Dubai - "Sand Castles or Sand Traps"

Dubai, one of the seven emirates of the United Arab Emirates (UAE), was originally known for its prominent pearl industry until the discovery of oil in 1966. Sheikh Rashid Saeed Al Maktoum used the wealth that flowed from this discovery to build the infrastructure necessary to grow and expand Dubai to position it as an international finance and trading center. Today, Dubai boasts world-class entertainment and sporting events, unrivaled luxury hotels, and, until quite recently, ambitious building projects which include: Burj Al Arab, the world's tallest free standing hotel, the Palm Islands, a construction of three artificial islands in the shape of a date palm, the World Islands, a massive man-made archipelago of 300 islands in the shape of the world, and Burj Dubai, the world's tallest man-made structure.

Once hailed the economic superpower of the Middle East it is now a shadow of its former glory following the effects of the global financial crisis. Dubai, also known as the "City of Gold" is not recession-proof, and is in free fall with its tourism and construction sectors unable to pick up the slack forcing the proud emirate to accept a $10 billion bail out loan from the central bank. Construction projects are being shelved or cancelled, and real estate prices have dropped by an extraordinary 40% in the first three months of 2009¹. Many construction projects were started at the time of the boom when oil prices were $100 a barrel, foreigners were allowed to own freehold property and the good times appeared to never end. However, the sand appears now to have been washed away with the tide, littering the Dubai shores with stones, grit and other sharp objects…

Is it a giant Ponzi scheme?

Many have compared the current issues in the real estate market to a giant Ponzi scheme in which large projects are continually announced in a bid to keep investment coming in. The developers had previously been able to satisfy the investors' expectations by selling the property once it had been developed. However, following the collapse of the real estate market, the developers and investors are finding it increasingly difficult to obtain any return on their money.

Investigations have now been initiated by the relevant Dubai regulatory authorities, including investigations into Sama Dubai, Nakheel, Al Fajer Properties and Dubai Islamic Bank.

The Sama Dubai case involved three former executives from the Lagoons project of Sama Dubai, and an executive of the Damac property company who were charged with accepting bribes to the value of Dh4.8 million ($1.3 million) in return for unlawful reselling of Lagoon plots belonging to Sama Dubai. Two individuals were also charged with divulging company secrets relating to client and land data and prices to a rival company without permission from Sama Dubai . A verdict is expected shortly.

A hearing date for the Dubai Islamic Bank case has been set for 8 September 2009. Dubai's public prosecutor has charged seven suspects with fraud, forgery and bribery to the value of Dh1.8 billion (US$490 million) from the Dubai Islamic Bank. The crimes allegedly took place between 2004 and 2007 by two former bank employees and five businessmen linked to the trade finance company CCH, and a real estate project in Dubai known as The Plantation. Public prosecutors have charged three businessmen with collaborating to establish companies and submit bogus documents to the bank to finance their projects. Two ex-Dubai Islamic Bank executives (the financing manager identified as UH and his deputy, RU) are accused of assisting the businessmen by granting them more credit to finance their projects, abusing their duties at the bank and, according to prosecution documents, accepting Dh 3.48 million ($950,000) and Dh 2.75 million ($750,000) in bribes respectively.

The most recent corruption case reviewed by a Dubai Court is against five executives of Tamweel Loading (the largest real estate finance provider) and Bonyan Holding. The individuals are charged with bribery for accepting plots of company-owned land in return for facilitating a partnership agreement between the two companies . Two of these executives (the acting chairman of the board of directors and an executive director of Tamweel) are accused of re-selling the plots at a higher price, resulting in an estimated Dh44 million ($12 million) profit. The duo were also charged with embezzlement for selling other plots for less than their actual price, making a profit of Dh13.8 million ($3.8 million). A hearing date has been scheduled for 6 September 2009.

The outcomes of the above court cases are considered to be a test of the emirate's judicial system especially in light of the fact that, arguably, Dubai's legal infrastructure has failed to keep up with the pace of its commercial growth. It will be especially important with regard to its business reputation internationally - earlier this year Standard & Poor's lowered its ratings on a number of government linked companies including Emaar Properties, DIFC Investments, Jebel Ali Free Zone and Dubai Holding Commercial Operations. The rating agency also put four Dubai-based banks on review for downgrade in anticipation of a further downturn in the market as a result of a shrinking economy and faltering tourism and construction industries.

The "clean up" campaign

In an effort to clean up the real estate sector, the Dubai authorities are pursuing a 15-month high profile fraud clampdown into state-linked developers. This has resulted in 25 executives being arrested across a wide range of companies. Further actions include the charge against Mr. Bin Kharbash (a former Minister and high profile figure), for financial wrongdoing at Deyaar, and charges made against two UAE nationals including Saad Abdul Razak (former CEO of Dubai Islamic Bank and Deyaar Board member).

Further initiatives include a "name and shame" program publishing the names of associations and individuals charged with corruptive practices. The Dubai authorities are aware that a strengthened regulatory environment is critical if they are hoping to attract developed markets and entities such as hedge funds to move to the Gulf. It is hoped that such practices could even improve the country's ranking on the Corruption Perception Index (CPI)². The scale is measured 0 to 10, higher numbers indicating less corruption. The UAE in 2008 scored 5.7. In light of such enforcement action, Dubai is taking a proactive role in ridding the emirate from further scandals.

The Dubai International Financial Centre ("DIFC") and The Dubai Financial Services Authority ("DFSA")

The DIFC was opened in September 2004 and, since then, has attracted several financial institutions, including banking and brokerage firms, wealth management, insurance/reinsurance companies and Islamic finance and ancillary services. The DFSA is the independent regulator for the DIFC.

The DIFC has been granted authority to self-legislate in civil and commercial areas. An amendment to the UAE Constitution and a resulting federal law concerning financial free zones have allowed the government of Dubai to create a legal framework based on best practices of leading jurisdictions in Europe, North America and the Far East. The result is the DIFC Authority and DFSA adopting and blending various legal/regulatory concepts to produce a "clear, flexible and practical legislative framework"³.

And, despite the recent scandals in the construction and tourist industries, it appears that the DIFC's regulatory framework may, indeed, be more attractive to many of the financial institutions who have suffered in the recent credit crisis and ensuing global recession. On 20 July 2009, the London Financial Times reported that the DIFC has "fared better than other financial hubs, such as Hong Kong, New York and London"⁴. The FT also reported that "tighter regulation in developed markets could spur more alternative asset managers, such as hedge funds, to move to the Gulf emirate".

The DFSA's Annual Report lists only one successful enforcement action and court order against a DIFC entity in 2008⁵, which may be encouraging to financial institutions that fear the increased vigilance of regulators in the US, Europe and Asia. However, it is likely that this figure will grow significantly in the next year as the Dubai authorities attempt to tackle the issues facing the real estate sector. Although real estate and construction firms may not necessarily be under the remit of the DFSA, it is likely that the financing provided to these companies may also come under strict scrutiny by a financial regulator eager to prove itself in the global financial industry.

How will this affect FI/D&O insurers?

Scandals such as those affecting the Dubai real estate industry can only assist in raising the profile of management liability insurance policies. Some large financial institutions in the DIFC have embraced financial lines coverage, e.g. blanket or fidelity policies, but have not yet appreciated the benefits of directors & officers liability or professional indemnity coverage. In light of these cases and the push for tighter regulation and corporate governance, board members may be more likely to sit up and identify potential exposure.

The typical FI/D&O policy usually contains exclusions for fraud, in the event of an admission or finding of fact. The policy's severability clause may also be relevant when considering whether some or all of the directors were complicit in any fraudulent behavior. Misrepresentation and rescission may also be an issue depending on what information was known at the time of the proposal for insurance. Local insurance laws will also be significant in determining whether global companies will require a locally issued policy, or whether a global umbrella-type policy will be sufficient. These are all issues which directors of global companies with operations in Dubai should consider when obtaining management liability insurance.

It is evident that the increased awareness of these risks may lead to a greater demand for executive liability policies in the Dubai and wider Middle East area. Therefore, insurers should also take note of the shifting regulatory sands that line the shores of Dubai....

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¹ Knight Frank
² Published by German based Transparency International since 2003
³ DIFC Laws and Regulations (www.difc.ae)
⁴ "Buffeting for banks from credit crisis", The Financial Times, 20 July 2009.
⁵DFSA Annual Report 2008.