Banks are facing an unprecedented rise in non-performing loans (NPLs) in the aftermath of the pandemic; in fact, the IMF reported that Middle East banks had to absorb $180 billion in NPLs and defaults in 2020 alone. Daniel Hall, Hannah Howlett and Christopher Jeffreys spoke to a group of experts about key trends in NPL recovery and the developing secondary market for NPL portfolios.
What key trends are you seeing in asset recovery, specifically in relation to non-performing loans?
Keith Hutchison: A series of relatively high-profile corporate frauds, investment collapses and bankruptcies from distressed market conditions (with concentrations in particular sectors, such as construction) have exposed regional lenders to significant NPLs. In the UAE that has affected both local and international banks.
Locally originated asset recovery has opened up from traditionally locally focused measures to the pursuit of broader and more sophisticated international asset recovery strategies. The advent of third-party funding in the region around 10 years ago (which seems to be about the time of the first commercial litigation in the UAE known to have been third party funded) has taken several years to gain real traction and trust from the market.
We are now at a point where banks have much greater awareness of the value of NPL portfolios as assets, as opposed to a more traditional case-by-case view on recovery which often would have focused on local enforcement that seldom produced tangible recoveries on larger and more complex cases. The shift I have seen is more banks coming to appreciate the availability of broader asset recovery strategies and the value-add available now in the local market from a variety of asset recovery specialists and professional advisors with regional and international experience.
We are within the first true wave of funded NPL portfolio asset recovery engaged by local and international banks. It seems that locally operating international banks were some of the early movers to engage with funders in this space, and while it has taken time, local banks are now either active or more readily prepared to countenance third party assistance with asset recovery. There remains a spectrum of familiarity of banks and financial institutions with international asset recovery options and potential strategies. Recognizing the value proposition from service providers with international scope and expertise in this area is also taking time to percolate for some.
Finally, a series of progressive commercial and procedural legislative reforms in the region (particularly in the UAE and Saudi Arabia) over the past few years have also enhanced mechanisms for pursuit of legal remedies. This has encouraged stakeholders to assess asset recovery in the region more favorably than 10 years ago. There has, however, been a bump in the road with the retroactive application by some UAE courts of very recent (January 2023) banking law amendments around provision of collaterals for personal lending. This has adversely impacted the enforcement of certain liabilities arising prior to the amendments coming into force. It is a real concern for lenders, and something they and investors are sure to watch keenly with several cases still progressing through the courts on the point.
James Fox: We have seen increased enforceability in the region, best exemplified by the reciprocity between the courts of England and the UAE and recognition of assigned arbitral awards by the onshore UAE courts.
In respect of NPLs, UAE banks are increasingly looking to enforce against assets held by guarantors in foreign jurisdictions. We often find that wealthy guarantors will have property assets in England. The ability to enforce UAE judgments in England and vice versa is therefore important. There is no treaty on mutual recognition and enforcement in civil matters between the United Kingdom and the UAE. However, in Lenkor Energy Trading DMCC v Puri  EWHC 75, the English court recognized a judgment of the Dubai court, finding it to be a final and conclusive judgment of a court of competent jurisdiction. Subsequently, in September 2022, in a letter from the UAE Ministry of Justice to the Director General of the Dubai Courts, the Director of the International Cooperation Department stated he found the principle of reciprocity to have been met for purposes of enforcement of English judgments in the UAE. We are currently seeking to enforce UAE judgments against assets held in England on behalf of banks looking to make recoveries against their NPL portfolio.
In respect of enforceability more widely, in a number of cases we have now been successful in recognizing foreign arbitral awards in the UAE on behalf of assignees in their own name. This has been both before the onshore UAE courts in Abu Dhabi and Dubai and the DIFC courts. This gives funders increased confidence when purchasing arbitral awards that they will be able to enforce those awards against assets in the UAE.
Paul Hughes: One major trend is the development of a restructuring culture (including in high-profile restructurings such as NMC and KBBO), alongside the gradual decriminalization of bounced cheques and other debtor offences. This means that rather than fleeing the region, people are restructuring their debts with a view to maintaining their business as a going concern.
Henry Quinlan: In the last two or three years, we have seen two growing trends in the banking sector across the Middle East and North Africa (MENA) region and India: First, an increasing willingness within banks to pursue individual borrowers and corporate and personal guarantors out of country (though this still remains the exception, rather than the rule); and second, and more significantly, the willingness of banks to sell, or obtain litigation funding for, their NPL portfolios (in particular, the elements of the portfolios requiring “out of country” recoveries), so that they can realize some value from their books of bad debt without having to invest significant additional time and money.
Banks are well known in many regions of the world for being very efficient at pursuing defaulters and any available security “in country”, but also for failing to pursue recovery actions, whether against defaulters, or the guarantors of the same loans, “out of country”.
There have been a few reasons for this, one of which is a lack of budget or human resources, which can lead legal and remedial teams choosing to prioritize action against domestic defaulters rather than undertake international recovery actions (where the costs tend to be higher, and the processes are not familiar). Another reason could be a lack of in-house expertise or incentive to pursue NPLs internationally, because of the complexity, the cost and the uncertainty of outcome associated with international attempts at recovery.
What is behind the recent rise in market activity, especially secondary market, in NPLs in jurisdictions like the UAE?
Keith Hutchison: The successful administration of the NMC group of companies in the Abu Dhabi Global Market (ADGM) has demonstrated that distressed UAE corporate debt can have investment value. It is public knowledge that there has been a fair amount of activity in secondary market debt around NMC. Increasing confidence in the insolvency and restructuring landscape generally, especially in some of the larger individual or group situations that have been well-publicized over the past two years, has prompted much more foreign investment interest in regional distressed debt, including in the UAE.
Significant international players in this space are openly active in the market, although some are still very tentatively seeking out opportunities and bidding only on a very limited number of what they may see as premium opportunities. The market is still nascent but appears to be gaining some momentum. It seems that of the five to eight or so largest distressed UAE debt situations in the public domain over the past five years, secondary or tertiary market activity has already settled for the large part.
The fact that secondary debt deals have been done tells us that, when conditions are right, local creditors of UAE debtors are willing to sell, whereas historically it may have been an extremely difficult concept for boards to accept to extract value from distressed situations. It has probably required a shift in mindset of boards and advisors to accept significant discounting on value, versus continuing to hold distressed debts on the balance sheet with no clear prospect of recovery otherwise, at least not within short-term frames for financial reporting.
I believe we will see more secondary market NPL deals in the coming 12 months. I see that mindsets are changing at decision-making level within institutions about how NPLs can be monetized in ways that before were either unknown or untested. With each announcement of a new NPL deal in the market, we are likely to see others following suit, not wanting to miss out, provided of course the price is right.
James Fox: The increased availability of third-party litigation funding has significantly boosted NPL activity in the UAE and wider MENA region in recent years. Banks were previously hesitant to commit to funding recovery options for NPLs. This is entirely understandable given the fear of "throwing good money after bad". In many cases, debts were branded as NPLs precisely because the bank took a view (rightly or wrongly) that they were problematic cases. Now that third-party funding is more common, this has given banks a route to achieving recovery in their NPL portfolios without the need to risk additional funds in legal fees. As a result, banks are now reassessing their NPL positions and considering whether any of the NPLs are good candidates for funded recovery options. This has resulted in a significant number of NPLs reaching the courts which otherwise might have simply sat as bad debts on the banks' books.
The process of implementation of the International Financial Reporting Standard (IFRS) 9 in the UAE has also impacted the way banks account for and report bad debts. IFRS 9 requires banks to be more forthright in their recognition of non-performing financial instruments, leading banks to be more critical in their assessment of NPLs. From what we have seen, banks appear to now be increasingly pro-active and realistic in classifying debts as NPLs, which has the associated benefit of focusing the banks' attention on the appropriate avenue for seeking recovery for NPLs (whether that be funded recovery or sale).
The Covid-19 pandemic has also contributed to the recent rise in market activity. The pandemic saw a number of businesses defaulting on their loans, which had considerable knock-on effects on debt financing, such as causing long term facilities to become repayable and creating indebtedness under guarantees in support of loans. This is particularly true in respect of certain highly impacted sectors (e.g., entertainment and hospitality). As a result, many banks are now in possession of larger portfolios of NPLs and are seeking ways to mitigate their losses.
Henry Quinlan: One major reason for the shift in approach is the occurrence of significant defaults (often involving fraud) in the region where the sums involved, and the reasons for the non-performance (including dishonesty), are such that banks are compelled to act.
Further, there is growing pressure being brought to bear on banks (from auditors, shareholders and central banks) to make provision against non-performing loans in their financial statements. In the past, the fact that a NPL could remain at full value on a bank’s balance sheet meant that there was little incentive for the senior management in the bank at that time to take action since, if it was unsuccessful in recovering some or all of the sums owed, that might result in the loan having to be written down or off.
Finally, there has been a build-up of significant NPL portfolios over time, as a result of a historic unwillingness of banks in the region to undertake international recovery actions. There has thus been increasing interest shown by investment funds and litigation funders investing in claims originating in the region, and the increasing efforts of law firms and accountants to inform banks of the availability of these alternative solutions for realizing value from their NPL portfolios.
How has the enforcement of NPLs changed in the past several years?
James Fox: Litigation funding is increasingly being used by banks as a tool to mitigate several challenges involved in enforcing NPLs, including the time and costs associated with litigation, the complexities of local legal procedures, and the risk of being unable to recover the debt even if the creditor obtains a judgment in its favor. Litigation funding enables banks and investors to pursue legal action in respect of NPLs that might otherwise be regarded as prohibitively expensive or risky (whether due to the credit worthiness of the debtor, the legal challenges present in the case or the perceived difficulty of recovering in the relevant jurisdictions).
One major change has been the increased use of the DIFC Courts and an expansive approach to the question of DIFC Court jurisdiction. In a case we recently acted in, the DIFC Court demonstrated its willingness to accept jurisdiction and issue a worldwide freezing order in support of a foreign arbitral award in circumstances where the debtor was not a DIFC resident/entity and did not have any assets in the DIFC. In another case the court was prepared to take an expansive approach to its power, citing the enforcement principle recently encapsulated in Broad International Ltd v Convoy Collateral Ltd  UKPC 24. Accordingly, a knowledge of the tools available in the DIFC Courts and the circumstances in which the DIFC Court will accept jurisdiction, can provide NPL creditors with an invaluable path. This is further bolstered by the increased levels of co-operation between the DIFC Courts and the onshore UAE courts in recent years.
Henry Quinlan: There are two main changes which have been seen in the market. First is the increasing willingness of banks to sell parts of their NPL portfolios to investment funds or litigation funders, either in full, or in part (i.e., where the funder pays an amount up front in order to “buy” a percentage of the recoveries made from pursuing the NPLs, and the bank retains the right to receive a percentage of the recoveries made, but is not required to contribute to the costs of the recovery action, which are borne by the funder). Second is the increasing awareness within banks of the availability of litigation funding as a solution for creating value from their NPL portfolios.
Keith Hutchison: A difficulty for those who come later to the table with NPLs for sale may be that portfolios acquired from other first-movers involve common debtors against whom decisive enforcement actions have already been taken, such that value is diminished for a possible sale. It was a fairly common feature of UAE lending over the 2010s for borrowers to be customers of multiple banks, owing significant NPL liabilities to more than one lender, such that a competing creditor race to enforcement ensues. This is likely to be a feature of NPL portfolios currently in the market. Equally, some investors may see value in aggregating claims against a particular common debtor as part of their strategy, so making a more attractive market for NPL portfolios involving such a debtor.
In the era of post-pandemic economic uncertainty, what are the major obstacles for banks looking to clean up balance sheets and unlock more value from their NPL books?
James Fox: Banks often find it difficult to identify the correct expertise necessary to achieve a successful outcome in pursuing NPLs. Effecting recovery of NPLs necessitates engaging asset recovery legal experts, often across multiple jurisdictions, in addition to expert asset tracers. Putting this team together is crucial to identify suitable assets and implement recovery proceedings against those assets. Banks sometimes make the mistake of engaging generic "dispute resolution" lawyers, without appreciating that asset recovery is a niche area of litigation that requires specialist skills and knowledge. By doing so, key strategic options for the recovery of NPLs can be overlooked and banks can miss out on viable paths to recovery.
Banks also sometimes fall victim to their own assumptions and, in the absence of expert advice, erroneously conclude that there is no viable path to recovery for an NPL. For instance, a bank might make assumptions as to the location of assets held by a debtor based on that debtor's country of residence without appreciating that high net-worth individuals typically own assets across numerous jurisdictions. Instructing expert asset tracers can turn up assets in a number of previously unidentified jurisdictions. Additionally, banks may assume that certain jurisdictions preclude the possibility of enforcing overseas judgments. Banks could benefit from obtaining specialized legal advice from asset recovery specialists, as there may well be inroads that can be made into problematic jurisdictions that can make enforcement possible (e.g., by first enforcing the judgment in an appropriate "conduit" jurisdiction and thereby making subsequent enforcement more likely).
Keith Hutchison: A major obstacle is the lack of collateral or any valuable collateral. There was a fairly long period of unsecured lending, especially in the SME sector, with many NPLs in the US$1M-5M range. Many would be unsecured, backed only by provision of personal guarantee. Absconding personal guarantors has been a real challenge. Pursuing assets internationally is not something many UAE-based banks would have been particularly familiar with historically.
Difficulties arise from facilities provided to borrowers by multiple lenders, often secured against common assets or pools of assets. Enforceable registration of security interests has been an issue, with certain asset classes more susceptible than others to material difficulties with enforcement. A low appetite of banks to pursue complex enforcements with multiple creditor interests and other interests (e.g., land leases) is perhaps understandable.
Henry Quinlan: The central obstacle remains unchanged, which is the simple fact that banks are not generally well placed to pursue international recovery actions against assets or guarantors located outside their home jurisdictions. The size of banks’ NPL portfolios, while often significant, tend not to be significant in comparison with a bank’s overall business, and there is often little incentive, or in-house expertise, to pursue expensive, unfamiliar, time-consuming recovery actions abroad—particularly where the outcome of those actions is uncertain.
In the present environment, where defaulters and their guarantors may simply not have sufficient assets to repay the sums due, and where banks themselves may be experiencing cashflow issues, there is likely to be even less desire to incur the significant cost and time involved in the pursuit of international recovery actions, making the concept of obtaining non-recourse financing for or realizing value in NPLs which might otherwise simply be written down or written off even more attractive.
There has been an increased interest among banks for the organized sale of NPL portfolios. How could this impact how banks deal with their books of bad debt?
Keith Hutchison: Banks are now more astutely analyzing their entire portfolios and assessing what value can be extracted from different segments of that portfolio and through which strategies. We have seen NPL portfolios effectively softly tendered to the market through funders and other asset recovery specialists. In other cases, we have seen deal-making through investor or asset recovery approaches directly to banks to discuss what NPL position they may have and what solutions may be offered.
Banks in the UAE seem now to have much keener awareness there may be value to be extracted from bad debts on their books through non-traditional solutions, where historically they may have seen NPLs solely as an accreting problem they did not quite know what to do with beyond local legal enforcement that may or may have delivered value. If debtor assets were outside the jurisdiction, or guarantors had absconded, that often would be seen as the realistic end of the road, but still provisions would be carried.
Presently we are seeing particular slabs of debt being put to market by some banks for proposals on either dealing with funded recovery solutions in the bank’s own hands or acquisition. Banks are becoming more sophisticated with their own in-house remedial and recovery teams, and likely will be prepared to self-fund what they assess as the better parts of their NPL portfolios, engaging assistance from asset recovery specialists and legal advisers, and going to market for funded solutions or sale of the more difficult end of their books. Funders and investors will of course not want to be chasing only the tail. This is where we may see an interesting next phase of market development, with banks opening up different segments of their NPL books for external assistance or acquisition.
The January 2023 amendment in UAE law I mentioned earlier around enforcement of certain credit facilities against borrowers and the question whether this also applies to guarantors may yet have an impact on how attractive some NPLs may or may not be going forward. Much depends on how the interpretation and application of the law pans out in the UAE courts, which may not necessarily see common approaches in different emirates. This could be especially relevant where targeting of personal guarantors locally and internationally is likely to have been a significant factor in the investment decision-making in NPL portfolio acquisitions over the past five years.
Paul Hughes: Overall, there is more certainty in the market with the introduction of credit ratings (such as the Al Etihad Credit Bureau Rating). Additionally, the enactment of the Security Rights over Movable Property Law provides for public access to information relating to any security interest in a movable asset.
Henry Quinlan: The reality is that banks find it difficult, or simply do not have the resource, to undertake international recovery actions, at least not on a routine basis. As a result, once domestic judgments have been obtained and the value of any available security has been realized, it is difficult for banks to recover any further value from their NPL portfolios. If those judgments or claims can be collated (and that exercise itself can be time-consuming where banks have a large regional footprint), then conducting an organized sale of that portfolio of loans can be an effective way for banks to realize additional value. The realization of value can come either from a straight sale, where the funder pays a sum up front and thereafter it is for the funder to pursue debtors and guarantors internationally; or the bank can agree to a partial “sale”, where the funder might pay an amount up front, and agree to share the recoveries. The latter solution is often preferable for both parties, as the funder is able to ensure that the bank will continue to cooperate in the provision of information to assist enforcement actions, while the bank retains some further upside in the event of recovery, and also ensures that no action is taken as part of the recovery which might have a reputational impact for the bank (and this is particularly important where, for legal reasons, the bank might have to remain as the named claimant in any enforcement action).
James Fox: Ultimately, this provides banks with another weapon in their arsenal for dealing with bad debt and gives banks flexibility in how they address NPLs. Historically, banks were presented with a rather unappealing binary decision when tasked with responding to NPLs: Either litigate and risk throwing good money after bad, or accept the loss and write off the NPL. There was no option whereby a bank could seek to recoup some of its losses without incurring a significant degree of litigation risk. Now, along with the option of offsetting risk by obtaining litigation funding, banks also have the option to eliminate risk entirely by selling off their NPL portfolios. This can provide some immediate financial upside to banks, in addition to giving them certainty over their balance sheet position.
The right way of dealing with a specific NPL will vary depending on the nature of the NPL and the specific circumstances of the bank. Banks will sometimes be in a position whereby they have the time to see the NPL recovery process through to conclusion (which can take years) in an effort to maximize their return. In other occasions, banks will appreciate the opportunity to make an immediate return from selling off NPLs. The rise of litigation funding and NPL purchasing have given banks far greater flexibility in how they manage their books of bad debt.
About the participants
James Fox is Managing Partner of Dubai and Head of Dispute Resolution in the Middle East at DWF. He practices commercial litigation, arbitration and ADR and has specific expertise in complex litigation, high value asset recovery, enforcement and financial services litigation.
Paul Hughes is a partner at Kobre & Kim and advises clients on matters involving cross-border shareholder and company disputes that have a nexus to the UAE. He splits his practice between international arbitration and courts in the DIFC and has extensive experience in the enforcement of judgments and arbitral awards, asset tracing, fraud investigations, banking litigation and other contentious shareholder disputes.
Keith Hutchison is a MEA Regional Board Member of Clyde & Co and a Partner in the firm’s Dispute Resolution Group based in Dubai. He handles a wide range of commercial dispute resolution work, with specialisms in financial and investment disputes, fraud, asset recovery, enforcement, and insolvency. He regularly advises clients on issues under DIFC law, UAE law and English law.
Henry Quinlan is a partner at DLA Piper with particular experience in international arbitration. He advises on a wide range of arbitrations under the auspices of the DIFC-LCIA, LCIA, ICC, AAA/ICDR, DIAC and other leading arbitral institutions, as well as ad hoc and UNCITRAL arbitrations.