Islamic Finance Resists Equity Shift, May Stunt Growth

Shariah finance has been labelled “copycat” for its reliance on debt funding

Reuters – KUALA LUMPUR, April 27 — When Kuwait Finance House Malaysia helped develop a US$1.3 billion (RM4.1 billion) real estate project in the country in 2005 as a partner in the deal, Islamic equity property ventures were a rarity.

Five years on, the bank is embarking on its fourth building project using a similar equity concept but few others in the industry want to follow the same path, reflecting Islamic finance’s slow and difficult shift away from debt instruments.

Debt funding’s dominance of Shariah finance has earned the US$1 trillion industry the tag of “copycat” and limited its growth as critics question its ability to offer a fairer way of sharing risks and rewards that truly distinguishes it from conventional banking.

“Profit-sharing or equity structures are the true way of doing Islamic financing,” said Siti Mariam Mohd Desa, Kuwait Finance Malaysia’s real estate advisory director.

“It is a different concept because if you were to give out straight loans, you may as well go to a conventional bank.”

As the global financial system emerges from the debt crisis and banks shy away from assuming added risks, practitioners want Islamic finance to rely more on partnership structures and less on straight financing which they say has created a brand of finance which is Shariah compliant in form, but not in spirit.

They say equity financing such as musharaka and mudaraba are closer to the Shariah’s aim of ensuring gains and losses are shared equitably and a shift back to it would help banks win new business beyond its traditional markets.

While Islamic finance has flourished in Muslim markets such as the Middle East and Malaysia, many non-Muslims are unconvinced, saying the industry differs from conventional banking only in name.

“We cannot add value in markets which are mimics of conventional markets. At the moment, it’s difficult to see the value-added,” said Safdar Alam, head of Islamic structuring at JP Morgan in Bahrain.

“It’s a real opportunity, with the increased awareness globally of Islamic finance, to demonstrate this value and the difference and benefits. This is a chance that we might miss if we don’t do this well quite quickly.”

But banks’ reluctance to bear the risk of projects funded, companies’ unwillingness to share profits and scarcity of banking capital make equity financing an unappealing proposition.

The recent property slump in the Gulf, where equity financing is more common, badly hit Islamic firms such as Bahrain’s Gulf Finance House and could compound banks’ fears of becoming project partners.

Kuwait Finance Malaysia, which uses the musharaka equity structure to develop real estate, had a non-performing financing level of 6.73 per cent in September, more than thrice the industry average.

Its parent Kuwait Finance House, the Gulf state’s top Islamic bank, posted a 24 per cent drop in net profit in 2009 to 118.74 million dinars.

Equity financing models were born out of a belief in Islam that the financier must share the risks if he wants the rewards and that profits should be earned through enterprise.

While equity funding is commonly associated with higher returns, bankers say it may not necessarily be more profitable than debt as the latter allows for higher leverage.

Traditionally, popular Islamic debt-based instruments such as istisna and murabaha have been likened to interest-based loans where banks take limited risks and are guaranteed a return.

But as Islamic finance grew beyond traditional roles such as agriculture financing to funding government budgets and billion dollar real estate projects, some banks began leaning more towards debt instruments to limit their risks.

As banks’ capital grows scarce, they will be wary of parting with large sums to back equity ventures, said Mohammad Faiz Azmi, PriceWaterhouseCoopers’s global Islamic finance leader.

“On the demand side, the issue are is there enough corporates who are essentially willing to give up the upside?” Faiz said, referring to profit-sharing structures.

“The reality is that the people that would want to have equity forms of financing are usually the ones that you want to avoid lending money to anyway.”

Some practitioners say the push for more Islamic equity financing is ill-conceived.

“From the shariah’s perspective, there is no such evidence to support (the view) that Islamic banks or whoever wants to do business should do profit-sharing more than debt-based,” said Shariah scholar Aznan Hasan, who advises Barclays Capital London and Malaysia’s stock exchange operator Bursa Malaysia.

“Whether it is debt or equity that suits you better, it depends on commercial and business decisions, not Shariah matters.” — Reuters

Mudharabah and Musharakah are NOT Debt Contracts. Get it?

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively last year.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers, they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

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?

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.

Asset Based vs. Asset Backed

A brief definition of the two forms of financing:

Asset Based:
Methods of financing in which investors look to the cash flow from an asset or a pool of assets for a return on, and the return of their investment.

Asset Backed:
A term used to describe a security which is backed or secured by a pool of assets such as leases or receivables, but not real estate. The security shall be serviced by the cash flow derived from the pool of assets.


Given the definitions, which would be the preferred structure for Shariah based financing?

The important thing to consider is the ownership of the (real) asset and not just the rights to the earnings or cash flow. For example, an Ijarah structure requires full ownership before one can lease out and earn lease rental from an asset. Therefore, in order to make it comply with Shariah, the structure must define the ownership of the asset as well as the rights and responsibilities of the owners and the counterparties.

There is nothing wrong with a security that derives its cashflow or income from a pool of assets. But in a partnership based structure, the rights to income from an asset is derived from the ownership of the asset and full ownership means legal ownership and not merely beneficial ownership. There must be a true sale of the assets and not merely an artificial beneficial sale.

Whether we call it asset based or asset backed, we must ensure that the assets and the rights associated with ownership belong to the rightful parties.