Did She Say That?

http://www.financeasia.com/article.aspx?CIaNID=118130
Dubai World creditors await court definition of Sukuk
At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

The quandary faced by the holders of Nakheel’s Sukuk has been well documented and discussed in recent weeks. At this juncture, how they will move forward with the restructuring depends on how the courts define this instrument called Sukuk.

In the above article, the global head of Islamic markets at Bursa Malaysia claims that a Sukuk is a bond. I find it appalling that a person of such stature as Raja Teh with all her experience can come up with such a statement which IMHO seriously undermines the principles of Islamic finance.

In case she forgot, a Sukuk is defined as follows:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity” by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, Standard 17).

“A document or certificate that represents the value of an asset” by The Securities Commission (SC).

A bond is defined as a fixed interest financial asset. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Click here for a comparison between Sukuks and Bonds.

If Sukuk is a bond, why bother with the Shariah structures & approvals, legal documentations etc.? Why bother calling it a Sukuk?

Let’s put it this way, Sukuks and bonds are like fish and chicken, they are both sources of food and can be cooked the same way but they will NEVER look the same, taste the same, they will never be the same.

It is a credit issue, so going forward, let’s use Nakheel/Dubai World as an example and learn from it. The first and most important lesson to remember is to structure a Sukuk as a Sukuk and not as a bond. And that includes evaluating the credit from the Sukuk perspective and not the bond perspective.

For as long as the Islamic finance industry is lead by people with a conventional worldview on Islamic finance, it will never break away from being a conventional product with an Arabic name.

The “will” to regulate

Islamic finance could also face a systemic failure and reputation risk unless there is a unified and dynamic regulatory framework applied not only domestically but also globally, warned an economist and former International Monetary Fund (IMF) executive director Dr Abbas Mirakhor.
He added that the industry may have more regulatory standards but there is no implementation of the standards in a unified manner and there is no organisation that supervises the instruments. Therefore, Mirakhor said that to ensure a decent chance of growth and development, one has to make sure the regulations are unified and accepted by all jurisdictions.
“We need to create a uniformed standardisation for Shariah products and at the same time you need a uniformed, comprehensive and universal regulatory system in place, which can have the authority of early warning when it comes to weak instruments," he said.
However, the question is whether it should be done via an association of Islamic banks or central banks that have Islamic Finance operating in its jurisdiction. Such arrangements are not difficult but it depends very much on the "will" of the participants, said Mirakhor. (Bernama)

In my previous posting, I made a feeble attempt at article review in which one of the points raised was the difficulty in finding a unified opinion due to the differing mazhabs followed by the different scholars. It was also raised that perhaps a product should be approved with a “warning” label as to which mazhab the approval was arrived at.

Speaking about “will”, a lot of jurisdictions leave the Shariah compliance and monitoring role to the individual banks, the question is, are the banks willing to let go of this “power” to approve products?

Given this major obstacle in reaching a unified stand, how then do we proceed with a global, central authority to supervise and regulate the industry? I feel the IFSB, AAOIFI, Fiqh Academy are global institutions which can (and should) play the regulators role, if allowed.

I agree with Mirakhor when he said a regulatory authority “needs to have enough mandate to supervise/regulate the policy”. Getting the mandate however, might not be so easy.

Article review – “Is AAOIFI Ban on Musharaka Sukuk Justified?”

A not so comprehensive review on the above article which appeared in the May/June issue of the Islamic Banker.

The title itself is misleading – AAOIFI did not ban Sukuk Musharakah, it is banning the current model of Sukuk Musharakah which has the elements of purchase undertaking (PU) and guarantees.

The gist of this article is based on the views of one mazhab overriding the views of the other mazhabs.

Badlisyah (BAG) – arguments for the Malaysian market player from the Malaysian (Shafie) perspective.

P.10, Col 1, para 3, line 4 – contradiction, Musharakah is NOT a debt instrument. It should not be treated as such as it defeats the purpose of structuring a Sukuk based on the principles of Musharakah.

P.10, Col 1, para 3, lines 6 to 10 – the Malaysian investors, market, legal and regulatory framework unfortunately does not support the Musharakah model. It is still a debt based market with debt based regulatory framework.

My opinion on the PU – giving debt characteristics to an equity based instrument. This is to satisfy the demands of the investing public who wants an “Islamic” structure but also wants the features of a debt.

My opinion on AAOIFI’s announcement - it should not create a panic, there should be a consensus on the “effective” date as in anything issued prior to the announcement should be given an exemption from the ruling.

Permissibility of debt trading – it is true that differing mazhabs have differing views, this is where the industry needs a respected global body to lay down the law as to which mazhab prevails. Alternatively, allow the practices of all mazhabs and leave it to the market to decide whether they want to subscribe to a certain issuance or not. In this case, each Sukuk issuance has to come with an additional label – that of the approving mazhab.

True sale versus Beneficial sale – BAG argues that it is merely an accounting issue. He contends that a beneficial sale is as good as a true sale (despite the asset still remaining in the balance sheet of the seller). The purpose of a sale in an Islamic transaction is to give absolute rights of the asset to the buyer (i.e. Sukuk investors). My question is; does beneficial sale accord absolute rights to the buyer when challenged in court, given that the name on the title remains under that of the seller?

My opinion on the trading of banking stocks on the GCC stock markets - the reason why they are traded at a discount is due to the fact that stock valuation is done based on conventional norms. If stock valuation is done with Shariah considerations, it may yield different prices.

BAG uses the argument that the PU is merely a Wa’d (promise) which is not legally binding. If the PU is put to test and challenged in court, would the holder of the undertaking be compelled, by law, to honour the undertaking? If they are, then it is no longer a Wa’d but a legally binding contract instead.

Loan/top-up/liquidity arrangement in case of shortfall in profits – in equity based structures, are the managers allowed to do the same? BAG again argues that this arrangement is merely a Wa’d and therefore not legally binding. Again, will it stand if challenged in court?

A guarantee by a third (non-related) party is seen as an act of benevolence, it should not have any strings attached or payments charged.

The recurring argument of substance over form – different mazhabs have different opinions on the subject and all their opinions are valid from the Shariah perspective. Again, to overcome this obstacle, label a product based on the approving mazhab and let the market decide.

P.14, Col 1, para 6, last 2 lines – oxymoron, Musharakah is not a fixed income instrument.


My conclusions –

Musharakah = equity. Therefore, if we choose to structure a Sukuk based on the principles of Musharakah, we should also adhere to the principles that govern equity structures.

Shariah parameters are split between the 4 main mazhabs. Any stand or ruling must be accompanied by the basis, i.e. which mazhab it was based on. At the end of the day, it is for the market to decide which is best suited for their needs.

AAOIFI Shari’ah Resolutions: Issues on Sukuk

Issuer: Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

The Shari'ah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), in view of the increased use of Sukuk worldwide, the public interest in them, and the observations and questions raised about them, studied the subject of the issuance of Sukuk in three sessions; first, in al-Madinah al-Munawwarah, on 12 Jumada al-Akhirah 1428 AH (27 June 2007), second, in Makkah al-Mukarramah, on 26 Sh'aban 1428 AH (8 September 2007), and third, in the Kingdom of Bahrain on 7 and 8 Safar 1429AH (13 and 14 February 2008).

Following the meeting of the working group, appointed by the Board, which met in Bahrain, on 6 Muharram 1429AH (15 January 2007), which was also attended by a significant number of representatives from various Islamic banks and financial institutions, the working group presented its report to the Shari'ah Board.

After taking into consideration the deliberations in these meetings and reviewing the papers and studies presented therein, the Shari'ah Board - while re-affirming the rules provided in the AAOIFI Shari'ah Standards concerning Sukuk - advises Islamic financial institutions and Shari'ah Supervisory Boards to adhere to the following matters when issuing Sukuk:

1. Sukuk, to be tradable, must be owned by the Sukuk holders, with all the rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally, as well as in accordance with the rules of the Shari'ah, in accordance with Articles (2) and (5/1/2) of the AAOIFI Shari'ah Standard (17) on Investment Sukuk. The Manager issuing the Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets.

2. Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally, in accordance with the guidelines mentioned in AAOIFI Shari'ah Standard (21) on Financial Papers.

3. It is not permissible for the Manager of Sukuk, whether the manager acts as the mudharib (investment manager), or sharik (partner), or wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus. It is not objectionable to distribute expected earnings, on account, in accordance with Article (8/8)3 of the AAOIFI Shari'ah Standard (13) on Mudaraba, or to obtain project financing on account of the Sukuk holders.

4. It is not permissible for the mudharib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase, in accordance with Article (3/1/6/2) of AAOIFI Shari'ah Standard (12) on Sharikah (Musharaka) and Modern Corporations, and Articles (2/2/1) and (2/2/2) of the AAOIFI Shari'ah Standard (5) on Guarantees. It is known that a Sukuk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or his non-compliance with the investor's conditions, whether the manager is a mudharib (investment manager), sharik (partner) or wakil (agent) for investments.

In case the assets of Sukuk of al-musharaka, mudharabah, or wakalah for investment are of lesser value than the leased assets of ‘Lease to Own’ contracts (Ijarah Muntahia Bittamleek), then it is permissible for the Sukuk manager to undertake to purchase those assets - at the time the Sukuk are extinguished - for the remaining rental value of the remaining assets; since it actually represents its net value.

5. It is permissible for a lessee in a Sukuk al-ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he {lessee} is not also a partner, mudharib or investment agent.

6. Shari'ah Supervisory Boards should not limit their role to the issuance of fatwa on the permissibility of the structure of Sukuk. All relevant contracts and documents related to the actual transaction must be carefully reviewed {by them}, and then they should oversee the actual means of implementation, and then make sure that the operation complies, at every stage, with Shari'ah guidelines and requirements, as specified in the Shari'ah Standards. The investment of Sukuk proceeds and the conversion of the proceeds into assets, using one of the Shari'ah-compliant methods of investments, must conform to Article (5/1/8/5) of the AAOIFI Shari'ah Standard (17).

Furthermore, the Shari'ah Board advises Islamic financial institutions to decrease their involvements in debt-related operations and to increase true partnerships based on profit and loss sharing, in order to achieve the objectives of the Shari'ah.

In the end, all praise is due to Allah, Lord of all the Worlds!

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.

Vulnerability of Islamic finance exposed?

Sukuk defaults expose vulnerability of Islamic finance

MANAMA/KUALA LUMPUR: First defaults of Sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the $1 trillion Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in Sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or Sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait’s Investment Dar said in May it had defaulted on a $100 million Sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, Sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

“Secular, non-Shariah courts upholding those structures are more likely to consider Sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders,” said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

A $650 million Sukuk issued by troubled Saudi group Saad, which is undergoing debt restructuring, for example is seen as an asset-based, rather than an asset-backed, Sukuk. Yields of the Sukuk jumped to above 70 percent in mid-June, as investors feared a default of the issue.

Most Sukuk are structured as asset-based instruments, rather than asset-backed securitization where “you always have a claim for that particular asset that has been sold to you as the investor”, said Megat Hizaini Hassan, an Islamic banking lawyer in Kuala Lumpur.

“Everybody is chasing the same assets if they have not been transferred to the name of the Sukuk holders,” said Samer Amro, senior associate at law firm Dewey LeBoef. Other uncertainties are likely to arise from Sukuk defaults, including a debate about how courts will interpret repurchase clauses which are structured to follow a controversial ruling by prominent jurist Sheikh Muhammad Taqi Usmani in late 2007. Taqi had ruled that repurchase guarantees found in most Sukuk contradict Islamic laws, as they violate the principle of sharing risks and returns.

“If you’re looking at the newer structures where the repurchase obligations are left to be determined at the time of repurchase, there may be some issues there,” said Megat Hizaini. “You don’t really know how the courts will treat it in the situation,” he said.

Islamic finance is governed by scholars’ rulings, national regulators and its own standard-settings bodies such as Bahrain-based AAOIFI, the Accounting and Auditing Organization for Islamic Financial Institutions.

“In the Middle East, it’s going to put to the test many of the legal protections that were originally built into the Sukuk,” said Mohammad Faiz Azmi, global Islamic finance leader at PriceWaterhouseCoopers, adding that countries in the region typically do not have bankruptcy laws as sophisticated as in Europe.

“When these Sukuk start to default, it would be very apparent which jurisdiction has a more robust system than others,” he said.

Corporates with perceived higher risks that are facing high borrowing costs and a sluggish regional IPO (initial public offering) market could use true Sukuk sales with full ownership transfers as an avenue to the capital markets.

“It adds some credit-enhancement, it adds credit-worthiness,” said Rizwan Khan, a senior associate at law firm Norton Rose.

But the paperwork involved in registering ownership transfers in the Gulf Arab region and restrictions on foreign ownership of land make true Sukuk sales difficult.

Issuers have to register the SPVs, to which asset ownership would have to be transferred, in Bahrain or the Cayman Islands, as regulatory frameworks in other Gulf countries like Saudi Arabia and Kuwait do not fully cover Sukuk structures. This turns the SPV into a foreign buyer, limiting the pool of assets.

“This is not going to change unless laws are enacted, in particular on the ownership issues,” Khan said.

Source: Reuters, Monday 20 July 2009 (27 Rajab 1430)


The article above highlights and proves how identical the Sukuk is with conventional bonds as most investors are not expected to have better legal redress than conventional bondholders as underlying assets have not been truly transferred to them. This will lead to Islamic bondholders not having any more legal safeguards than conventional counterparts in case of default because their structure is merely asset-based and not asset-backed where they have a claim for that particular asset that has been “sold” to them. To make it worse, the courts may regard the Sukukholders as mere creditors instead of equity holders.

A good way to address this issue is to ensure that future Sukuk issuances be done in the true Shariah spirit, especially when it comes to asset ownership. The transfer of assets in such transaction must not be done just for the purpose of making it “Shariah compliant”. In a Shariah based structure, the equity element is always present, the debt element comes later. It is not possible to structure a debt based Sukuk without having equity ownership first.

Sukuk

The Islamic Securities Guidelines (issued by the Securities Commission) defines Sukuk as: A document or certificate that represents the value of an asset; The Shariah Standard 17 under the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) applies Sukuk to Investment Products: Certificates of equal value representing, after closing of subscription, receipt of the value of the certificates and putting to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.

Sukuk

• Undivided beneficial ownership in the underlying assets, entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the Sukuk assets.
• Sukuk represent ownership in existing and/or well defined assets.
• Sale of a Sukuk represents a sale of a share of assets, business activity or project.
• The subject of the contract in Sukuk is a contract based on lease or a defined business undertaking between the Sukukholders and the originator.
• The underlying Sukuk assets, business or project must be Shariah compliant in nature.

Bond

• A contractual debt obligation, the issuer is required to pay interest and principal to bondholders on certain specified dates.
• Bonds represent pure debt on the issuer.
• Sale of a bond basically represents sale of a debt.
• Bonds basically create a Lender/Borrower relationship i.e. a contract whose subject is purely earning money on money.

Sukuks and Bonds are totally different instruments, serving different purpose, with different mechanics and goals. It would be erroneous to structure a Sukuk based on the conventional platform and norms. One must always look at structuring a Sukuk purely from the Islamic perspective and this includes contracts, legal documentations, pricing and the operational mechanics/modus operandi.

What are the factors that will make issuers and investors choose Sukuk over Bonds? From my observation, the decision is made mostly based on cost and price considerations. The attractiveness of Sukuk as compared to bonds in the Malaysian market is mainly due to the various incentives given by the authorities, especially tax exemptions/allowances. However, Sukuks are often structured to fit the conventional Bond model in the pursuit of mandates from clients.

Valuation:

Sukuk valuation at any point should be done based on market value; therefore both at issuance and dissolution, the Sukuk must reflect the market value of the underlying assets (except for Musharakah or Mudharabah where the value at issuance reflects the amount of equity injected into the venture). The same is true during an event of default and investors should expect to receive trhe market value of the asset and not a predetermined amount (principal) when a default occurs.

Role of the authorities:

The authorities that govern the financial markets play a very important and crucial role in developing the Sukuk market. Incentives should not stop at tax breaks but must also include providing the right platform for the Sukuk. Platform means the infrastructure, guidelines, rules and regulation, pricing and trading mechanism. Investor as well practitioners’ continuous education is of utmost importance, being a developing science,

Islamic banking faces new challenges and new developments all the time. Above all, the market, both the sell and buy sides must be fully aware of and understand what Sukuk and Islamic finance is all about. It is not about taking a conventional debt instrument; execute a few more legal documents and giving it an Arabic name.