Dubai's banking legislation to create a more attractive investment environment

September 2016 saw the approval by the UAE government of a new bankruptcy law, which came into effect at the end of the year. The law supersedes the country’s previous insolvency framework, which was largely laid out in the 1993 Commercial Transactions Code. Critics of the previous framework argued that it was excessively harsh regarding the treatment of individuals such as company directors and general managers in the event of insolvency and related issues like cheque-bouncing, for which such individuals could be held personally liable before the law. This encouraged senior figures at companies facing financial difficulties to leave the country – a practice that is known locally as skipping – which in turn increased the likelihood of distressed firms going under and made it a lot more difficult for creditors to recoup losses.

The new legislation is applied to commercial companies, state-owned firms and individual traders, however it does not apply to private individuals. It also does not apply within the Dubai International Financial Centre or the Abu Dhabi Global Market financial free zones, which have their own insolvency frameworks, though it does apply in all other non-financial free zones in the country.

Protective Processes

The legislation creates several new processes for companies in financial distress. Companies that are experiencing financial difficulties but are not yet insolvent can apply for a measure known as protective composition, which allows for their debts to be restructured, provided their creditors agree. Another process, insolvency with restructuring, also allows for insolvent firms to restructure their debts, subject to agreement from the lenders, under court oversight.

If neither scheme can be applied, the law lays out a liquidation process for insolvent companies. It also provides for a separate process to restructure distressed financial institutions. The law further mandates the creation of a new financial restructuring committee, which will oversee financial restructuring processes and maintain lists both of accredited financial restricting experts and of individuals previously subject to disqualification or other bankruptcy-related orders. The latter measure, in combination with the launch in November 2014 of a national credit bureau, should help banks to lend with greater confidence, supporting credit activity.

A key protective measure for companies facing difficulties and their senior management is a provision that allows them to apply for a stay of prosecution for bouncing cheques (which remains a criminal offence), provided they have applied for one of the above procedures. It is a common practice for borrowers in the UAE to sign post-dated cheques to lenders as security for loans, which the lenders can seek to cash in the case of non-payment, meaning that many indebted companies running into financial difficulties under the old framework had the threat of prosecution for bouncing a cheque hanging over them. Additionally, a company’s failure to declare bankruptcy within 30 days of not being able to pay debts is no longer classified as a criminal offence. Instead, a disqualification order can be applied.

However, some observers say the impact of the law will be limited, as bouncing a cheque ultimately remains a criminal offence for which the signatory can be held personally liable. Legal observers say that despite the regulatory changes, the extent to which individuals can and will ultimately be held liable for the debts of failed companies remains somewhat unclear, and it is widely agreed that this, and ultimately the wider impact of the law, will depend in part on how courts choose to interpret and implement the law and provisions of related legislation, which has yet to be seen.

Difficulties For Small Businesses

Rajai Ayyash, managing director and gulf regional executive for global client management at BNY Mellon, said the new legislation was accommodating to small and medium-sized enterprises (SMEs) in particular. “The bankruptcy law means SME owners are no longer on the hook in terms of being personally liable if their businesses fail, which will encourage more entrepreneurship, risk-taking and general business development,” he told OBG. Recent worsening of credit quality in the segment may lead to a number of test cases that will help establish precedent for its implementation.

Oil Price Impact

SME access to credit, though constrained, improved somewhat in the early years of the decade. However, since late 2015 and early 2016 it has come under renewed pressure, both in Dubai and in other emirates. In 2012 and 2013, as the economy began to recover from the 2008-09 crisis, banks began to lend quite aggressively to SMEs. However, many SMEs involved in trading were badly affected by the fall in international oil prices in 2014 and 2015, which also saw a concomitant decline in commodity prices.

As a result, stock they were holding plummeted in value, leaving them unable to repay existing loans, with banks subsequently tightening their lending. “Trading SMEs were overleveraged and were really impacted by the downturn, with rice traders the first to be hit hard,” Chafic Mourad, senior executive officer of the UAE unit of Lebanese bank Bankmed, told OBG. “Some banks began to panic and cut ties with SMEs, which was a big blow for the segment, and even SMEs that were doing well began to see their credit lines frozen,” he said, adding that the financial crunch had resulted in around Dh10bn ($2.7bn) of debt write-offs. This gave rise to a number of defaults and skips, which sparked substantial concern in the banking sector. “Some SMEs that were heavily dependent on banks are still finding it difficult to obtain funding,” Mourad told OBG. As a result, classified loan rates in the segment rose from 4% as of mid-2015 to over 10% across 2016 as a whole, passing the 20% mark by December of that year, according to figures from the Central Bank of the UAE. However, Mourad said the situation began to turn around once oil prices returned to around $50 a barrel in July 2017. According to industry players, banks subsequently made a collective decision to avoid shutting SMEs out of credit markets, which was driving a vicious cycle, and the worst is now over.

In light of the small share of bank lending made up of SME loans, the impact of the problems in the segment on the banking industry has been limited, putting pressure on profits at some institutions – in particular smaller banks, for whom SME loans constituted a larger proportion of their overall lending portfolios – rather than threatening the stability of any individual bank or the wider financial system. Furthermore, Mourad told OBG that upcoming developments, such as the ramp-up for Expo 2020, building work at Al Maktoum International Airport and the construction of a major new mall in neighbouring Abu Dhabi, would also see credit begin to flow into the segment in large amounts once more, in particular for well-managed SMEs.

Nevertheless, some banks remain sceptical of the segment’s outlook. Speaking in July 2017, Nitish Bhojnagarwala, assistant vice-president at Moody’s Investors Services’ Financial Institutions Group, told OBG that while lending to the sector continued, banks were still exercising prudent underwriting standards with regard to SME lending. “Some underwriting is taking place selectively, with enhanced due diligence, but the availability of credit has not returned to pre-2015 levels,” he said. “The SMEs segment was overleveraged, which caused some small businesses to default and create funding challenges elsewhere, particularly for those borrowers who were performing,” he told OBG.

New Rules For Lending

In response to the cutback in credit to the segment, the central bank has drafted new rules to encourage SME lending. In February 2017 international media reported that the institution had circulated a draft regulation to all banks that would require them to establish dedicated SME units and strategies, including specific targets for lending to the segment that, if not met, would oblige banks to provide an explanation to the sector regulator. The draft rules also stipulated that banks refrain from applying “unreasonable collateral requirements” on loans to businesses and offer explanations for any rejected loan applications.

Other initiatives aimed at helping the sector include a programme launched in early 2017 by Dubai SME, a resource centre for SMEs that is part of the Dubai Department of Economic Development, under which smaller businesses can apply for ratings based on a wide range of factors such as quality of management, leadership and human resources. This programme is expected to, in hand with other beneficial impacts, facilitate access to bank lending.