of standstill arrangements for any period of restructuring, although timely, is necessary in many transactions to ensure a level playing field among lenders and to create a form of stability. Ensuring all parties abide by these standstills is, however, difficult at times due to some situations where lack of familiarity with the process and lack of confidence in the process makes it less effective. Nevertheless, given the local legal environment, these informal arrangements are quite key, albeit at a pace and sometimes expectations that put the process to the test.
Langdon: In our experience, assuming a debtor is viable, the most likely solution for creditors is to seek a consensual restructuring of defaulted financial debt. However, this is really only sensible when the financial condition of the debtor has deteriorated but the situation is not irreversible. For the lost cause cases, there may well be no option but to follow the Saudi Arabian bankruptcy and insolvency route. However, banks in the Kingdom seem to be prepared to go to some length to try to turn a distressed creditor around. While we have seen examples of fairly quick action taken by the banks, standstill, settlement and, if possible, enforcement, steps can be quite time consuming and involve protracted negotiations with various stakeholders to implement.
FW: Are consensual restructurings in your region analogous to other jurisdictions?
Langdon: Broadly speaking, consensual restructurings in the region are analogous to other jurisdictions, but there are, of course, wrinkles. Typical maturity solutions, changes to capital structures, sale of non-core assets, etc., are looked at by the bankers and turnaround specialists. We’ve seen strong escrow arrangements put in place at the standstill stage of a restructuring with aggressive supervision of assets and cash controls. Also, given the novelty of debt workouts in the Kingdom, banks are less experienced in approaching standstills and restructuring processes and tend to rely more heavily on their advisers or internal specialists. The restructuring teams at the banks are under extremely heavy workloads, with many handling multiple workouts at the same time. The banking community in the Kingdom is also very small and tight and so there is very much a natural consensual approach to workouts where banks tend to shepherd any outliers.
Bishara: Most emerging markets will have similar challenges as they lack infrastructure and precedents required to effectively deal with restructurings and insolvencies. Even within the region almost no two consensual restructurings are alike, with varying parties, requirements and expectations.
FW: Do Islamic financial structures challenge conventional debt restructurings? If so, how?
Bishara: Islamic transactions are based on underlying contracts that have to be taken into account upon restructuring. It adds a further dimension to the restructuring effort; we would, however, not necessarily call it more challenging.
Langdon: Typical debt restructurings are generally predicated upon conventional debt – Islamic debt, with its variety of structures and forms, can create interesting challenges. With the current economic environment, Sukuk bonds, for example, are seeing more defaults and the integrity of default and creditor protections under Sukuks are now being tested. The core structure of Islamic finance transactions raises challenges: pricing and underlying assets, along with maturity mismatches and roll-overs of murabaha transactions. A further challenge is that even if a commercial solution may be applied in respect of the restructuring of an Islamic facility, Shariah approvals may not be easily obtained.
FW: Is Islamic finance inherently more risky than conventional debt, in terms of recourse and workout solutions? What impact do Shariah principles have on the process?
Langdon: We don’t think that Islamic finance is inherently more risky than conventional debt. Particular types of Islamic structures may actually present less risk than conventional loans: Ijara structures, for example, where financiers retain title to an asset and in effect lease use of the asset for the tenor of the financing may offer enhanced security over the financed assets. Recourse under Islamic structures may, in Islamic states such as the Kingdom, offer greater certainty as to recovery of ‘profit’ amounts or, in conventional terms, amounts analogous to interest. However, there are challenges to bear in mind. Recent English court cases have considered the position of Shariah law in the context of English law governed documentation and it is important for financiers to establish up front diligence on borrowers’ capacity and authority to enter into a financing – though, in fairness, this is essentially the same for conventional or Islamic finance structures. Preserving the Shariah compliance of an Islamic facility in a work out can also be a challenge, particularly in cases where perhaps more conservative financiers or Shariah boards are involved.
Bishara: While Islamic debt is not necessarily riskier than conventional debt, workouts do require additional understanding of Shariah principles and their practical application in order to figure out possible solutions. In most instances, complex Islamic transactions are backed by tangible assets making it less riskier than comparable conventional financial instruments. In both cases, however, the transaction structure, quality of documentation and risk due diligence ultimately determines the flexibility available for restructuring.
FW: What is the outlook for restructurings in your region for 2010 into 2011?
Bishara: The general expectation is for continued need for restructuring into next year and that with more experienced restructuring professionals and lenders in the region, it is likely to see these transactions managed more effectively and take less time. It will be important for some larger restructurings to emerge successfully and that may be the required impetus to encourage corporates to be more proactive in taking initiatives required.
Langdon: We expect to see the completion of about three formal major restructurings in the next few months – though there may be others in the pipeline. It should be recognised that for every formal standstill and restructuring going on in the Kingdom in respect of distressed credits there are many other stretched credit situations being resolved. We expect to see less distressed credits throughout 2011 as liquidity returns to the credit market and general economic conditions improve.
Hani Bishara leads Ernst & Young’s Restructuring group in the Middle East. For over 13 years he has provided restructuring, insolvency and turnaround corporate finance services to businesses in financial difficulty across a wide range of industries. Experience includes providing a variety of solutions for all stakeholders when businesses begin to underperform or face liquidity issues. Mr Bishara has significant experience in telecom, financial services, manufacturing and real estate sectors. His experience is originally from the North American market but has spent the last two years working exclusively in the Middle East. Mr Bishara is a licensed trustee in bankruptcy (Canada), a chartered insolvency and restructuring professional, a chartered accountant, and holds an MBA from the Schulich School of Business. He can be contacted on +971 4312 9290 or by email: Hani.Bishara@ae.ey.com.
Christopher Langdon is a finance partner in the Riyadh office of Latham & Watkins. He advises on a broad range of project finance and development transactions, banking and financial restructuring, including in relation to Islamic financing. Mr Langdon has been involved in many of the significant financial restructurings in Saudi Arabia and has particular expertise in the restructuring of Islamic finance transactions. Legal 500 writes Mr Langdon is “proactive and can be relied on to take charge of a task in its entirety.” He recently co-authored “Islamic Finance Restructuring: Sector Overview” which was published by Islamic Finance News in July, 2010. He can be contacted on +966 1 207 2511 or by email: email@example.com.
© Financier Worldwide
Ernst & Young
Christopher W. Langdon
Latham & Watkins LLP