Although recent global economic indicators suggest various countries are slowly, but surely, emerging from recession, the eyes of the business world remain firmly fixed on the banks. "When will they return to lending as normal?" "Have they made sufficient provisions?" “Would a closer analysis of their loan portfolios reveal a yet deeper malaise?"
In brief:
Our legal due diligence experience in respect of UAE lending practices and procedures suggests there are “gaps” in the enforceability of the guarantees and security given to support the borrower.
If UAE banks are to safeguard their regulatory capital and limit the additional amount of economic capital they need, then lending practices and procedures will need to change.
Strong relationships with customers remain the key to successful contractual lending and borrowing arrangements. However, lending on the strength of relationship (or name) alone is not economically viable or justified.
In the UAE, the risk management activities inherent in running a corporate or investment banking business remain of crucial importance, not least because of the strong local characteristic of "name lending", by which is meant lending or providing other banking facilities to family or other private businesses, primarily on the strength of the "name" or "names" of the proprietors standing behind the business, rather than on the strength of the asset quality and underlying credit of the particular business. Of course, in practice, there is commercial overlap between the proprietors and the companies which they own, but the credit analysis can break down where poor banking practices and procedures result in poorly constructed legal documentation and gaps in guarantee and security support documents.
Recent UAE news has highlighted the distinction between "regulatory capital" and "economic capital". Whereas regulatory capital is essentially the capital which a bank is required to maintain by its regulator as a measure of capital adequacy, economic capital represents a deeper cushion of capital more accurately measuring the risks in the assets of the particular bank.
For UAE banks, this concept of economic capital providing a more effective measure of risk, than mere capital adequacy, will be the more significant, if any closer examination of a particular bank's lending and supporting documentation were to reveal "gaps" in enforceability of the guarantees and security given to support the borrower. Our legal due diligence experience in respect of UAE lending practices and procedures suggests there are indeed such “gaps”. If a bank’s credit/risk management committee has approved a loan on the basis that it is a secured loan, it would indeed be a concern, and increase the bank’s economic risk, if the security turned out to be defective as a matter of law.
Let us assume the family business consists of a holding company or other legal entity (e.g. partnership) and many trading subsidiaries doing business across a broad range of different business sectors.
If UAE banks are to safeguard their regulatory capital and limit the additional amount of economic capital they need, then lending practices and procedures will need to change. The rating agencies that rate UAE and other GCC government and corporate bonds will no doubt have a big influence in acting as a catalyst for change in improved operational quality. So too will the banks' shareholders; and also will the individual bank's credit/risk management committees, which now wield significant power and authority within their bank.
Many “what if” questions need to be adequately and satisfactorily answered in the affirmative and not left to doubt and/or subsequent action. For example:
Management and Corporate Governance
Is it clear who are the management members of each company?
Has their identity been fully validated?
Is there a board of directors additional to the general manager(s) of the company?
Is it clear from the company's memorandum and articles of incorporation what the management can and cannot do?
Does the bank have a clear audit trail of documentation identifying who were the directors and managers of the company during particular periods of time during the contractual period of the banking relationship and, therefore, who approved versions of which particular documents and who authorised which transactions?
Where a person (as would be usual in a family group of companies) is a director or manager of many companies, is he acting for the benefit of one company when he undertakes certain actions for another company, e.g. giving a cross company corporate guarantee?
Legal Documentation
Is there a good commercial reason to choose English law to govern the facility agreement for facilities to be made available to a UAE group of companies, when any security interests given over UAE assets will necessarily need to be governed by UAE laws?
Corporate and Personal Guarantees
Are the guarantees unequivocal in their terms?
Are they guarantees or merely sureties?
Do they have monetary limits?
Are they dated and correctly executed?
Are later-in-time entered standard form guarantee documents in conflict with earlier-in-time entered standard form guarantee documents?
Where there are personal guarantors, have they given security to support their otherwise unsecured obligations?
What credit analysis has been carried out in respect of particular individuals, who may have given personal guarantees in respect of many companies, not just to the particular bank, but many other banks as well?
What risk scenario analysis has been done to test how creditworthy are the personal guarantors were some or all of their personal guarantees to be called (e.g. what if a personal guarantor became bankrupt)?
Security
Have all the steps required as a matter of UAE law to perfect the particular security interest been effected?
Has a particular class of assets been given as security to another bank at an earlier point in time?
Is the borrower or other obligor in breach of any contractual lending documentation with another bank by giving security to the particular bank?
Does a fall in loan-to-value ratios require the provision of additional security and has such additional security been obtained?
Readers may also wish to refer to our What is Effective Security article for a more detailed discussion.
Priorities of debts and ranking of security between banks
In short, are the priorities and ranking clear as a matter of UAE law?
Has pre-drawdown due diligence been carried out to verify the true situation vis-a-vis other banks?
Internal bank systems
Is the totality of documentation provided by the borrower/obligor group of companies, which will be input into the bank's electronic systems, sufficiently clear and quickly retrievable to enable the bank's operations team to correctly corroborate and validate the corporate authorities authorising all future transactions?
Does the information contained within the documents held in the bank's physical storage system tell the same story as the electronic versions of those documents held within the bank's electronic storage system?
Conclusion
The global financial crisis has changed the banking landscape forever. Things will certainly not be the same. Strong relationships with customers remain the key to successful contractual lending and borrowing arrangements. However, lending on the strength of relationship (or name) alone is not economically viable or justified. The cost of maintaining sufficient economic capital will dictate the new future. In the UAE, there will indeed be a new age for name lending.
The first of its kind in the Middle East, the Netting legislation recently enacted in the DIFC enforces close-out netting in case of insolvency. Hadef & Partners highlights the main provisions of this new law.
After undergoing a period of consultation, an Enactment Notice was issued on December 7, 2014 in relation to the DIFC Netting Law DIFC Law No 2 of 2014 (“Netting Law”) which came into force on December 14, 2014 in the Dubai International Financial Centre.
The Netting Law is concerned specifically with the application of close-out netting – sometimes called default netting. Close-out netting in its simplest sense is a process that takes place when an event has occurred which has resulted in a default and the contractual relationship between the parties is to be terminated. In close-out netting, the idea is that all obligations are accelerated, the original contracts are terminated and a calculation is made by which a single amount is then owed by one party to the other party. This process reduces exposures on open contracts if one of the parties to those contracts should become insolvent before the agreed settlement date under the relevant contract. All old agreements disappear and are replaced by a new one. This process should be distinguished from other forms of netting such as payment netting which is concerned with reducing the risk of one party to a contract who agrees to pay or deliver something under that contract and the other party to that contract becomes insolvent before he pays or delivers – in other words, an arrangement which nets out the respective obligations of those parties in advance of the agreed settlement date.
Close-out netting is most commonly encountered in the context of derivative contracts. These type of contracts may include contracts for the sale of commodities or other property and also contracts for the exchange and delivery of money such as foreign exchange contracts and interest swaps. Many of these transactions are documented in ‘over-the-counter’ form. The enactment of the Netting Law has been anticipated by many financial institutions as it provides a statutory framework in relation to the application and enforceability of close-out netting provisions agreed between parties in respect of such transactions.
The Netting Law is based on the International Swaps and Derivatives Association (ISDA) model law. In terms of its application, the Netting Law is potentially broad and applies to any ‘qualified financial instrument’, ‘netting agreement’ or ‘collateral arrangement’ governed by DIFC law or which is entered into by a person incorporated or registered in the DIFC or organised under DIFC law.
Close-out netting therefore aims to reduce financial risk and exposure often encountered between counterparties in over- the counter derivative transactions.
In addressing the enforceability of ‘netting agreements’, the Netting Law provides at Article 8 that the provisions of a netting agreement will be enforceable in accordance with its terms including, where applicable, against an insolvent party and will not be limited by the appointment of a liquidator or any provisions of law related to bankruptcy, liquidation, insolvency proceedings or any other provision that may apply to an insolvent party.
Prior to the enactment of the Netting Law, in the event of insolvency of a counterparty in any such transaction, recourse of the non-defaulting counterparty was subject to the provisions of the DIFC Insolvency Law No 3 of 2009 (“Insolvency Law”) and the DIFC Insolvency Regulations (“Insolvency Regulations”). Notably, the Netting Law provides at Article 2 that where there is conflict between the provisions of the Netting Law and the Insolvency Law or Insolvency Regulations the provisions of the Netting Law will prevail (except for section 7 of the Insolvency Regulations which concerns, against other things, the ability of a counterparty to have recourse to financial collateral in the event the insolvency of the other counterparty).
In practice, the Netting Law will be expected to apply to all banks and financial institutions that enter into derivative contracts within their ordinary course of business and also the relevant counterparty in such transactions where the underlying agreement elects the DIFC as the choice of governing law or where one of the parties is incorporated in the DIFC.
The new DIFC Netting Law will be welcomed by many financial institutions for providing greater clarification in terms of the operation and enforceability of close out netting provisions in the DIFC. UAE Federal laws as they currently stand do not adequately address the consequences of close-out netting and early termination on bankruptcy. The new DIFC Netting Law therefore provides more certainty in terms of the operation of close-out netting provisions where DIFC is selected as the governing law for derivatives transactions. This ultimately provides the market with a greater choice of laws which can be enforceable in principle in the Emirate of Dubai and those Emirates who have signed up to enforceability protocols with the DIFC.
Article originally published in The Oath, February 2015.
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