Dubai Crisis Tests Laws of Islamic Financing

NEW DELHI — The debt crisis in Dubai is about to test one of the fastest-growing areas in banking, Islamic finance, and put the city-state’s opaque judicial system on trial, according to bankers and experts in finance.

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Kamran Jebreili/Associated Press
The Dubai International Financial Center. Financiers were surprised when the emirate moved to freeze some debt payments.

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Times Topics: Sovereign Wealth Funds | DubaiMany loans and bonds that comply with Shariah, or Islamic law, were issued in recent years by Dubai World, the investment arm of Dubai, and other Persian Gulf companies as oil-rich Middle East nations increased spending, and the global credit crisis fed debt investments in emerging markets.

But, because there have been few major defaults in this market, there is little precedent for arbitrating the unique terms of these instruments.

That is likely to create many legal issues for investors in Dubai World, which sent jitters through global markets by seeking to delay payments on $59 billion in debt. Abdulrahman al-Saleh, director general of Dubai’s finance department, said Monday that Dubai World was not guaranteed by the government, and the creditors would need to “bear some of the responsibility” for the company’s debt.

Shariah-compliant investments prohibit lenders from earning interest, and effectively place lenders and borrowers into a form of partnership. Yet there are no consistent rules about who gets repaid first if a company defaults on such debt, said Zaher Barakat, a professor of Islamic finance at Cass Business School in London.

The first test of what that means for investors may happen around Dec. 14, when payments on a $3.5 billion Shariah-compliant bond owed by Dubai World’s real estate subsidiary, Nakheel, come due. If Nakheel defaults on its payment, legal proceedings may be initiated.

It is unclear what may happen next. Nakheel bondholders have formed a creditors’ group representing more than 25 percent of the outstanding debt, a legal adviser to the group said Monday.

Holders of these bonds “are going to argue that they are in the secured position on the underlying asset,” said one bank investor involved in the issuance of some of Dubai’s Shariah-compliant debt. That means that bondholders could insist on being repaid before banks, upending the traditional bankruptcy hierarchy.

“No one has tested the legal system or the documentation,” a lawyer briefed on the situation said.

The 237-page prospectus for the Nakheel bond provides little clarity. In the case of a bankruptcy by Dubai World or Nakheel, bondholders have no guarantee of “repayment of their claims in full or at all,” it said. Under Dubai law, it added, no debt owed by the ruler or government can be recovered by taking possession of the government’s assets.

A default would also pose a major new test for Dubai’s courts, which have never handled a major bankruptcy of one of the government’s own companies, lawyers and bankers said.

Unlike its neighbors, Dubai has kept its judiciary system separate from the United Arab Emirates Federal Judiciary Authority. The decisions of the Dubai courts, which are controlled by the emirate’s ruling family, can be fickle, say lawyers in the region.

For example, in order to bring a court case against a government-owned or government-run entity, a corporation or individual needs to get permission — from the government. In the prospectus for Nakheel bonds, investors are warned that “judicial precedents in Dubai have no binding effect on subsequent decisions,” and that court decisions in Dubai are “generally not recorded.”

Global issuance of Shariah-compliant bonds and loans grew 40 percent in the first 10 months of 2009 from a year ago, Moody’s Investors Services said in a November note to clients. The total amount of Shariah-compliant debt outstanding is estimated at about $1 trillion, up from $700 billion just two years ago. About 10 percent of Dubai’s $80 billion debt load complies with Shariah, bankers and analysts estimate.

Malaysia was traditionally the hub of Islamic finance, but much of this new activity has been centered around Dubai, and foreign and local law firms and banks there helped the emirate raise much of its debt. Dubai even has a school that turns students into “certified Islamic finance executives,” whose stamp of approval is required for an instrument to be deemed Shariah-compliant.

The surge in Islamic finance has led to hiring sprees at banks, and given rise to a series of new financial indicators like the Dow Jones Islamic Market index. Hoping to appeal to the Middle East’s huge sovereign wealth funds, even non-Islamic institutions have started to raise money using Islamic finance.

In October, the British Treasury drew up rules that would soon allow Britain to issue Shariah-compliant government debt. The same month, the World Bank issued $100 million in Shariah-compliant bonds.