The Dubai International Financial Center was established in 2004 as a “gateway” to the capital of the oil-producing countries of the Gulf Cooperation Council. Yale SOM’s Ira Millstein and Jonathan Koppell spoke with a group of experienced investors in the region about the DIFC and the role of capital in the GCC.
DESIGNING A NEW CAPITAL MARKET
Ira Millstein: What does it mean that the Dubai International Financial Center is a “free zone”?
Nasser Saidi: One needs to recall that the United Arab Emirates is a federal state. It’s a federal state similar to what the U.S. was antebellum, where you had a great deal of autonomy and freedom for the individual states, in terms of legislation and regulations.
Attempting to liberalize and reform the banking and financial sector and introduce legislation at the federal level might take a long time, because you have to achieve consensus across all the emirates. The DIFC, on the other hand, is a federally chartered financial free zone aimed at implementing international best practice.
Millstein: Where we are right now?
Saidi: Where we are right now. The DIFC was established under Federal Law No. 8 of 2004 which required an amendment to the UAE’s constitution. The law allowed the creation of federal financial free zones. Dubai then passed Law No. 9 allowing the creation of DIFC and giving it independence within Dubai.
So, if you wish, we are like the Vatican within Rome. I call the DIFC the Vatican of international finance. We have 110 acres within which we have independence in that the laws of Dubai and the UAE (civil and commercial) are dis-applied within the DIFC, though criminal law (e.g., federal anti-money laundering and counter-terrorist financing legislation) continues to apply.
This independence allowed the DIFC to innovate in the legal and regulatory domains and set up new institutions. We started with a tabula rasa and picked what worked best across international financial centers and applied these rules and regulations within DIFC. DIFC is a common-law jurisdiction; the law of England and Wales applies, and if there’s a gap, we turn to New York law. DIFC is unique in a region based on civil code legislation.
We have our own employment law, companies and commercial law, and real estate law, our own banking and financial law, our own securities laws and regulatory law. We have a single, independent, comprehensive risk-based regulator, the DFSA, responsible for the laws and regulations relating to all financial and ancillary services within the DIFC. We have our own courts.
Millstein: And the judges are independent?
Saidi: The DIFC Courts is an independent judicial system dealing with matters arising from and within the DIFC. The chief justice, Sir Anthony Evans, comes from and is based in the UK.
Millstein: That’s really interesting and attractive.
Saidi: And the deputy chief justice comes from Singapore. The courts are ultramodern, so you can have a hearing by video conference with the presiding judge in Singapore, and witnesses in other parts of the world.
Similarly, you also have 18 free zones in Dubai, although they do not have as much independence as DIFC has. Those free zones act as clusters of activity, attract foreign direct investment, and lead to economic diversification. For example, the Internet City free zone is dedicated to IT and media. Within the free zones, two things are very important. You don’t need a local sponsor, meaning you can have your own staff and management and you can own property. In addition, the free zones are also tax-free jurisdictions.
Millstein: That’s even more interesting and attractive.
Saidi: Free from income tax, as well as property tax and capital gains tax.
Millstein: No taxes?
Millstein: Who supports you?
Saidi: Our main source of income is from property leases and sales. DIFC received an endowment, a 110-acre piece of land, admittedly in a prime location, which it has developed. All the infrastructure that you see around you in DIFC — investments will total in excess of $18 billion — is entirely private-sector financed. We got that piece of land, we built, we sold plots, and we generated the income to set up everything else. More than 70% of our income now comes from leasing. We also generate income from licensing and land fees and service charges for water, utilities, and the like.
Millstein: Why wouldn’t everybody come here?
Saidi: People are trying. We have run out of space and are now considering a DIFC2.
Ismail Odeh: Everyone wants to come here.
William Foster: There is a practical limit.
Millstein: The lack of taxes is fine, but more important is the law, its enforceability — all the things you have that permit business to thrive in a market-oriented way.
Saidi: The legal and regulatory setup, with an independent court and single regulator, has been very attractive: it provides good investor protection in a region with strong growth prospects. That’s why everyone is trying to get in here.
Remember, though, that we are restrictive in terms of the “fit and proper” criteria for registration and licensing. That is, companies should be in financial services and related ancillary services. Banks are mainly into wholesale and investment banking, not retail.
But anybody who wants to be a regional financial player wants to be here. DIFC was set up to be the financial market for the region. That’s why it’s so interesting. That’s why I’m here.
Odeh: Isn’t QFC [Qatar Financial Center] the same?
Saidi: QFC is a similar model. In fact, the people who helped set up DIFC went on to Qatar. It is a revolution for the region.
CAPITAL MARKET FOR THE REGION
Jonathan Koppell: What’s the trajectory for DIFC?
Saidi: You need to think of this as a model for financial market liberalization and reform. The strategic importance of DIFC is that within this big region spanning an eight-hour time zone between Europe and Asia and some 42 countries, a financial free zone was created, which is onshore. The laws and regulations are based on common law, and as such are instantly recognizable to international players. DIFC is now a standard-setter for the region, a model for other countries. Indeed, we have been approached by countries as far away as the Caribbean and Latin America and Korea and Africa to establish DIFC clones.
The purpose is to be the capital market of the region. Hence our focus has been on investment banks. And they’re all here now.
We also have our own fully integrated exchange — electronic platform, without any restrictions as to who has access as an investor. This is important, because in all the other markets in the region, there are restrictions on investors in terms of access. If you list a security on the DIFX, that security is available to any investor, worldwide. And the beauty of that is, given the liquidity that exists in the region, if companies or governments list securities here, they can tap that liquidity in a multi-currency environment.
Millstein: They can tap the liquidity, and in addition, if something goes wrong, they have someplace to go for redress, which is not perceived to be the case in many other places. My view is if you have access to real courts with real judges, and a chance to enforce your rights, you have the beginnings of a true market economy. Without that, you’ve got nothing. All the promises in the world don’t count if they can’t be enforced someplace.
Saidi: Absolutely. And then take it to the next step and think of what’s happening at the level of the region. The GCC [Gulf Cooperation Council] countries are now going towards greater economic and financial integration. As of the first of January 2008, they have a common market, with a removal of trade barriers, tariffs, and customs duties for within-GCC trade, and a common tariff wall for external trade. Second, they have allowed any GCC national to invest either physically or in terms of portfolios anywhere within the GCC without restrictions.
Millstein: That really puts you in a very favorable position.
Koppell: Are other GCC countries trying to attract international capital with similar mechanisms?
Odeh: Saudi Arabia doesn’t have anything like this. Bahrain and Qatar do.
Saidi: And that is a good thing, in my view, because you really need to grow the markets. The financial markets of the region are underdeveloped, given the financial resources.
Foster: The free zones can be an important catalyst.
Koppell: Does this make it easier for an investor to stay local, so to speak?
Saidi: It means that the DIFC can be the architect and the designer of a two-way flow: an inflow of capital into the region, but also the outflow of capital out of this region to anywhere else.
Foster: Think of the free zones more as gateways, and that’s about access for local capital to opportunities that would otherwise not be available to them, and also access for foreign capital to local opportunities that wouldn’t otherwise be available to them.
CAPITAL OF THE REGION
Millstein: Could it change the rest of the region if your structure really takes off?
Yasar Gamali: I think it will come of age. There has been a lot of groundwork. It won’t happen overnight. Another question is, why is it not the overnight success that perhaps it should be?
Gamali: It’s a success, but it’s not an overnight, bonanza success. I think the reason for that is that most of the money that is in the region is of the region. Although international money is coming in now, still the bulk, the great bulk of the money in the region is of the region. It is either —
Saidi: But it is also typically managed and controlled and invested outside the region. I think the big difference now is that you’re setting up the market and financial infrastructures and the architecture so that that money and liquidity can be managed and controlled from within the region.
Gamali: I think money that is being invested with the Morgans and the Goldmans is still outside. It has come back to some degree, but it is still outside. I’m talking about the money that is actually in the economy in terms of the land, in terms of businesses and investment. This money of the region is largely family money. A typical investor would want to basically buy a piece of land or an asset. Bang! He just wants the title and that’s it. And in addition to that, he’ll be looking to try to get a sweetheart deal if that is possible — if that means paying a little bit of a commission to the agent and getting a lower price, that will happen. That’s all considered fair trade. I’m talking about the real world. There is no great value being put on corporate governance. Rather it’s, “This is my asset, paid for by my money, and used by me, and I don’t care what you think.”
So it’s not institutionalized money, as such. When it does become institutionalized, and when it does come to have a higher degree of foreign money involved, then you will start putting value on the high benchmarks that DIFC is offering.
If I can draw a parallel — DIFC is like Hong Kong, and out there is like China. Do you see what I mean? DIFC is more regulated, more professional and so on.
Foster: Also, this is a very high-growth region. If you look at the UAE alone, there are less than five million people here, and 50 registered banks. And they all make money. And in an environment where they don’t actually have to worry about productivity and efficiency, they’re not so concerned about the factors that will drive them to places like the DIFC when the going gets a bit rougher.
Odeh: One of the reasons for family businesses, and possibly for existing companies, to hold back from entering the DIFC is that they have something that works, so why should they try this new concept in the DIFC? “Let it be there for a while. If it proves it’s working well, I’ll try it.”
Gamali: Also, unfamiliarity with common-law legislation plays a role. It will take time for people to absorb and understand that.
Foster: These are just the reasons why it hasn’t been remarkably more successful than it has.
Saidi: But if I look at the forecast that we had for where we would be four years on, we are way above forecast. We have run out of space — 11,000 people now are working within DIFC. That’s remarkable.
Koppell: Are there entities that will make a conscious decision not to be within the DIFC because they are wary of the exposure it brings?
Gamali: Many of the family offices and other entities made the decision to stay where they are. They don’t take third-party money to manage. It is not an immediate goal. There is no need to have greater transparency. It is governed and governed well just for the advancement of the mission statement, if you like, of the owner. There is no advantage to moving into the DIFC. Actually it is an advantage to stay where you are. You are sheltered. You are not exposed. You do have greater power to defend yourself than going into DIFC.
Foster: I agree.
Gamali: This is the case with proprietary money. But any bank, any other organization that wants to attract investors, would need the legitimacy and the legal framework, and also the prestige, of being in DIFC, because the question would be “Why are you not in DIFC?” A lot of commercial banks are outside of DIFC, but that’s a legacy issue. All of the new guys who have come in with the new Dubai, if you like, be they fund managers, hedge funds, or investment banks, have gone into the DIFC. So it’s the old breed and the new breed.
CAPITAL FROM THE REGION
Koppell: When there was all this negative attention to sovereign wealth funds — I don’t think it’s fair, but put that aside for a moment — could you envision as a response to say, “Look, we don’t have any negative intentions; we’re willing to put these funds under the DIFC”?
Saidi: If you look at the adverse reactions to SWFs, they didn’t have much to do with whether or not you were present in a particular jurisdiction. It was more what you were attempting to acquire.
Foster: Acquiring, and your ethnicity.
Saidi: Yes. It was xenophobia and what you were acquiring. For example, this was obviously a part of the issue when Dubai Ports World purchased P&O.
Odeh: We don’t have problems with where the fund is domiciled. Our problem, at least globally, is where the fund invests, the other side of the equation. And then the question comes up: Where will my fund invest? Going to the U.S. has proved to be problematic in some areas.
Saidi: If I’m investing in the U.S, I’m subject to U.S. laws and regulations. I’m not subject to the laws of where the money came from. So if I go in, as some investors and funds have done, and buy into Citibank and others, I’m subject to U.S. laws.
Millstein: So these firms in the free zone, the investment banks, are here attracting capital to be invested in the region for one business or another. And they’re also here to service the sovereign wealth funds. Correct?
Gamali: The funds are independent, though the investment banks help the funds with due diligence, they help them with the deal flows. A lot of the fund managers like using the big names, largely American investment firms. The big, bulge bracket investment banks go to the funds to pitch to them. They look at them as a corporate client. So they pitch to them advisory services, ideas, fund management, the full spectrum — money market, equity, hedge funds, private equity, and so on.
Saidi: There is a lot of farming out, which is important. In many cases you’ll find the funds working on an asset-allocation basis with geographical and asset class/instrument categories. The larger funds would have several outside fund managers for the same risk category so as to benefit from the competition, and that way they can measure their performance. So the farming out, I think, is the bulk of it, apart from the SWFs who have their own experienced investment teams.
Gamali: They are passive, that’s the key thing. If they buy a stake in a company, be it a majority or minority stake, they don’t put a manager there. At the most, if it’s a significant investment, they may take a board seat. They do not go beyond that. They simply don’t have the expertise and the pool of talent, the people. Their talent, as you’ve said, is on the asset allocation side — asset allocation and to hear the ideas to populate that asset allocation model that they have with investment suggestions.
Koppell: So let me raise the central concern that comes up when people criticize or speculate about the potential harm that these funds could have, which is that there is somehow going to be politically motivated interference.
Gamali: They don’t have the ability. They don’t have the people, even, to turn around a company. They’re not like a private equity firm. They don’t have a team of people to go in there and dismantle boards. They’re entirely powerless.
Odeh: They’re just making an investment, no more, no less. They are passive investors.
Millstein: Well, from a corporate governance perspective, we’re not happy with that.
Koppell: So the notion that there will be decisions made about where to invest or what directions to allocate resources on political terms...
Saidi: Is absolute nonsense.
Gamali: It is for two reasons. One is they’re not geared up like that. And, secondly, they don’t want to take the responsibility of being part of a bad decision. Let me clarify. If I’m, say, an investment officer in one of these funds, and I buy into your company, I want to be in a position where I don’t force you to make a move, because if I do take that decision for you, then I’m accountable. And if you come back to my boss and say, “Well, I took the decision to satisfy my significant investor,” I don’t want to take that responsibility. You will see them shying away significantly from getting involved in the direction of the company. It’s very much right through all of the sovereign wealth funds.
Koppell: What about the reverse of that situation: Say the fund manager gets a call from somebody in the royal family or the government saying, “Look, this may not be the best investment ever, but we’d really like to see you help out Citibank. Make it work.” Is that something that is a plausible scenario?
Odeh: It may be, but you have to be able to convince them to do it.
Gamali: I think the real question, more pointedly, is that you receive a call from a family member that they want you in on a particular project, you look at the economics and see it’s not right for you, or you don’t like it, and you say no. And then they ring you again and say we want you in this. And you say no.
Koppell: So then what happens?
Gamali: It’s case-by-case... You can always say no. And I think in Dubai, more or less, a no is a no. But it’s a relationship exercise at the end of the day. You have to take it with the quantitative plus the relationship.
Koppell: There was an irony in the negative reaction to the investment sovereign funds made in Citibank — my interpretation was that it was actually a favor to the American economy. This was not a hostile act. This was a very friendly act.
Saidi: Agreed. There is a history, in particular, with Citibank and Prince Alwaleed bin Talal who, back in...
Odeh: 1989. I was there; I’m an ex-Citibank.
Saidi: At that time it was very much profit-motivated — a great opportunity to come into a big bank, well-diversified, etc., that fell onto hard times — and did extremely well.
Odeh: Now he is putting in more. He loves Citibank. It made most of his wealth. I don’t know if it is still a purely economic play, but he may be protecting his interest as the largest single shareholder.
THE RESPONSIBILITIES OF CAPITAL
Millstein: I sense that the sovereign wealth funds don’t believe they have the expertise to meddle, and so on. But from the U.S. and UK standpoint, and maybe even for the rest of the world, they are an important source of long-term capital, and will be for a long time. And we look upon it as a potentially good, stabilizing force in the corporate governance world and in the performance of most of our corporations.
The other day, in a speech, I said the capital market has become a zoo. We don’t know what all these species are. We don’t know what a hedge fund is anymore. There are so many varieties. Who knows what it is? It’s somebody with money who wants to do something. That’s all we know. So, looking at SWFs, we see something good, not just in terms of getting capital, but in terms of their ability to stay with an investment for a much longer period of time, because they want to protect the investment for their own citizens.
I know that they’re reluctant to be more active for any number of reasons, including the political aspects. But we don’t think, long-range, that being passive is a good idea. Supposing an SWF invests in a company that’s going bad, and CalPERS and several others say, “We ought to do something about this.” That’s what’s happening now. They’re forming consortia of investors that talk to one another about companies with difficult situations. And they need to stick the pin in someplace, and make something happen for the benefit of all the shareholders. They’re not doing it for a short-term gain. They’re doing it because management is not performing.
Gamali: Yahoo is a case in point.
Millstein: Yes. Why should SWFs be absent from that party? There’s no reason in the corporate governance world for sovereign investors to be absent from that party. Could we build a bridge for you to the corporate community and to the political community, which said, “All right, we want to build a long-term investor relationship. How do we go about doing that?” And wouldn’t it be wonderful to have our corporate community aware of the fact that SWFs want to be long-term investors.
Saidi: One point on activism: I think it’s not only activism by the future wealth funds, as I prefer to call them, and foreign investments. I think you also have to look at activism domestically. Activism is very new in the
region, and getting people to be much more active on boards is part of that overall process.
Gamali: I agree. But what I’ve been surprised by is the remarkable pace of change. About eight years ago, I was at an investment bank, and I was setting up equities research in Saudi Arabia. The biggest problem was this: If you were reviewing, for example, a large corporation with a state-ownership component, and you said that it was overpriced, you would see all of your business from all of the affiliates and the government just shut down. You couldn’t do it. So I suggested that we basically look at a sector and say you’re either positive, neutral, or negative on that sector. But you couldn’t actually talk about a stock price, because of the consequences. That was the case then. Look at where we are now. All researchers now are happy to say if things are overpriced. That has been a huge shift.
Foster: Yes, just in three years.
Gamali: Literally. So we are seeing changes happen at a very fast pace. Some of the cultural sensitivities, I think, need to be taken into account. This is not a confrontationalist culture. But by the same token, whatever your race, color, religion, or creed, when you start losing money, basically culture goes out the window.
The markets are dominated by the retail investor, at the moment, who doesn’t do the research. But it is moving. Once you have the institutional funds moving in, the money is going in longer-term, and going in based on research, you will get the stabilizing effect.
Millstein: Supposing you’re investing overseas in several major companies and the performance begins to fail, what is your remedy? Look on and lose money on it, just forget about it?
Odeh: When you made that investment, what was your exit strategy?
Millstein: To sell?
Odeh: That would be the last resort.
Millstein: I think so. And all I’m saying is that the traditional base of corporate governance in the world is shareholder responsibility. Shareholders have some responsibility for the investment they make and keeping an eye on the company in which they have invested. That’s not only overseas, but here as well.