When is Sukuk not Islamic? Far too often it would appear, according to claims made in a recently published commentary on sovereign Sukuk issuance. But, says Robin Amlot, authors Shazhad Siddiqui and Parvez Daruwalla also offer constructive proposals for the way forward.
In Sovereign Sukuk: reconsideration, realignment and the end of Shari'a arbitrage?, Shazhad Siddiqui and Parvez Daruwalla review the intrinsic nature of a Sukuk and its application particularly in the sovereign Sukuk market. The authors provide a critical review of existing practices and provide a framework for the market to adhere to the letter and the spirit of the fundamentals of Islamic finance.
The first sovereign Sukuk issuance was the Government Investment Certificates issued by the Malaysian Government in 1983. However, with no real infrastructure and a lack of transparency in the 1980s there were no major developments in the Sukuk markets. It was the success of securitisation in conventional markets that provided a framework and a real impetus to successful asset-backed structures in Bahrain and Malaysia in
the late 1990s.
Siddiqui and Daruwalla begin by reviewing the different types of Sukuk. While a typical Sukuk issue will involve the establishment of a special purpose vehicle (SPV) which issues the Sukuk and invests the proceeds, there are a variety of types of Sukuk that have been used to create a bond-like security.
In discussing Murabaha Sukuk, the authors note that the liberal interpretation of Islamic jurisprudence in Malaysia, with respect to bill discounting, has generated a lot of activity in Murabaha Sukuk, going on to say, "Malaysian investment bankers have further disaggregated the instrument separating the cost (principal) and profit (interest component, similar to stripping conventional bonds). The Malaysian practice has not been found acceptable in other parts of the Muslim world."
By contrast, Ijarah Sukuk are most commonly issued in the Middle East. However, as Siddiqui and Daruwalla also point out these "have garnered their fair share of controversy".
"One of the most contentious issues revolves around the guarantee of principal repayment to Sukuk holders at the end of the term. This is typically achieved by an asset repurchase by the lessee at the original sale price from the SPV (bullet structure) or as a gift of the asset to the lessee by the SPV (amortising structure) at the end of the term of the Sukuk. The glaring similarities between a conventional bond and an Ijarah Sukuk have led to the questioning of the Shari'ah compliance and validity of the transaction."
In fact, as we all now know there has been a wholesale rethink on the validity of such transactions by AAOIFI. However, notwithstanding this, the Ijarah Sukuk market has been active, notably in the sovereign space. "Issuers, mostly from the Islamic world, have 'jumped on the bandwagon' and provided structures that resemble conventional bonds in substance while adopting components of Islamic finance in attenuated form." The authors give detailed examples of such Sukuk.
The report goes on to discuss Wakala Sukuk, providing further case studies and also briefly reviews Salam Sukuk.
Different but still the same?
A summary of the factors differentiating Sukuk and conventional bonds is followed by a rather more detailed, perhaps depressingly more detailed review of how Sukuk and conventional bonds are rather too similar, entitled 'Elements of Riba, Gharar, Qimar, Maysir and lack of Qabd in existing Sukuk structures'. In fact the report claims to identify a unanimous consensus on the attributes of Riba and then points out that all of these attributes may be found in almost all sovereign Sukuk!
"Several Sukuk provide fixed income payments without a true sale of the Sukuk assets to the investors; there is merely artifice in the form of a trust sale, the legal implications of which will be increasingly litigated in courts worldwide. Moreover, there is a provision for accrual of fixed payments if income is not sufficient for payment of distribution on designated dates.
"Then there is the matter of interest benchmarking. While the majority of Shari'ah scholars have allowed benchmarking of profit to prevailing interest rates such as LIBOR (the London Interbank Offered Rate), no scholar will obviously allow the direct payment of interest to a Sukuk holder. However, the fine line between form and substance appears to have confused some market participants."
With regard to purchase undertakings (in the form of Wa'd) Siddiqui and Daruwalla suggest that AAOIFI's statements are ambiguous, claiming that sovereign issues have used the organisation's ruling to justify repurchases at nominal value (if nominal is used as face value) for Ijarah Sukuk. "This ruling violates the fundamental concept of risk sharing, particularly with respect to assets that fluctuate in value."
The report goes on to say that many of the Sukuk examples it cites "are clearly not asset-backed but rather asset-based". It says, "The assets play a ceremonial role in masking the undertaking of unsecured obligations in conventional markets."
Call in the lawyers
Sukuk documentation invariably mentions legal risks attached to the proposed transaction. In several of the offerings discussed, there are often detailed provisions regarding enforceability of rights under a Sukuk, waiver of sovereign immunity by a sovereign issuer or its affiliate companies and risks flowing from bankruptcy."
A detailed discussion of the circumstances surrounding the Nakheel/Dubai World debacle and the events that followed is used to highlight questions that arose regarding the potential enforceability against Sukuk assets or issuers. The authors believe that, "Sukuk issuers, sovereigns and regulators must clarify critical issues pertaining to enforceability to facilitate the growth of Sukuk, especially in times of default and use their significant resources to bring the whole industry into greater compliance with the letter and spirit of Shari'ah".
As the report points out and recent events in the courts have already brought home (see Islamic Business & Finance, April 2010, p.18), "There is an element of Gharar that arises when the very issuer of Sukuk is disclaiming the Shari'ah compliance of an offering labeled 'Sukuk'."
The way forward
Sukuk issuance in the Middle East has been overshadowed by conventional bond issuance. The Islamic bond market was 'tested' for the first time. It has been suggested that government intervention and the recovery seen in the oil price since its lows in the first quarter of 2009 may assist in the recovery of the Sukuk market. However, Siddiqui and Daruwalla argue that, "The only true path to recovery is a wholesale return to the core principle that there must be a true sale of assets on the issuance of Sukuk. This will assist in the effort to convince investors about the soundness and integrity of Sukuk structures and provide a greater measure of certainty regarding treatment of Sukuk in the event of default or bankruptcy.
Sukuk represent the ownership of assets in an investment pool. Such a pool may, of course, invest in any of the contracts deemed acceptable by Islamic jurisprudence. Therefore, say the authors, "Debt-based Sukuk such as Murabaha and Salam Sukuk should conform to the set of rules (restriction of trading in debt and short selling) established for such contracts by jurists through centuries of scholarship. Similarly, equity-based Sukuk such as Ijarah, Musharakah and Mudaraba Sukuk should conform to the core principle of profit-and-loss risk sharing."
However, Siddiqui and Daruwalla are not simply concerned to point out the shortcomings of Sukuk structure, they also offer an outline of an ideal sovereign Sukuk structure which captures the reasonable certainty (not guarantee) of periodic payments via rental payments and the uncertain component of profit-and-loss sharing. The example put forward is based on the Ijarah structure because, "It is, by all accounts, the structure of choice of sovereign Sukuk issuers worldwide."
Parvez Daruwalla is presently a Manager, Pooled Investments with the Ontario Financing Authority in Toronto. Shahzad Siddiqui is a Toronto-based lawyer and investment banker. Sovereign Sukuk: reconsideration, realignment and the end of Shari'a arbitrage? is published by Euromoney Books as an e-book only. It is available from the EuromoneyBooks website, price $298.
© Islamic Business and Finance 2010
