Innovation in Sukuk structures

Transcription

1 Chapter 10 Innovation in Sukuk structures Moinuddin Malim, Badr Al-Islami The word Sukuk first appeared in the early days of the Islamic empires and could originally be described as a credit note issued to soldiers and government officials. They could exchange it for commodities, materials or goods via the treasury or the finance ministry. Today, the word Sukuk is used to describe Shari ah-compliant debt capital market instruments and has raised growing interest in the finance industry worldwide. From the issuance of the first ever sovereign international Sukuk by Malaysia in 2002, the Sukuk market has been growing exponentially until the recent global financial crisis. Although, almost all Islamic banking products are made to deliver the same economic results as conventional ones, they are designed within a Shari ah-compliant legal structure. Today, however, Sukuk has been the focus of much debate amongst Shari ah scholars. Many discussion points have been raised: they challenge Sukuk s raison d être as Islamic bonds have the same economic outcome as conventional ones and follow the same life cycle post issuance. Some scholars have argued that Sukuk do not seem to be in line with the original purpose of the Shari ah. This chapter will try to present a concise and to-the-point discussion on various arguments around the different Sukuk structures and analyse whether they require innovation and development. Also, it will describe the various platforms used for the issuance of Sukuk and try to answer the question of the necessity to change the local laws to better suit the Shari ah requirements as well as analyse whether the conventional elements can be removed from the Sukuk structures. Prior to expanding on the discussion which has become the most debated issue in the Islamic banking and financing circles, it is necessary to understand the evolution of the Sukuk industry compared to the global bond markets. Historical overview Today the total amount of Sukuk issued in any currency stands at slightly more than $133 billion. 1 Exhibit 10.1 below shows Sukuk issuance since 2001, with a peak reaching $46.52 billion in Islamic IB-chapter 10-ppp.indd /02/ :20

2 Part II: Islamic capital markets Exhibit 10.1 Global Sukuk issuance $m 46, ,405 18,807 18, ,673 4,039 4,662 4,799 10, Source: [Data as at July 31, Securities Commission, Malaysia, Quarterly Bulletin for The Malaysian Islamic Capital Markets, Zawya Sukuk Mointor, Bloomberg, Liquidity Management Center Global Sukuk Table, Global Investment House Global Reserch List of Sukuk ( ).] The Sukuk market seems to have recovered in terms of aggregate volume from the slump of 2008 which saw volumes drop to $18.8 billion for the full year. As of July , total aggregate volume of Sukuk issued already stands at $18.5 billion, a definite progress on the previous year as five months worth of issuance are still to be taken into account to get the full year picture[author query: update?]. If we were to consider solely international US dollar-denominated issuance of Sukuk tapping into wider distribution channels, then the total aggregate volume is slightly higher than $42 billion. Eighteen percent of those are considered pure sovereign issues and the remaining 82% are classified as corporate issues as shown in Exhibit 10.2 below. However, further analysis reveals that most of the corporate issuers are either sub-sovereign or blue chip companies. For the revival of Sukuk market, more sovereign and sub-sovereign Sukuk will need to be issued to gain investors confidence back. Despite the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) recognising 14 Shari ah-compliant Sukuk structures, global data shows that only five of those namely Ijarah, Mudharabah, Musharaka, Murabaha and Istithmar take up to 90% of the Sukuk market share. Out of those, Ijarah has been the most popular structure used by international Sukuk issuers whereas Musharaka has been the most used by domestic ones. This is mainly due its popularity with Malaysian issuers. Other Sukuk structures include Al Salaam, Bai Bithaman, Ajil, Bai Inah, Al Istithmar and Manfa a. Exhibit 10.3 shows that Islamic structures have the adaptability to meet the obligor s needs and assist them in raising capital through a combination of available modes of financing Islamic IB-chapter 10-ppp.indd /02/ :20

3 Exhibit 10.2 International Sukuk issuances (sovereign/corporate) $m 16, , , , , , , , Corporate Sovereign Source: [Data as at July 31, Securities Commission, Malaysia, Quarterly Bulletin for The Malaysian Islamic Capital Markets, Zawya Sukuk Mointor, Bloomberg, Liquidity Management Center Global Sukuk Table, Global Investment House Global Reserch List of Sukuk ( ).] Exhibit 10.3 Sukuks by structure Others 17% Ijarah 28% Musharaka 34% Mudarabah 10% Murabaha 11% Source: [Data as at July 31, Securities Commission, Malaysia, Quarterly Bulletin for The Malaysian Islamic Capital Markets, Zawya Sukuk Mointor, Bloomberg, Liquidity Management Center Global Sukuk Table, Global Investment House Global Reserch List of Sukuk ( ).] Islamic IB-chapter 10-ppp.indd /02/ :20

4 Exhibit 10.4 Sukuk issuances by country UAE 20% Others 2% Bahrain 5% Indonesia 2% Kuwait 1% Saudi Arabia 9% Qatar 2% Pakistan 2% Malaysia 57% Source: [Data as at July 31, Securities Commission, Malaysia, Quarterly Bulletin for The Malaysian Islamic Capital Markets, Zawya Sukuk Mointor, Bloomberg, Liquidity Management Center Global Sukuk Table, Global Investment House Global Reserch List of Sukuk ( ).] Exhibit 10.5 Sukuk issuances by currency USD 29% AED 5% BHD 3% IDR 2% SAR 7% PKR 1% MYR 53% Source: Data as at July 31, Securities Commission, Malaysia, Quarterly Bulletin for The Malaysian Islamic Capital Markets, Zawya Sukuk Mointor, Bloomberg, Liquidity Management Center Global Sukuk Table, Global Investment House Global Reserch List of Sukuk ( ) Islamic IB-chapter 10-ppp.indd /02/ :20

5 Innovation in Sukuk structures In terms of Islamic debt capital markets, it is undoubtedly Malaysia which, as early as the 1990s, introduced a series of measures to develop Sukuk in the country. Exhibit 10.4 shows how other countries now have caught on the trend and how the global Sukuk market is geographically split at a global level. Exhibit 10.5 shows the currency denomination: besides the Malaysian ringgit, the US dollar is the preferred currency of denomination. This is even more the case for international Sukuk. While there have been attempts to issue in British pound, euro or Japanese yen, they have not had the success issuers had hoped for. Today, following the example of Malaysia, countries such as Saudi Arabia, Indonesia, Pakistan and, to a lesser extent, the UAE, have successfully launched local currency Sukuk. We also need to understand that capital markets activity in these countries (except Malaysia) has been non-existent or fairly limited. They will be able to develop thanks to a basic infrastructure, clear policy guidelines and as well a defined Shari ah framework all of which will encourage corporate as well as sovereign issuers to use capital markets as an instrument to raise liquidity. One interesting aspect of Sukuk is that most of the issues to date have been subscribed by institutional investors including corporate houses, insurance companies, pension funds mutual funds, hedge funds and banks both Islamic and conventional. This can be explained by the fact that Sukuk yield superior returns which otherwise would not be available, especially to banks which buy Sukuk on a held to maturity (HTM) or available for sale (AFS) basis. The main reason for the banks active role in the Sukuk market and especially up to the global crisis has been the surplus liquidity due to high oil prices and booming economies. Basic structures and issues While there are a variety of Sukuk structures available, the most common of them used to date are based on Al Ijarah (sale and lease back), Musharaka (partnership and joint venture), Mudharabah (trusteeship and fund management), Murabaha (deferred sale) and Wakalah (investment agency). Appendix A provides simplified flowcharts on how these structures work. The attraction of Sukuk is that a combination of those structures can be used to put a Sukuk together so that it can meet clients requirements and fit with their existing investment models. In addition to the basic few Islamic structures highlighted above, the salient features of the different types of investment Sukuk are summarised in the table in Appendix B. The suitability of a Sukuk structure over another is a choice made solely by the obligor or issuer and based on the availability of underlying assets or the project under consideration. In an ideal world, it would be very simple for all obligors to issue Sukuk Al Ijarah which has minimal Shari ah compliance issues. However, it is up to the market to gauge its risk appetite as well as determine acceptable return criteria. Today, any individual or corporate contemplating using Islamic financial products should consider the following factors prior to switching from existing conventional to Islamic practice. Generally, consumers are driven by the price and will not pay more for a Shari ah-compliant solution. In all Islamic countries, conventional banking remains the dominant player and controls the pricing of the underlying instrument Islamic IB-chapter 10-ppp.indd /02/ :20

6 Part II: Islamic capital markets Islamic financial institutions and Islamic instruments face the dilemma that both by way of practice and existence, they have been structured to conform to the characteristics of conventional finance and hence do not follow a form as prescribed in traditional Shari ah jurisprudence. During the last decade or so, Islamic finance has received a tremendous boost mainly due to the popularity of Sukuk and the way these instruments have co-existed alongside the conventional debt capital markets. However, as basic Shari ah law is not implemented in any of the Muslim countries economic models, it is not difficult to gauge why Sukuk s structures are closely replicating conventional bonds. The rationale behind the latitude from Shari ah scholars and their supervisory boards with Islamic institutions regarding the structure of Islamic instruments including Sukuk has been to encourage the migration of investors from conventional practices to Islamic hereby gaining critical mass. We have not yet reached the critical point where at least the majority if at least two thirds of the banking industry has migrated to an Islamic model. There are however jurisdictions such as Saudi Arabia, Brunei, Iran and Sudan where the finance industry is mostly Islamic. Malaysia, who has introduced a dual banking system, has positively supported and developed Islamic banking and finance. To implement a fully Islamic financial system, we would need to narrow down and switch the products from asset-backed (products that conform to the Islamic jurisprudence in spirit) to asset-based (products that fully comply with Islamic jurisprudence). However, Shari ah scholars are split in their opinion whether Islamic finance has reached the necessary critical mass to operate this switch or whether it still needs to replicate the conventional modality in essence, while retaining Shari ah principles. One school of thought maintains that no latitude should have been given in the first place and strict compliance to Shari ah must be adhered to. However, this view will not help the Islamic industry to develop and prosper. It would be virtually impossible to migrate to a total Islamic banking and finance system without first acquiring significant market share. If Shari ah authorities have so far tolerated the irregularities or Mafasid when Sukuk begun to be issued and at a time when there were only a handful of Islamic financial institutions, now is a bad time to revisit the matter. This does not mean that key rules should not be respected when structuring any type of Sukuk but we must not drive the change towards the most purist form until Islamic finance as a whole has a major market share and/or has reached critical mass. Structuring Sukuk The structuring of Sukuk has come under scrutiny post the AAOIFI ruling issued in February 2008, coupled with the economic downturn which has affected the global markets. 2 The structuring of Sukuk, especially those based on Mudarabah, Musharaka or Wakalah, has been the focal point of discussion of various Shari ah forums including the AAOIFI recently. The argument was first raised by a prominent contemporary Islamic jurist, Sheikh Muhammed Taqi Usmani in his article in Much debate and discussion have since followed. However, we need to fully understand the finer points of discussion between the various schools of thoughts under the Islamic jurisprudence, which is why some confusion has arisen for those who are not familiar with the spirit of Islam and its evolution since Prophet Muhammed (Peace be Islamic IB-chapter 10-ppp.indd /02/ :20

7 Innovation in Sukuk structures upon Him). While there are is a handful of Islamic banking Shari ah scholars who agree that Islamic banking and finance should follow principles based on Fiqh (Islamic jurisprudence), 4 they have all formed their own opinions: either supporting the general consensus or providing a different interpretation for it. This is mainly why confusion exists in the banking and finance community, which tends to rely heavily on Shari ah Fatwas (the ruling by a Shari ah scholar), either when structuring Islamic transactions or simply when participating in them. According to Dr Hussain Hamed Hassan, Shari ah scholar to a number of Islamic banks, whenever a Shari ah-compliant contract is entered into or an Islamic product is structured, it has to be in line with a basic Shari ah principle stipulating that, It is the Essence and Purpose, nor the Form and Technology, that Matter. What he means is that we need to fully grasp the core structure and essence of the product s underlying contracts rather than its form. We also must be cautious of the danger of not applying any Shari ah principles, which could lead to neglecting or negating the texts of Shari ah. Dr Hassan would ideally like to see a balanced approach in line with the spirit of Shari ah and urges all other Shari ah scholars not to restrict the scope of Ijtihad (process of decision making by Shari ah scholars) 4 when faced with the challenges of finding Shari ah-compliant solutions for issues which are neither in the explicit Shari ah texts nor in the rulings made by Fuqaha (Shari ah scholars). In light of above, we need to understand the basic issues linked to Sukuk structuring and the concerns raised by the AAOIFI in some detail. Business plan and its feasibility The AAOIFI s ruling stipulates that Shari ah scholars should consider the implementation and the modus operandi of the Fatwas as well as ensure the underlying contracts comply with any Sukuk structure at each stage of the transaction challenges the basis of the existing Sukuk structures used so far. One of the five basic principles of Shari ah governance in Islamic finance is the objective to protect the capital and assets. Islamic financial institutions (IFIs) are almost always prohibited by Shari ah scholars and their Shari ah supervisory boards from entering into any investments or transactions which are not financially viable from the start. Additionally, Shari ah also considers the risk and returns ratio to ensure the underlying transaction is feasible and is not based on speculation. Therefore, the premise of taking Fatwa beyond the stage of a mere seal of approval from Shari ah scholars into its real interpretation requires closer inspection and compliance by all parties involved in the Sukuk structure. Many Sukuk have arrangers, book runners as well as rating advisers who work with the issuers to ensure the bond is sold to the widest possible network and attains the highest possible ratings. However, under the Shari ah, these institutions also have the fiduciary duty to ascertain whether the issuer has the essential financial capability, a viable business plan and has conducted a feasibility study for which the funding is being sought under the Sukuk offering. This has been so far one of the weakest link for most of the Sukuk post closure, except for true securitisation. More than often, Issuers themselves put together a business model to comply with the minimum acceptable by a Shari ah scholar, without substantiating it. However, from the Shari ah perspective, it is clearly the issuer s responsibility to ensure that the business plan and the financial planning are well thought of in order to enable the issuance of Islamic IB-chapter 10-ppp.indd /02/ :20

8 Part II: Islamic capital markets the Sukuk. Similarly, investors should consider the credit worthiness of the issuer as well as the feasibility study in order to fully assess the risk they are willing to take. Therefore, Shari ah holds the issuer responsible for the integrity and accuracy of the business model. Additionally, under Islamic jurisprudence, if the issuer fails to deliver the desired returns due to an inherent flaw in the feasibility study and on which premises investors bought the product, then the Sukuk manager is liable for the full compensation of the investment. From a liability view point, there are three schools of thoughts: some Islamic jurists state that it is the person (Sukuk manager or managing partner) presenting the feasibility study who is fully responsible for the Sukuk s failure to produce the expected results apart from a case of force majeure. Some others deem the Sukuk manager responsible for capital protection only, with the exclusion of returns. And a third thinks that a pure risk and reward sharing model is the way forward. This has caused more concerns within the Sukuk industry. It will be interesting to see how this debate will evolve and if Shari ah scholars will reach common ground to enable this industry to truly grow. However, one thing is very clear and all Shari ah scholars seem to agree: the Sukuk manager is responsible for providing evidence that the failure of the Sukuk and the consequent loss of capital for the investors were not due to his own negligence. Having an accurate and viable financial plan takes care of most of the issues faced by the issuers when it comes to Sukuk issuance, especially under the Mudharabah, Musharaka and Wakalah structures. Basically, a Sukuk should be issued only when solidly backed by the financial and business planning, that is, the underlying assets for which the Sukuk is issued. Ownership and transferability of assets The question of ownership and transferability of the Sukuk s underlying assets emerged as a contentious issue, which has sparked much discussion within the Shari ah fraternity. This is due to the various Madhabs (different schools of thought within Islamic jurisprudence ) 4 and the various regulators drafting the law of the land based on conventional banking as well as conventional finance platforms of different regions. The AAOIFI and other Islamic bodies including the Islamic Financial Services Board (IFSB) have addressed the Shari ah concerns. The IFSB has issued the Capital Adequacy Requirements for Sukuk, Securitization and Real Estate Investment under IFSB-7 Published Standards. 5 While the AAOIFI is keen to see ownership and transferability of assets under Sukuk structures, the IFSB s Standard addresses the capital adequacy requirements for Sukuk and securitisation. The purpose of the IFSB is to provide clear guidelines on the asset re-recognition criteria, especially for Islamic asset-backed securities (ABS). One of the achievements of the IFSB has been to distinguish between three types of Sukuk structures: (1) asset-backed (ABS); (2) pay through; and (3) pass through. It became necessary to make this distinction as not all Sukuk issued today are true ABS, though they may appear to have real assets supporting them. Prior to delving into the debate of ownership and transferability, it is essential that we understand the basic difference between asset-backed structures and asset-based structures. Asset-backed structures. Islamic ABS are similar to conventional ones: they expose the Sukuk holder to losses due to impairment of the asset (or cash flows) and the credit risk is Islamic IB-chapter 10-ppp.indd /02/ :20

9 Innovation in Sukuk structures essentially based on the underlying value of the asset (or cash flows) and not that of the obligor. Asset-based structures pay through. Any Sukuk structure whereby the income generated from the underlying asset is paid to the Sukuk holder through the issuer and where the obligor has issued a purchase undertaking will constitute a pay through structure. Usually such structures are based on transactions where the obligor undertakes to purchase the asset on maturity or a termination event at the exercise price. The exercise price is designed to compensate the Sukuk holder for principal and profit. In such cases, the credit risk is based on the obligor s corporate credit rating and can also carry any other form of credit enhancement. Asset-based structure pass through. In a pass through structure, a separate entity issues the purchase undertaking for the asset to the Sukuk holders exercisable at maturity or during the tenure of the Sukuk in case of an event of default or breaches. Hence the obligor is not obliged to repurchase the assets or issue any undertaking to this effect. Credit enhancement can come from the separate entity which may have recourse on the obligor but it guarantees the repayment of the Sukuk to Sukuk holders. For the AAOIFI s Shari ah condition to be met, a Sukuk must transfer all ownership rights in the assets from the obligor to the investor via Sukuk structure. However, from a pure Shari ah perspective, the requirement of asset transfer stems from the legal title transfers under the law of the land which depends on the jurisdiction and the applicable legal system. While some jurisdictions recognise the beneficial and/or equitable title, ownership rights do not necessarily require transfer of registered and/or legal title of the asset. Also under Islamic jurisprudence, there is no requirement for a registered and/or legal title of the asset to be transferred as long as there is a legally-binding contract between the parties. However, in some jurisdictions, registration of title is considered a conclusive proof of ownership of asset. Furthermore, if the essence of the AAOIFI s ruling is to enable and/or allow the investors to step into the obligor s shoes and perform related duties pertaining to the ownership then it essentially entails the appointment of an administrator from inception. The IFSB recognises that from a Shari ah perspective, subject to independent interpretation of the jurist in their own jurisdiction, there are four key criteria that need to be considered in order for a sale under Sukuk structure to be classified as a true sale. 1 Transfer of assets should not be construed as a secured loan structured to avoid bankruptcy or insolvency proceedings by the court or other competent authorities. 2 The bankruptcy or insolvency of the obligor must not affect the assets that have been transferred to the Sukuk holder via the issuer. 3 In case the Sukuk holder or issuer elects to do so, the assets must then be transferred. 4 The sale must be free and clear of all prior overriding liens. Most importantly, we need to understand that the local banking and financial laws under which the Sukuk are issued are in their infancy in most of the jurisdictions. The desire of Shari ah scholars and various Shari ah regulatory bodies to bring substance over form will not be realised in the short term. There are often conflicts between local jurisdictions and the Shari ah laws and often, there are no ways of finding a compromise between the two. The ownership and trans Islamic IB-chapter 10-ppp.indd /02/ :20

10 Part II: Islamic capital markets ferability of assets need a lot more concerted efforts by the legal and Shari ah fraternity. It is imperative to develop alternatives similar to the Malaysian model, that is, to develop a parallel Islamic banking system which recognises the needs of Shari ah compliance vis-à-vis local laws (to be improved upon further) when it comes to Sukuk structures and let it evolve over time. The purchase undertaking Sukuks have created valuable opportunities for the investors in general, and for the ethical investors more specifically, while contributing positively towards the development of the national economies and business activities. The success of Sukuk can be attributed to the use of existing conventional platforms as well as the structures through which the obligator s credit risk has been captured to create instruments on par with conventional bonds, even if this is the cause of most contention today. The main area of disagreement is not whether Sukuk are Shari ah-compliant but rather the underlying structure itself. At times, Shari ah scholars have given a broader interpretation and issued Fatwas on those guidelines. One of the main points of contention is the purchase undertaking, especially in non Ijarah-based structures where the Sukuk manager (managing partner, managing agent and investment agent acting as the Mudharib, Musharik or Wakeel) provides a purchase undertaking. While there is no debate when purchase undertaking is performed by a third party, disagreement essentially revolves around the obligor (in his capacity as Sukuk manager) extending an undertaking to buy the Sukuk back at exercise price which is designed to compensate the Sukuk holder for principal and profit upon maturity or on the termination event. Additionally, in debt-based Sukuk where the goods have been sold or assets delivered, there is no question of having any purchase undertaking at face value at all. Similarly in a Salam Sukuk prior to delivery of goods, the issuer s obligation is a tangible liability on the debt in monetary terms to the seller and this does not constitute a purchase undertaking either. However, jurists from different Madhabs have conflicting opinions on purchase undertaking prior to delivery of goods. Today, confusion comes from the use of purchase undertaking mostly in Mudharabah, Musharaka, Wakalah and to a lesser extent Ijarah structures (only for the value consideration which means that scholars do not have any objection to a purchase undertaking for the applicable market value at the time of re-purchase of the assets). The main cause of this debate, triggered by the AAOIFI ruling of 2008, is that purchase undertaking is considered equivalent to a guarantee of principal and profit. However, there is a conflict between Shari ah scholars regarding the purchase undertaking as a guarantee of principal or profit. Some maintain the popular view that purchase undertaking is only a promise and as such, a purchase understanding should not be considered as a guarantee, which negates the essence and purpose of the contract based on trust in the case of Mudharabah, Musharaka and Wakalah structures. The issues pertaining to purchase undertaking are more complex than they seem. Some Shari ah scholars maintain that when a purchase undertaking is issued by the Sukuk manager, it does not mean that in case of a natural loss, damage or destruction of the underlying assets, the Sukuk manager is liable to pay back the principal. Unless stipulated in the Sukuk conditions, there is also no need for the Sukuk manager to sell or liquidate the asset at maturity Islamic IB-chapter 10-ppp.indd /02/ :20

11 Innovation in Sukuk structures Shari ah does not prohibit Sukuk managers or any of the related parties from buying the assets back at maturity for a value which is determined by a prescribed and pre-agreed mechanism or formula between the issuer acting on behalf of the Sukuk holder and the obligor. In most cases, the market price may be difficult to ascertain at the time of the issuance of the Sukuk and more critically, the nature of the asset may be of a strategic importance to the obligor who may not want to sell the assets in the secondary market. Additionally, the lack of availability of active secondary market may also cause the asset value to be inaccurately calculated in relation to the actual value perceived by the obligor. Hence, conditions such as selling the asset at fair market value may not be a satisfactory solution for purchase undertaking to be associated with Sukuk. Most Shari ah scholars agree that in a purchase undertaking and under the Mudharabah, Musharaka or Wakalah contract conditions, the Sukuk manager cannot be made to guarantee the principal and/or a fixed amount of profit. However, some scholars allow purchase undertaking on the basis that the issuance of purchase undertaking at the original value is not the same as providing a guarantee. While this is yet another issue to be resolved by the Shari ah scholars, it is clear that a purchase undertaking cannot be considered as a guarantee unless it is possible to pay the principal back to the Sukuk holders in all circumstances. Some Shari ah scholars supporting purchase undertaking consider it a unilateral agreement only binding the originator of the promise but not allowing the beneficiary to enforce the promise in case of an actual purchase at maturity or of a termination event caused by a total or partial loss. On the other hand, Shari ah scholars cannot seem to agree on whether the originator can be made to purchase the assets at a higher value in case the fair market value of the assets is higher. In cases where purchase undertaking value is inferior to the fair market value, then most Shari ah scholars maintain that Sukuk holders cannot be made to pay for the difference unless the Sukuk manager can prove without doubt that the value deterioration was not caused by his action or lack of. In cases of total loss or destruction of assets due to causes independent of the Sukuk manager, only then the loss can be passed on to the Sukuk holders. These are the two conditions stipulated by the majority of Shari ah scholars, which pose a problem for traditional arrangers and the legal fraternity as the risk is passed on to the Sukuk holders, which is not the case for conventional bonds. Usually a conventional bond (unless it is an asset-back security) is settled in full on maturity. If those two conditions are to be implemented, then it will be a difficult proposition to introduce this instrument on a debt platform and mostly, it will be difficult to find any investors with such a risk appetite unless the rewards are proportional to the risk. While the purchase undertaking issue remains unresolved, we need to understand the basis under which purchase undertaking as a promise has been allowed by Shari ah which states that: (a) whoever takes something has to return it; and (b) the claimant has to produce evidence of his claim and the party who denies the claim must swear that his stand is correct. Hence the onus of proof is on the Sukuk manager. This is the core of the purchase undertaking and its use in Sukuk. Having said that Shari ah scholars still need to devise a more flexible mechanism and let it evolve with time and practice. Profit distribution Over the last few years, Sukuk have seen their structures change to render them more viable and also similar to conventional instrument. These changes were introduced to ensure inves Islamic IB-chapter 10-ppp.indd /02/ :20

12 Part II: Islamic capital markets tors used to conventional bond fundamentals do not shy away from underlying Islamic structure which sees them take a quasi equity or asset risk. Added variants such as Shari ah compliant liquidity facilities were applied to structures such as Mudharabah, Musharaka and Wakalah where the income generation ability of the underlying assets may not suffice to pay out the periodic coupon payment under the Sukuk. This is due to time mismatch of cash inflow and outflow or shortfall in cash inflows or any other reason. It is very clear that Shari ah does not allow the Sukuk manager to provide the investors any guarantee of payment in the form of a fixed return, profit or a coupon based on any underlying benchmark. However, when we probe deeper into the underlying structure, we need to understand how Shari ah looks at it. Is there a need for a detailed feasibility study to ascertain the viability of the underlying project and the expected returns? What is the ratio of distribution of the net profit between the Sukuk manager and the Sukuk holders? While Shari ah allows the Sukuk manager to get an incentive and a share in the profit distribution, the calculation and methodology of such an incentive fee should be fixed under the Shari ah guidelines. There is no specific Shari ah provision in investment and Ijarah Sukuk structures preventing the Sukuk manager from taking the balance of excess profit. However, some contemporary Shari ah scholars object to this as those structures seem to have combined different aspects of the Sukuk such as liquidity facility, interest free loan from the Sukuk manager, purchase undertaking at face value, and so on. The matter of ascertaining profit prior to the proposed periodic distribution date is the core responsibility of the Sukuk manager for any type of Sukuk. Here, the major emphasis is on the fact that most of the Sukuk s underlying assets in general do not have a clearly ascertainable market value. In either case, attaining an estimate of fair market value is left on the judgment call of the Sukuk manager. Most Muslim jurists agree that the Sukuk manager acting as a trustee may value the asset according to the market and/or to the best of his abilities. Such valuation is acceptable for determining profit or loss incurred on the asset vis-à-vis the actual book value of the asset. In case the value being assessed is greater than the book value, then the Sukuk manager can either liquidate such portion to realise a profit or sell it to a third party, or even buy the portion himself. Shari ah scholars are split on the issue of on account profit distribution in case the profit is less than expected or in case there was no profit or a loss in the market value of the assets during the investment activity. The solution adopted by most Shari ah scholars is to allow the Sukuk manager to arrange for cash either through an interestfree facility to be deducted from future profits or through the actual liquidation of the asset or from the proceeds at the time of purchase undertaking being exercised. However, this has to be a voluntary act by the Sukuk manager and not a binding contract enforced by the Sukuk holders. In order to protect the Sukuk holders, not servicing profit is considered a cause for termination and the purchase undertaking is invoked whereby the obligor is bound to purchase the Sukuk s underlying assets at the exercise price. Rating and listing of Sukuk Given the high oil prices and increased customer interests in Islamic banking, the Middle Eastern banks have been faced with huge liquidity pools which they have invested in Sukuk Islamic IB-chapter 10-ppp.indd /02/ :20

13 Innovation in Sukuk structures Those have provided higher yield in comparison to other money market products. With Sukuk as a new investment vehicle, arrangers found it easier to sell a rated Sukuk to a bank treasury than to the corporate banking unit as it had to go through a detailed credit and cash flow sensitivity analysis. Most treasury departments were allowed to invest in rated securities through their propriety book. Additionally, in many jurisdictions, banks are not allowed to invest in cross border securities including Sukuk unless they are rated. This issue together with demand from the Issuer to tap into a larger distribution network and bigger Sukuk denomination encouraged issuers to seek a rating for the Sukuk and/or the obligor. The listing of Sukuk gave investor confidence from a compliance, transparency and disclosures perspective, which is what a renowned regulator requires from the Issuer. The choice of listing is based on investor s acceptability of the listing exchange and level of confidence on its governance, compliance, transparency. Today, London, Dubai, Luxembourg, Bahrain and Labuan (Malaysia) are the favourite listing options by the Issuers for US dollar-denominated Sukuk whereas local currency Sukuk are typically listed on their local stock exchanges. International rating agencies including S&P, Moody s, Fitch, Capital Intelligence and other local rating agencies realised the potential of this new product and developed their understanding of Islamic finance. Today, rating agencies consistently aim to share objective and accurate insights of Sukuk as well as other Islamic products for the benefit of all market constituents. Notable support has come from S&P and Moody s in helping investors understand the risk associated with Sukuk. There is no material difference in the risk analysis between a Sukuk and a conventional bond. While assigning a rating, the agencies do recognise that collateral foreclosures can be much more difficult in some markets than others. They also understand that Sukuk based on Musharaka, Mudharabah and Wakalah can bear above-average credit risk. However, the rating agencies have been able to provide market participants with independent and objective opinions about the creditworthiness of issuers and Sukuk while restraining from commenting on the Shari ah compliance of a particular issue or issuer. Additionally, rating agencies do not provide any recommendation on sell, buy or hold a particular security. Rating agencies do provide opinion on the ability and willingness of an issuer to meet financial obligations in a timely manner while taking into consideration the relevant legal and jurisdictional aspects of the Sukuk transaction. When legal counsels are engaged by the arrangers and the issuers, rating agencies also resort to their opinions to analyse issues such as enforceability, recognition of choice of law, insolvency and security-related matters. The sole purpose of the rating agencies is to help investors make informed decisions and issuers access debt markets. In addition, they also help issuers benchmark their creditworthiness against their peers to enable investors to effectively price each Sukuk based on its merits and risk consideration. The Middle Eastern experience shows that a typical five-year US dollar-denominated and unrated sovereign or sub-sovereign Sukuk is better subscribed in the regional market as the Issuers are better known to the investors whereas the rated sovereign or sub-sovereign Sukuk attracts wider distribution as shown in the exhibits below. In the past five years[author query: state specific years], it has been noticed that unrated Sukuk are not easily sold outside the Middle East unless the issuers are sovereign. Additionally, arrangers are able to seek a bigger share of non-banking investor type for similar type of issuers when Sukuk are rated as seen in the exhibits below Islamic IB-chapter 10-ppp.indd /02/ :20

14 Part II: Islamic capital markets Exhibit 10.6 Distribution-rated Sukuk Asia 20% Middle East 50% Europe 30% Source: [Author query: please supply details. If author s own, please state Author s own.] Exhibit 10.7 Distribution-unrated Sukuk Asia 10% Europe 20% Middle East 70% Source: [Author query: please supply details. If author s own, please state Author s own.] The above exhibits also clearly provide challenges for arrangers and issuers. One of the key challenges is reduce dependency on the banking markets and encourage participation of the retail investors in Sukuk issuance. This will not only boost confidence in local capital markets but also channel the funds lying idle in demand deposit or low yielding fixed deposits. It is essential to note here that international banks play a precursor role in the distribution of Sukuk to wider audience due to their presence in multiple markets, their bond desks, access to private banking contacts and other distribution channels which are linked to various liquidity pools around the world. The success of the Sukuk as an investment instrument would have been dampened had the international banks not partnered with local conventional and Islamic banks. Additionally, international banks bring the sophistication required to broaden the struc Islamic IB-chapter 10-ppp.indd /02/ :20

15 Innovation in Sukuk structures Exhibit 10.8 Investor composition-rated Sukuk Private banking 10% Pension/insura nce 15% Islamic banks 30% Asset management 20% Conventional. banks 25% Source: [Author query: please supply details. If author s own, please state Author s own.] Exhibit 10.9 Investor composition-unrated Sukuk Pension/ insurance 5% Private banking 5% Asset management 10% Islamic banks 35% Conventional banks 45% Source: [Author query: please supply details. If author s own, please state Author s own.] turing abilities of the Islamic Shari ah community. By working with Islamic institutions, they offer Shari ah-compliant credit enhancement tools, adding flavour to Sukuk such as convertibility, warrants, tranching and so on. The partnership between international banks, Shari ah scholars and Islamic institutions has greatly benefited the investors. The approach to structuring Sukuks There is a genuine need to take a more pragmatic approach to re-visit the underlying Islamic structures and their role in creating Sukuk. While a lot of debate has followed the AAOIFI February 2008 ruling, we need to emphasise that while maintaining the sanctity of Islamic Islamic IB-chapter 10-ppp.indd /02/ :20

16 Part II: Islamic capital markets jurisprudence, Islamic law allows Ijtihad, Ijma and Qiyas. 4 However, the onus of providing a liberal structure and the underlying Fatwas by the Shari ah scholars still obliges the Shari ah scholars, obligor, issuer, the structuring agent, the lawyers and even the rating agencies to implement a process which follows the Shari ah approved business plan or feasibility study. Essentially, we need to maintain the spirit of Shari ah and avoid clouding different aspects of Shari ah into one unified opinion which either approves or discredits the Sukuk and its underlying structure. Will innovation in Sukuk and its evolution lead this industry in a different direction? We need to have an open-minded approach and be ready to adapt to new solutions. We need to be ready to consider changing delivery platforms so that Sukuk and its underlying structures can evolve towards their ultimate goal of creating a pure Islamic economy, based on ethical principles, which can benefit all regardless of their beliefs or differences in religion. However, if purists persuade the general masses to get rid of all of the irregularities currently existing in Sukuk structures, Sukuk are in danger of becoming not only less popular but also of disappearing completely. Also, is now the right time to change Sukuk structures? Do we need to issue specific types of Sukuk on different platforms: Ijarah Sukuk on the bond platform as it currently exists, and Mudharabah, Musharaka and Wakalah on quasi equity or fund-based platforms? It is too early to start confusing investors, as it was not long also when the Islamic financial terminology was aligned as closely as possible to the global financial audience. On the other hand, standardisation of Sukuk regulations based on the guidelines provided by AAOIFI and IFSB will most definitely improve the brand image, reduce cost and time to market. While Islamic finance thrives to achieve harmony amongst its players, one needs to remember that Sukuk do not dominate any given market as the major source of capital raising. The total aggregate Sukuk raised to date [Author query: state specific time here?] in any currency stands at best as slightly higher than $133 billion and does not even represent 0.16% of the $83 trillion of outstanding bonds in the global bond market as at As Khalid Howladar, senior credit officer for asset-backed and Sukuk finance at Moody s says: As Sukuk issuers begin to face distress, it is important that investors focus on the substance and not the form of their risk, which is a concern in Islamic Finance. 7 Moody s further confirms that while most Islamic participants acknowledge that Sukuk should grant the investor a share in either the asset or the business venture along with related cash flows and the underlying risks; most Sukuk structures are designed to replicate conventional bonds. It acknowledges that assets in such structures are there for Shari ah compliance purposes only and ultimately have no reflection on the underlying risk of the asset especially in a distress situation. While the AAOIFI and IFSB have been trying to standardise and harmonise the underlying structures as well as the documentation used for the creation of a Sukuk, the actual decline in the Sukuk market was more due to the global credit market conditions rather than a direct reaction to the statement made by the AAOIFI. In Moody s opinion, the AAOIFI s statement will have a positive effect on improving transparency and will effectively result in bringing the substance in Sukuk. This should also help investors share risks of the assets. Moody s would like to see the AAOIFI s guidelines push Islamic transaction towards broad standardisation and hence force the investors to understand risk and return profile of each structure separately, irrespective of the type of Sukuk structures used Islamic IB-chapter 10-ppp.indd /02/ :20

17 Innovation in Sukuk structures There is no argument that Sukuk do need to move towards creating security in favour of Sukuk holders, even if actual asset ownership transfers are not possible for any reason. Shari ah scholars encourage the Sukuk manager to establish reserve accounts to protect the Sukuk s capital investment and be able to pay profit and return on the pre-agreed periodic payment dates rather than having liquidity facility. The Sukuk holders take the risk of real assets which have a potential to depreciate over time. If reliance is shifted to purchase undertaking from obligor at market value, Sukuk will become an un-marketable instrument. Should we move towards changing the periodic distribution on the basis of the asset s ability to pay back the principal and profit repayment during the term of the Sukuk? Additionally, the key to success in Islamic finance and more particularly in Sukuk is reliance, not only upon Shari ah scholars Fatwas and guidance on documentation, but also on the regulators who need to actively promote meaningful changes to the legal, regulatory system and other infrastructures. It is not an easy task as the regulators in almost all jurisdictions are more accustomed to a debtbased financing system. This is also not taking away any credit from regulators who are now forced to consider such changes due to popular demand and/or market forces. Only when these changes are implemented, will we see truly indigenous Islamic financial markets. These are a few of the considerations which will form the basis of how Sukuk will be structured in the future. There is an investor base and issuer demand both in the Islamic and in the secular world. The Sukuk system is in its evolutionary stage and currently provides a great tool for portfolio diversification. Sukuk have been effectively used by Issuers to tap into the liquidity pools available in different regions. Even though Sukuk in some selective Muslim countries have become the favourite way to raise capital, it has not reached the point of being the main source of capital raising. There may also be the case where a formal domestic capital market may simply not even exist in those countries. Additionally, some countries such as Malaysia, closely followed by Pakistan, Saudi Arabia and Indonesia, are tapping in the retail and mass consumer segments for capital raising activities through Sukuk. In this regard, whether it is Sukuk or a conventional bond, the choice needs to be available to all investor segments including the mass retail market. Until Sukuk becomes a popular investment vehicle available to all segments thorough various platforms, it is not expected to reach the level of sophistication as desired today by a few eminent Shari ah scholars. Emerging market leader The Kingdom of Saudi Arabia being by far the largest economy in the Middle East thanks to its massive oil wealth has been working slowly and gradually to create and maintain buoyant Islamic finance deals globally as well as at home. While all of the Saudi Banks offer Islamic banking products as demonstrated by the establishment of Al Inma Bank along with Al Rajhi Bank, National Commercial Bank, Saudi British Bank or Riyad Bank and are undertaking an increasingly high number of Shari ah-compliant transactions. The World Bank and International Finance Corporation have issued a report, Doing Business 2010: reforming through difficult times and have ranked Saudi Arabia the 13th easiest place to do business globally amongst 183 countries. A much improved performance if we compare it to its rank of 67th place back in This is a position which gives Islamic finance more weight as well as positions the Kingdom to provide an excellent channel to encourage Sukuk issuance at all levels Islamic IB-chapter 10-ppp.indd /02/ :20