Distress resolution in Islamic finance

Sukuk are based on specific contracts borrowed from Islamic modes of financing. Islamic strictures require investors to share risks with the entrepreneurs they finance. Sukuk (Islamic securities) come mostly in two varieties, musharakah (basically a joint venture agreement) and ijarah (more like an operational lease agreement). Yet defaults did happen, even in the case of musharakah Sukuk discussed in this study. So is Islamic finance failing to deliver on its promises?

 We analyze four major defaults on sukuk that have happened since 2007. These case studies make clear that most problems can be traced back to clauses and structures that made the Sukuk more like conventional bonds. Furthermore, once default happened, most of the Sukuk discussed did not transfer the underlying assets to the Sukuk holders. So, in the event of default, due to limited recourse provisions, Sukuk holders often had no collateral to resort to.

The case studies highlight the importance of the legal institutions of the country where the collateral is likely to be contested. Interestingly enough, strict adherence to Shariah principles would have considerably simplified restructuring because Shariah compliance implies a clear allocation of property rights: in Sukuk, investors will receive full title to the underlying sukuk assets in distress situations. So the answer to the question 'is Islamic Finance failing to deliver on its promises?' is a qualified no.

Sukuk Mechanism

In ijarah sukuk the originator establishes a special purpose vehicle (SPV), generally a trust, incorporated as an offshore company.  Subsequently, the SPV purchases assets from the originator, and funds this transaction with the proceeds raised through issuing trust certificates (sukuk). Then the assets of the originator are transferred to the SPV which holds these assets as a trustee for Sukuk investors following a declaration of trust. 

Next, through a lease agreement, the same assets are leased back to the originator, being the lessee, on which periodic rent is paid by the lessee to the Sukuk holders through the SPV. There is generally a repurchase undertaking by the originator according to which the originator is obliged to buy the assets back from the SPV on maturity of Sukuk or upon an event of insolvency, at the market/fair price or at a price on which both parties agree at the time of (re)purchase.[1] The repurchase agreement is independent of the main Sukuk agreement. The process enables Sukuk redemption and reimbursement of the amount to the Sukuk holders.

In musharakah (joint venture/co-ownership) sukuk joint venture is established between the SPV and the originator in which the originator also contributes through investing funds/assets into musharakah through an SPV. Accordingly musharakah assets, jointly owned by the SPV and the originator, are invested in some business and the periodic streams of income generated by these assets are shared between the Sukuk holders and the originator according to a pre-specified ratio. The loss is borne by the partners proportional to their investments.

Distress situations and Restructuring

Under Islamic law, if a debtor defaults due to "natural factors" s/he should be given the opportunity to pay the debt when possible. Also if the debtor is not able to repay at all, the lender is encouraged to write off the debt. But if the loan is backed by assets as security, the debt can be liquidated to recover the principal amount. In the case of asset-backed ijarah and musharakah Sukuk, the certificate holders have recourse to the underlying assets in the event of default provided that all the legal arrangements required to become a genuine owner of the assets are put in place. Apart from the risk of capital loss and/or default on rental payments, there are other risks involved in acquiring complete recourse to the Sukuk assets namely: legal risks and risks related to the enforceability of the court ruling.

Prime sukuk defaults

Consequences in the event of default have not received much attention in most of the sukuk offering letters, nor from scholars of Shariah (Islamic law) who initially approved the product. The first sukuk default occurred on 16 October 2008 when East Cameron Partners (ECP), a US oil and gas company, filed for bankruptcy protection under chapter 11 of the US Bankruptcy code, claiming its inability to pay the periodic returns on its USD166 million sukuk issued in June 2006.

Subsequently, the first sukuk default in the Gulf region occurred on 12 May 2009 when Investment Dar, a Kuwaiti Islamic investment company, declared its failure to pay biannual return on its USD100 million sukuk. Just a few weeks later, Saad Group, a Saudi conglomerate, failed to pay periodic rental payments on its USD650 million sukuk, issued in 2007. Next, in the last week of November 2009, the Government of Dubai announced a standstill for six months for all its debts, including the largest Nahkeel sukuk of USD3.5 billion just  few weeks before sukuk maturity. The default was prevented eleventh hour by the Abu Dhabi government through a USD10 billion bailout package. Several issues emerged following the defaults.

Critical Issues [the italicized headlines under this one are subheadlines of this, so different font or size]Governing Law and the enforceability of Foreign Courts' Ruling in cross-border contracts

Although designed to comply with Shariah, sukuk were in practice governed by English law[SO1] , because some concepts--like SPVs, commonly used in conventional financing--do not give the same rights to investors in some GCC jurisdictions following civil law. This has created problems for sukuk issuance in jurisdictions like Bahrain and UAE. In some states non-recognition of a SPV may render contracts void.[2] Particularly, the investors' right of recourse to underlying sukuk assets, in the event of default proposed in the offering circulars, then becomes ambiguous. There may be conflicts with Islamic law in some contract clauses of contracts governed by English law. Several recent rulings of English courts clarify that in case of any contradiction between Islamic law and English law, the latter would prevail.

Ownership of the Sukuk Trust Assets: are the contracts bankruptcy proof?

For sukuk to be Shariah compliant, Sukuk holders must have the ownership of the underlying real assets. However, the GCC-originating sukuk do not fulfill this requirement as the ownership of the underlying assets was not transferred to the Sukuk holders properly.

The only instance in which the ownership of the underlying assets was in fact transferred to the sukuk investors in a bankruptcy-proof manner was in the case of the US-based ECP sukuk. In that case, the investors' rights were protected through the courts.

Residual risk and Repurchase Undertakings as part of Sukuk

Shariah principles do not allow an agreement to repurchase sukuk at face value (repo) upon maturity, as this arrangement renders Sukuk identical to conventional bonds which are not  permissible under Islamic law.  Because of this, credit risk became an issue for all of the Sukuk amount plus outstanding rentals in case of ijarah sukuk. Similarly, in musharakah sukuk, equity of the sukuk is transformed into debt but residual risk remains for the full amounts issued because of the stricture against repurchase agreements at fixed prices. 

 Credit Enhancement

Credit enhancement is a technique through which the borrower increases its credit worthiness or at least the credit standing of the debt issued in order to achieve better subscription, credit rating and pricing of the loan. Credit enhancement usually takes place through external guarantees, insurance and/or provision of collateral. In musharakah sukuk, it is not permissible for the manager of Sukuk acting as partner in musharakah to undertake to offer loan contracts with guaranteed returns. When actual earnings fall short of expected earnings, investors are obliged to share profit and loss with the originator. However, a reserve account can be established to cover (part of) the shortfall in expected earnings.

Limited Recourse

There is thus far only limited recourse to sukuk's underlying assets in the GCC region. This means that sukuk represents beneficial ownership rights only in the trust assets, and the sukuk investors have no recourse to the originator's assets nor the creditors of the originators have rights on the sukuk assets. To have recourse to the trust assets, ownership of the assets should have been transferred to the SPV, acting as trustee of the sukuk holders. This was not done in the sukuk issued in GCC region.

Role of the Shariah Boards

Apparently, while deciding the Shariah compliance of underlying sukuk structures, administrative and procedural issues were generally overlooked by the Shariah boards, especially in GCC originated sukuk[SO2] .  For instance, lawful transfer of the ownership of sukuk assets to sukuk holders; the status of the trust entity in concerned jurisdiction; and earning capacity of the underlying Sukuk assets to generate returns offered in Sukuk documents, were all ignored by Shariah boards, with adverse implications when the sukuk issuers defaulted.

In practice, the transfer of the ownership of the underlying Sukuk assets was not accomplished legally in any of the three GCC-based cases. Research by Hayat, Butter and Koch (2012), show that around twenty Shariah scholars hold more than half of the market, and the top three receive about USD4.5 million as fees annually; so this market is beset by the same incentive conflicts that we have seen in the case of regular rating agencies in Western finance: a strong incentive to be excessively lenient in certification, i.e. a conflict of interest problem, sub-standard governance practices, lack of consensus regarding certification standards, and added to that in the case of the Shariah boards: a limited knowledge of finance.

Conclusions

Islamic finance instruments occupy a rapidly growing niche in world capital markets and have been presented as an alternative to interest based conventional bonds. They are often seen as asset-backed securities free of interest, and meeting the criteria of Islamic finance. Issued by Islamic and non-Islamic entities alike, sukuk promises access to a large pool of capital in the Islamic world while eliminating some of the high risk taking incentives characteristic of more conventional financial instruments.

But mishaps have happened and resolutions have been more mired in controversy than expected. Our study shows however that strict compliance to Shariah principles of ownership and risk-sharing would have both reduced the incidence of defaults and facilitated restructuring[SO3] , as in particular the history of the ECP sukuk demonstrates.

The asset-backed structure of sukuk accompanied with a ban on derivatives and sale of debt can thus potentially make the world a less risky place.  However, the experience of these four default episodes discussed suggests that benefits in accessing a wider investor base can only be achieved if the sukuk follow the rules prescribed by Islamic jurisprudence strictly. These principles need Sukuk to be asset-backed and free of interest.

Also, sukuk and all the legal constructs that form part of the arrangement should be recognized in the law of the jurisdiction concerned. Eligibility of sukuk for secondary market trading (now only permitted in Malaysia and Indonesia) would make them more liquid. Furthermore, the case studies show the damaging impact of ambiguity concerning Shariah compliance. Both the transparency of sukuk and the resolution of distress situations would benefit from further standardization. Increased codification of the requirements Shariah compliance implies, and a further professionalization of the Boards that decide on compliance would increase acceptance of Islamic Finance in global capital markets, and unlock the growing pool of capital in Islamic countries.

About: Sajjad and Sweder researched this report at the University of Amsterdam, and Sweder at Tinbergen Institute. For a full length version of this paper including extensive references, see S. van Wijnbergen, S. Zaheer, Tinbergen Institute Working Paper 2013-087 with the same title. The researchers can be reached at s.zaheer@uva.nl and s.j.g.vanwijnbergen@uva.nl 

© Business Islamica 2013