Business operators and investors as far away as the United Kingdom and India are probably acquainted with the terms “convertible loans” and “convertible notes”.
A notable trend within the UAE freezone business setup sector is the increasing adoption of “convertible loans” as popular financial instruments. Startups are using “convertible loans” for raising funds as an alternative to bootstrapping (where startups depend on their personal funds) or traditional bank loans to meet working capital requirements.
Perhaps, owing to this increasing adoption, we are witnessing a significant rise in interest and inquiries about the legal framework governing such convertible loan notes within the UAE freezone environment.
Broadly speaking, the legal viability of such funding instruments is indeed a grey area shrouded with ambiguity within a civil law framework such as the UAE.
What are Convertible Loans?
Essentially, convertible loan notes are unsecured loans provided by an investor (or noteholder) to a company/borrower, and such loan sums could convert into ordinary shares of the company’s share capital in accordance with the agreed contractual terms. A noteholder’s principal loan sum may or may not be subject to an interest component.
A noteholder and the company must document the terms and conditions of such a convertible loan transaction by way a properly drafted written agreement in compliance with applicable laws and regulations. Typically, a convertible loan agreement must contain the necessary contractual rights and obligations of the noteholder and the company, including but not limited to the following: principal loan amount, interest applicable, maturity date, conversion mechanism or conversion trigger events, conversion price formula, conditions to conversion, and ‘events of default’ allowing a noteholder to demand immediate repayment of the principal loan amount (along with accrued interest if applicable).
UAE Legal Framework – An Overview:
At the outset, it may also be worth making the point that such loans from an individual investor to a company would not fall within the prohibition stipulated under the relevant provisions of the UAE Penal Code, which applies to loans between natural persons.
Further, before discussing the legal landscape pertaining to these financing instruments in the UAE freezones, it is worth noting that the UAE Federal Company Law (Article 31 of the UAE Federal Decree-Law No. 32/2021 on Commercial Companies), which is applicable to the UAE mainland entities, expressly permits ‘joint stock companies’ incorporated in the mainland to issue such convertible (negotiable) securities.
Consistent with the legal treatment in common law jurisdictions such as the United Kingdom and India, the Dubai International Financial Centre (“DIFC”) and the Abu Dhabi Global Market (“ADGM”) -as common law-based financial free zones within the UAE (differing from the civil law system observed throughout the rest of the UAE)- appear to offer a recognized and favourable legal framework for convertible loan notes.
Legal Grey Area in UAE Non-financial Freezones?
Moving to the UAE non-financial freezones which house thousands of businesses- from a prima facie reading of certain freezone regulations and theoretically speaking- it may appear that convertible loan notes could become a legally feasible proposition. However, the enforceability of such convertible securities on the ground could be challenging.
Simply put, in this context, “enforceability” means giving the investors the assurance that their investments (by way of executing a convertible loan agreement with the issuing company) would be legally binding upon the parties, that their interests would be protected in terms of conversion of the loan into actual shares at some point in the future and that they would have adequate legal recourse if the company (borrower entity) fails to meet its obligations under the agreement in terms of conversion into company shares or repayment of the principal loan sum (along with accrued interest if applicable).
Practically speaking, with respect to UAE (non-financial) freezone companies, investors could find themselves disappointed in terms of enforceability of the underlying convertible loan agreement (executed by the parties) if the company does not comply with conversion of the loan to actual shares as per the contractual terms.
Possible Solution?
In summation, at present the enforceability of convertible loan note agreements cannot be confirmed in terms of UAE (non-financial) freezone companies. Accordingly, it may be worthwhile to consider incorporating a holding company in the DIFC or the ADGM (which would hold the shares of the subject freezone entity) and the convertible loan notes can then be issued to the prospective stakeholders at the holding company level- since there is greater legal certainty in relation to the legal recognition and enforceability of such financial instruments in these common law jurisdictions.
Concluding Remarks:
With the UAE’s legal framework continually evolving and international investor interest on the rise, it is to be hoped that the legal treatment (and reliability) of these increasingly popular funding instruments will develop over time.
Disclaimer: This blog provides general information (as of May 2025) and must not be construed as legal advice. For bespoke and up-to-date legal advice relating to convertible loans in the UAE, it is essential to consult a qualified legal professional with relevant experience and expertise.
At James Berry & Associates, we possess substantial legal expertise to advise and assist clients with all facets of commercial/business law. Should you wish to seek specific legal advice and assistance for your business, please click here to contact our Corporate and Commercial department.
Managing Partner
Legal Consultant