* Dana says it has discovered outstanding sukuk are unlawful
* Seeking ruling on this in UAE courts
* Existing sukuk to mature in October
* Current cash balance far below amount needed to repay sukuk
* Some creditors say they will fight (Adds creditors' comments, details on sharia compliance, analysis)
By Davide Barbuscia
DUBAI, June 13 (Reuters) - Abu Dhabi-listed Dana Gas has proposed swapping $700 million of outstanding Islamic bonds because it had discovered they were "unlawful", prompting an outcry from some creditors.
The price of Dana's sukuk plunged after Dana's proposal on Tuesday, with one creditor in Dubai describing it as "very investor unfriendly" and another saying it made no sense as the bond had been judged sharia-compliant when it was issued.
Dana's 9 percent bonds were offered at 87 cents on the dollar, down from 91-92 cents previously, while shares in the company closed 15 percent higher.
The Dubai-based portfolio manager said Dana would have trouble tapping the debt market again if it unilaterally declared its paper illegal and said he had already contacted the company's investor relations office to express his strong disapproval of the proposal.
Dana, which had a cash balance of $298 million in March, originally announced its intention to hold discussions with sukuk holders in early May.
Dana said at that time it needed to focus on “medium-term cash preservation” because of difficulty getting payments from production assets in Egypt and Iraq. The existing sukuk, half of which are exchangeable into equity, will mature this October.
But on Tuesday, Dana said it had received legal advice that the paper was not sharia-compliant and was therefore unlawful in the United Arab Emirates.
As a result, Dana said, it was proposing to creditors that they swap it for new sharia-compliant instruments with four-year maturities and profit distributions at less than half the rate of the existing instruments. The new paper would not feature any conversion into equity.
New York-listed Houlihan Lokey is advising Dana Gas on the matter, while a committee of sukuk holders has appointed New York-based boutique investment bank Moelis as adviser for the restructuring negotiations.
Dana said it was seeking a consensual agreement with investors but had started proceedings in UAE courts to seek a declaration on the lawfulness of its existing sukuk.
The sukuk use the mudaraba format, a common Islamic finance structure which resembles an investment management partnership. Dana said it had discovered they were illegal because of "the evolution and continual development of Islamic financial instruments and their interpretation".
A source with direct knowledge of the situation said the firm planned to argue the sukuk were not sharia-compliant because their repurchase price was fixed, the coupon was the result of interest-based not profit-based calculations, and the coupon paid out regardless of Dana's financial performance.
Islamic finance stresses risk-sharing, which some scholars take to mean investors in sukuk should not be able to count on fixed coupon payments.
Dana said profit payments from its proposed new instruments would comprise cash and payment-in-kind (PIK) elements.
"The PIK element is absurd - there's no reason why the company would not pay in cash, especially in the light of the fact they're now receiving some payments from Egypt," the first creditor, speaking on condition of anonymity, told Reuters.
Dana also said it was proposing pre-payments for the new sukuk at par prior to its maturity, providing a path for early pay-down for the holders. It did not give details. (Editing by Andrew Torchia and Alexander Smith)