Tuesday, December 1, 2009

God and the Devil are in the Details

God and the Devil are in the Details
Because this is a long post here is a summary:

1.) If the Nakheel Sukuk restructuring results in a recovery to the bondholders of less than they would get in a liquidation of Dubai World the hedge funds in the creditor group will block the restructuring and thus set off a cascade of events which will put Dubai World into default.

2.) The ability of Dubai World to segregate its subsidiaries that are on a “firm financial footing” from Nakheel is doubtful at best.

3.) Because it is likely that the hedge funds have purchased CDS on Dubai World even if they do not get paid off as Nakheel bondholders, if they can force the ISDA Determination Committee to declare Dubai World in default and conduct an auction then be paid on the CDS.

4.) Therefore I think the probability of a successful restructuring of the Nakheel Sukuk is near zero and the probability of a Dubai World default is approaching one.

Sheikh Mohammed bin Rashid Al Maktoum has had some harsh words for his creditors lately. Asking them to “shut up” and saying that they “do not understand anything.” Abdulrahman Al Saleh Director General of the Dubai finance department said that the “creditors should bear part of the responsibility.” Indeed, they should and they will. However, just as there are unpleasant realities for creditors in the Nakheel Sukuk (a Sukuk is an Islamic bond) documentation so too are there some surprises for the debtors. Dubai may be about to discover that access to international capital markets is a two edged sword that can cut even those who rule by decree.

In the past 24 hours things have calmed down in the world financial markets. There has been a big equity rally and credit spreads have tightened. Dubai announced a number of developments that have begun to put its creditors at ease. Dubai World has put out a statement limiting the scope of the restructuring to Nakheel and Limitless and reaffirmed that DP World and the Free Zones remain on a firm financial footing and are outside the proposed restructuring. The statement further announces that Dubai World is in negotiations with its banks and asks the Nakheel Bondholders to nominate someone with whom they can negotiate. A creditor group of Nakheel bondholders holding more than 25% of the outstanding Sukuks has formed. It sounds like Dubai is about to get on with the difficult task of bringing about the its requested standstill agreement. Markets have eased as a result. How likely is this?

The negotiations with the banks are probably likely to go well. It’s a relatively small number of creditors and some of them are controlled or influenced by Dubai directly and others know that if they want business from the Emirate and perhaps other sovereigns in the region they should probably be fairly accommodating to the wishes of Dubai Inc. But what of this investor group that has been formed? How accommodating are they likely to be and what can they do?

The Creditor Group is led by QVT, a hedge fund spun out from Deutsche Bank several years ago and it has retained Ashurst a UK law firm to explore its options. To understand these and what they imply it is necessary to read the Nakheel Sukuk documentation as well as to have a familiarity with a common hedge fund strategy involving buying bonds and CDS on related entities and using the bonds to influence a restructuring.

The restructuring would constitute a Modification of the rights of certificate holders and therefore is governed by Section 17 of the prospectus. This requires a 75% vote of the certificate holders to approve a restructuring. So the investor group does not have enough votes to APPROVE a restructuring but they do have enough votes to BLOCK one. Naturally one must then ask what happens if these Sukuk holders do successfully block a restructuring? The answer to that is in Section 13 which defines a “Dissolution Event.” 13.1(a) states that failure to pay the Sukuk redemption amount within 14 days of its payment date, a circumstance that at this point is a virtual certainty.

OK so the hedge funds can block a restructuring and force a dissolution event, then what? That’s in section 14. The Trustee is to take certain enforcement actions to secure the assets of the Trust (land in Dubai) and, if necessary under 14.1 (e) make a claim under the Dubai World Guarantee.

And what is the Dubai World Guarantee? As spelled out in the documentation: “The obligations of the Guarantor under the Dubai World Guarantee constitute an unsecured, direct, unconditional and unsubordinated obligation of the Guarantor which will at all times rank pari passu with all other unsecured and unsubordinated obligations of the Guarantor, save for such obligations as may be preferred by provisions of law that are both mandatory and of general application.”

That is to say that non-payment of the Sukuk by December 28th constitutes a dissolution event. A dissolution event triggers the Dubai World Guarantee. The Dubai World Guarantee makes the Sukuk holder an unsecured creditor with all other creditors of Dubai World and therefore can trigger the default of Dubai World. What are the assets of Dubai World? Equity stakes in all the Dubai entities which are “on a firm financial footing.” Hmmm.... what does all this mean?

Before I answer that it might first be a good idea to consider what is likely behind the strategy being employed by the Creditor Group. Basically the creditor group should not agree to any restructuring that pays them less than they would get in the liquidation of Dubai World. The assets in the Trust to which the Sukuk holders have recourse are partially developed real estate projects in Dubai which have declined massively in value since the original issuance. Some of these cannot even be legally held by non-Emiratis and therefore the recovery to the hedge funds who hold the sukuks if they do not trigger the Dubai World Guarantee is likely to be lower than if they did meaning the guarantee is VERY likely to be triggered.

There has been a lot in the press about how difficult it might be to successfully recover in Dubai given the fact that the court system there is likely to favour the ruler at the expense of the bondholders. The logical thing for the hedge funds to have done would have been to buy Dubai World CDS. Thus for the hedge funds it may not even matter and in fact, for them the lower the recovery on Dubai World the better. As I mentioned yesterday the organization which will determine whether there has been a default event or not is not the Dubai Courts but the IDSA Determinations Committee.

Imagine you went out and bought $50 million face worth of Nakheel Sukuks which would have cost you around $22.5 million last Thursday. Then let’s say you bought $200 million of CDS against Dubai World. You join the creditor group and when Dubai proposes a restructuring you block it. A dissolution event occurs and your agent triggers the Dubai World Guarantee. The Dubai courts refuse to acknowledge this Guarantee. The hedge funds submit this to the IDSA DC which then determines that a default has occurred and an auction as held. The Dubai World Creditors, shaken by the actions of the Dubai Courts and fearing that they too will not be paid sell their holdings in the auction so that the price of the Dubai World bonds is $0.45 on the dollar implying that the CDS will pay out $0.55 or $110 million to our theoretical hedge fund.

Therefore if they get Dubai World to Honor their Guarantee they make over 100%, if Dubai refuses and they trigger a Default Event they get paid out on their CDS and make over 100%. They can’t lose and they have no incentive to cooperate with the Dubai government.

Win win for hedge funds, lose lose for Dubai. Welcome, gentlemen to the rough and tumble world of the international financial system.

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