East Cameron Gas Sukuk Bankruptcy
East Cameron Partners (ECP) issued sukuk of USD165.67 million in June 2006 with a maturity period of 13 years as a private placement under Regulation D and an international offering under Regulation S, which means that the sukuk certificates represented an ownership stake in ECG. (Colon: 2019) East Cameron Partners (ECP) was an independent oil and gas exploration company that owned leasehold interests in a producing natural gas and condensate field in federal waters adjacent to Cameron Parish, Louisiana. East Cameron’s leasehold interests consisted of a 100% undivided record title interest with a 79.87% net revenue interest subject to certain Overriding Royalty Interests in East Cameron Block 71/72. These lease interests arose from federal oil and gas leases governed by the Outer Continental Shelf Lands Act and administered by the Minerals Management Service of the United States Department of the Interior. (East Cameron Partners L.P. v. Louisiana Offshore Holding LLC & Ors ..)
ECP saw the sukuk issuance as an affordable and flexible finance opportunity through which it could raise the funds needed to purchase other shares from the non-operating partner, Macquarie Bank, whom wished to sell its share in the business. The underlying contract was musharakah in which sukuk investors owned so called Overriding Royalty Interest (ORRI) in two gas properties located in the shallow waters offshore the state of Louisiana, USA through an SPV. Specifically, the structure of the transaction involved the purchase of an ORRI carved out of US federal offshore leases as mentioned herein. Under local (Louisiana) law, ORRI are considered real property. Because the transaction involved real property, the Shari’ah Scholars approved this as an asset-backed securitization in the form of a sukuk al-Musharakah. The sukuk investors share the profits and losses in the production of the originators in a pre-determined ratio determined by their relative capital shares fixed in the sukuk documents. The SPV was called East Cameron Gas Company (ECGP) and incorporated in the Cayman Islands. (Goud: 2010)
The Issuer entered into a funding arrangement with Louisiana Offshore Holdings (LOH) with the proceeds of the issue flowing back to the oil and gas operating company, ECP. Proceeds from the gas production flowed to LOH (Owner of the ORRI) and were shared between the Issuer and ECP. The Issuer passed along its share of the proceeds to the ECP sukuk investors to repay the 11.25% expected return and part of the principal. (Hawkamah Institute of Corporate Governance: 2011) Although the investors would share in the profits or losses derived from the success or failure of the underlying assets, the investors bore the risk of the oil and gas reserves being insufficient to fully support the issuance of the sukuk, natural disaster risk, and price fluctuation risk. (Hawkamah Institute of Corporate Governance: 2011)
This was the first sukuk issued by a company based in the United States and rated by Standard and Poor’s. The sukuk were initially rated CCC+ by Standard and Poor’s and then downgraded to CC and finally D. Although the East Cameron Gas sukuk had a fixed payment of 11.25% annually, there was also a variable component because the sukuk returns depended upon the production quantities (the ORRI specified a fixed quantity of natural gas be delivered to the SPV). It also contained a redemption feature by where a percentage of the sukuk would be redeemed if production exceeded a certain level.
Sukuk holders were also exposed to risks found in the energy sector i.e. the volatility of natural gas and condensate prices, which may adversely affect payments on the sukuk. In order to hedge against severe price fluctuations in oil and gas markets, there was a Shari’ah compliant hedge that established a price collar between $7 and $8 per million BTU (MMbtu) on half the expected products gas production and a put option at $6 per MMbtu for an additional quarter of anticipated production (Goud: 2010).
Further described in the offering document was that closing transactions would occur including “purchase of natural gas put options for US$4.05 million pursuant to a Hedge Agreement (the “Hedge” Agreement) with Merrill Lynch Commodities, Inc. (the “Hedge Counterparty”) that, in combination with other hedges provided under the Hedge Agreement, are intended to mitigate the Purchaser SPV’s exposure to change in natural gas prices. In addition, Merrill Lynch Credit Products LLC would provide a letter of credit on behalf of the Purchaser SPV to secure the Purchaser SPV’s obligations under the Hedge Agreement. The Shari’ah compliant hedges limited the impact of rising and falling prices on the ability of the production to be sufficient to generate returns for investors. (Goud: 2010)
In sum, the issuer SPV, East Cameron Gas Company (ECGP), incorporated in the Cayman Islands issued USD165.7 million of sukuk whose proceeds would be used to buy the ORRI from the Purchaser SPV following a Funding Agreement for USD$113.8 million. The remaining amount was appropriated for a development plan, a reserve account, and the purchase of put options for natural gas to hedge against the risk of fall in gas prices. The originator contributed his share of the capital in the form of transfer of ORRI into the purchaser SPV. Next, the purchaser SPV, holding ORRI in the properties, would be entitled to around 90 percent of ECP’s net revenue generated through gas production. (Zaheer: 2013)
The production would be sold to two off-takers with Merrill Lynch as a backup off-taker. Proceedings of the oil and gas sale would be transferred to an allocation account. After paying around 20 percent to government and private ORRI, the remaining amount would be transferred to the Purchaser SPV. Next, the purchaser SPV would allocate 10 percent for the originator and the remainder for the payment of expenses, periodic sukuk returns, and redemption amount. Any excess amount would go to originator and early redemption of the sukuk equally. Upon maturity of sukuk, the issuer SPV would redeem all the sukuk against the amount left to be transferred to the sukuk holders (Zaheer: 2013).
Instead of being solely used to support the capital and operating costs of drilling and operating wells in the Gulf of Mexico for East Cameron Partners, the proceeds were also used to pay most of the conventional debt of the company. This brought the debt-to-equity ratio of the company to a Shari’ah compliant level, however, also bankrupted the sukuk.
Furthermore, the originator’s business was located in the Gulf Of Mexico making it vulnerable to severe weather and other effects. Shortly after the September 2008 Hurricane Katrina damaged the underlying assets of the sukuk, S & P downgraded the issuance as a result of the negative impact from the hydrocarbon mix shortfall enforcement event on the overriding royalty interest in oil and gas reserves (ORRI), which was the primary collateral for the sukuk. This enforcement event was triggered by the breach of the 90% minimum stressed reserve level of the hydrocarbon mix threshold stipulated in the transaction documents (Lampasona, 2009). Thus, in 2008 ECP experienced a shortfall on the ORRI in oil and gas, which is the primary collateral used as the underlying asset to the sukuk contract. Consequently, the shortfall event triggered breach of approximately 90% of the reserve level of the threshold contained in the contractual agreement. (Busari: 2019)
On September 17, 2008, a Notice that an Exogenous Enforcement Event, namely a Hydrocarbon Mix Shortfall Exogenous Enforcement Event, was served on the Purchaser SPV (LOH) and East Cameron Partners LP (the “Originator” and, subsequently, the “Debtor”)(McMillen: 2011) S& P downgraded the transaction to CC from CCC+ when the structure hit the aforementioned trigger, breaching 90% minimum stressed reserve level of the hydrocarbon mix threshold.
On October 16, 2008 East Cameron Partners filed for bankruptcy protection under chapter 11 in the United States Bankruptcy Court for the Western District of Louisiana “Bankruptcy Court”, claiming its inability to pay the periodic returns on the East Cameron Gas sukuk to sukuk certificate holders.
In March 2009, the agency cut the deal to D on skipped payments and withdrew the rating; the latter event was in response to a failure to receive service reports (Lampasona: 2009).
The issue at hand for the Bankruptcy Court was whether or not the transaction was a secured loan or a true sale. True sale is a situation whereby contractual parties agree to transfer a financial asset for fair value with the intent of a sale (Busari: 2019) The originator claimed that the transaction was not a true sale, but a secured loan. ECP argued that the ownership of ORRI was not transferred from ECP to Louisiana Offshore Holdings or “LOH” as the transaction was not a true-sale agreement. ECP further claimed that the underlying asset is merely a pledge as security for a loan in favour of LOH. (Busari: 2019)
Specifically, according to Colon, ECP requested that the bankruptcy court declare (1) the sukuk transaction was a loan; (2) that the conveyance of the ORRI (i.e.) the underlying asst securitizing the sukuk and making the private/international offering of ECG a worthwhile investment, did not transfer ownership of the ORRI to ECG; and (3) the ORRI, was merely security for ECG’s loan to ECP. (Colon: 2019). Colon points out that ECP requested the court to interpret the distinctions of the sukuk transaction that made in Shari’ah compliant as ineffective, as nothing more than a conventional secured loan. (Colon: 2019)
Under conditions of a true sale, the sukuk investors would have the sole rights to the underlying assets and would not have to stand in line behind any other creditors. The contractual agreement of the true sale would ensure the bankruptcy remoteness of the SPV whereby in the event of a default, the sukuk holders could have recourse to the underlying asset that has been established through a true sale agreement. (Busari: 2019) Under the secured loan, the originator would have rights to the assets only after resolving creditor claims in Chapter 7 liquidation.
In a motion to dismiss ECP’s complaint and accompanying memorandum of law, the Sukuk Certificate Holders responded to the request for declaratory judgment by arguing: (1) that the ORRI conveyance was indeed a true sale under controlling Louisiana law; (2) that ECP’s statements of law should be disregarded in favour of Louisiana’s version of the Uniform Commercial Code; (3) that the complaint should be dismissed because it asked the court to rewrite the contract; and (4) the complaint should be dismissed because though asking the court to recharacterize the sukuk as a loan, it left out every major detail of what the loan should be. (Colon: 2019). The Court granted the sukuk certificate holders motion to dismiss and the court did not deviate from the objective terms of the sukuk agreement. (Colon: 2019)
The court found that it was a true sale and that the sukuk investors had the sole rights to the underlying assets. Hence, it was decided that the sukuk holders are the owners of the ORRI from the oil and gas reserves as the ORRI is considered real property in the jurisdiction of the state of Louisiana. However, the matter was unclear as to whether sukuk holders enjoyed contractual rights to the assets like bondholders or creditors or whether they enjoyed proprietary rights and were, therefore, considered by the courts to be equity holders (Khnifer, 2010).
The court ruled that the SPV assets would be treated as the product of a true sale. The sukuk certificate holders were able to get full ownership and possession of the assets without sharing it with the other creditors. This essentially meant that the SPV did in fact own the assets and was not merely a collateral holder for secured loans. While the event proved successful for sukuk investors, it was a setback for the Islamic finance industry in that the deal was structured as a purchase rather than a distribution to owners. The assets of the sukuk went to the certificate holders free and clear of claims of creditors, however, a precedent was set that the sukuk certificate holders did not own undivided interest in the assets. The sukuk certificate holders were treated as if they were third party buyers rather than the asset owners or even secured lenders (Khnifer: 2010). The Bankruptcy Court did not apply Shari’ah law to the transaction and settled the sukuk bankruptcy as a conventional and common law transaction thereby turning it into a conventional transaction by default. However, the court did uphold the sukuk agreement. It would be ideal if there was one Sukuk Bankruptcy Tribunal (SBT) attached to the Dubai World Islamic Finance Arbitration Centre (DWIFAC) to settle all of the world’s sukuk disputes and bankruptcies located in Dubai, UAE rather than common law jurisdictions scattered around the world.