Monday 04, December 2017 by Jessica Combes

Moody's: the Dana Gas court case


Key takeaways from the Dana Gas court case Dana Gas (unrated), a natural gas company based in the United Arab Emirates (UAE), announced in June 2017 that it had received legal advice that its Sukuk Al Mudarabah, issued in 2007, and restructured in 2013, is not Shari'ah compliant and is therefore unlawful under UAE law.

The Sukuk had obtained Shari'ah and legal clearance at origination. The company proposed to exchange the Sukuk with a new instrument on inferior terms, and started legal proceedings in the UK and UAE to protect its interest against actions by the Sukuk holders.

While we still await the outcome of the UAE court case, which is scheduled to start in December, the English High Court ruled on November 17th that the purchase undertaking attached to the Sukuk is valid and enforceable under English law. Dana Gas has announced that it will appeal the judgement.

The ruling by the English court is credit positive for the Islamic finance industry because it adds certainty around the legal enforceability of the Sukuk. The conclusion of all the ongoing legal cases will however be needed to have full clarity on this.

Additionally we believe that greater standardisation of Sukuk structures would reduce the complexity and uncertainty associated with these instruments, and be beneficial for the development of Islamic Finance. Although Moody's does not rate this Sukuk, when we assign credit ratings to Sukuk these do not express an opinion on the Sukuk structure's compliance with Shari'ah law.

The issue of Shari'ah compliance only becomes relevant if it creates a potential credit risk. A Sukuk's compliance with a given set of Shari'ah principles or views are subject to various Islamic schools of thought. Shari'ah standards may vary over time and also across geographies and it is this subjectivity that contributes to Shari'ah compliance risk.

Dana Gas is seeking to restructure its Sukuk
Dana Gas stated in a public disclosure to the Abu Dhabi Securities Exchange in June 2017 that it had received legal advice that its outstanding Sukuk is not Shari'ah compliant and therefore illegal under UAE law. Dana Gas also stated that the next two payments (which include profit and principal) would not be paid, as a result of this.

The company sought to exchange the Sukuk for new Shari'ah compliant securities offering inferior terms with a profit rate less than half that previously offered. This led to Dana Gas taking out injunctions in the English courts (governing jurisdiction for the purchase undertaking as per the Sukuk documents), and the Sharjah UAE Federal Court of First Instance (where the company is based) to protect its interest against any hostile action by the Sukuk holders.

On 17 November, the English High Court of Justice ruled that the purchase undertaking attached to the Sukuk Al Mudarabah issued by Dana Gas PJSC is valid and enforceable in accordance with its terms pursuant to English law, which is the governing jurisdiction for the purchase undertaking while the Mudarabah agreement is governed under United Arab Emirates (UAE) law.

Dana Gas is expected to appeal this ruling, as per their announcement to Abu Dhabi Securities Exchange on 19 November. Hearings before the Sharjah court are expected in December 2017.

Moody's ratings–when assigned to Sukuk–address credit risk rather than Shari'ah compliance
Although Moody's does not rate this Sukuk, when we assign credit ratings to Sukuk, these do not express an opinion on compliance of a Sukuk structure with Shari'ah law. Our Sukuk ratings focus on the ‘substance’ of the Sukuk without being distracted by the ‘form’. We consider the legal integrity of the Sukuk structure as this is the transaction documentation that governs the cash flows and the risks to which the investor is exposed.

Shari'ah compliance would become relevant if an enforceable judgement was obtained that allowed an issuer to forego its payment obligations on the grounds of Shari'ah non-compliance. The emergence of the use of Shari'ah non-compliance as a reason to not pay would undermine the Sukuk market and Islamic finance industry. Such a judgement would create a contingent credit risk for other existing and future Sukuk issuances.

A missed payment of profit and/or principal–even during court discussions–would constitute a default
Dana Gas's Sukuk investors did not receive the profit distribution which was scheduled for July, nor have they received the principal and profit which would have fallen due in October 2017 based on the original maturity of the Sukuk. While we do not rate the company, we note that this action would have triggered an event of default according to Moody’s definition under points 1 and 3 below.

Moody's definition of default:
1. Missed or delayed disbursement of interest and/or principal, excluding delayed payments made within a grace period;
2. Bankruptcy, administration, legal receivership, or other legal blocks (perhaps by regulators) to the timely payment of interest and/or principal;
3. Distressed exchange where: (i) the issuer offers bondholders a new security or package of securities constituting a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or paramount, lower seniority, or longer maturity); and (ii) the exchange had the apparent purpose of helping the borrower avoid default;
4. A change in the payment terms imposed by the sovereign that results in a diminished financial obligation, such as a forced currency re-denomination (imposed by the debtor, himself, or his sovereign) or a forced change in some other aspect of the original promise, such as indexation or maturity.

Moody’s places strong emphasis on a Sukuk's governing law
International Sukuk issuances have been frequently governed by English law. The ratings agency ordinarily does not differentiate between the credit risk of conventional bonds and Sukuk obligations. In the case of Sukuk, however, there is a risk that a local court could overrule English law in the event of dispute. If the assets underlying a Sukuk are held within the jurisdiction of a local court, this could potentially complicate recovery for investors.

Final conclusion of all related legal cases will be needed to provide a clearer picture
The English High Court ruling, which is in line with the market’s expectation, is credit positive for the Islamic finance industry generally because it adds certainty around the legal enforceability of the Sukuk transaction documents, which tend to be complex to comply with Shari’ah principles.

The judge made the ruling without representation from Dana Gas as the company claimed it could not attend because Sharjah UAE Federal Court of First Instance (where the company is based) issued an anti-suit injunction at the request of and in response to actions by several Dana Gas shareholders, who sought to have the UAE Sharjah Court decide the matter.

The current situation does not however represent a final outcome. Dana Gas stated on 19 November that it expects to appeal the ruling. Additionally there is the UAE court hearing which has yet to commence. Despite widespread media attention, investor demand for Sukuk has remained strong since this case has emerged. According to Bloomberg data, there have been close to $30 billion in Sukuk issuances across a wide range of sectors since the coverage of the case started in June, some highly oversubscribed. Unless there is an outcome that supports Dana Gas's position, or further similar cases emerge, we do not expect this to change.

Greater standardisation in the Sukuk market could prevent further similar cases
A Sukuk’s compliance with a given set of Shari'ah principles or views are subject to various Islamic schools of thought. This subjectivity contributes to Shari'ah compliance risk. The Sukuk market is growing rapidly with larger volumes and numbers of issuers seeking to utilise this form of funding. As Sukuk structures become increasingly complex, standardisation will become essential to avoid similar cases.

Moody’s expects, going forward, that the industry will introduce tighter legal requirements to protect investors. In addition, regulatory efforts, especially in the Gulf Cooperation Council countries to standardise Shari’ah governance, will help to standardise Sukuk structures, and support the enforceability of the Shari'ah opinion at origination, thereby reducing the complexity and uncertainty associated with these instruments. At present there are significant differences in the extent of standardisation of Islamic Finance standard in different markets, as illustrated in the box below.

The Sukuk market is standardised in Malaysia, but not elsewhere
The Sukuk market is split into two major markets: Malaysia is the largest in terms of volume; and Gulf Cooperation Council countries have the largest number of issuers. The rest of the world has a limited number of issuers and volumes, but is seeing its share increasing over time as more issuers are using Sukuk to raise funds.

Malaysia: Sukuk issuance started in the 1990s and witnessed rapid growth. Malaysia benefits from (1) a single regulatory authority and a proactive government and (2) a clear and comprehensive framework for Sukuk with documentation/reporting standardised where possible. Gulf Cooperation Council: The GCC represents around 30 per cent of the total long term outstanding Sukuk. Issuers in these markets rely on different Shari'ah boards and scholars to certify whether structures are Shari'ah-compliant or not. This leaves the door open to various interpretations. A structure that may be deemed Shari'ah-compliant by one board may not be deemed so by another. Some issuers, facing difficulties, may seek to exploit such discrepancies. As a result a complex Sukuk structure results in increased legal and credit risks.

Steps are however being taken in some countries to increase standardisations. In September 2017, the Bahrain Central Bank announced new regulations that will make Islamic banks in Bahrain subject to an independent external Shari’ah compliance audit, to ensure that all their activities are Shari’ah compliant. In May, the UAE's cabinet approved the creation of a centralised Shari’ah authority for Islamic finance to support its growth and development.

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