Dubai currently has no effective insolvency law. Try to imagine it: How would creditors recover their entitlements? Does it lead to more arbitration activity? Does it explain why the Dubai International Arbitration Centre received more than 300 new cases last year and why arbitration is increasingly used?

Insolvency Law—Is It Necessary?

By definition, when a company reaches a state of insolvency it no longer has sufficient assets to meet its liabilities, this makes the management and distribution of those assets of paramount importance. There is value in the company that goes beyond its physical assets: knowhow, goodwill, ongoing relationships, employee loyalty and other ephemeral aspects that cannot easily be transferred by contract. If, however, the company’s physical assets are disposed of in a piecemeal manner, those additional elements may be lost, thereby reducing the company’s total value. If this happens, value and total return to the creditors are lost, and from this loss flows a fundamental principle of bankruptcy law: asset maximisation.

But asset maximisation is not, in itself, enough. The individual creditor may consider that there are sufficient assets for its debt to be realised and it is not until a later creditor tries to enforce its claim that the insolvency will prove fatal to further creditors' claims. The first creditor to act will therefore secure a greater return than the slower, less well informed, or less well positioned creditor. The competing processes add uncertainty and the costs of preventive and protective action (including monitoring), which further devalue the asset.

Thomas Jackson, one of America's foremost academic experts on bankruptcy law, has analysed the concept in some detail, and concluded that the neutral bankruptcy principle would be to ensure a collectiveand compulsory insolvency regime: compulsory, to prevent any creditor from jumping the queue, and collective, to ensure the greatest return for the greatest number of creditors.
The concept of pari-passu (equal and proportionate) distribution of assets on insolvency in so many jurisdictions is a further neutral aspect of insolvency machinery. This principal ensures each creditor a proportional return wherever it finds itself in the process and removes another element of individual incentive. Logically, this process would include a stay on individual litigation or arbitration to prevent the race to the tribunal and the associated costs and asset attrition. Certainty and transparency would be a requisite so that repeat players could put their faith in the system and would not have incentives to seek to cheat or avoid the system to the overall detriment of their fellows.

Professor Jackson was attempting to rationalise US bankruptcy law, but consider what the absence of an appropriate collective and compulsory bankruptcy process, with no clear structure for creditors, might mean for a legal system. It is for this reason that reform is contemplated in the United Arab Emirates. 

The Need for Reform in the UAE

According to Dahlia Khalifa, a senior World Bank adviser, it takes an average of five years to close a business in the UAE because of inadequate insolvency laws:

In the UAE, because there is not a very strong insolvency regime, there are actually very few companies that go through the insolvency process.....What needs to be addressed is the creation of an insolvency regime so companies can go through a very clear process to resolve issues if there are any criminal obligations or results that come from filing for bankruptcy.
It has been reported in Gulf News that the UAE will introduce a new law “within months” to deal with the increased volume of corporate bankruptcies in the economic downturn. But where does that leave insolvencies in the meantime and what has this to do with arbitration?

If an efficient insolvency structure puts the creditors into an orderly system, enforcing a collective and compulsory proceeding for the greater good, and specifies how the financial remains of a failed company are to be dealt with, what happens in Dubai when the structure fails to achieve that? A free-for-all, perhaps, with creditors scrambling to lay hands on whatever assets are left. As a result, there are probably more disputes, with creditors urgently trying to establish their entitlements, but no appropriate insolvency rules to regulate these claims and impose a central, collective and cost effective distribution of assets and entitlements.

These issues are clearly at the forefront of thought in Dubai. As recently as early March 2010, the Dubai International Arbitration Centre (DIAC), in cooperation with the International Bar Association (IBA), organised a roundtable discussion regarding  international insolvency laws and dispute mechanism models.  Dr Hussam Talhuni, Director of DIAC, said that the purpose of the discussion was to apprise the business community and all stakeholders about the application of international insolvency laws in the context of the domestic law and to bring the discrepancies in the dispute mechanism models to the notice of legal practitioners. The participants were presented with some of the insolvency models implemented in the United States, France, Canada, Switzerland, and the United Kingdom.

A Link with the Increased Number of Arbitrations?

The number of arbitrations commenced in the Dubai International Arbitration Centre in 2009 — approximately 300 — is a truly staggering number when measured against the size of Dubai's business community. Presumably, there also would have been a large number of parties who could have gone to arbitration but decided against pursuing a failed company.

The remarkable number of arbitrations commenced in 2009 is entirely consistent with the theory that the absence of an effective insolvency regime leads to a rise in disputes, as part of the scramble for what little cash may be left. The number of arbitrations, therefore, may not evince the popularity of arbitration, but rather, simply reflect the inadequacy of the existing insolvency regime. 
Look also at the arrangements specially made to deal with the investment company Dubai World. In December 2009, Decree 57 was issued by the Ruler of Dubai to facilitate the restructuring of the Dubai World group of companies, with a special tribunal set up to deal with claims and a modified legal regime. The Decree needed to address a jurisdictional issue but the special arrangements underline the absence of the necessary modern insolvency machinery.

The acid test for the theory (as to the likely explanation for the 300 arbitrations) will come after the promised new insolvency law has come into force and has become well-used. If the number of requests for arbitration drop away in some sort of correlation then the theory can claim some proof.

Until then it is very much a matter for debate.