As if the credit risks in this environment are not enough, risks soar from the prospectus pages of Dubai’s recent $2 billion sukuk. The offering document highlights legal issues that span across jurisdictions and legal systems. With the troubles of its distressed affiliate, Nakheel, still playing out in parallel to this offering, one is reminded all too clearly of a fundamental: while sukuk offerings may come with the greater certainty associated with their asset-backed structures, other drawbacks are inherent as well.

In a bold move, the government of Dubai last week launched a $6.5 billion bond offering, consisting of a nearly $2 billion sukuk and a $4 billion conventional offering. With the Emirate’s state-owned companies hard-pressed to restructure debt, the timing was strategic amid this year’s high demand but relatively low sukuk offering rate. The offering was the first for the real estate-reliant Emirate since early 2008, before the industry’s global crash, and it was one of the biggest of the year. Though much of it is boilerplate, lawyers and investors alike should take an extra look at such prospectuses and their presentation of structure and risk.

Legal Structuring

The questions of governing law, jurisdiction and enforcement authority are often present a tangled legal web in sukuk prospectuses, and this one is no exception. In fact, this prospectus provides particular color around the judicial conflict that may arise.

Offering entities sometimes prefer to maintain governing law of a country like Malaysia, where the statutory law is based at least in part on Islamic principles, making for clearer outcomes should a conflict arise. But increasingly, perhaps with an eye to global investment, sukuk prospectuses identify governing law as English (as did offerings from CBB Sukuk of Bahrain and Gulf Investment Corp. of Kuwait) or, less commonly, New York (such as Petronas’s $1.5 billion dollar sukuk). In the case of the Dubai government’s sukuk, the “Trust Certificates of each Series will be governed by, and construed in accordance with, English law.” This is, perhaps, predictable, given that the second, conventional tranche of the Dubai government’s offering is a conventional notes offered through the LSE and filed with the FSA.

Nonetheless, should a dispute arise related to either of these offerings, how and where it would be resolved is not as clear cut as the prospectus seems to spell out. According to the sukuk’s offering documents, even though “the courts in England who shall have exclusive jurisdiction to settle any dispute arising from such Transaction Documents, [w]here an English judgment has been obtained, there is no assurance that the Government has, or would at the relevant time have, assets in the United Kingdom against which such judgment could be enforced.” If, therefore, “the judgment were to be enforced in the UAE, under current UAE federal law, the UAE courts would be unlikely to enforce such judgment without re-examining the merits of the claim and may not observe the choice by the parties of English law as the governing law of such Transaction Documents.”

In addition, “even if English law is accepted as the governing law, this will only be applied to the extent that it is compatible with the laws . . . and public policy [of the UAE].” And further adding to judicial uncertainty, “as the UAE judicial system is based on a civil code, judicial precedents in the UAE have no binding effect on subsequent decisions [and] there is no formal system of reporting court decisions in the UAE.” All creating a catch 22, it seems, leading the savvy investor to question how much stock to place in governing law in the first place.

Separately, Dubai provides notable color around the conflict of laws presented by two international treaties to which it is a party: “The 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards entered into force in the UAE on 19 November, 2006. However, the UAE and France signed a bilateral convention for the mutual enforcement of arbitration awards in 1991, which was ratified by the UAE in 1992.” Additional details can be found in the international prospectus, available in the Related Resources panel.

To top it all off, Dubai DOF Sukuk Limited, the issuing entity, was incorporated with limited liability in the Cayman Islands. As background, many offering entities incorporate in the Cayman Islands due, in part, to flexibility in structuring, an established regime of trusts law, lower costs, favorable tax structure, and relatively fast turnaround time compared to other western jurisdictions. Recent high profile, high value offerings such as Petronas, AcrossAsia Ltd. and Emaar Sukuk Ltd., for example, all incorporated in the Cayman Islands. For more on Cayman Islands incorporation, see Islamic Finance Law: Think Global, Look Local, available in the Related Resources panel.

To be fair, the issues articulated as enforcement risks in Dubai’s sukuk offering are not unique to this prospectus. It is, in fact, a risk of global financial transactions and the murkiness of international law and the interplay of local laws on a global stage. For more on this judicial uncertainty as seen through Tamweel’s recent offering, see Islamic Finance Law: Think Global, Look Local, available in the Related Resources panel.

Sharia Oversight

For investors choosing the Dubai government sukuk due to a preference for Sharia-compliant offerings, the prospectus notes, “The Sharia Advisory Board of Dubai Islamic Bank PJSC and Standard Chartered Bank have each confirmed that the Transaction Documents are Sharia compliant.” But as with any Sharia board decision, “there can be no assurance that the Transaction Documents or any issue and trading of any Trust Certificates will be deemed to be Sharia compliant by any other Sharia board or Sharia scholars.” Notably, not even the Government of Dubai “makes any representation as to the Sharia compliance of any Series [since] differences in opinion are possible.”

Nearly all sukuk prospectuses note the differing opinions as a risk, but some, such as DB Sukuk, Meezan Bank, and the Family Shariah Fund Ltd. provide more detail around their Sharia boards, often describing the scholars’ backgrounds, credentials and current employment. See Islamic Finance: Scholarly Advice Disclosed, available in the Related Resources Panel.

Legal Counsel

Just as Dubai is making a splash with its offering, the law firms it chose merit note as well. Representing Dubai Sukuk DOF Limited on issues as to Cayman Islands law is Maples and Calder (UAE). Counseling the Dubai government as to English law is the London office of Taylor Wessing, while the same firm’s Middle East office is counseling the government on issues of UAE law. Meanwhile, Allen and Overy’s London and Dubai offices are representing the dealers (Dubai Islamic Bank PJSC, Emirates NBD PJSC, Mitsubishi UFJ Securities International plc, National Bank of Abu Dhabi P.J.S.C., Standard Chartered Bank, UBS Limited) and the delegate (Deutsche Trustee Company Limited) on issues of English and UAE law, respectively.

Sukuk Structure

The offering is structured as a sukuk ijara, meaning that it represents an ownership interest in leased assets. The lease agreement associated with this offering was entered into “on 28 October 2009 between Government of Dubai (in its capacity as Lessee), Dubai DOF Sukuk Limited (in its capacity as Lessor).” Under the terms of the agreement, the Government of Dubai will to take on a lease for the duration of the sukuk offering until its maturity in 2014, during which it “will make rental payments at regular intervals to Dubai DOF Sukuk Limited.”

Sukuk ijara have widely been viewed as the most popular and stable sukuk. Still, it is accompanied by a number of related risks which are explained in the prospectus. For example, the prospectus notes that “office lease rates in Dubai are now below levels experienced at the end of 2006 and are approximately 50 per cent of the level in the third quarter of 2008. Similarly...residential property lease rates have fallen by about 40 per cent.” It remains to be seen how the lingering commercial real estate slump may affect investments, but investors, be warned: The risk factor is there.

Other Notable Risks

As highlighted in last week’s Islamic Finance Risks: Dubai’s $2 Billion Breathing Room?, available in the Related Resources panel, sukuk risks and the disclosure of those really do matter. For the reasons discussed above, the Dubai sukuk promises to stand out as one of 2009’s offering notables. Yet on the heels of Nakheel’s debt crisis, a number of risk disclosures, in addition to those discussed earlier in this article, stand out:

• “Investors should note that given the lack of consolidated reporting of the assets and liabilities of Dubai’s GREs [government-related entities, such as Investment Corporation of Dubai], the overall financial position and potential future financing requirements of Dubai’s GREs may not yet have been fully identified.”

• The government of Dubai “has borrowed from the UAE Central Bank. The expectation is that the entities supported by the fund will be able to repay such support in a timely manner [but no] assurance can be given that all entities supported by the fund will be able to repay their support in a timely manner as this will be dependent on a variety of factors beyond the Dubai governments control.”

• “Dubai is also dependent on expatriate labour and has made significant efforts in recent years to attract high volumes of foreign businesses and tourists to the Emirate. These steps make it potentially more vulnerable should regional instability increase or foreign militants commence operations in the Emirate.”

Dubai’s offering has been hailed as yet another milestone in Islamic finance, in particular, a sign of renewed appetites for investment, and on a larger scale, possibly even a signal of the health of the financial system. Some of the above risk scenarios may seem remote, but they are nonetheless real. Islamic finance holds promise for investors and lawyers alike…but with lessons learned from Nakheel at hand, and jurisdictional boundaries still murky, risk disclosure should be carefully undertaken.