Adrian Dommisse and Wasif Kazi from Fitch Ratings tackle some of the issues posed in securitisation in an Islamic environment. This is the second part of a two-part review. The first part was published last month.
Non-consolidation
Where a parent company rather than an orphan SPV structure is adopted in a jurisdiction which permits the consolidation of the assets and liabilities of related companies upon a bankruptcy or insolvency, the local legal opinion should confirm that creditors of the parent company will not be able to reach the assets of the SPV through a consolidated bankruptcy or insolvency process.
Bankruptcy remoteness of the issuing vehicle
In many jurisdictions, the commencement of bankruptcy or insolvency proceedings against a company incorporated in that jurisdiction (including an SPV) will usually cause the assets of the insolvent company to be distributed according to an order of priority imposed mandatorily by law or by a court order, rather than in the order contractually agreed by and among the company's creditors. Although secured creditors may still have a prior-ranking claim to the proceeds of a liquidation of the company's assets, many jurisdictions will impose a stay or moratorium on secured creditors' enforcement of their rights during the continuation of bankruptcy or insolvency proceedings. This leads to inevitable recovery delays. In addition, in some jurisdictions, the realisation of collateral may follow a procedure controlled by the courts rather than the creditors with an interest in the collateral.
Accordingly, the principal purpose of using a bankruptcy-remote SPV in a securitisation transaction is to make the initiation of bankruptcy or insolvency proceedings unlikely. This, therefore, minimises the risk that the assets of the SPV will be distributed other than in accordance with the pre-defined, contractually binding order of priority agreed in the transaction documents. When assessing the bankruptcy remoteness of an SPV, Fitch would, as a starting point, expect certain considerations to be dealt with, as detailed below.
- The SPV's purpose should be limited to transaction-related activities only. The vehicle should generally not have any employees, own any land, be permitted to incur indebtedness to third-party creditors or otherwise engage in activities that may cause it to have creditors outside the securitisation transaction. These restrictions should be effected by: (a) limiting the SPV's purpose in its constitutional documents, if permitted in the relevant jurisdiction; and incorporating into the transaction documents covenants from the SPV that restrict its business activities as described above.
- All transaction documents should contain non-petition clauses whereby all transaction creditors, including the originator, the investors, any liquidity or credit enhancement providers, swap providers and any other parties to the transaction, agree not to initiate any bankruptcy or insolvency proceedings against the SPV while there are notes outstanding, and for the appropriate "suspect period" (plus one day) thereafter.
- All transaction documents should include limited-recourse clauses whereby all transaction creditors agree that the liability of the SPV to pay any principal and interest claims will be made only from the proceeds of the securitised assets and any facilities available for this purpose, such as credit enhancement. Furthermore, the documents should stipulate that these funds are payable only in accordance with the priority of payments. It should be unambiguous that once those proceeds have been fully realised and applied in accordance with the priority of payments, the SPV's obligation to all remaining transaction creditors will be extinguished.
- If permitted in the relevant jurisdiction, the SPV's constitutional documents should contain restrictions on the shareholders' ability to initiate voluntary bankruptcy or insolvency proceedings, and/or the transaction documents should include covenants from the SPV not to enter into such proceedings. This will be of particular importance where a parent company structure is adopted.
Fitch has not, to date, seen any legal opinion confirming that non-petition or limited-recourse clauses are enforceable in a Shari'ah jurisdiction. The agency would specifically expect the legal opinion to address whether a waiver of a right to claim relief against a party is valid prior to the accrual of that right.
The legal opinion should also address whether any purpose limitations included in the constitutional documents of the SPV would be binding on third parties who deal with the SPV in good faith and without notice. In addition, it should address whether any limitations on the ability of the SPV's shareholders to initiate voluntary bankruptcy or insolvency proceedings would be enforceable.
The security structure
In any securitisation structure, it is critical for investors to have the benefit of first-priority security interests over the collateral (subject to creditors who are mandatorily preferred by law). Moreover, such security interests must be perfected in accordance with all applicable laws. The concept of a security interest is not recognised by Shari'ah law in a manner entirely consistent with the understanding in Western jurisdictions. Accordingly, Fitch will expect the legal opinion to address the nature of the security interests created under the transaction documents. The opinion should also address enforceability against third parties (including the originator, any insolvency official of the originator and any creditors) and any perfection requirements, such as the registration mechanisms or other recording required to achieve this. Similarly, an opinion should explain the effectiveness and priority of the security interests in the event of bankruptcy or insolvency proceedings against the SPV. To date, Fitch has not seen a legal opinion that adequately addresses these issues in respect of a Shari'ah jurisdiction.
Enforceability of transaction documents
Although Fitch recognises that some level of legal uncertainty is inevitably present in securitisations worldwide, a base level of certainty about legal outcomes is fundamental to the agency's ability to assign a securitisation rating. To assist it in reaching the conclusion that sufficient legal certainty exists in the relevant jurisdiction, Fitch will expect legal opinions to confirm that the transaction documents are valid, binding and enforceable in accordance with all applicable laws, without broad qualifications that materially affect the strength of the opinion.
To date, Fitch has not seen a legal opinion in respect of a Shari'ah jurisdiction that meets the above standard. In the agency's experience, opinions received for Shari'ah jurisdictions qualify their opinion that the courts or other adjudicative authorities in the relevant jurisdiction would enforce the transaction documents in accordance with their terms with broad qualifications such as those detailed below.
- Shari'ah law by its very origin and nature often takes the form of general principles; this necessarily leaves the courts or other adjudicative authorities of the relevant jurisdiction with considerable discretion both as to the interpretation of a particular Shari'ah law precept and the manner in which it should be applied in the context of a particular transaction or set of circumstances.
- There are at least four different schools of Islamic jurisprudence, each of which may interpret Shari'ah precepts differently. Although one school typically predominates in a particular jurisdiction, it is possible that the courts or other adjudicative authorities in that jurisdiction may apply the precepts of another school if it is considered appropriate in relation to a particular matter. Additionally, it is not uncommon for differing views to exist on particular issues within each school of jurisprudence. Decisions of courts or other adjudicative authorities in Shari'ah jurisdictions are often not recorded and, even if recorded, are generally not considered to establish a binding precedent for later decisions.
Some opinions reviewed by Fitch have gone so far as to state that a court or adjudicative authority in the relevant jurisdiction has the discretion to enforce a contract other than in accordance with its terms, or to reject enforcement where it would, in the opinion of the court or the adjudicative authority, be inequitable or unfair under Shari'ah precepts.
The above discussion does not imply that securitisation ratings cannot be assigned in a jurisdiction that vests discretion in its judiciary. For example, the courts of England and other common-law countries will, in any exercise of their equitable jurisdiction, be vested with certain discretion in the application of equitable principles. However, as indicated above, it appears that the discretion vested in courts and adjudicative authorities in Shari'ah jurisdictions is often far broader than is typical in many Western jurisdictions.
When this legal uncertainty is viewed in the context of a legal system that may not recognise certain key legal characteristics on which a securitisation rating ultimately rests, it may be difficult for Fitch to derive sufficient comfort that the collateral underlying a securitisation will be available to the investors in a distress situation.
Specific enforceability issues
In light of the express prohibition on the charging and payment of interest under Shari'ah law, the local legal opinion should confirm that any payments in the nature of interest (whether structured as commissions, service charges, and profit shares or otherwise) contemplated within the transaction are themselves enforceable. Alternatively, to the extent that they relate entirely to the off-shore elements of a transaction, the legal opinion should confirm that the arrangements are compliant with Shari'ah precepts.
Another issue raised by legal opinions reviewed by Fitch is whether remedies exercisable under transaction documents upon the occurrence of an event of default other than a payment default are consistent with Shari'ah precepts. Fitch has not yet seen a clean legal opinion on this issue. Consequently, it is uncertain whether definitions of events of default, such as those relating to breaches of collateral-based triggers or other covenants, are capable of supporting an enforcement of security. This is potentially significant, since early-warning devices such as collateral-based triggers that are designed to pre-empt asset deterioration and allow for accelerated repayment of investors are important aspects of any securitisation structure.
Choice of law and enforcement of judgments
The legal opinions should confirm that the law chosen to govern each aspect of the transaction would be upheld by the courts or adjudicative authorities of the chosen jurisdiction, the jurisdiction of incorporation of the parties and the jurisdiction in which the collateral is located.
Foreign judgments or arbitration awards in Shari'ah jurisdictions will typically be enforced only if they do not contain anything which contravenes Shari'ah law and subject to certain other jurisdiction-specific considerations. These may include whether a judgment issued by a court in the Shari'ah jurisdiction would be recognised and enforced in the relevant foreign jurisdiction.
Accordingly, it may not be sufficient to structure a securitisation with an off-shore issuing SPV and selecting a foreign governing law (such as English law or New York law) to govern the key contractual relationships between the parties. This, in itself, will not address all Shari'ah law risks where the collateral is located in a Shari'ah jurisdiction and enforcement against the collateral and its proceeds ultimately relies on the courts or other adjudicative authorities in that jurisdiction recognising and giving effect to the foreign law judgment.
Tax
Since the use of SPVs for financing transactions in Shari'ah jurisdictions is relatively new, the tax classification and absolute tax obligation of an SPV may be uncertain. In such jurisdictions, this issue should be addressed by a tax directive from the appropriate authority, or an opinion by reputable tax consultants. To date, Fitch has not received sufficient comfort on these tax issues for any proposed transaction in a Shari'ah jurisdiction.
Fitch's current position summarised and potential resolutions
Fitch believes that Shari'ah law opinions may not support securitisation ratings that rely upon the interpretation or enforcement of investors' rights by a Shari'ah court. This applies both where the chosen law is Shari'ah law, and where another law is chosen but an eventual court order or arbitration award must be executed against collateral assets located in a Shari'ah jurisdiction.
Solution: A full wrap by a financial guarantor?
Where transactions do not rely upon these legal opinions, securitisation may be possible. This can be accomplished through the use of a guarantor, even one that is located within the Shari'ah jurisdiction. If this is the case, Fitch would focus on factors such as:
- The systemic importance of the guarantor entity and its credit reputation to the country's economy and, in particular, its banking system;
- The importance of such transactions to a relevant sovereign's financial system, as an incentive for the government to support the entity in honouring its transaction obligations;
- The importance of this type of financing for the Islamic banking community;
- The guarantor's credit rating, as a measure of its desire to protect its international credit reputation; and
- Whether the relative size of the transaction obligation compared with the entity's total assets does not represents a concern in terms of the entity's rating.
On the basis of the above initial analysis, Fitch would determine the likelihood of noteholders having to enforce a claim against the guarantor entity in a rating stress scenario consistent with that entity's rating. In these circumstances, the rating of the guarantor would cap the rating of the securitisation.
This was the case in the Fitch-rated Solidarity Trust Services Ltd. transaction, which securitised loan-type assets originated by means of Shari'ah-compliant financing techniques, namely Ijarah, Morabaha and Istisna'a contracts. In that transaction, the IDB provides an unconditional and irrevocable financial guarantee for the full maturity value of the notes, whose terms are governed by English law and whose chosen jurisdiction is England. Fitch rates the transaction 'AA', based on its 'AA' rating of the IDB. The IDB also provided a liquidity facility covering any timing mismatches between the underlying assets and the note obligations. The rating did not assume the true sale of the underlying assets to the transaction SPV. Because of the guarantee, however, the rating does not rely upon a Shari'ah jurisdiction upholding an order by an English court, the validity of the true sale and other relevant legal issues.
The rating process would further include:
1. A review of the transaction documents. In this regard, the guarantee document should include a clear obligation by the guarantor to pay the Issuer;
2. A pronouncement by a Shari'ah board that the transaction is Shari'ah compliant; and
3. A review by Fitch and its independent counsel of appropriate legal opinions confirming that the transaction documents are legal, valid, binding and enforceable under the chosen law.
Analysis of asset risk
The solution discussed above, and seen in prior transactions, presupposes that the guarantor entity assumes the full asset risk. Fitch would, of course, undertake an analysis of the asset risk if requested; however, it should be clear to the agency that the guarantee will fully cover any cash shortfalls.
Alternatively, the structure should demonstrate that investors would receive the cash flow from performing assets despite the agency's concerns about Shari'ah law's treatment of their claims. It should also show that any asset risk is covered by a source of credit enhancement that is isolated from the Shari'ah jurisdiction.
Conclusion
Securitisation opportunities abound in countries with Shari'ah legal and financial systems. For certain Arab states, export finance in respect of oil and petrochemicals is an obvious area. Bank assets also afford opportunities, although certain banks may have access to low-cost funding where their depositors opt for interest-free deposits to be compliant with Shari'ah. Some countries may have a large number of nationals working abroad, offering the prospect of worker remittance securitisations.
These candidate assets are complemented by the favourable economic standing of many Islamic sovereigns, which may be capable of supporting investment-grade ratings.
As explained in this article, though, Shari'ah jurisdictions may face challenges in providing sufficient legal certainty to support securitisation ratings. Unless the transactions are structured to adequately address the legal considerations discussed above, Fitch may be unable to form an opinion on the enforceability of an investor's rights to the underlying collateral. However, structures may indeed be able to resolve these challenges where, for example, an appropriate entity guarantees payment to the Issuer. The agency looks forward to further developments in the securitisation of assets based in Shari'ah jurisdictions.
This report has been drafted in conjunction with the law firm Gide Loyrette Nouel.
© Banker Middle East 2005
