Dubai’s $2 billion sukuk, just placed on October 28, may have bought property company Nakheel some breathing room.  That said, Nakheel’s experience shows that risks and disclosure really do matter.  The property company has been the subject of much discussion, with an impending December 2009 debt repayment (and feared default) on its horizon.  The curious thing is that Nakheel’s risks have long been known – after all, risk factors in their offering documents have been quite clearly described. Even with some room now to breathe a little easier, Nakheel’s risks are not over. Despite all the fuss over Nakheel’s sukuk due December 2009, it is just the beginning of a series of debt maturities in 2010 and into 2011.

With the oversubscription of so many high profile offerings of late, it seems the investor appetite for risk is returning. Risk disclosure in offering documents is fairly boilerplate. Amid the excitement of the promise of Islamic finance, as with any new offering, these standard risk disclosures may seem inconsequential. But as firms increasingly globalize, the lack of transparency typical of Gulf-based financial players may be a time bomb waiting to go off – and when it does, issues of jurisdiction and liability will be at the forefront. Nakheel, it is now speculated, may be dodging the restructuring ball – but the lesson to be learned merits attention from lawyers and investors alike.

As background, Nakheel is a real estate development company and the property arm of the government-owned Dubai World. Nakheel, with an expected financial shortfall, was the subject of much attention following the defaults of Kuwaiti investment firm Investment Dar and Saudi conglomerates Saad Group and Ahmed Hamad Algosaibi earlier this year. Its shortfall, it was widely speculated, would cause it to default on the sukuk maturing in December 2009. Nakheel’s success is Dubai’s success, as Dubai thrived as the real estate market peaked, but was hit hard when the market crashed. In contrast, the oil rich emirate of Abu Dhabi was reportedly not as hard hit. As a result of the halted real estate activity in Dubai, firms such as Dubai World were really hard hit. As a side note: Dubai World is majority owned by the president and Sheikh and manages government-owned companies and projects.

Like nearly all prospectuses, Nakheel’s 2006 sukuk offering explicitly stated risk factors. To the untrained eye, these disclosures are boilerplate – but unlike offerings in a different day and age, many of these disclosed risks were telling of things to come. Nakheel warned in its risk disclosures that:

• Nakheel Holdings 1, Nakheel Holdings 2 and Nakheel Holdings 3 “do not, and are not required to, produce audited financial statements. Full accounting information is not available in respect of these entities.”
• “There can be no assurance that if Nakheel Holdings 1, Nakheel Holdings 2 and Nakheel Holdings 3 prepared such consolidated audited financial statements, they would not be materially different from the position of Nakheel set out elsewhere.” 
• Parent company “Dubai World’s subsidiaries are involved in a diverse range of business and as such are diverse in nature, operation and strategy. Therefore, Dubai World’s subsidiaries are subject to a range of differing risks and challenges.”
• Nakheel “may not complete its properties that are under construction or in initial stages of development.” 
• There could, at some point, be “mismatches between expenditure and income.” 
• Nakheel could fall victim to “an inability to complete development projects on schedule.”
• Nakheel might experience “a decline in rental or occupancy rates.” 
• “Like every valuation of property and property-related assets, the valuation of Nakheel’s property and property-related assets is inherently subjective,” and subject to a variety of external factors.
• “The illiquidity of real estate investments could significantly limit the Co-Obligor Groups ability to respond to adverse changes in the performance of its properties and harm its financial condition.” 

This is just a selection from Nakheel’s risk disclosures, but in hindsight, looking back on the real estate crash and credit freeze over the past year, it seems almost prophetic.

Now that the financial crisis seems to be easing, across the Gulf, there are a number of offerings aimed at alleviating debt or raising capital, including the National Bank of Abu Dhabi, Saudi Arabia’s Saudi Electricity, and the (to date) anonymous twin offerings that, according to Reuters, will be arranged by Al Rajhi Capital, the investment banking arm of the biggest Saudi Islamic lender, Al Rajhi. As Islamic finance offerings move toward center stage, the lack of transparency will become an even greater risk in and of itself. Many of the countries where offering entities reside do not have the financial or governance disclosure requirements that mandate corporate transparency expected in the Western world.

The struggle for transparency among Islamic finance players is a real bone of contention. The relative transluscence (or even opacity, in the minds of some) that is common in the Gulf region is a particular point of contention in countries used to more imposing higher levels of disclosure. According to Reuters, the head of Dubai World in 2008 warned that “European attempts to force greater transparency on sovereign wealth funds [were] making the continent unattractive for investment.” Furthermore, he reportedly stated that transparency moves at the time were “discriminatory” and would “deter him from investing” in the region.

As rumors of Nakheel’s potential debt default picked up, the legal minded began to ponder how creditors, including sukuk holders, would be prioritized should the default manifest. Nakheel’s 2006 prospectus noted as a risk that “as a result of the majority of the assets of Dubai World being located in the UAE, there may be insufficient assets of  Dubai World located outside the UAE to satisfy in whole or part any judgment obtained from an English court relating to amounts owing in connection with the Certificates.” Dubai’s recent steps however, may help Nakheel, which is in apparent financial recovery, avoid the questions of jurisdiction and liability…at least for now.

Which leads to our next point -- Debt restructuring is a nearly untested process when it involves Shari’a-compliant offerors and offerings, but in the conventional finance world, often involves courts and litigation. (For more on this topic generally, see Islamic Finance: Restructuring Proof? Ask East Cameron). Where investor risk is introduced, litigation is always on the horizon. And with multiple jurisdictions involved in sukuk transactions, each of which may use a very different legal system, a complex legal web is woven. The recent spotlight on sukuk offerings has exposed the global scope of both their successes and failures.

Consider, for example, the complicated set of litigations playing out in New York, involving Saudi entities Mashreqbank and Ahmad Hamad Algosaibi & Brothers. Though the appropriate interpretation of law may be murky, one thing has become apparent: the question of who has jurisdiction over these transactions must be sorted before the underlying issues of bankruptcy, debt restructuring, and demands for restitution by frustrated sukuk investors can be adequately adjudicated in the Islamic finance market. For more on jurisdictional liability, see Litigating Islamic Finance: Will the Gulf Come to NY?, available in the Related Resources panel.

The blockbuster sukuk offerings from the past few months suggest that the investor appetite for risk is, indeed, returning – but what should not be forgotten is that even though most sukuk have proven profitable investments, they are, nonetheless, risks. Reporting standards vary across the globe, but legal counsel should aim for the highest standard of transparency. After all, in a global offering, global liability is always of concern. As for Nakheel – Dubai’s most recent offering suggests that the emirate may, after all, be able to successfully restructure the debt owed by government-related entities.