The active trading of loans made to a borrower that has become unable to repay in full (known as non-performing loans or distressed debt) has been a feature of the North American and European loan markets for a number of years.
These markets experienced particularly strong growth following the financial crisis which resulted in tighter capital adequacy requirements and banks seeking to reduce their exposures to such debt. This led to the development of a robust and fairly standardised distressed debt market, utilising Loan Market Association standard terms.
The primary ways in which a financier can trade such debt (legally or economically):
- by transfer (i.e. assigning or novating interests in accordance with the loan terms);
- by sub-participation; or
- through synthetic arrangements (such as credit default swaps).
Here, we consider the growing market for distressed debt trading in the Middle East, particularly in the United Arab Emirates (UAE) and the Kingdom of Saudi Arabia (KSA). The distressed debt market in these jurisdictions is somewhat less developed for various reasons, including (i) a historically unhelpful legal regime, and (ii) negative attitudes towards financial distress often resulting in a mere reshuffling of deckchairs.
In recent years, however, both the UAE and KSA have made considerable advances in overcoming these issues, including by introducing new regimes for corporate insolvency and taking security.
However, there can be a number of challenges in trading debt in such markets. One such challenge is the means by which debt can be traded and potential buyers should be mindful of two key points in this respect:
- The first of these is with respect to the traditional tool of assignment. Although the UAE's Civil Code and recent Mortgage Law make reference to the concept of an assignment, its use as a device for transferring rights or taking security is not fully developed, nor are the requirements for perfection especially clear.
- The second is due to the licensing requirements. Although foreign lenders often make loans to UAE entities, this is technically a licensed activity and certain types of security (such as land mortgages and commercial pledges) can only be granted in favour of locally licensed institutions. Consequently, it is not uncommon for distressed debt in the Middle East to be traded by sub-participation, rather than by way of assignment.
Other challenges include those relating to the trading of secured debt. Although security may be of limited value in a distressed debt trade (particularly in jurisdictions such as those in the Middle East where enforcement has traditionally been court-led), the availability of security may still be an important consideration, especially if it allows a creditor to achieve secured status in insolvency proceedings.
For debts created in the UAE after the enactment of security reforms in 2016, purchasers of secured debt ought to confirm whether the security has been registered with the Emirates Integrated Registries Company (EIRC). One of the many benefits of the EIRC is that it allows for registrations to be updated and therefore purchasers of bilateral loans would need to ensure the beneficiary of the registrations is amended, if only to ensure that the selling creditor does not benefit from priority status in any insolvency proceedings. For older financing arrangements, the picture is unfortunately more complicated and may give rise to some of the licensing issues raised earlier in this article.
Original wet-ink security or credit support documents are also of heightened importance in Middle Eastern jurisdictions for the purposes of enforcement. This is particularly true in KSA, where Promissory Notes, which can only be enforced in original form, often serve as an important form of credit support. This was highlighted in a case before the English courts (Golden Belt 1 Sukuk Company B.S.C.(c) v BNP Paribas [2017] EWHC 3182 (Comm)), which found a bank to be negligent in arranging a Sukuk (Islamic bond) financing where it failed to ensure the promisor delivered a wet-ink promissory note.
As with many other jurisdictions, the COVID-19 pandemic has impacted employment levels in the Middle East and, consequently, their tourist- and expatriate-driven economies. This, combined with positive legal developments and the potential for greater returns than may be available in more traditional markets, means we anticipate the Middle East becoming an increasingly important market for distressed debt trading in the medium term.
Originally published 7 July, 2022.
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