EAST CAMERON GAS SUKUKBy: Camille Paldi

CEO of FAAIF

EAST CAMERON GAS SUKUK PARTIES

Originator: East Cameron Partners Issuer: East Cameron Gas Company

EAST CAMERON GAS SUKUK SUMMARY

Sukuk Name: East Cameron Gas Company SukukIssue Size: USD $165,670,000Closing Date: 15 June 2006Shari’ah structure: MusharakahCurrency: USDMaturity/Tenor: 13 yearsUnderlying Assets: Oil and gasRated by: Standard & Poor’sRating: CCC+ to CC and in March 2009 DPayments: QuarterlyReturn: 11.25% (Courtesy of Jassim Mahadik)

EAST CAMERON GAS SUKUK

East Cameron Partners LP saw the sukuk issuance as an affordable and flexible finance opportunity through which it could raise the funds needed to purchase other shares from its non-operating partner, Macquarie Bank, whom wished to sell its share in the business.

East Cameron Partners LP (“ECP” or the “Originator”) is an independent oil and gas exploration and production company, based in Houston, Texas whose producing assets consisted of two gas properties located offshore of the State of Louisiana, USA.

EAST CAMERON GAS SUKUK

East Cameron Partners (ECP) issued sukuk of USD165.67 million in July 2006 with a maturity period of 13 years.

This was the first sukuk issued by a company based in the United States and rated by Standard & Poor’s.

The underlying contract was musharakah (co-ownership/joint venture) in which sukuk investors own so called Overriding Royalty Interest (ORRI) in two gas properties located in the shallow waters offshore the State of Louisiana through an SPV acting as a trustee of sukuk holders.

EAST CAMERON GAS SUKUK

Specifically, the structure of the transaction involved the purchase of an ORRI carved out of U.S. federal offshore leases. Under local (Louisiana) law (which is often the de facto law governing oil and gas leases, although they are leases issued by the U.S. government's Minerals Management Service (MMS)), 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 providers of finance (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.

EAST CAMERON GAS SUKUK

The SPV was called East Cameron Gas Company (ECGP) and incorporated in the Cayman Islands.

The originator also contributed its funds into the musharakah.

The assets of the musharakah were co-owned by the sukuk holders and the originator company ECP.

The sukuk were secured by a mortgage on the assets of the issuer, which included the ORRI and secured accounts. The sukuk were initially rated CCC+ by Standard & Poor’s and then downgraded to CC and finally D.

EAST CAMERON GAS SUKUK

The East Cameron Gas sukuk had a fixed payment of 11.25% annually. However, there was also a variable component because the sukuk returns depended upon the production quantities (the overriding royalty interest (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.

RISKS IN THE EAST CAMERON GAS SUKUK

Sukuk holders were exposed to risks found in the energy sector (i.e.) the volatility of natural gas and condensate prices, which may have adversely affected payments on the sukuk.

In order to hedge against severe price fluctuations in oil and gas markets, there were a series of Shariáh compliant hedges that established a price collar between $7 and $8 per million BTU (Mbtu) on half the expected products gas production and a put option at $6 per MMBtu for an additional quarter of anticipated production (Goud, 2009).

SHARIAH COMPLIANT HEDGE

Further described in the offering document was that closing transactions would occur including "the 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 changes 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."

SHARIÁH COMPLIANT HEDGE

The Shari'ah-complaint hedges limited the impact of rising and falling prices on the ability of the production to be sufficient to generate returns for investors.

The hedges are described in the third section of the fatwa (pricing) written by Sheikh Yaqoobi and DeLorenzo in the sukuk offering circular. The Shari'ah board explains that the hedges are Shari'ah-compliant because they represent a commercially valuable obligation by the hedge counterparty to purchase a fixed amount of oil & gas at specified dates in the future at fixed prices.

The fatwa describes the 'obligation' created by the hedges as iltizam (Goud 2009).

SHARIAH COMPLIANT HEDGE

The iltizam leases have been used in Azerbaijan and are described by a CIS-based oil and gas company, Ansad Petrol:

"Iltizam was a system of mutual obligations where the oil-bearing land could be rented under certain conditions from khans (the historic owners) granting the lessee temporary use of oil wells, salt lakes, dye works, storehouses, etc.

The rental agreement, usually for a five-year term, was signed by an authorized representative of the owner and the lessee. The system for selecting lessees was similar to the modern day tender with the highest offer being successful.

SHARIAH COMPLIANT HEDGE

The basic minimum rent was announced by the government and those wishing to participate were obliged to give a pledge consisting of half of the annual rent.

The lessee had the right to export the oil and could fix his own price paying an agreed amount originally to the khans and thereafter to the treasury of the Russian state.

According to available records, the net profit of the lessee was about 14-15 per cent.

SHARIAH COMPLIANT HEDGE

The relevant factor about whether the iltizam transaction was Shari'ah-compliant is whether it has a 'commercial value' (i.e. it provides a commercial value to both parties and is not created for the purpose of speculation).

EAST CAMERON GAS SUKUK STRUCTURE RE-CAP 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 though gas production.

EAST CAMERON GAS SUKUK STRUCTURE The production would be sold to two off-takers with Merill 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 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. (Courtesy of Sajjad Zaheer)

EAST CAMERON GAS SUKUK 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 Shariáh compliant level, however, also bankrupted the sukuk.

EAST CAMERON GAS SUKUK

On October 16, 2008, East Cameron Partners filed for bankruptcy protection under chapter 11, claiming its inability to pay the periodic returns on its USD166 million sukuk issued in June 2006.

RISK OF NATURAL CATASTROPHE

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).

S AND P RATINGS

S&P downgraded the transaction to 'CC' from 'CCC+ when the structure hit the aforementioned trigger, breaching a 90% minimum stressed reserve level of the hydrocarbon mix threshold.

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 servicer reports (Lampasona, 2009).

OTHER RISKS

The prospectus placed great emphasis on the originator's possible failure to successfully develop exploitable reserves or improve production capabilities.

This may have adversely affected the viability of its operational structure.

Moreover, unless the originator replaced its oil and natural gas reserves, its reserves and production may have declined, which would have adversely affected the payments on the sukuk (Khnifer).

TAX TREATMENT RISK

There was also uncertainty with respect to U.S. tax treatment of the sukuk and alternative tax characterizations by the U.S. regulatory authorities, which may have materially affected investments in the product (ECG Prospectus, 2006).

BANKRUPTCY AND LEGAL RISKS It was also uncertain as to how the articles of the investment

offering prospectus stood in the face of US bankruptcy court. In October 2008, East Cameron Partners (the originator)

filed for Chapter 11 and created uncertainty about how the sukuk holders would be treated under U.S. bankruptcy law, which was untested at this time using this kind of Shari’ah-compliant structure.

After one year and a half, the bankruptcy judge issued a court order accepting the transfer of East Cameron's assets to the sukuk holders.

Precedent was established with respect to creditor rights in Islamic structures.

BANKRUPTCY AND LEGAL RISKS

The originator claimed that the transaction was not a "true sale," but a secured loan disguised as a true sale.

Under conditions of a true sale, the sukuk investors should have had the sole rights to the underlying assets.

Under the secured loan, the originator would have rights to the assets only after resolving creditor claims in Chapter 7 (liquidation).

BANKRUPTCY AND LEGAL RISKS

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, 2009).

BANKRUPTCY AND LEGAL RISKS

In their desire to deliver products (sukuk) that resemble credit instruments (like bonds), originators have sometimes blurred the distinction between credit and equity and this has led to difficulties for sukuk holders (Khnifer, 2009).

In this case, the originator spent a lot of time on the matter of credit enhancements (protecting banks) and very little time on protecting investors' rights (Khnifer, 2009).

BANKRUPTCY AND LEGAL RISKS

In an order dated 31 March 2010, the judge issued a decision. The sukuk certificate holders were able to get full ownership

and possession of the assets without sharing it with the other creditors.

As a matter of U.S. law, the result was the treatment of the SPV assets as being the product of a true sale.

According to Robert E. Michael, the true sale element was upheld by allowing the debtor SPV to be the Seller.

This essentially meant that the SPV did in fact own the assets and was not merely a collateral holder for secured loans.

BANKRUPTCY AND LEGAL RISKS

A court document points out that the judge approved the Asset Purchase & Sale Agreement between East Cameron Partners and EC Offshore Properties, Inc., which was owned by the certificate holders.

According to Blake Goud, the Asset Purchase Agreement transferred the title over both leases (East Cameron Block 71/72) to the sukuk certificate holders.

The purchase price, which was not to be paid in cash, included the liabilities assumed by the buyers, as well as the $4.865 million extended as Debtor In Possession financing (DIP).

The total DIP financing included all principal, interest, fees, expenses, and other charges (Goud, 2010).

BANKRUPTCY RISK MANAGEMENT

There were two SPVs, one onshore and one offshore.

BANKRUPTCY RISK MITIGATION

Due to the fact that the transaction was asset-backed, this should have made it easier for the sukuk holders to trigger the bankruptcy and take control of the assets.

However, due to legal flaws in the structure of the sukuk, it took 1.5 years for resolution of the bankruptcy.

It is clear that if a third SPV independent of the others had been formed under a Musharakah, this would have made the separation of the assets from the bankruptcy estate much easier. Furthermore, if we had an Islamic Finance Bankruptcy Court, this would help streamline the process.

SUKUK HOLDERS AS THIRD- PARTY BUYERS

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 interests 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 2009).

LEGAL RISK MITIGATION

Creation of an Islamic Finance Bankruptcy Court (IFBC) as a branch of the Dubai World Islamic Finance Arbitration Center (DWIFAC) to handle all sukuk defaults.

A standardized dispute resolution contract attached to all sukuk transactions designating the Islamic Finance Bankruptcy Court (IFBC) and Dubai World Islamic Finance Arbitration Center (DWIFAC) as the governing law and dispute resolution procedure for the sukuk transaction.

LEGAL RISK MITIGATION

This will prevent uncertainty in sukuk bankruptcy and dispute resolution by providing one global forum for the sukuk dispute resolution.

In this manner, we may avoid ad hoc tribunals set up by British law firms to settle sukuk bankruptcy (Nakheel and Clifford Chance) as well as bring sukuk litigation out of common law jurisdiction courts to a forum, which understands Shariáh law and dispute resolution and follows its own precedence.

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FEEL FREE TO CONTACT ME AT CAMILLE@FAAIF.COM

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