Department of Technical Quibbles: The Arabtec Liquidity Crisis and Basic Accounting

Last Conference:  Abu Arqala's Name Tage

A 1 June Gulf News article on liquidity problems at Arabtec caught Abu Arqala’s lately reopened eye last week. 

http://gulfnews.com/business/sectors/construction/arabtec-running-out-of-options-for-liquidity-1.1839055 

I don’t have an issue with the contention that Arabtec’s liquidity is strained.  Nor that the company is struggling.

The firm’s financials show it is indeed having financial difficulties.  The auditors’ qualified opinion for 2015 made even “less pretty” by the “matter of emphasis” comments and the income and cash flow statements paint a rather unhappy picture.   

But I do have a beef with two statements in the article. 

These appear to be based on less than a solid knowledge of accounting or UAE laws.  Because they are coming from “experts” I think they could well mislead readers.  Those concerns prompted this post and the start of a new feature on this blog “The Department of Technical Quibbles” or DOTQ for short.  

       Here are the two “offending” quotes.

• “Analysts questioned whether Arabtec would be able to break even this year after the company held a general assembly on Wednesday to get shareholder approval to pull Dh1 billion out of its statutory reserve.” [This may sound like the company can lay its hands on AED 1 billion in “cash”. It also seems to infer that accounting entries about past events can affect the future].

• “He said that having such massive losses also makes banks more reluctant to give out loans, which leaves the statutory reserve as the only resort for immediate liquidity.” [The “found cash” theme again.]

Let's drill a bit deeper into what Arabtec is doing.

First, what Arabtec is proposing is an accounting entry.   

1. If shareholders approve, Arabtec will debit the statutory reserves by 1 billion AED and credit retained (accumulated) losses with the same amount.   
2. This accounting entry will take place solely on the liability side of Arabtec’s balance sheet.  Assets will be unaffected.  Keep this in mind as it will be a central idea in the "fourth" main point below.    

Second, a glance at the shareholders’ equity account as of 31 March 2016 shows that the statutory reserve is included in shareholders’ equity along with other equity accounts resulting in total shareholders’ equity of 3.2 billion AED.   

1. What that means is that after the entry, the balance sheet total shareholder’s equity will not change. In effect the statutory reserve has already been netted against the accumulated losses on an economic basis.   
2. If bankers and financial analysts do not understand this, may God protect them from their lack of knowledge and from making duff loans or investments.  
3. http://www.arabtecholding.com/FinancialReports/FY16Q1_English.pdf

Third, if there isn’t a cash benefit, why is Arabtec taking this step?  For legal reasons.  

1. Like other GCC states, the UAE requires (Article 285 Commercial Companies Law 1984, as amended) that companies take action when accumulated losses are greater than 50% of statutory or legal capital.  At that point, companies have two choices:  dissolve the company or continue.  In the latter case the situation must be rectified. 
• Article 285:   If a joint-stock company sustains loss amounting to one half of the capital the Board of  Directors shall convene an Extra-Ordinary General Meeting and resolve whether the company shall be maintained or dissolved before the term fixed in its Articles of Association.  Should the board fail to invite the Extra-ordinary General Meeting of it was impractical for the General Assembly to adopt a resolution on the matter in question, any interested party may file an action demanding dissolution of the company.”  http://niemands.ru/files/uae_law/uae_companies_law_niemands.pdf 
• The rectification takes place via raising new capital or by reductions in legal capital, offsetting reserves against the loss, or merger.  The following two cases illustrate the process.  
• Takaful Emarat Insurance (2014).  http://feeds.dfm.ae/documents/efsah/2014/May/22/611c52f3-1780-4c38-9cc5-41d9f35e3eff  /TAKAFULEM_FS_Q1_E_13_05_2014_0607PM_NM.pdf    
• United Insurance Company (2015) http://www.asiainsurancereview.com/News/View-NewsLetter-Article?id=33206&Type=MiddleEast 
• Reducing legal capital raises a host of inconvenient issues, e.g., redenomination of nominal share price/par value, reduction in the number of shares, etc.  Raising new capital is expensive and difficult at such times, though perhaps not when one has a motivated government shareholder. Using existing reserves is relatively painless.
2. As of 31 March 2016, Arabtec’s legal capital was 4,615,065,000 AED.  Its accumulated losses at that point were 2,273,762,000 AED.  A further 33,770,501 AED—a relatively small amount--would trigger the operation of Article 285.  
3. By acting now, Arabtec “buys” itself legal breathing room by pushing the 50% trigger further out.  It’s also much easier to take this step at an AGM than at an EGM.  
• Last year the company had to postpone its AGM/EGM by a week due to lack of a quorum at the first meeting.  http://gulfnews.com/business/sectors/markets/arabtec-postpones-egm-agm-ue-to-lack-of-quorum-1.1497868   
4. Does Arabtec need breathing room?  Sure looks like it.

• A modest 34 million AED will trigger Article 285.
• 1Q 16 losses were 48 million AED. 
• There is no evidence of dramatic turnaround in the last few months. 
• The company’s management is privy to to-date undisclosed 2Q16 performance. 
• Perhaps, the limit has been breached already, but since the AGM voted 1 June to use the reserves, the problem is solved.  For now at least.  

Fourth, but what about the liquidity the second quote refers to? 

1. Liquidity generally refers to two things. 
• The ability to convert assets to “cash” quickly and at or very close to their carrying values on the balance sheet. 
• The ability of a firm to pay its current debts and obligations as they come due. This is different than “solvency” which deals with long term obligations and debt.  
• The more quality current assets one has and the fewer current liabilities the more liquid the firm. 
• But Arabtec’s proposed action has no effect on non-equity liabilities or on assets.  When the entry is made, the same assets and non-equity liabilities will be on the books after the entry as were there before.  The entry will not change their characteristics or values. 
2. Often individuals not familiar with accounting believe that if there is a “reserve” on the liability side—particularly one called a “statutory” or “legal” reserve--there is an account with “cash” of an equivalent amount on the asset side in a proverbial “lock box” that can’t be touched. That is not the case.  Liabilities merely show how assets were funded.  
3. As the company’s financials show there is no “pot” of “cash” sitting on the balance sheet that is equivalent to the statutory reserve amount and that will be freed up by accounting entry proposed by the company.  http://www.arabtecholding.com/FinancialReports/ARTC_FS_Ann_E_2016.pdf      

Fifth, how would the company’s accounting entries regarding past accumulated losses and accumulated statutory reserves affect its ability to turn a profit or generate cash in the future?  The entry doesn’t provide additional cash.  It doesn’t change the value of assets or non-equity liabilities. It doesn’t change current economic conditions.  In short, it doesn’t.

إعادة فتح "باب الاجتهاد" المالي - قريبا

بعد تقريبا ستة سنوات الصمت

سنفتح من جديد "باب الاجتهاد" المالي  - -- قريبا

نفس مقالات طويلة 

نفس كتابة غامضة

باذن الله افكار مفيدة 

Comment Moderation Enabled

Regretably, persistent posting of rubbish advertisements on the site has compelled me to enable comment moderation.

If you have a legitimate post, be patient. 

It may take a few or more days before it appears.

Awal Bank Chapter 11 Filing Update - Request for Extension of Time to Provide Information

Here's an update from Bell Pottinger Middle East on the case.  BPME is the PR company used by Charles Russell for the Awal Bank engagement.

Awal Bank files request for extension of time

Bahrain, 4 November 2010: Charles Russell LLP, acting as External Administrator and Foreign Representative (the “Foreign Representative”) of and for Awal Bank BSC (“Awal Bank”) has filed a request for an extension to the deadline to file schedules of assets and liabilities and statement of financial affairs (the “Schedules”) in the Chapter 11 Case commenced on 21 October 2010.

The request follows the first day hearing that took place on 26 October 2010 at which the Foreign Representative sought an order to establish a workable protocol to administer the Chapter 11 Case in cooperation and coordination with the Bahraini administration. After hearing from both the Office of the United States Trustee and counsel for the Foreign Representative, the Bankruptcy Court directed that the Motion be further considered at a later date in order to allow more time to assess the information provided and after giving opportunity for creditors to make representations regarding the relief requested in the Motion.

The Foreign Representative has determined that additional time is required to assess, among other things, creditor views in relation to the Chapter 11 Case. Upon this assessment being undertaken, the Foreign Representative will determine whether to further pursue the Chapter 11 Case. The Office of the United States Trustee has indicated it has no objection to the Foreign Representative’s request for additional time to file the Schedules.

In October 2009 the Foreign Representative obtained “foreign main proceeding” recognition from the Bankruptcy Court under Chapter 15 of the U.S. Bankruptcy Code for Awal Bank’s administration proceedings in Bahrain.

The Bahraini administration governed by the Central Bank of Bahrain and Financial Institutions Law (“CBBFIL”), continues to be recognised as the foreign main proceeding under Chapter 15. The U.S. based legal activities form part of a multinational litigation process, with court proceedings also currently underway in Bahrain, the Cayman Islands, the Kingdom of Saudi Arabia, Switzerland and the United Kingdom.

Please contact David J. Molton, Esq. from Brown Rudnick LLP, counsel to the Foreign Representative, at 00 1 212 2094822 with any inquiries.

Gulf Finance House - Draft Terms on New Sukuk = 23% Annual Return

 Choose Your Door Carefully.  Some Deals are Better than Others.

As you recall, GFH announced with great fanfare its plan to raise up to US$500 million in new capital.  If you don't, here's an earlier post.

I've just gotten a copy of the draft term sheet for the Sukuk from a reliable source.

First, a recitation of the terms:

1. Type - Convertible Murabaha Facility
2. Status - Senior Unsecured Debt
3. Maturity - 3.5 years
4. Profit Payment (aka Interest Rate) - Indicative 12% per annum!
5. Conversion Price - US$0.31 per share
6. Incentive Structure - If conversion election made before 31 December 2010, last 2.5 years Profit Payment in shares at US$0.31 conversion price.

Before the commentary, two very important caveats:

1. GFH's shareholders have not approved the issuance.  GFH's first OGM and EGM failed for lack of a quorum.  
2. The terms sheet is marked "indicative" meaning it's not binding, but rather serves as a basis for discussion/negotiation with potential investors. 
3. Nonetheless, these terms provide a window into what GFH's board and management believe will be necessary to secure investor interest.  In that regard, I'd note that the accompanying investor presentation (a future post will comment on that) states:  "Some commitments already received from Chairman, strategic investors, and related parties".  So you can be pretty sure that GFH has drawn on these disinterested parties to set market-based terms.

Now to the commentary.

1. Assuming a take and hold investor who does not elect conversion until after 31 December 2010, the promised return (IRR basis) is roughly 23% per annum. 
2. 12% of that return composed of cash (the "interest payments").   It's hard to see GFH earning sufficient returns to have much left for shareholders after the interest payment is made.
3. 11% of that from the discount on the shares (assuming the shareholders approve the 1:4  reverse split and GFH trades at 4 times its current US$0.125 per share.  A rather substantial dilution of existing shareholders.
4. The total promised return reflects the weak financial condition of the company when it has to offer essentially private equity like returns for its debt.  Of course, the actual return will depend on GFH's performance which may indicate a market judgment on the probability of such performance.
5. It also establishes what might be considered an "unfortunate" benchmark for GFH's debt issues. Particularly, when one considers this is apparently an early offer to potential investors.  And as we all know the first price in the suq is not the last.

Gulf Finance House to Ask Sukuk Holders for Three Year Extension

Reuters is quoting an unnamed GFH spokesman that the Bank intends to ask the holders of its US$200 million Sukuk issue (US$137 million outstanding) to roll the Sukuk on its original terms for three years.  That is, to extend the maturity from 2012 to 2015.

I'm not sure if "chuzpah" is an Islamic banking term, but it would sure seem to apply here.  The Sukuk is currently trading at around just a whisker over 50% of face value.

I'd also note that earlier this week GFH formally stated that it had not issued the information the Gulf Daily News report that it intended to either (a) sell assets to  US$90 million in debt next year or (b)  reschedule debt.   If you recall the original GDN article, there was a third alternative mentioned - which was extinguishing debt via asset transfers.  Interestingly enough, what is mentioned in the GDN article is precisely what I see  on page 13 in the copy of GFH's October 2010 "Return to Growth" Presentation to investors which I recently obtained. 

It is, I suppose, indeed sad that someone is issuing presentations using GFH's highly respected name in such a fashion.

As to pricing for GFH debt, please see my soon to be issued companion post on the draft terms for GFH's proposed new Sukuk.

National Bank of Kuwait – Related Parties’ Loans Analysis

One of our regulator and insightful commenters, Advocatus, said that there were rumors in the market that NBK was experiencing problems with its exposure to M Al Khorafi and had to extend the loans more than once to keep them from becoming classified as non performing.

An intriguing comment.

Abu Shukri is known as a careful banker, but even Homer nodded from time to time. And sometimes it is very hard to say "no" to a very well connected shareholder. As they say: "Past performance is not a guarantee of future results."

Without access to NBK's internal records, it's not possible to say one way or another. Let's look and see if we can find any signs of difficulties in NBK's financials.

Related Party Information

The first assumption is that loans to MAK or other AlKhorafi entities would be reported in the Related Parties Section. The data below is taken from the Related Party Notes in the Bank's Quarterly financials and is expressed in millions of KD.

Quarter	RP Loans	Collateral	% Cover
1Q07	215.1	519.7	242%
2Q07	262.2	608.4	232%
3Q07	294.9	634.3	215%
4Q07	307.3	672.6	219%
1Q08	285.5	728.2	255%
2Q08	295.2	742.0	251%
3Q08	316.6	719.1	227%
4Q08	350.6	494.4	141%
1Q09	278.8	451.5	162%
2Q09	310.4	544.9	176%
3Q09	189.7	363.8	192%
4Q09	219.3	343.8	157%
1Q10	210.7	380.2	180%
2Q10	186.5	350.7	188%
3Q10	183.7	413.1	225%

1. Collateral coverage is reasonably comfortable, except for 4Q08. If there was a problem with Related Party loans, it's likely this is when it occurred. Two factors accounted for this change: a very dramatic decline in collateral and an increase in outstandings. 
2. The significant drop in collateral coverage in 4Q08 coincides with the dramatic decline in market values following the collapse of Lehman. This suggests that the collateral is composed of equities and other marketable securities. 
3. One would also expect that this would be a time of liquidity and cashflow stress leading borrowers to draw down additional amounts to cover their needs. 
4. However, there is remediation on the principal side in 1Q09 with a KD71.8 reduction (twice the increase in 4Q08). That's quite remarkable because this was not exactly a "boom" time for Kuwait or the world in general. 
5. Further declines in 2010 appear to indicate that there is no problem with RP loans. By 1Q10 these were below their 1Q07 level. Collateral coverage remains comfortable and the absolute of loans outstanding is below those in 1Q07. 
6. I'd guess that Zain shares make up a good portion of the collateral for MAK exposure. But that is just a guess. If so, the Itisalat acquisition should lead to a further dramatic reduction in RP loans.

Renegotiated Loans

Another place to look is for the IFRS #7 Note on renegotiated loans. 

1. Note 28.1.4 to NBK's 2009 financials state that only KD8.4 million of loans were renegotiated in that fiscal year and nil the year before. I didn't seem similar disclosure in the 2007 financials.
2. If NBK were having problems with MAK exposure, one might expect to see larger "renegotiated" amounts, though it is possible in this sort of situation for a bank to extend a new loan to repay another short term loan and treat it as a new loan. One would expect that interest would have to be paid in full for the auditors to sign off. I'd note that one's expectations are not always fulfilled.

Conclusion

The financials don't disclose any problems, though as mentioned above this analysis is based on an external diagnosis without benefit of x-rays (details of NBK's exposure to the AlKhorafi Group).

International Investment Group - KPMG Report to be Released

IIG announced in several venues today that its new board had approved the release of the KPMG report to certificateholders of its Sukuk.

"Unfortunately", AA missed this "wonderful" investment opportunity.  What was I thinking?  And, so, I won't be getting a copy.

Anyone who has a spare copy that they don't mind sharing please contact me via this blog's Contact Page.

Awal Bank Chapter 11 Filing - Statement on Behalf of Charles Russell

In response to my request I received the following from Alisdair Haythornthwaite at Bell Pottinger Middle East (UAE).   BPME is a division of Chime Communications, a leading UK public relations firm (among other things).

Awal Bank BSC Chapter 11 Case Update

U.S. Court Delays Consideration of Awal Bank’s Proposed Chapter 11 Protocol

Bahrain, October 27, 2010:  Charles Russell LLP, acting as External Administrator and Foreign Representative (the “Foreign Representative”) of and for Awal Bank BSC (“Awal Bank”) attended a “first day” hearing on October 26, 2010.

At the hearing, the Bankruptcy Court considered the Foreign Representative’s Motion for Entry of an Order Establishing Protocol for Chapter 11 (the “Motion”).  After hearing from both the Office of the United States Trustee and counsel for the Foreign Representative, the Bankruptcy Court directed that the Motion be further considered at a later date after giving opportunity for creditors to make representations regarding the relief requested in the Motion.

The U.S. based legal activities form part of a multinational litigation process, with court proceedings also currently underway in Bahrain, the Cayman Islands, the Kingdom of Saudi Arabia, Switzerland and the United Kingdom. It is therefore necessary that any Protocol established in the U.S. works alongside the work being undertaken in Bahrain. In this regard the Foreign Representative is considering whether to further pursue the relief requested in the Motion.

In October 2009 the Foreign Representative obtained “foreign main proceeding” recognition from the Bankruptcy Court under Chapter 15 of the U.S. Bankruptcy Code for Awal Bank’s administration proceedings in Bahrain. The Bahraini administration governed by the Central Bank of Bahrain and Financial Institutions Law (“CBBFIL”), continues to be recognised as the foreign main proceeding under Chapter 15.

I'll keep monitoring the Bankruptcy Court of the Southern District of New York for electronic filings on the case to see if there is anything on the Court's reasoning for its decision. 

Damas - New AED 614 Million Agreement with Abdullah Brothers

Damas announced on Nasdaq Dubai that it had revised its agreement with the Abdullah Brothers regarding the amounts they owe to Damas.

One key item is the fixing of the price of the 1,840,250 grams of gold the Brothers stole from the Company at AED 256 million.

Presumably, this has been set so that Damas is not disadvantaged.

Setting the amount owed is a key step.  Collecting it may prove a bit more difficult.

Awal Bank Chapter 11 Filing

There's a report in AlQabas Thursday edition that Judge Groper denied Awal Bank's Chapter 11 petition.  At this point, there is nothing posted on the NY Southern District Bankruptcy Court website.  The last document there is the notice of 26 October for the hearing to be held today (27 October).

Gulf Finance House 3Q10 Financials: A Train Wreck

Studio Lévy & fils  1895
When You Turn the Corner Make Sure the Track Goes There

Get out your magnifying glasses and join me in reading the full 3Q10 financials that GFH submitted to the Dubai Financial Market Wednesday morning. Since I've got my soapbox out for a later tirade, I might as well take this opportunity to suggest to the  DFM that they invest a few dirhams in upgrading their electronic imaging system for faxes they receive. There really is no good reason in this day and age that the output cannot by A4 size.

Looking at the financials we see from Note 12, that GFH's US$115 million loss was primarily caused by provisions. Some US$101 million of them. But not provisions for investments. Rather US$60.5 million for an investment banking service receivable. And US$36 million from the sale of investments. I guess if one sells assets of "volatile" quality, one might expect some "volatility" in the receivables from the sales.

That being said, GFH has continued to maintain in its Other Assets the US$134 million "magical asset provision" and US$161.8 million in "Financing to Projects".

Another unfortunate trend is operating income which is running US$60.7 million negative for the first nine months of 2010 as compared to US$36.7 million for the comparable period the previous year. This is due to a collapse in revenues. On the cost side GFH has actually done quite nicely in bringing costs down.  But, if one can't pay the light bills from operations, it's hard to see a bright future.

As a result of the net loss, GFH's CAR has slipped below the 12% minimum set by the CBB. In the financials, KPMG coyly states in Note 2: 

"Further, the capital adequacy ratio of the Group as at 30 September 2010 was below the minimum required by the regulatory ratio …"

No quantification is given. We don't know if GFH just missed the ratio and has a CAR of 11.99%. Or, if it's CAR is 1.9%. You might think that the auditors would consider it important to quantify this shortfall. It certainly is a bit of "material" information that stakeholders would like to know. And more importantly should know.

If like me that's what you think, you're disappointed by KPMG's apparent lack of action on this point. They were silent on this topic. And they did not force GFH to disclose this information in a note to the financials. It's unclear if this is due to desire not to embarrass its client. Or slavish adherence to some accountant's taqlid as to the wording used for "emphasis of matter".

Note to Central Bank of Bahrain: It might be a good idea to specify in Module PD that when the CAR regulatory threshold is breached, the Licensee state the resulting ratio with details of the calculation. And if anyone from the CBB is reading this, I'd reiterate my earlier suggestion that Module PD be amended to require that Licensees report on the BSE the more detailed of (a) what Module PD requires and (b) what they are required to report on other exchanges. There is no reason that Bahraini investors should get second rate incomplete information which is available to investors in Dubai or elsewhere.

We don't have all the information required to calculate GFH's CAR at 30 September 2010. But we can make some estimates which should give a pretty good directional sense of the CAR.

The Table below summarizes these:

	30-Jun-10	Case A	Case B
Regulatory Capital	US$   363,220	US$   248,220	US$   114,229
Total RWA	US$2,811,417	US$2,683,417	US$2,549,417
CAR	12.92%	9.25%	4.48%

Notes & Assumptions:

1. 30 June 2010 CAR is as per GFH's Basel II Pillar 3 Disclosure. 
2. The key assumption is that there is no real significant change in Regulatory Capital or Total Risk Weighted Assets (Credit, Market and Operational Risk) except for the adjustments specified in the two "cases". These adjustments are made from the 30 June figures reflected above. This is a simplifying assumption so the ratios derived will not be exact but should be "close enough" to get a good sense. 
3. Case A: US$115,000 (the 3Q10 loss) is deducted from Regulatory Capital and US$128,000 is deducted from Total RWA at 100%. 
4. Case B: US$134,000 (the "magical asset" provision) is deducted from both Regulatory Capital and Total RWA. And again at 100%.

And if you have any doubt about the realisable value of any of GFH's other assets, like those Project Financings which may very well be to the same firms whose financial condition caused their bankers to pull the GFH guarantee, it's not too much of a stretch before the CAR is negative.

The results are to say the least not encouraging. It's hard to see how even the "Prettiest" words could convince even the "wisest" of investors to put equity into this firm.

The Gulf Daily News is reporting that they've seen a GFH "Investor Presentation" in which GFH states it intends to sell assets to raise cash to pay back some US$90 million in debt maturing next year or restructure that debt. In further discussions with GFH, the GDN was told that other options being considered were an IPO of some of its mega projects (North Africa and India) or perhaps giving creditors land, shares or other of GFH's highly valuable assets. There is a danger with the latter for creditors. As the choice assets are stripped from GFH's balance sheet, remaining creditors are left with lesser ones to settle their debts. The only option not mentioned here was putting a brick from one of these projects under EJ's pillow in the hopes that the Real Estate Jinn would put US$500 million under his pillow.

It's hard to imagine a "wise" creditor putting funds into GFH. 

And it takes a bit of "optimism" to see a real future for GFH. 

You can find more posts on GFH by using the Label "Gulf Finance House".