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Dubai Crisis: How Immune is the Sovereign?

21 December, 2009
Over the last few weeks, investors, governments, financial analysts and stock markets across the world have been on tenterhooks as a mini crisis unfolded in Dubai. Dubai World, a conglomerate owned by the Dubai government, with diverse interests from ports to real estate, asked its creditors for a six-month moratorium on repayment of a portion of its borrowings.   
With its debts mounting to $60 billion, the triggering point of the surprise announcement seems to be twofold.
One, A $3.5-billion payment due on December 14, 2009 (owed by Nakheel, Dubai World’s real estate subsidiary), the first of about $26 billion in payments due over the next 3 years (a default on the payment of bonds by Nakheel at the end of the grace period (two weeks from the due date), will trigger defaults on two other securities, bringing the total debt to $5.25 billion).
Two, questions regarding whether Abu Dhabi would bail out the Dubai government and its commercial concerns. The latter question was partly addressed when Abu Dhabi made a payment of $10 billion to the Dubai government to help it repay the Nakheel bonds. 
Tension in the global economic community was exacerbated by an announcement by the Dubai government that any assumptions of a government guarantee were misplaced and that creditors would need to assume standard risks that they typically undertake while lending funds to any other entity. Although the Dubai government had not guaranteed any of the borrowings of Dubai World, this highlights guarantees by a government (also called sovereign guarantees) and the ability to hold governments judicially accountable for such guarantees in various jurisdictions.  
Sovereign Guarantees 
A sovereign financial guarantee of a borrowing means that the government of that country agrees to pay in the event of any default on that borrowing. Typically, a sovereign guarantee is provided for a project if a state instrumentality is involved in such project or if such guarantee is deemed to be necessary to attract investment.   
For example, the Maharashtra government had provided a counter guarantee for the payment of dues by the State Electricity Board of Maharashtra to Enron. The Indian central government provided a further counter-guarantee in the event of a default by the State of Maharashtra.  Such guarantees compelled the State of Maharashtra and the Government of India to pay Enron in the event of a default by MSEB.  In addition to the guarantee, the State of Maharashtra specifically waived sovereign immunity which meant that if the State of Maharashtra were unable to pay Enron, Enron could potentially seize state assets for the repayment of arrears.   As detailed in Guarantee of the State of Maharashtra to the Dabhol Power Corporation, February 10, 1994, the waiver of sovereign immunity stated that the guarantee constituted private and commercial acts of the government rather than governmental or public acts and no immunity could be claimed by the government in respect of the guarantee.
In a recent example from this year, where a sovereign guarantee was provided by a government was that of the Ukrainian government for a debt on Eurobonds of $500 million (containing an unconditional and irrevocable sovereign guarantee) owed by the state-run energy company Naftogaz to its creditors.   
Sovereign Immunity  
The genesis of the concept of sovereign immunity is in the English law maxim “The King can do no wrong”.  Sovereign immunity is dealt with differently in various jurisdictions. Since it seems inequitable that the state and their agents have no liability at all, most jurisdictions allow the state (both domestic and foreign) to be sued in certain circumstances to reduce the adverse impact of the doctrine of sovereign immunity.  

The federal government may not be sued unless it waives its sovereign immunity. This was codified in the US by the enactment of the Foreign Sovereign Immunities Act of 1976 (the “Act”).  Section 1605 (a) of the Act incorporates commercial activity as an exception.  The rationale for adopting such an approach was expressed by Lord Denning as “a foreign government which enters into an ordinary commercial transaction with a trader….must honour his obligations like other traders: and if it fails to do so it be subject to the same laws and amenable to the same tribunals as they are” (Thai-Europe Tapioca Service v Government of Pakistan, The Harmattan (1975) 1 WLR 1485 at 1491F).  The Act mandates that whether government conduct is commercial is to be determined by the course of conduct or particular transaction or act, rather than by reference to its purpose (Section 1603 (d) of the Act).  
The principal test was developed both by the statute and the courts to determine whether sovereign activity is commercial or not.  It looks at the outward form of the conduct that the foreign state performs or agrees to perform such as whether it was a market transaction which could be conducted by a private party (Republic of Argentina v. Weltover, Inc., 504 US 607 (1992) at 617).   
State Immunity Act of 1978 (the “SIA Act”) was passed in UK which also included commercial transactions as an exception to the rule of sovereign immunity.  Section 3(3) of the SIA Act defines commercial transactions to include loan or other transaction for the provision of finance or guarantee, among other things. 
There is no specific legislation in India that codifies the doctrine of sovereign immunity. One of the earlier judicial rulings in this regard was in 1965 when the Supreme Court held that actions by public servants in the exercise of a statutory power or sovereign functions may not be questioned in a court of law. (Kasturi Lal v. State of UP, AIR 1965 SC 1039). However, in 1994, the Supreme Court blurred the distinction between sovereign and non sovereign functions and stated that in the modern age, the state should not be allowed to claim immunity for its actions barring defence, foreign affairs, etc. (Nagendra Rao v. State of AP, AIR 1994 SC 2663). But it fell short of overruling the theory of primary and inalienable functions.  Since, the Indian government has not reacted in kind and codified the ruling of the Supreme Court, determination of sovereign immunity is still done on a case to case basis.  
There continues to be differences in the practice of various countries in applying the sovereign immunity doctrine.  In light of such uncertainty, the United Nations Convention on the Jurisdictional Immunities of States and Their Property in December 2004 was introduced which is awaiting ratification by 30 states.  As of today, 28 countries have signed the treaty.  This treaty if adopted, would serve as the new international norm on sovereign immunity.   
Considering the hurdles of sovereign immunity, pursuant to Dubai laws, it is difficult to sue the Dubai Government as permission is required from the government before a government controlled company can be taken to court in Dubai. Additionally, Dubai’s judiciary has never handled a bankruptcy of a government company in the past. Taking these obstacles into account, the foreign bondholders of Nakheel led by QVT along with a number of other hedge funds, are in the process of commencing litigation against Dubai World in the British courts for its important assets (including ports and real estate assets held by the conglomerate’s investment arm, Istithmar).  This suit is based on the contention that Dubai World is a guarantor of Nakheel bonds. 
Islamic Financing 
Media reports suggest that the $3.5 billion debt that Nakheel was due to repay on December 14 comprised entirely of Islamic law compliant bonds (i.e. Sukuk Bonds).  Due to the tenets of Sharia law, such bonds have particular restrictions with respect to participation in interest bearing instruments.  Profits made by a lender are usually in the mode of profit sharing with the borrower and not interest earned on the funds loaned. However, it is not clear under Sharia law as to how the lenders are to be treated if there is a default on such Sukuk Bonds. 
Sukuk Bonds are Islamic securities similar to conventional bonds, but returns are derived from underlying assets to comply with Islam’s prohibition of interest rates.  It has not been proven that while in theory Sukuk Bond structures give investors ownership in assets underlying a Sukuk Bond, in practice these assets often merely serve to comply with Islamic law and investors will have no ownership rights in case of default, making the risk profile of a Sukuk Bond similar to a conventional bond.  
The recent era saw easy credit availability leading to massive debt including those by government run entities.  As the Dubai crisis exemplifies, that era is now over and creditors must deal with debt servicing issues. 

(Shantanu Surpure, Managing Attorney, Sand Hill Counsel.  Assisted by Rashi Saraf and Nischal Reddy, Associates, Sand Hill Counsel)


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Dubai Crisis: How Immune is the Sovereign?

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