 | Gregory Man Senior Associate Clifford Chance LLP |
Since its debut on the international financial market, sukuk issuance has grown and developed significantly year on year. From a market worth less than U.S.$500 million in 2001 to one worth over U.S.$60 billion in 2007, the sukuk market experienced phenomenal growth between 2001 and 2007. Despite this growth, in 2008, the number of sukuk issued globally declined for the first time - this slowdown in the issuance of sukuk has been attributed to a number of different factors by commentators in the market, including the global financial turbulence and resulting market conditions.
The treatment of sukuk in a default scenario
Headlines relating to sukuk defaults by Kuwaiti firm The Investment Dar Company, the financial difficulties surrounding Saudi conglomerates the Saad and Algosaibi Groups and previous uncertainty around the repayment of sukuk by Dubai property developer Nakheel, have also led to investor uncertainty as to the treatment of sukuk in a default scenario. In particular, recent events may have left investors nervous as to whether they have a claim over the assets underlying the issuance or not and whether sukuk are more 'secure' than conventional bonds because they are backed by tangible assets. If there is a claim over the assets, investors could expect priority in realising their investment in a default scenario. However, if this is not the case, investors would be unsecured creditors in the bankruptcy of the obligor. This uncertainty may have arisen because a number of structural features are typically present in sukuk such that they are constructed on the foundations of tangible assets, for example, land, real estate or machinery and equipment.
So have some investors been misplaced in their belief that sukuk offer a more secure investment than conventional bonds?
Asset-based sukuk structures
To date, the issuers of sukuk and the financial experts who assist in selling such securities have tried to meet the requirements of Shari'a compliant investors who have sought a similar fixed income risk profile to a conventional bond based on the financial performance of a corporate entity with which they are familiar and in which they wish to invest. In the majority of unsecured sukuk transactions, although the investment is prima facie also an indirect investment in assets, ultimately the investors have no direct recourse to the assets themselves or any recourse is contractually restricted to selling the asset back to the obligor. Therefore, the repayment of the investment is ultimately dependent on the exercise of a purchase undertaking by the obligor of the assets at maturity or upon the occurrence of a default. Thus, as with a conventional bond, the investors take credit risk on the obligor who has granted the purchase undertaking. Whilst typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default. As a result, offering documents prepared for most sukuk transactions have very little disclosure (if any) in respect of the physical asset; instead, disclosure focuses principally on the balance sheet, business and risks of the obligor.
While Shari'a principles do require a transfer of control and risk (as well as reward) in relation to an asset from the seller to the investors, to date, the actual analysis as to whether a transfer of the asset is perfected and immune from the bankruptcy of the seller (a typical feature of conventional asset-backed securitisation) has not been a necessary feature of sukuk. That is because the majority of Shari'a compliant investors who currently make up the market appear to prefer taking risk on the corporate rather than taking true control of (and risk on) the assets, which would require detailed disclosure and analysis in the offering document of statistical data on the performance of the underlying assets.
Taking true asset risk - asset-backed sukuk structures
There are, however, Shari'a compliant structures in existence for an investor who wishes to have exposure to asset-risk and to have direct recourse to those assets as opposed to exposure to the credit risk of the particular obligor.
One conventional product that has attracted a great deal of attention over the last few years for its potential compatibility with Shari'a principles has been asset-backed securitisation. One of the cornerstones of the majority of conventional asset-backed securitisation transactions is a true-sale of assets. In order for the instruments ultimately evidencing an investment in an asset-backed transaction to achieve the appropriate credit rating, the transfer or sale of assets needs to be a sale which would survive the insolvency of the original owner (i.e. the assets are isolated from the bankrupt estate of the originator). This is only achievable to the extent that the transfer represents a true transfer of ownership which is legally perfected. Many market commentators describe this type of structure as the next stage of evolution for Islamic financial institutions, allowing financial institutions to move assets off their balance sheets as their asset books continue to grow relative to their capital base.
The Sun Finance Limited securitisation, a securitisation of proceeds derived from the sale of plots of land by Sorouh Real Estate P.J.S.C. on the Shams and Saraya Master Developments in Abu Dhabi, was one of the few Shari'a compliant sukuk to combine Shari'a principles with asset-backed securitisation. In this transaction, the desired credit rating on the instruments was achieved by ensuring that the credit analysis was dependent upon the performance of the pool of assets and not the corporate credit of the originator. In order to achieve the true transfer of ownership, the relevant plots of land which were the subject of the securitisation were sold by the originator to a newly established limited liability company in Abu Dhabi and the sale of such land was legally perfected by registering the land in the name of that company at the Abu Dhabi Lands Department. By perfecting the sale and structuring the transaction such that investors had exposure to the direct sale proceeds of the land, the rating of the sukuk was based on asset performance rather than the originator's credit-worthiness. The result is that the investors in the sukuk certificates have sole recourse to the securitised assets for the repayment of their investment. To the extent that the assets do not perform and generate insufficient profit, the investors do not receive the expected profit on their sukuk certificates. In this way, the transaction represents a fully asset-backed, Shari'a compliant, non-recourse financing.
Pre-requisites for the further development of asset-backed sukuk structures
Whilst Shari'a principles seem harmonious with the nature of asset-backed securitisation and the 2008 Sun Finance transaction demonstrates that the structuring exists to create this product, for asset-backed securitisation to become more widespread in the GCC, there will likely be three pre-requisites: firstly, investors will need to demonstrate a commercial desire to take the risk (and reward) associated with the true sale of assets in an asset-backed structure, including the management of those assets in a default scenario; secondly, those companies seeking finance will need to demonstrate a desire to sell their assets (which will have accounting and shareholder equity implications); and thirdly, a robust legal framework will need to evolve as, currently, bankruptcy and asset-selling laws in many jurisdictions in the GCC remain opaque and militate against securitisation structures.
Conclusion - where does the future of the sukuk market lie?
In conclusion, the question of whether or not sukuk offer a more secure investment than conventional bonds will depend on the way in which the sukuk has been structured. To the extent that a sukuk structure is asset-based, investors will be exposed to a similar risk profile to an investment in a conventional bond where they will ultimately be exposed to the credit risk of the underlying obligor. In a true asset-backed sukuk structure, the sole recourse of the investors will be to the performance of the underlying pool of assets which collateralises the sukuk.
While such asset-backed structures, which have removed the exposure to the credit risk of the originator, may have more widespread appeal given the recent tendency towards potential credit defaults by many well known corporates in the region and with transactions such as the Sun Finance transaction paving the way, the author believes that a more widespread movement towards fully asset-backed structures is unlikely in the nearer term as the pre-requisites for such a move highlighted earlier in this article would hinder such a development. It would appear that ultimately, investors are not prepared to take true asset risk and are still desirous of investing in a corporate credit with which they are familiar.
But equally, investors have also begun to demonstrate that they may be less willing to invest on the same unsecured basis or at least on the same commercial terms as they have previously done where they would be exposed purely to the credit risk of a particular underlying obligor.
The indications are therefore that the sukuk market may be moving towards a hybrid structure which lies somewhere between the current asset-based sukuk structures and true asset-backed transactions. Such structures would provide investors with recourse to both the corporate credit of the obligor which they desire as well as to the assets themselves to the extent that the obligor fails to fulfil its obligations, making for a much safer investment as a result of the dual recourse.
There is certainly precedent for similar transactions in the conventional "covered bond" industry. In covered bond transactions, investors have initial recourse to the corporate credit of the issuer of the covered bonds. However, to the extent that the issuer fails to fulfil its obligations, the investor will also have recourse to an earmarked pool of assets.
In these turbulent times, no one can say with any certainty what the future of the sukuk market will be. What has become clear is that investors have begun to scrutinise and attempt to better understand the true nature of their investments and the recourse which they are afforded. Furthermore, the Islamic finance industry has experienced increasing levels of development and innovation in recent times and there is no reason to believe that it will not continue to do so as it evolves to cater to the changing demands of the market.
Gregory Man
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