Bilal Aquil from Clyde & Co. in Dubai gives an expert insight on Sukuk from a legal perspective
Current Sukuk issuance is at approximately $10 billion. Almost every month there is a new Sukuk issue which purports to be financially the largest issue in history, only to be superseded by another Sukuk issue. Recent Sukuk issues have been oversubscribed and in some cases by 150% which illustrates the potential of this instrument.
Sukuk is commonly described as an 'Islamic bond'. However, this is a very general analogy, and it would be better described as Islamic investment certificates (Sukuk certificate) which represents an undivided beneficial ownership of an underlying asset. It is important to make this distinction as it is not an alternative to an interest based security. Sukuk allows Islamic institutions to invest in compliance with the Shari'ah (Islamic law), which means avoiding payment and receipt of riba (interest or making unjust enrichments), avoiding gharar (gambling or speculating future outcomes) and not investing in haram (forbidden) businesses. The Shari'ah encourages trade and making a lawful return on capital if the capital provider is prepared to share the risks in the business venture. Other Islamic prohibitions include the trading of debt contracts at a discount and forward foreign exchange transactions (which involves risk and speculation). The structure of each transaction has to be approved by a board of Shari'ah Scholars and therefore be compliant with the principles of Islamic finance.
In relation to Sukuk, the Saudi Arabian Fiqh Academy ruled (under Decision Number 5 of 1988) that any collection of assets can be represented in the form of a written note or certificate which can be sold at a market price but the composition of the group of assets, represented by the security, consists largely of physical assets and financial rights, with only a smaller percentage comprising cash and interpersonal debts. This decision, although non-binding, has paved the way for the growth in Sukuk.
Market trends
Recent Sukuk issues have been used by Sovereigns and corporates in the Arabian Gulf region, Pakistan, Malaysia and Germany. Qatar's Sukuk was a ground breaking sovereign deal in 2003, with an issue of US$700m, being financially the largest Sukuk sovereign issue and the first of its kind in a civil-law jurisdiction, only surpassed in 2004 by the Dubai Civil Aviation Authority Sukuk of $1 billion. A flow of interesting Sukuk transactions followed in 2004 with a $100m issue for Tabreed, a United Arab Emirates (UAE) company that provides cooling equipment, and the German State of Saxony-Anhalt sovereign Sukuk issue for 100m, the first Shari'ah compliant transaction for a European borrower. The government of Bahrain has been proactive with a cumulative sovereign Sukuk value of $1.13 billion.
In 2005, the Pakistani Government's Sukuk issue of $600m to finance the Lahore-Islamabad motorway with a listing on the Luxembourg Stock Exchange was a ground breaking start to the year. This was followed by another notable corporate Sukuk issue by the Dubai Metals and Commodities Centre for $200m, with an option for Sukuk holders to elect to be paid in gold bullion. The latest Emirates Sukuk issue of $550m is the first airline Sukuk of its kind. The most notable Sukuk are summarised in the table in Figure 1. There are many other Sukuk issues in the pipeline by sovereigns and corporates in the Arabian Gulf, Pakistan and Iran and it is estimated by the end of this year the total Sukuk issue will reach almost $15 billion.
Sukuk structures
There are different types of Sukuk, each depending on the nature of the financing structure of the underlying asset that is linked to the Sukuk certificate. For example, there are Sukuk variations on Ijarah (leasing), Modarabah (profit sharing), Musharaka (equity participation) and Istisna'a (conditional sale of items to be manufactured). Ijarah Sukuk has been used in the Qatar, Pakistan, and the Bahrain Sukuk issues.
This article focuses on the Ijarah, Istisna'a and Musharaka Sukuk models with a summary of the salient Shari'ah and legal issues arising from transactions and draws insights from recent Sukuk issues.
Ijarah Sukuk
An Ijarah is similar to a lease for a pre-determined period where the usufruct of a specific property is transferred from the owner to another person in exchange for a rental payment. Under the Shari'ah there are guidelines which need to be followed in order for an Ijarah lease to be effective. For example, Shari'ah requirements include the duty to insure, repair and maintain the property being placed on the lessor as owner and the lessor must bear the risk of any loss of or damage to the property (provided not caused by the negligence or misconduct of the lessee). In the event of late payment, the Shari'ah scholars have allowed provision in the lease under which the lessee is obliged to donate to charity an amount of delay penalty to recognise the delay in the rental payments. Rental flow from under an Ijarah is payable monthly, quarterly or annually and therefore provides an income stream for Sukuk.
In order to comply with the principles of the Shari'ah, Sukuk must be asset linked if they are to be tradable. For instance, it is common for a Sukuk to be backed by pools of Ijarah (leasing) contracts - Sukuk al-Ijarah ('Ijarah Sukuk') under which beneficial ownership of the assets is vested in the Sukuk holders. The Sukuk (if they are to be tradable) cannot be linked to Islamic contracts such as Murabaha sales as it contravenes the Shari'ah principles of debt trading and introduces gharar (uncertainty) to the transaction. However, since Ijarah Sukuk represent a beneficial ownership of the underlying leased asset, it is possible to trade Sukuk certificates in a secondary market at par for a premium or discount.
Figure 2 illustrates the structure of a typical Ijarah Sukuk. In this diagram, the Seller, being a government entity or a corporate, sells certain assets (such as land, buildings or machinery) to a Special Purpose Vehicle (SPV) for a fixed price. To raise the required finance to acquire the asset, the SPV issues Sukuk certificates to investors (the Sukuk holders) at par value in an amount equal to the purchase price (Sukuk proceeds). The Sukuk holders therefore acquire a beneficial interest in the SPV's assets. The SPV is appointed as a Trustee and Agent for the Sukuk holders (pursuant to a Declaration of Trust) and it holds the assets on trust for Sukuk holders. The SPV leases the asset (under an Ijarah lease) to the corporate (being the lessee) which is an entity closely affiliated to the seller or may be the seller itself. The corporate pays periodic lease rentals to the SPV. The lease rentals are benchmarked to LIBOR plus a profit margin spread. The SPV collects the lease rentals and distributes the amount to the Sukuk holders, in proportion to each Sukuk holders' entitlement. On maturity or an early dissolution event, the SPV sells the asset to the seller at a pre-determined value. This structure was used in the recent issues by the State of Saxony-Anhalt, the Kingdom of Bahrain and the Government of Pakistan. Ijarah Sukuk have become almost common and financiers are exploring different structures for Sukuk, such as the Istisna'a Sukuk and Musharaka Sukuk.
Istisna'a Sukuk
Istisna'a is used for project finance, financing industrial equipment and manufacturing of various capital goods. Under an Istisna'a financing, the bank contracts (usually by a SPV) with a purchaser to deliver the contracted items on a future date assuming responsibility for project completion (Istisna'a), and then appoints sub-contractors to complete the project under its supervision through a separate contract (parallel Istisna'a). On completion of the project, the project assets are delivered to the original purchaser (or SPV) which has the responsibility for paying the pre-determined purchase price. The financing for this transaction comprises a profit margin included in the purchase price and is usually benchmarked to LIBOR. Sukuk certificates can be issued based on the expected stream of payments.
In an Istisna'a/Ijarah Sukuk structure, the SPV will have a contract for works with either the contractor or the Seller for the project and a forward lease with the Seller. The SPV will therefore issue Sukuk certificates to raise finance for the project under an Istisna'a. The Sukuk issue proceeds received by the SPV will be used to pay the contractor or company to build and deliver the future plant or machinery (the asset) which will then become the property of the SPV so that it can lease this asset to the corporate (pursuant to an Ijarah lease). The corporate will pay advance rent until the project is completed and rent from the date of delivery.
Istisna'a/Ijarah Sukuk represent debt obligations and therefore are not tradable for cash for below the par value in a secondary market until the assets are delivered.
Recent Sukuk issues
The following two case studies provide a practical illustration of the legal and Shari'ah issues of an Ijarah /Istisna'a Sukuk for Tabreed and the Musharaka Sukuk in the Emirates issue.
Tabreed
The National Cooling Company (Tabreed) Sukuk issue follows the Ijarah/Istisna'a structure. The Tabreed Sukuk was issued by Tabreed Financing Corporation, a special purpose vehicle (SPV) incorporated in the Cayman Islands. The funds from the Sukuk issue were used to pay Tabreed to finance future cooling plants in the UAE. Tabreed transferred certain assets (being the existing plants) to the SPV. The transferred plants were leased by the SPV to Tabreed pursuant to an Ijarah lease agreement, and the Ijarah lease periodic rentals from these assets are paid to the SPV which are then distributed to the Sukuk holders. In this arrangement, the SPV holds the assets on trust for the Sukuk certificate holders. In addition, Sukuk proceeds were used towards investments in other central cooling plants to be manufactured on an Istisna'a basis. It is a Shari'ah requirement that at any one time, the underlying assets are not less than 51% of the value of the underlying assets.
Tabreed and the SPV entered into future leases in respect of future cooling plants to be constructed. The pre-rentals are payable by Tabreed pursuant to an undertaking to lease the future plants on the basis that if the future plants are not manufactured or acquired according to the specifications in the 'agreement to lease' by a specific date, these pre-rentals shall be repayable by the SPV.
Upon maturity of the Sukuk (or if earlier, upon the acceleration of the Sukuk following the occurrence of a dissolution event under the documentation), Tabreed is required to purchase the existing plant from the SPV. Furthermore, in order to provide additional comfort to investors, Tabreed guaranteed the SPV's payment obligations under the Sukuk and agreed to make up any shortfall in the amount received in respect of the underlying assets and the amount which the holders of the Sukuk expected to be paid under the terms of the Sukuk documentation.
Shari'ah issues
A key Shari'ah issue in the Tabreed Sukuk relates to the composition of the pool of the underlying assets. The pool of underlying assets to be purchased by the SPV comprises the main plant, the plants which have not yet been constructed or acquired, investments in other construction activities and any surplus cash. The Shari'ah Scholars in this transaction stipulated that 'at any one time the underlying asset shall comprise not less than 51% of the SPV's underlying assets'. If this percentage falls below 51% Tabreed is required to purchase the cooling plants from the SPV.
Musharakah Sukuk
In Sukuk al Musharaka (Musharaka Sukuk) the corporate or the originator and the SPV enter into a Musharaka agreement (an equity participation type joint venture) for a specified period (usually between 5 to 7 years). The profit ratio between the SPV and the corporate is pre-determined at the start of the venture. Each party contributes their share towards the venture whether it is cash, management or other experience. In this case, the corporate (musharik partner) provides the assets (such as land or existing plants or machinery) to the Musharaka joint venture and the SPV (as the other musharik partner) contributes to the investment from the Sukuk proceeds. The corporate irrevocably undertakes to acquire the SPV's share of the Musharaka joint venture on a periodic basis at a pre-determined price at the end of the specified period of time, by which time the SPV will have no shareholding in the joint venture Musharaka. The Emirates Sukuk was structured on this basis.
Emirates Sukuk
The Emirates Sukuk issue is based on the Musharaka Sukuk which is an innovative shift from the commonly used Ijarah Sukuk structure. Under this structure, Wings FZCO ("Wings") (a special purpose vehicle incorporated in the Dubai Airport Free Zone) issued floating rate Sukuk certificates to investors. Wings used the proceeds of the Sukuk issue to contribute to the Musharaka between Wings and Emirates (each as partners to the Musharaka). The purpose of the Musharaka (joint venture) is to develop and lease to Emirates a new engineering centre and a new headquarters building in Dubai. The periodic rental payments from the Musharaka are to be used to pay the periodic payments on the Sukuk certificates which are listed on the Luxembourg Stock Exchange. It is anticipated that there will be further use of this type of structure in future issues by other corporates in the region.
Legal issues
A number of legal issues need to be considered in the structuring of Sukuk transactions. The basic legal questions include: who are the parties; where are they registered, what security is being offered, and the location of the assets. It is also important to select carefully the jurisdiction of the SPV being used. The main reason for using a special purpose entity to acquire the assets and issue certificates is to protect the assets from claims by creditors or liquidators of a bankrupt corporate. The jurisdiction of the SPV depends on where the deal is being organised which is left for the corporate or sovereign to decide. Cayman Islands, British Virgin Islands, Luxembourg are the typical offshore jurisdictions for a SPV, but other locations such as Labuan, Bahrain, Qatar and Dubai Free Zones (such as the Dubai Airport Free Zone or Jebel Ali Free Zone) have also been used.
Other legal and banking issues to consider include the priority and enforceability of security interests provided in relation to the underlying assets, tax and regulatory issues such as foreign ownership of certain assets, in particular in the Gulf Co-operation Council states. Investors should seek legal opinions on the valid transfer of the asset (as collateral) to the SPV and it is important to ensure that such transfer cannot be 're-characterised' as a secured loan or avoided upon an insolvency of the originator. In addition to creditor protection, other legal opinions are required on the tax implications of an issue as well as the impact of foreign financial services regulations such as the UK Financial Services and Markets Act 2000 and US Regulation 144. If the Sukuk is listed, the issue needs to be compliant with the rules and regulations of the exchange, for instance the Luxembourg Stock Exchange, which has been used for recent Sukuk issues.
Conclusion
The Sukuk structures identified above are broadly similar to asset backed securitisation. Sukuk remain a popular choice to raise finance for a variety of projects such as enabling project financing of plant and machinery in different industry sectors for example the development of new headquarters or the financing of future cooling plants. The Ijarah Sukuk has to date been the preferred structure but institutions are now utilising different techniques such as the Musharaka Sukuk which reflects the cutting edge development of Islamic finance. The development of Sukuk is confined to what is permissible under the Shari'ah, however bankers and lawyers in conjunction with contemporary Shari'ah scholars are developing innovative solutions to provide an attractive alternative to conventional interest financing instruments. It is hoped that this innovation continues together with the demand from global investors.
Bilal Aquil is a Solicitor with Clyde & Co., Middle East Regional Office in Dubai and was formerly Head of Islamic Finance for a major City law firm in London.
© Banker Middle East 2005
