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.