Sukuk Ijarah, Part I

Ijarah - is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the aqad (contract). The ownership, rights and obligations as the owner of the leased asset remains in the hands of the lessor for the duration of the lease. Any costs incidental to the usage are the responsibility of the lessee.

A Fixed Asset based Sukuk Ijarah should have the characteristics of a Real Estate Investment Trust (REIT). If I was to structure a Fixed Asset Sukuk based on the Ijarah contract, it would probably have the following characteristics:

Issuer:
An SPV owned by the Trustees on behalf of the Sukukholders

Principal Activities of the Issuer/SPV:
Owner, manager and Lessor of [warehouses/hypermarket/office, commercial, industrial, educational, residential buildings/ships/aeroplanes – thereafter referred to as ASSETS].

Tenure of Investment:
5 years (for example)

Structure Description:
Investors will receive Sukuk Ijarah issued by the SPV as evidence of their investment in the SPV. SPV shall utilise the investment proceeds to acquire ASSETS (as described in [the hypothetical] Appendix A). The legal title of the ASSETS shall be transferred to the SPV and held in trust for the Investors.

The ASSETS shall not engage or be a party to any activities contrary to or forbidden by Shariah.

The ASSETS shall be leased to the market at the appropriate lease rental rates (as verified by the appointed valuer or industry expert) and for a lease period not exceeding 5 years (or any number of years as agreed by the investors).

Any costs incidental to ownership such as taxes and insurance shall be borne by the Lessor.

Any costs incidental to usage, such as utilities expenses, repairs due to wear and tear and content insurance shall be borne by the Lessee.

Lease rental net of (minimal) SPV cost shall be remitted to Sukukholders half yearly (or annually, quarterly, monthly)

SPV shall instigate legal action against lessees who deliberately and fraudulently dishonour the lease agreements. Failure of the lessees to pay rental due to economic reasons does not require immediate legal action. Instead, a solution has to be found to ensure the lessees are able to resume payment of the rental soonest possible.

Investors wishing to exit the investment, at any time, may sell their share of ownership to anyone, at the prevailing market price of the asset. The prevailing market price shall be based solely on the market value of the asset or NAV.

At the end of 5 years, the ASSETS shall be sold to the market at current prices and Investors will receive their share of the sales proceeds according to their share of investment.
The investors may decide to continue with the investment if the so wish and investors wishing to exit the investment may dispose their shares in the manner described above.


Difference from some of the Malaysian Sukuk Ijarah in the market:

• Under this structure, the SPV assumes full legal ownership of the assets, not just the beneficial ownership.
• This structure does not have a purchase undertaking with a predetermined price, the properties are disposed to the market, at market prices.
• Rental is priced at the real market rental rate and not benchmarked against any interbank rate (LIBOR etc) or interest rates.
  

This structure is basically a REIT. It is not a mind-boggling alien structure that should be scorned upon so correct me if I’m wrong, why isn’t there any such Sukuk structure out the in the market?

Shariah Compliant vs. Shariah Based

The difference is quite obvious; a Shariah compliant product is one that meets all compliance criteria, it may not necessarily be Shariah based (like “Shariah compliant derivatives” for example) but it is sufficient that it does not contravene any Shariah ruling. A Shariah based product on the other hand is already compliant; it is after all based on Shariah perimeters which makes compliance automatic.

Shariah compliant products may have its origins in conventional banking. To make a financial instrument Shariah compliant, all that needs to be done is to remove those elements or components which contradict with Shariah and replace them with a Shariah acceptable concept. Multiple contracts may be used to facilitate and complete the transaction and inevitably some form of legal trickery could be involved. I would agree with the definition of a Shariah compliant product being a conventional product which has been “Islamised”. An example of a Shariah compliant product is an Ijarah transaction where only the beneficial ownership is transferred and not the legal ownership.

A Shariah based product is a financial instrument which is derived from the laws of Shariah. It may share some similarities with existing conventional products but it did not originate form any conventional products. Structuring Shariah based financial solutions is easier because there is no need to find ways to circumvent Shariah prohibitions in order to achieve Shariah compliance. A Mudharabah venture capital model is an example of a Shariah based product.

Making existing financial products Shariah complaint is an easy, short term approach. It will satisfy the market’s need for Shariah compliant products but it will not distinguish Islamic finance as an alternative model to conventional banking. Merely Islamising and making existing conventional products Shariah compliant will cause the Islamic finance sector to converge with the conventional sector. Convergence means being one and the same and since Islamic finance is not the same as conventional finance; convergence should not be allowed to happen.

BBA is an example of a Shariah compliant financial product whose roots can be traced to conventional debt based lending. As a consequence, the mechanics and pricing of a Bai Bithaman Ajil financing is identical to that of a conventional loan.

Being different products running on different concepts and platforms, convergence cannot happen even on pricing. An Ijarah based mortgage carries different risks compared to a collateralised debt based mortgage. Therefore, given the different risk elements of the two similar products, the pricing cannot be identical; it should reflect the underlying risks involved.

Islamic finance is an alternative to conventional finance and hence convergence should not happen.

Bursa Suq Al Sila

I have always thought that Shariah based finance is always trade based as decreed in the Quran, 2:275 “… Allah hath permitted trade and forbidden usury …“

Based on my limited knowledge, a trade is a transaction where money and physical goods or services are exchanged. Therefore, is it a bona fide trade when the intention to take physical possession in absent?

Inah is a contract involving the movement of money form one party to another using “trade” to facilitate the transfer. The trade in Inah is (IMHO) a smokescreen, a legal trick to “legalise” the transfer of money including the additional (profit) amount. The Malaysian market has finally accepted this fact and phased out the use of Inah when conducting Shariah based financial transactions. The argument is however based on the number of contracting parties and NOT the absence of intention to take physical delivery of the traded goods. Based on the “number of contracting parties” view, the Tawarruq is formulated and deemed compliant despite the intention of taking physical delivery is still absent (OIC’s Fiqh Academy decided that Tawarruq may not be compliant after all but some scholars argue that “organised Tawarruq” should be allowed – I have no idea what organised Tawarruq is).

So, how do we move money from one party to another the Shariah compliant way? Where and how do we place idle funds?

I propose a property clearing house be set up, containing a pool of real estate assets, each individual property with their own legal title. The properties must be generating economic activity/value such as a warehouse, shophouse or residential properties, or even industrial properties/factories. The clearing house will own all the property and sell the property to those wanting to place idle funds for short periods. The properties will then be leased back to the clearing house and at the end of the agreed lease period be sold back to the clearing house at current market value. Given that the lease/investment period is short, between 1 week and 6 months, fluctuation in values should not be too drastic.

The proposed structure will at least eliminate the element of buying and selling assets purely for the purpose of transferring money and getting a little bit more back. The lease and sell back will be determined based on the prevailing market prices thus eliminating concerns concerning riba and gharar.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any enonomic activity but instead it creates debts.

What is Tawarruq? To me, it is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another. I commented on the issue previously (http://shariah-finance.blogspot.com/2009/05/commodity-trading.html) and I sort of feel vindicated by OIC’s declaration.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. My guess is Commodity Murabahah will be next.

Defaulting Sukuks

Reuters reported that industry experts are warning more Sukuk defaults are coming after Kuwaiti firm Investment Dar defaulted on their USD100 million Sukuk. At the same time, Saudi conglomerates Saad Group and Ahmad Hamad Algosaibi & Bros are restructuring their debt, triggering concerns of a spill over effect on the Islamic finance industry. Neale Downes, a Bahrain-based lawyer at Trowers & Hamlins, estimated that 5-8 percent of Islamic bonds, or sukuk, in the market are susceptible to default as many were raised for real estate projects which have been hurt by the slowdown. "The longer the global recession goes, the higher the likelihood of default," said Mohammad Faiz Azmi, global Islamic finance leader at PricewaterhouseCoopers. "People are now using reserves or savings to try to keep themselves going. How long can that last? So far what we've seen is the tip of the iceberg."

My question is; if the Sukuk is structured on a pure profit and loss sharing (PLS) concept, can it default? In my opinion, PLS structures do not recognise defaults. This is because by definition, PLS means sharing profits when they are made (according to predetermined ratios) and absorbing losses when they arise. PLS is not a contract where returns (coupons/profits/dividends) are guaranteed regardless of actual performance. Defaults are caused by the guarantee d returns element in the structure – just like in the conventional bond arrangements.

However, Sukuks structured on an Ijarah or Murabahah contracts may default if the contracted payments are not made. This is because such contracts are not contracts of partnership but instead lease contract (Ijarah) and debt contract (deferred payment Murabahah). In this case, payment of coupon/profit/lease is contracted and obligatory, non-payment will result in a default.

When reporting on Sukuk defaults, it must be made known what is the underlying contract it was based on. I am still of the opinion that partnership based Sukuks have no risk of default apart from in cases of negligence or fraud.

Controller of Compliance

Dr Mohamad Nedal Alchaar, secretary-general of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) declared at the IFN 2009 Issuers & Investors Asia Forum that his organization will determine the Shariah compliance of a product, and that this could be done from the latter half of next year.

This model of a central body deciding/monitoring/controlling Shariah compliance of financial products is not new; Bank Negara Malaysia and the Securities Commission is already playing that role (for the Malaysian market) as no product is allowed to be sold without their seal of Shariah compliance.

With a central compliance regulator, what will happen to the individual FI’s Shariah Advisory Committee (SAC)? What is their role? Are their decisions/recommendations binding? A central Shariah compliance authority could relegate their role to a mere secretariat, vetting Shariah issues before being approved (or rejected) by the central body.

A central, globally accepted Shariah controller of compliance being the standard setter and standard bearer could help in solving the standardisation issue. But, isn’t the OIC Fiqh Academy already doing that?

Any central body wishing to determine the Shariah compliance of a product would not be successful if standardisation of the Shariah interpretation is not in place. We should work towards that first.