Restructuring

The global market for Islamic finance has been growing at exponential rates, with the overall size of the Islamic financial industry increasing from approximately $80 billion in 2000 to approximately $1.3 trillion at the end of 2011. It’s therefore not surprising that the United States Bankruptcy Court for the Southern District of New York recently approved a first-of-a-kind Sharia-compliant debtor-in-possession (DIP) financing and exit financing package in Arcapita Bank’s bankruptcy cases. Sharia is the moral code and religious law of Islam.

Arcapita is a privately owned Sharia-compliant investment company, which holds minority ownership interests in a global portfolio of operating companies and other portfolio assets. The global economic downturn, and in particular the Eurozone debt crisis, severely limited Arcapita’s ability to refinance a $1.1 billion syndicated facility that was set to mature on March 28, 2012. Despite having widespread support for an out-of-court restructuring from its existing lender group, Arcapita was unable to obtain the 100% lender consent required to restructure its syndicated facility, partly due to minority holdout lenders who sought to be bought out at par before they would agree to any modification of Arcapita’s existing syndicated facility. Arcapita filed for chapter 11 protection on March 19, 2012.
The case is significant in that it involved the first approval of a Sharia-compliant DIP financing and exit financing package by a U.S. bankruptcy court. The key principles of Sharia relevant to Islamic finance as currently practiced in the United States include prohibitions on:

• transactions that are based solely on chance or excessive speculation, rather than on productive economic activity that generates a return;
• uncertainty, in contracts (thus requiring all of the fundamental terms of a contract to be ascertained at the outset);
• unjust enrichment, most commonly described as the prohibition of the payment or receipt of interest;
• transactions with an unethical purpose; and
• the unfair exploitation of one party by another.

As described in the motion to approve the DIP financing, one form of Sharia compliant financing, a “Murabaha,” typically consists of a sale by the “lender” of a specific amount of commodities for a set price (which consists of the actual out of pocket costs of the “lender” plus an agreed upon profit) to the “borrower.” The “borrower” agrees to pay for the commodities on deferred payment terms. The “borrower” then sells the commodities, for cash, to a third party. The end result is that the “borrower” receives an immediate cash infusion and incurs a future obligation to pay the “lender” the agreed upon price.
Arcapita commenced its chapter 11 cases with approximately $120.1 million in available cash, a significant portion of which went to fund existing deals in which Arcapita was invested to preserve the going concern value of Arcapita’s assets and investments in its portfolio companies. Arcapita required additional funds to complete its restructuring, and thus sought $150 million of Sharia-compliant DIP financing. Arcapita and Silver Point, a Greenwich, Connecticut-based hedge fund that specializes in investing in distressed companies, initially negotiated a commitment letter for Silver Point to provide the Murabaha financing, however following extensive negotiations between parties-in-interest, Arcapita eventually selected a Murabaha financing package to be provided by Fortress Credit Corp., an investment management firm based in New York City.
The Silver Point DIP was initially structured as an initial $125 million multi-draw term facility that could be increased by an additional $25 million, of which $25 million was sought on an interim basis, with the remainder being subject to the entry of a final order by the Bankruptcy Court. The subsequent DIP package negotiated with Fortress provided for a $150 million Murabaha DIP facility comprised of an initial $100 million multi-draw term facility and a $50 million delayed draw term facility, which was conditioned on additional due diligence to be performed by Fortress. Outstanding obligations under the Murabaha DIP facility accrued profit at a rate equal to 1-month LIBOR plus a 10% margin per annum on the unpaid principal amount of the facility. The facility also included a 3% upfront fee (reduced by a $2 million commitment fee).
The DIP motion and order were relatively standard in terms of form and substance, though the approval order for each of the financings included specific findings with regard to the commodities transactions underlying the Murabaha financing (i.e., the sale of London Metal Exchange metals and other Sharia compliant commodities that may be specified by Arcapita). These findings included that the purchases and sales of commodities through purchase contracts give rise to an extension of credit by the existing secured parties in the form of DIP obligations; are essential to the DIP facility and thus provide a basis for the Debtors to access the liquidity required to operate their businesses and preserve and enhance their enterprise value for the benefit of their stakeholders; and are necessary for the Debtors’ overall restructuring. The commodities transactions are also specifically authorized on an interim basis by the Bankruptcy Court under section 363(m) of the Bankruptcy Code, and on a final basis under section 363(b)(1) of the Bankruptcy Code
Like the DIP Motion and order, the term sheets setting forth the DIP and exit financing proposals also were themselves fairly standard, and the Sharia aspect of the financing is apparent only in the description of the “Murabaha Transactions” provided in the Murabaha DIP Facility Term Sheet, which, as described above, involve the sale by an investment agent of commodities specified by Arcapita pursuant to purchase contracts, following which Arcapita will pay a deferred sale price for the commodities. The commodities themselves are simply London Metal Exchange metals and other Sharia compliant commodities that may be specified by Arcapita.
While the DIP financing and exit financing proposals were contested by some parties-in-interest who questioned whether the Murabaha financing was indeed Sharia compliant, rather than an (impermissible) organized tawarruq (monetization), Judge Lane ultimately agreed with the Debtors’ position, supported by their Official Committee of Unsecured Creditors, that the compliance of the DIP financing with Sharia law is not – and cannot be – before the Bankruptcy Court, and that the standards for approval of DIP financing are set forth solely in the United States Bankruptcy Code, which does not mention Sharia compliance as a prerequisite for approval of a debtor’s request for financing.
Ultimately, Arcapita borrowed $150 million under the original DIP facility from Fortress, and repaid approximately $40 million of those borrowings with proceeds from asset sales. With the original DIP facility scheduled to mature prior to the anticipated effective date of Arcapita’s plan of reorganization, Arcapita and Goldman Sachs negotiated a replacement $150 million Murabaha DIP facility and up to $350 million in exit financing. The replacement Murabaha DIP facility has a profit rate of 8.0% per annum in cash plus 1.75% payable in kind (almost identical to the original DIP facility), subject to a 1.5% LIBOR floor.
As long as the proposed form of DIP financing is permissible under the Bankruptcy Code, a bankruptcy court may approve a Sharia-compliant financing structure. The ease with which the U.S. bankruptcy system is able to adapt to alternate forms of financing is a testament to its design and inherent flexibility. Other Islamic institutions and businesses in distress with a U.S. nexus may in the future consider U.S. bankruptcy courts as appropriate forums for restructuring, should (Naudhubillah) they need it. Masaa Al Khair!