On Monday, September 25, London’s High Court began hearing the case of a $700 million sukuk payment default. The case — which had the potential to upset the $2 trillion Islamic finance industry — went forward even though the courtroom was missing one key element: the defendant.
Dana Gas, one of the UAE’s largest private natural gas companies, stopped making payments on its sukuk in June, claiming that this non-bond instrument, which had attracted international investors with its very bond-like 8% yield, had become a little too bond-like. These “Islamic bonds” were now considered a violation of Islamic law — or at least Islamic law as interpreted by UAE religious scholars, the same body that had previously sanctioned the sukuk’s creation.
Dana Gas claimed that not only was it prohibited from making payments, but its company representatives were also prohibited from attending the British trial. Dana Gas pointed to an injunction against the proceedings issued by a judge in Sharjah, the Emirate in which Dana Gas is based. The judge argued that the matter had to first be settled in UAE courts before a foreign case could begin — a decision the UK judge deemed a stall tactic and the company’s creditors deemed collusion. After months of negotiations between the company and its international creditors, including Goldman Sachs and Blackrock, Dana Gas was now claiming that a financial instrument issued under British law, denominated in U.S. dollars, and sold to U.S. and European investors was a purely domestic matter.
Holders of conventional bonds issued in the emerging markets are used to dealing with various types of risk: default risk, rate risk, market risk, and even J risk, the risk arising from the uncertainty of judges’ rulings. But exegetical risk is a new one. And it’s a risk few of even the most iron-stomached investors are likely to take because disagreement between religious scholars is less a risk than a certainty. You don’t become a religious scholar if you dislike critiquing other scholars’ interpretations of religious texts, no more than you become a creditor if you dislike interpreting balance sheets. But when religious law and securities law conflict, whose interpretation counts?
Sukuk have always been controversial. Based on sak, a 7th-century IOU issued by Muslim traders, the modern sukuk was designed in 1988 specifically to help Islamic banks work around prohibitions in Islamic law, specifically the supposed prohibition against collecting riba, or interest. Islamic law traditionally considered gold and silver stores of value, not assets, so it was thought that a lender collecting interest on gold or silver could potentially distort this value, while benefitting society no more than a common gambler. Bernie Sanders would evidently have found common cause with scholars in 7th-century Damascus.
But I say “supposed” prohibition because classical Islamic legal scholars and financiers believed Sharia law prohibited interest on gold or silver, not fiat (i.e., paper currency). Interest on fiat was acceptable because fiat was not considered an actual store of value. But according to conservative 20th– and 21st-century Islamic legal scholars — who, like all conservative legal scholars, tend to sacrifice nuance and historical precedent for purity — all interest is forbidden.
This prohibition left modern Islamic banks with a serious problem. Sharia-compliant financial institutions grew rapidly throughout the Middle East in the late 1970s and early 1980s, as petro dollars began flooding the region following the 1973 Oil Crisis. Conservative scholars were buoyed by a backlash against western powers who had installed local dictators, exploited the region’s resources, and, most importantly at the time, supported Israel in the Yom Kippur War. These conservative scholars considered conventional banking un-Islamic, so they promoted the creation of financial institutions that could manage the region’s newfound wealth while upholding Islamic law. But these scholars argued that not only could Islamic banks not buy or sell interest-bearing bonds, they also couldn’t borrow on the interbank market because this practice was considered excessively risky and, therefore, also not Sharia compliant. Islamic banks were, consequently, left with highly illiquid balance sheets and a much less stable business model than their conventional counterparts — a high price to pay for scrupulous rule-following.
Enter the sukuk. These instruments — although technically not bonds — are structured almost exactly like bonds. A sukuk-holder agrees to provide a corporate or sovereign entity with cash for a set period of years in return for a guaranteed stream of payments that look suspiciously like interest, with a final payment that looks suspiciously like a principal repayment. But, in theory, a sukuk isn’t a debt; it is a temporary ownership stake in an asset, normally a profit-generating tangible asset like a building. In theory, the semiannual payments that the company makes to the sukuk-holder represent a share of the asset’s profits, not interest. And, in theory, the final balloon payment represents the issuer’s repurchase of the investor’s stake in the asset, not a principal repayment.
In a stroke of financial ingenuity that even the most secular investor would have to admire, Islamic financiers had created an instrument that appeared to avoid interest prohibitions as well as prohibitions against trading debt at a discount, while simultaneously offering all the benefits of a bond.
In theory.
Since the early 2000s, Islamic finance has grown from a nascent subset of global finance into a $2 trillion industry, with the sukuk market alone representing over $300 billion in outstanding instruments. Even non-Muslim-majority countries, like the UK, have issued sukuk — a 2014 issuance by the British government was 20 times oversubscribed. And the market has only been growing in recent years. In 2016, $16.7 billion of investment grade USD-denominated sukuk were issued, and 2017 eclipsed this mark with over $19 billion in issuance, as low energy prices drove supply, and the global hunt for yield drove demand.
This growth, especially the growth in the international market, has depended on issuers’ willingness to structure sukuk to be as bond-like as possible. If a U.S. hedge fund is going to buy a sukuk, the instrument better be issued under UK law, it better be denominated in hard currency, and it better guarantee the payment of profit and principal. But these guarantees are precisely what trouble many Islamic scholars, who believe issuers are sacrificing fidelity to Islamic law in their attempt to woo global investors.
No single governing body exists to oversee the creation of sukuk or address conflicts surrounding differing interpretations of Sharia’s financial proscriptions. Religious scholars in different Muslim-majority countries are free to develop and change their interpretation of what constitutes a Sharia-compliant financial instrument, just as modern scholars were free to expand the riba prohibition to include interest on fiat. So conservative religious scholars created the original problem, the solution, and the new problem — and the only thing they agree on is that they agree on essentially nothing.
But when religious interpretation is used to justify the nonpayment of hundreds of millions of dollars, you can be sure that no creditor is going to allow the defaulting company to simply point to a scholar and say, “He says I can’t pay you.” Because finding a legal scholar or judge to support a heterodox interpretation is rarely difficult. Just as secular EM companies are often able to find local judges willing to interpret securities law to benefit local shareholders — regardless of the merits of the case — companies in religious countries often have little trouble finding scholars who will sanction their use of religion to justify even the most absurd, and most secular, of claims.
Which brings me back to Dana Gas. The company doesn’t appear to be have stopped making payments on its sukuk because of rigid religious scruples. It appears to have stopped making payments because of its very profane lack of cash.
In Dana Gas’s 2016 annual report, published months before the sukuk payments ceased, the company repeatedly noted that capital preservation was its primary near-term priority and that maintaining sufficient liquidity would only be possible if the company could swap its existing sukuk for a new instrument with a later maturity date and a much lower profit rate. But, under UK law, the company couldn’t force its well-funded creditors to accept this swap. And these well-funded creditors had no intention of accepting a swap with a significant net-present-value haircut.
So this debate isn’t really about doctrine; it’s about liquidity.
But even the severity of the company’s cash crunch is up for debate. Dana Gas’s creditors argue that the company is entirely capable of meeting its payment commitments, despite the evidence to the contrary. While it’s true that the company received a welcome infusion of cash following a lengthy — and expensive — legal battle with its delinquent partners in the KRG (i.e., the Kurdistan Regional Government in Iraq), it’s also true that the company still has almost $1 billion in receivables and is still struggling to compel its delinquent Egyptian partners to pay. The company also faces a future of depressed natural gas prices — something it did not anticipate when it originally issued its sukuk. And, perhaps most importantly, when your company’s cash position is dependent on the ability of ISIS, Donald Trump, Vladimir Putin, and Recep Tayyip Erdogan to act in a measured fashion, your capacity to pay should be considered somewhat less than secure.
But the creditors are continuing to claim that the company has the ability to pay because it’s in the creditors’ interest to interpret the company’s financial statements in this manner, just as its in Dana Gas’s interest to argue that the numbers tell a completely different story. Whether we’re discussing ancient religious texts or a balance sheet audited by KPMG, interpretation is everything.
Even though conflicting interpretation has enabled Dana Gas to avoid payment thus far, conflicting interpretation could also box the company into an unpleasant corner. The company’s excuse for nonpayment was, unsurprisingly, dismissed by the British courts, but the company is appealing the decision with the support of courts in the UAE. The company may then have an unpleasant choice: it can either pay its creditors, publicly admitting that it’s acting in violation of religious law, or it can continue not to pay and dramatically increase the cost of accessing the public markets at the precise moment when the company is most in need of cash.
Who knew interpretation could be this complicated?