Saturday, November 7, 2009

Restructurings & Islamic Financing - Part 1

No, this post isn't a reflection on Surah Al-Baqarah Ayah 280, though perhaps that would make an appropriate topic for a future post.

Rather it's about some of the wrangling that has occurred about the legal nature and thus the legal status of "Islamic" deposits and loans versus those of conventional banks to borrowers in corporate distress.

As you might expect, in such situations legal status matters quite a great deal as it affects the payment of obligations.  At these critical times, creditors are looking to maximize the recovery of their obligations.  Borrowers are looking to avoid being needlessly harmed.  At that point the law can be a convenient tool to protect one's interests (and principal too!).  This is also usually the first time the parties to the transaction have really seriously focused on legal issues.

Because of the teachings of the Islam (prohibition against interest as well as other matters,) Islamic financings have different structures and thus different legal documentation than non-Shari'ah financings.  Many of these structures are of recent invention and application.

By contrast, even in the Muslim world, non-Shari'ah financing instruments have been used for a long time.  Therefore, they have been tested in a variety of court cases from simple breach of contract to corporate distress situations - reorganization, administration, and liquidation.   The  law is fairly well defined and ample precedent exists in common law countries.  Where the civil code prevails, the code has been amended, as necessary, in the light of experience.

By contrast Islamic financings have not yet been rigorously tested, particularly in the furnace of corporate distress and bankruptcy.  This is changing.  Two recent defaults on Sukuks (The Investment Dar and Sa'ad Group) will be the test cases (sorry for the pun) on this instrument.   Other defaults (Bahrain International Bank in 2002, The Investment Dar in 2009, etc) have tested and will test other Islamic financing structures.  But this process has only begun.  The robustness of Islamic financing structures will only be established after several rounds of such testing.

This post (the first of a planned series on this topic) will deal with short term financing.

To focus the discussion on what I hope are key details, I'll look only at financial institution distress.

When an Islamic financial institution wants to lend funds to another financial institution, it does not place a deposit as say Deutsche Bank might with HSBC at least not in the outward form.  But both place a sum of money for the same tenor and earn the same interest rate.

Two structures are commonly used:
  1. Wakala
  2. Murabaha
To place the discussion in context, let's first review a conventional non-Shari'ah deposit.  The depositor places funds with the bank and is paid an agreed  interest rate.  The bank takes the depositor's money and funds a loan, an investment, etc.   The bank's obligation to repay the deposit is completely separate from the performance of the asset (loan, investment, etc.)  If the bank makes a duff loan, it still owes the depositor his money back.

Islamic deposits take a completely different legal form.

Under a Wakala (fiduciary) contract, the bank acts as the client's agent (Wakil) in selecting an investment to be made with the funds.  The client is the principal (Muwakkil) in the investment transaction.  Therefore, repayment of the client's funds is conditional upon the performance of the asset.  If the investment turns out to have been bad, the client  loses his money, unless the Wakil  has been negligent.

This form of Islamic deposit appears equivalent to a non Shari'ah trust account.  Based on that legal interpretation, it would not be part of the assets of the bank.   In the event the bank went into liquidation,  those assets would not be part of the bank's estate in bankruptcy.

By contrast  the assets funded by a conventional deposit would be part of the bank's estate.  And  the proceeds from those assets would  be shared among all creditors according to their legally established priority for repayment.

Under a Murabaha (cost plus financing) arrangement, the bank (the Purchaser) and its client  (the Seller) agree to trade goods - usually commodities.  The bank acts a purchasing agent for the client, buying commodities (often non precious metals) from one party and arranging a forward sale of these commodities to another party on behalf of the client with payment to be made on a deferred basis.

If you relate this structure to a conventional deposit, the time between the spot purchase and the deferred payment is the tenor of the deposit.  The difference between the cost of the purchase of the commodities (the deposit) and the deferred sales price (cost plus profit) is the profit margin.  In conventional banking this would be called the interest.

Now let's take these two concepts into the world of corporate distress.

First, Murabaha transactions.

When Bahrain International Bank ("BIB") encountered problems in 2002, its creditors' initial assessment (which by the way turned out to be too pessimistic, I am told) was that  they would recover  only 15% of the face value of their obligations.

As one might expect,  this concentrated a lot of minds that previously had apparently been highly unfocused on credit and legal issues.  Some clever non-Shari'ah creditors came up with  a way to get their claims preferred over the Islamic creditors.  If successful in this endeavor, they would enhance their recovery to 25% to 30%.

How could they do this?

Most legal jurisdictions have a special bankruptcy regime for banks which gives depositors and lenders priority over certain other creditors.  Some of the conventional banks argued that the Murabaha transactions were sales and purchase contracts not deposits.  And, thus, their own deposits should be paid first with any money left over (the expectation was there would be none) used to settle these non deposit "commercial transactions".  As you can see from the structure and legal contract described above, there is some merit to this argument.

For their part, the Islamic banks vigorously defended their transactions as deposits.  To do otherwise would be to take a loss.

The Central Bank of Bahrain refused to entertain the non-Shari'ah creditors' argument.  The Murabaha transactions were treated as deposits.  Whether this was solely a legal decision or whether public policy considerations (preserving Bahrain as an Islamic banking center) played a role is not clear.  Given the language in the Murabaha contracts, one could well imagine the basis for  a contrary decision.

Now, let's look at Wakala transactions, where the shoe is on the other creditor's foot.

Currently, The Investment Dar Kuwait ("TID"), an Islamic investment firm, is in the midst of a  very difficult KD 1 billion (US$3.5 billion) restructuring. Some Islamic banks and other creditors which have placed funds with TID on a Wakala basis are arguing that these are really fiduciary transactions.  Therefore, they are not part  of TID's assets.  As such, they should not  be shared with creditors of TID.   Rather they   should be returned immediately to the Islamic banks.  An article in the 11 October issue of AlQabas includes language which suggests that this interpretation is supported by the Central Bank of Kuwait ("CBK") 

As an aside, AlQabas is a newspaper.  It is not the CBK.  Nor is it a court of competent jurisdiction.  Time and proper authority will determine the status of these transactions.

Given that often the most bitter fights in a restructuring are among creditors themselves rather than between creditors and the borrower, the BIB and TID stories suggest potential areas of dispute between Islamic and non-Shari'ah creditors.  And depending on the particular structures used apparently ammunition for each side to get its claims preferred.

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