FINANCIAL RE-STRUCTURING OF GOVERNMENT-RELATED ENTITIES IN THE UAE
Authored by: James Farn
James Farn, Head of Banking & Finance at Hadef & Partners in Abu Dhabi recently contributed this article to the The Oath magazine where he discusses the key issues and trends affecting financial restructuring of Government-related entities (GRE’s) in the UAE.
A Government-owned entity (GRE) is a legal entity created by government to undertake commercial activities on behalf of its own government. A GRE may be partially or totally controlled by government and is invariably set up to deliver key services to population. One of the unique features of a GRE is that it can be affected by extraordinary government intervention during a period of financial difficulty.
Although a GRE may also have public policy objectives, it can be differentiated from other forms of government agencies or state entities established to pursue purely non-financial objectives. Unlike the State (federation), Emirates and other specific organs of the government in the UAE, because a GRE is formed to carry out a commercial activity on behalf of its sponsor, it will be treated as ‘trader’ for the purposes of the CCL and may therefore be made bankrupt.
GRE’s form an important part of the economies in the major Emirates of Abu Dhabi and Dubai, accounting for significant proportions of GDP jobs, economy activity and growth. A large proportion of Emirati debt remains tied up in GRE’s and many of these debts are due to mature this year (2014) and in forthcoming years.
What are some of the key issues and trends affecting financial restructuring of GRE’s in the UAE?
One of the key criticisms often aimed at GRE’s when they get into financial difficulties is that they are often seen as ‘too big to fail’. This may lead to government intervention to prevent the failure – a GRE therefore gains an implicit guarantee at the taxpayers’ expense that it does not have to pay for. This funding advantage in turn creates incentives for GRE’s to become bigger and more complex, with little incentive to improve efficiency, financial transparency and corporate governance procedures. As the commercial activities of GRE’s become ever-more concentrated, this increases the possibility of greater financial distress in the future.
Some particular trends are prevalent in the UAE. In Dubai, there have been no significant asset sales to reduce existing debt burdens and therefore higher demands are being placed on the government’s depleted funds. Since most of these funds are increasingly earmarked to help repay bonds, the government is also negotiating with banks in the restructuring of GRE debt.
Given the uncertainty as when and how a trader may be in a state of cessation of payments (and therefore the time of which the directors or managers may be under an actual obligation to file for bankruptcy), financial restructurings in the UAE invariably follow a consensual agreement or standstill route rather than commencement of formal bankruptcy or protective composition proceedings. This option is sometimes taken in order to minimise the risk of criminal sanction for failure to file for bankruptcy within the requisite 30 days from date of cessation of payment (‘bankruptcy-by-negligence’). As a consequence, some GRE’s are now trying to push their borrowing away from holding companies and into their more profitable subsidiaries where the assets and cash flows are. This strategy may help shift debt away from entities that will struggle to repay it and may help in the short-term. However, if this strategy shifts the debt burden onto entities that were not responsible for it, this could limit their ability to generate much needed growth and therefore actually dampen investment and growth in the medium to longer term.
Much of the increased liquidity in lending markets in the UAE since the financial crisis has also found its way into the pockets of GRE’s on the basis that they are perceived to be a ‘safe bet, based on a perceived alignment of a GRE’s credit rating with that of its government sponsor. This growth in lending activity has encouraged recent regulatory developments, including a UAE Central Bank directive imposing caps on lending to GRE’s. Although local banks should (in theory) now be in the process of writing down or selling of their loan books to fall within the required thresholds, there appears to be some reluctance to do this. Writing down large amounts of loans could cause banks to enter into another round of provisioning. A sale of debt in the secondary debt market (assuming the existence of buyers) could be interpreted as a ‘distressed sale’ and lead to another set of write-downs in credit ratings for both borrowers and lenders alike, so impasse is inevitably reached.
The UAE courts also have a discretion to defer a declaration of bankruptcy if it is in the ‘best interests of the national economy.’ Consequently, creditors have arguably been less willing to consider initiating bankruptcy proceedings against GRE’s in financial difficulties (in particular those in strategic sectors of the UAE economy) in the knowledge that the courts have an overriding discretion to defer bankruptcy proceedings in any event.
What issues or factors are likely to support a more coherent and better restructuring environment for GRE’s in the UAE?
The process of financial restructuring assumes that a borrower’s problem is one of liquidity rather than solvency. If asset prices begin to fall, there is a risk that GRE’s may not be able to pay when the loans start to mature. The re-pricing of risk in the region could trigger a sudden reversal of the recent deposit inflows into the UAE banking sector. Part of the role of a central bank is to monitor individual bank liquidity conditions to ensure that banks have the needed liquid assets to respond to any such reversal.
Federal and Emirati governments alike can take an active role by, for example, writing-off impaired assets and communicating the composition and maturity profile of the GREs’ liabilities as well as their financing strategy.
UAE commercial banks are strongly interconnected with GRE’s through government and ownership and financial linkages. Government control of banks and high exposure to GRE’s point to potential governance issues. Some of these banks have also been heavily involved in lending to GRE’s and GRE debt restructurings. Key steps for further strengthening GRE corporate governance should include delineating clearly their commercial and non-commercial operations, strengthening the role and independence of company boards to allow for more effective decision making and improving risk management practices. For example, Abu Dhabi has made progress in monitoring and disseminating GRE debt and other financial data through its Public Debt Management Office. Data availability on financial conditions, debt stocks and maturity profiles of Dubai’s GRE’s is arguably some way behind.
The federal government as well as the governments of Dubai, and Abu Dhabi have all made progress in developing medium-term fiscal frameworks and help avoid boom-bust cycles in the UAE economy. As a main tool for macroeconomic management under a pegged exchange rate regime, fiscal policy should aim at de-linking government and GRE spending from the volatility of oil prices.
The new federal bankruptcy law (if and when promulgated) will introduce a new ‘out-of-court’ insolvency procedure (Financial Reorganization Procedure) which is intended to offer an alternative to a consensual work-out or standstill. It remains to be seen whether this procedure will be successful and whether a single out-of-court procedure will be sufficient under the new draft law in order to encourage a more widespread ‘rescue’ culture within the UAE business community.
This article was recently published by The Oath magazine.
This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the develop jurisdiction of the UAE