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Saudi Scandal Lifts Veil On Gulf Finance

A multibillion-dollar Saudi debt default generates pressure for corporate governance reforms in the Gulf.

Banks in Saudi Arabia have traditionally enjoyed a cozy relationship with prominent family-owned businesses in the country. The practice of so-called name lending — extending credit based on the reputation and standing of a company’s owners rather than on a rigorous examination of its financial health — is prevalent, not surprising for a culture that prizes deference and discretion over transparency. Bankers were only too happy to do business on such an informal basis while the economy was booming and global liquidity was abundant.

Today, however, a stunning corporate scandal involving two of the country’s most prominent family-owned conglomerates — Saad Group and Ahmad Hamad Algosaibi & Brothers — has shattered the industry’s complacency. The two companies have traded stinging allegations of financial misconduct in dueling lawsuits in Western courts, with AHAB accusing Saad and its chairman, Maan al-Sanea, of defrauding it of $10 billion. Both companies have defaulted on debts, which bankers estimate total as much as $22 billion, and the Central Bank of Bahrain has placed their Bahraini banking subsidiaries into administration. The Saudi Arabian Monetary Agency, the country’s central bank, has frozen the personal bank accounts of al-Sanea.

This unprecedented airing of financial allegations involving onetime pillars of the Saudi business establishment has sent shock waves throughout the country and across the Gulf region and prompted calls for radical reform of the way business is conducted. Dramatic improvements are needed in corporate governance and transparency to give investors a true picture of the health of companies. And lenders need to look beyond mere reputation and perform rigorous credit analyses before making commitments.

“There will be a regional impact” from the scandal, says Shayne Nelson, CEO for the Middle East and Africa at Standard Chartered Bank. “Banks will need to become more sophisticated in their lending, and good governance will have to prevail.”

The incident has dealt a blow to a Saudi economy that was already suffering from the decline in oil prices over the past year. Jadwa Investment, a Riyadh-based investment firm, recently reduced its forecast for the country’s economic output this year — by half a percentage point to a decline of 1 percent — because of concerns about the health of family businesses and an expected tightening of credit to the sector. “Bank lending decisions will now be driven by credit officers rather than relationship managers,” says Paul Gamble, head of research at the firm.

The ramifications also extend across the Gulf region, where authorities were already struggling to deal with the fallout from the global credit crisis and a collapse in local property markets. Authorities in Kuwait, Qatar and the United Arab Emirates have intervened to prop up their banking sectors over the past year, following the collapse of several Kuwaiti finance houses and a sharp decline in real estate values in Dubai and other markets.

The Saudi banking scandal is, on one level, a family affair. Al-Sanea, a Kuwaiti-born former Air Force pilot, is married to the daughter of one of the three founding brothers of AHAB, a company with interests in banking, construction, shipping and bottling. He worked at AHAB’s remittances subsidiary, Money Exchange, for two decades even as he was building up his own Saad Group. Al-Sanea made a splash on the global financial scene two years ago when he bought a 3.1 percent stake in London-based banking giant HSBC Holdings. Earlier this year, Forbes ranked him as the 62nd-wealthiest person in the world, with a worth of $7 billion.

The first hint of the affair surfaced in late May, when SAMA announced, without giving any reasons, that it was freezing al-Sanea’s bank accounts. The move was an ominous development for the Saad Group, a conglomerate with interests in construction, banking, information technology and travel that claimed $30 billion in assets and $7.1 billion in cash at the end of 2008.

Only a few days before the SAMA announcement, in a move little noticed at the time, Mashreq Bank, a Dubai-based lender owned by Abdul Aziz Al Ghurair, a prominent UAE businessman and a speaker of the UAE Federal National Council, sued AHAB in New York State Supreme Court for $225 million it claimed it was owed in a foreign exchange swap transaction.

AHAB countered with legal actions in the Cayman Islands and New York in July, alleging that al-Sanea had generated fraudulent transactions — through Mashreq and other third parties — to siphon roughly $10 billion out of Money Exchange. The New York suit seeks $1 billion in punitive damages from Mashreq for allegedly aiding and abetting fraud. Mashreq has rejected AHAB’s counterclaim as being “completely without merit.”

In response to AHAB’s complaint, a Cayman Islands court froze $9.2 billion of Saad Group’s worldwide assets. In August, meanwhile, the Central Bank of Bahrain appointed administrators to run the International Banking Corp., which is owned by AHAB, and Awal Bank, owned by Saad Group, after they defaulted on their debts.

Bankers have been holding discussions to try to unravel the complex web of companies and agree on a way forward, but have so far made little progress. They estimate that the two groups owe about $22 billion to more than 80 regional and international banks.

Three European banks — Barclays, Royal Bank of Scotland and Calyon, the investment banking arm of Crédit Agricole — have petitioned the Cayman Islands Grand Court to liquidate Saad Investment Co., a Cayman-based subsidiary of Saad Group, contending that it had failed to make payments on a $2.8 billion syndicated loan.

According to Standard & Poor’s, within the Gulf, gross loan exposure to the Saad and Algosaibi groups amounts to $9.6 billion for 30 banks in the six-nation Gulf Cooperation Council it surveys. All but two banks had some net exposure to the two groups, and those exposures exceeded 10 percent of adjusted total equity at ten banks, S&P says.

Banks across the region have boosted loan-loss provisions sharply in the first half of this year, which analysts believe is partly because of exposure to the two groups. National Commercial Bank, Saudi Arabia’s largest bank by assets, increased its loan-loss provisions more than sevenfold, to 425.1 million riyals ($113 million), in the second quarter. In the United Arab Emirates, where the central bank reportedly told lenders to boost their provisions for exposure to Saad and Algosaibi, Emirates NBD, the country’s largest bank by assets, more than tripled its loan-loss provisions, to 1.61 billion dirhams ($438 million), in the first half, which led to a 20 percent drop in net income in the period.

The governor of SAMA, Muhammad al-Jasser, said last month that the Saudi government was considering ways to deal with the fallout from the debt defaults, but he insisted that the banking system was secure and that the authorities would not buy impaired assets from banks. “There is no systemic risk to the Saudi banking system from the debts of the two firms. Profitability, however, could be affected,” he explained.

Victor Lohle, a senior credit analyst at Standard Chartered in Singapore, is also sanguine about the systemic impact. He estimates that Saudi banks have $5 billion of exposure to the Saad and Algosaibi groups. “Although significant, the exposure must be put into the context of a system with equity of about $50 billion,” he notes. “We expect most of the banks’ financial profiles to remain sound.”

The affair has, however, put a spotlight on the weak standards of corporate governance and lack of transparency that prevails in business and finance across the region, bankers and analysts say. Family-owned companies have traditionally disclosed only the barest details about the health of their businesses or even the roles played by their directors.

“The family ownership of certain GCC banks and corporate groups creates, at least in theory, specific risks that may be difficult to assess, including succession risk, key-man risk, related-party exposure and contagion risk,” Emmanuel Volland, a credit analyst at Standard & Poor’s in Paris, wrote in a recent report on the Saad-Algosaibi affair. “Overall we believe that these family-ownership structures are a negative credit factor.” Volland also criticized the “minimal” disclosures by the Saad and Algosaibi groups, their creditors and regulators since the problems first surfaced. “While there are legitimate concerns with preserving truly proprietary information, lack of adequate information or signals from the affected parties tends, in our view, to weaken confidence,” he added.

Changing corporate practices won’t be easy. Governance reform “needs to be addressed against the cultural backdrop in the Gulf, which places great emphasis on reputation and discretion,” notes Alan Wood, a partner at law firm Pinsent Masons in Dubai.

As long as Gulf companies and banks restricted their activities largely within the region, there was little pressure to change those opaque practices. But growing links with international markets and financial institutions are generating demands for reform.

“There has never been a need for local firms to become more transparent and adopt best corporate governance practices,” says a senior executive at a British bank with extensive experience in the region, who spoke on condition of anonymity. “In the West, regulation has evolved over many years, and we have had major failures. This is the first in the Middle East, and they do not know how to deal with it. This is the shock that will change the system.”

Some analysts also believe the Saad-Algosaibi affair will hasten reform efforts. “The case should harden attitudes against name lending, especially for publicly listed corporations and those accessing international debt markets,” says Ben Simpfendorfer, a seasoned Arabist and former Middle East strategist who now works as the chief China economist at Royal Bank of Scotland in Hong Kong. “More foreign ownership of local stocks would thus be an important step forward.”

Sultan bin Saeed al-Mansouri, the UAE minister of the Economy, said in a speech to the Dubai Chamber of Commerce last month that the situation has hurt investor confidence, and he acknowledged the need for reform. “Now is the right time to act,” he said.

The GCC Board Directors Institute, a Dubai-based nonprofit that seeks to improve corporate governance standards, issued a report earlier this year highlighting the need for reform in the six GCC member states — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. The report, “Building Better Boards,” notes that only 55 percent of GCC companies disclose the main executive positions of board members, compared with 100 percent in Europe, and only 32 percent of companies disclose other positions held by board members, compared with 97 percent in Europe. It urges a reduction in the number of boards on which directors serve; the appointment of strong audit, nomination and remuneration committees; efforts to attract more international directors to the boards of Gulf companies; and the promotion of greater corporate transparency.

“The region’s capital markets regulators have been stepping up efforts to introduce standards of governance for companies on their exchanges,” says Soha Ellaithy, program manager at the BDI. “We expect that there will be more efforts on the part of all GCC regulators to improve transparency and oversee corporate activities given the recent events.”

It remains to be seen whether such efforts will have a significant impact on corporate behavior anytime soon. In recent years, Bahrain, Dubai and Qatar have created financial centers that promote high standards of regulation and corporate disclosure, including the requirement to publish regular results under International Financial Reporting Standards. A recent study by the Dubai International Financial Center estimated that Gulf family businesses could be worth as much as $500 billion and were a potentially rich source of public stock offerings. But Dubai’s pioneering international stock market, Nasdaq Dubai, has managed to attract only 15 listings since its founding in 2005, with a total market capitalization of $24 billion. Many of the region’s family-owned businesses sit on large cash piles and see little need to change the way they have conducted business for decades.

Many investors criticize the region’s largest market, the $283 billion Saudi Tadawul, for poor disclosure standards and a lax attitude toward insider trading. In August Saudi Arabia’s regulator, the Capital Markets Authority, imposed its first jail sentence for insider trading. Najam Eddin Ahmad Najam Eddin, the former chairman of Bishah Agricultural Development Co., was sentenced to three months in jail and fined 100,000 riyals ($26,667) for insider trading in Bishah shares.

The absence of any retail fallout from the Saad-Algosaibi incident, at least so far, could also blunt reform efforts. “I don’t believe the scandal will provide the impetus for change in corporate governance, unlike Enron did in the U.S.,” says Sharon Ditchburn, managing director of Capital Advantage, a Dubai-based regulatory and compliance consulting firm. “It hasn’t affected the average person as much as Enron. The Saad-Algosaibi issue is more limited, less transparent and likely to be covered by bank profits and government assistance.”

For reform advocates that scenario would represent a huge lost opportunity. Banks already stand to lose billions in the Saad-Algosaibi affair. If governments and regulators fail to draw the right lessons and adopt governance reforms, the losses for the region are likely to be much higher.

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