An innovative partnership Sukuk with multiple
layers of risk-mitigation
January, 2015
This Document is Not for Distribution
‫بسم اهلل الرمحن الرحيم‬
© Islamic Development Bank, SABIC Chair, ISRA, Agha and Co
2014-2015
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Introduction
While the Sukuk market is growing in size, it is still very limited in product
diversity. The variety in investors’ preferences requires a corresponding variety
in product offerings. While the existing Sukuk satisfy preferences for debt-like
instruments, there are very limited options for equity-like Sukuk. While
musharakah represents the “Cinderella” of Islamic financial instruments, it has
very few applications in the Sukuk market.
The objective of this project is to develop a financial instrument that applies
principles of musharakah while at the same time provides a variety of riskmitigation techniques to meet diverse risk preferences of investors. The
outcome, Multi-level Musharakah Sukuk (MLP Sukuk for short) is an
innovative structure allows investors to diversify and issuers to tap potential
new markets.
Background
In 2012, SABIC Chair for Islamic Financial Markets organized a workshop to
discuss issues with prevailing Sukuk structures, and possible solutions and
alternatives. The Financial Product Development Center at the Islamic
Development Bank (the “Center”), was invited to contribute. The Center
proposed a Musharakah Sukuk variant that offers investors certain degrees of
protection comparable to conventional funding instruments while endeavoring
to adhere to core Shari’ah precepts.
The Center subsequently proposed to form an international team dedicated to
developing an alternative structure that takes into account the issues and
challenges facing prevailing Sukuk, while addressing economic and financial
needs of issuers and investors, within Shari’ah precepts. Accordingly, the
International Shari’ah Research Academy (ISRA) and the specialist Islamic
finance law firm, Agha & Co, were invited to participate in the project
The project commenced in June 2013 and the aim was to develop a Sukuk
structure that imposes no debt burden on the issuer while providing investors
with unique core features that should give them sufficient comfort to replace
conventional bonds, or bond-like Sukuk structures. The goal was not only to
improve upon the prevailing Sukuk structures but also to design a possibly new
financial instrument that adds value to financial markets at large.
The final outcome was a structure that allows the best of bonds and equities. In
brief, MLP Sukuk enjoys the following features:
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•
It provides a general-purpose, sustainable source of funding for
corporates and Islamic financial institutions.
•
It represents non-debt financing to corporates, with multiple levels of
protection and risk mitigation to investors.
•
It enjoys comparable levels of seniority as bonds, and can have a
comparable level of authority as equity.
•
It provides an additional layer of protection through “capital cushion,”
which represents an Islamic alternative to “over-collateralization” in
conventional finance.
•
The structure is consistent in principle with OIC Fiqh Academy
resolutions and AAOIFI Shari’ah standards
•
The structure does not require legislating new laws or regulations.
The Team organized conducted several workshops and meetings to discuss,
deliberate, and develop various aspects of the MLP Sukuk structure. As a new
structure, it may still need further scrutiny but the Team believes that it has
been developed well enough to be offered to the industry at large as the core
skeleton of future complete structures.
We hope that the MLP Sukuk would help further develop the Sukuk market,
and enhance its diversity and liquidity. We also hope that this product will spur
additional healthy innovation that enables Islamic financial industry to offer
investors and issuers new instruments that adhere to genuine Shari’ah precepts
but equally add genuine value to global financial markets.
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Overview
This is a concise preview of the MLP Sukuk.
Structure
•
A company interested in raising corporate financing (the “Corporate”),
creates a Special Purpose Vehicle that is bankruptcy remote (the “SPV”).
•
The Corporate then transfers (some of) its assets to the SPV, and the
SPV issues Sukuk to the Corporate in proportion to the in-kind
contribution of the value of the transferred assets.
•
The SPV issues additional Sukuk certificates that are purchased by
investors, who become partners with the Corporate in the SPV.
•
The SPV appoints the Corporate as the manager of the SPV. Sukuk
holders have the right to monitor and supervise the management.
•
The Corporate promises to redeem the Sukuk of investors from its share
in aggregated profits generated by the SPV.
In this manner, investors share the assets but not the liabilities of the
Corporate. This gives investors a senior claim against their share of the assets,
comparable to that of senior creditors.
Capital Cushion
To attract investors, Corporate could offer investors a “discount” via additional
Sukuk certificates, e.g. 10-15% of their capital contribution. This cushion will
result in the first 10-15% of loss being absorbed by the Corporate. It plays a
similar role of “over-collateralization” in conventional finance.
Third Party Protection
Risk-averse investors may obtain additional protection for their investment
from a third party. This is done as follows:
The Third Party (e.g. a Takaful company, an investment bank, or any other
financial institution) shall establish a fund, e.g. Sukuk Protection Fund,
whereby Sukuk-holders trade in their Sukuk for units in the fund. The Fund
shall invest in a variety of Sukuk and Islamic investments. In addition, the
Third Party shall invest some of its own capital in the Fund on a longer term
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horizon, such that units of the Third party will be effectively “permanent,”
while units of the investors are redeemable. In this manner investors’ units
become layered with protection and are buffered with additional capital
cushion (over-collateralization). This mechanism offers an additional layer of
protection, over and above diversification offered by the Fund.
The Third Party would monitor the performance of the Sukuk and would act as
an agent on behalf of investee Sukuk-holders to oversee the performance of the
Corporate.
Naturally, returns on the Fund’s units would be lower than returns on Sukuk
issued directly from the SPV on account of the Third Party’s being responsible
for establishment of the fund, transaction management, agency function and
reserves allotment.
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Seniority
An important aspect of the MLP Sukuk is the seniority of its holders with
respect to the underlying assets. This section aims to clarify this feature, and to
show how Sukuk holders compare to creditors of the Corporate, or bond
holders in conventional financing.
In corporate finance, senior creditors have the first claim the assets of the
Corporate. All other investors (subordinated debt holders, preferred shares
holders, and common shareholders) are subordinated to senior debt holders.
In MLP Sukuk, we aim to put Sukuk holders at an equal level of seniority with
respect to the underlying assets as of that of senior debt holders. The prevailing
corporate financial instruments will not allow for this arrangement directly.
Only through an SPV that this outcome can be achieved.
Process
The process of Sukuk issuance goes as follows:
1. A Special Purpose Vehicle (SPV) is created, as a means to protect investors
from the bankruptcy of the Corporate.
2. Assets are transferred from the Corporate to the SPV (assuming approval of
creditors of such transfer, in addition to any other regulatory requirements).
The SPV issues Sukuk certificates to the Corporate in return for its in-kind
contribution.
3. The SPV issues additional Sukuk to external investors, in return for cash
contributions. External investors now share the assets of the SPV with the
Corporate.
4. As pointed out earlier, the Corporate will remain the manager of the assets.
5. Sukuk are redeemable conditional on the performance of the underlying
assets (more on this later).
Profits
The Corporate and investors share profits as agreed. Investors get their agreed
share of profits periodically as dividends/coupons. It can be agreed that, if the
share of investors in profits exceeds a certain level, excess returns are put into a
reserve account to give investors protection for fluctuations in returns. The
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share of the Corporate in aggregate profits shall be used to redeem the Sukuk
held by investors, as below.
Redemption
In principle, the Sukuk can be perpetual, as it is the case with some of the
Sukuk issued recently by Islamic banks and other corporations. Or it can have
an agreed maturity.
For the MLP Sukuk, the Corporate issues a promise to redeem the Sukuk held
by investors if the Corporate’s accumulated share in aggregated profits is
adequate to accomplish such redemption. Accordingly, the Corporate shall
redeem the Sukuk at nominal value. If, however, the accumulated share of the
Company in profits is not sufficient, the Corporate is under no obligation to
redeem, although it might decide voluntarily to redeem from other resources.
Hence, the promise to redeem is not a debt obligation on the Corporate. It is
conditional upon realization of sufficient profits.
In this manner, the Sukuk are a genuine partnership in the underlying assets.
There is no guarantee by the Company that investors will get back their capital.
If the Company decides to redeem at nominal value, then investors agree to sell
their Sukuk to the Company. Investors agree to give up any capital gain in
return for the liquidity provided by redemption. According to AAOIFI Standard
no. 12 on Musharakah, clause 3/1/5/9, if the profit realized is above a certain
ceiling, it is permissible to agree that the profit in excess of such a ceiling
belongs to a particular partner. Hence, investors can agree to give up capital
gain if total profits are such that the Company’s share equals or exceeds the
nominal value of investors’ Sukuk.
Note that, by the conditional promise, there is an implicit priority of external
Sukuk holders over the Company in realized profits. The Company has to give
up its share in profits to buy external investors’ Sukuk, which means that
external investors are getting the profits up to the nominal value of their Sukuk.
However, since profits are not guaranteed, external investors are not
guaranteed their capital.
Loss
If Corporate’s share in aggregate profits is not sufficient to redeem Sukuk held
by investors at nominal value, the Corporate might offer investors one of two
options. One is to redeem at loss. The other is to convert the Sukuk into
perpetual Sukuk. Effectively, the Sukuk are perpetual Sukuk callable by the
Company at the agreed maturity date. The call however is mandatory if the
Corporate’s share in aggregate profits equals or exceeds the nominal value of
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investors’ Sukuk. Otherwise, the call is not obligatory, and Sukuk will be
perpetual.
Shari’ah Aspects
The idea of sharing assets without sharing liabilities has been known in fiqh for
quite some time. In discussing mudharabah arrangements, the capital provider
(mudharib) has the right to require the mudharib not to buy on credit, and that
if the mudharib decides to do so, only the mudharib is responsible for such a
debt ("‫ "مضاربة‬،‫)املوسوعة الفقهية‬.
The Shari’ah Committee of the Islamic Development Bank has approved the
concept whereby investors provide funds to the issuer or the Islamic bank, such
that investors share the assets of the bank (mudharib) but not the liabilities
(Ruling 26-2008).
The idea was discussed in the Islamic Financial Services Board (IFSB) while
preparing the revised draft of its Capital Adequacy Standard (IFSB-15, Dec.
2013), whereby the Standard notes that Rabbul-mal (investors) “would not be
liable for the general liabilities of the IIFS (and notably for the amount owed to
current account holders)” (p. 8, ftn 12).
These findings consider this arrangement as part of mudharabah, not
musharakah, whereby investors share the assets and liabilities of the issuer. The
latter however might be better described as “equity” as they end up with the
same rights and obligations of equity shareholders.
Tradability
Since the MLP Sukuk represent a genuine partnership with the Corporate, they
are tradable irrespective of the composition of the assets (debts, cash, tangible
assets, usufructs). This is in accordance with the principle of “Subordination” in
Sharī’ah (‫)قاعدة التبعية‬. According to this principle, assets are subordinated to
the company’s legal entity, management and tangible capital used for managing
the entity. Since Sukuk holders share of the ownership of these components,
Sukuk are tradable regardless of the nature of the underlying assets. The OIC
Fiqh Academy adopted a resolution supporting this view at its 21st session in
2013.
Assets
It is important to decide which assets the Company plans to share with external
investors. The Corporate might decide to share some specific assets; however, it
would be much more flexible to the Corporate if external Sukuk holders share
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in the general pool of assets. This also gives investors better diversification and
stability of returns.
To share in the general pool, however, requires the transfer of all assets from
the Corporate’s balance sheet to the SPV’s balance sheet. This should not be of
concern, however, since the SPV is to be consolidated with the Corporate’s
statement.
Consolidation
From an accounting point of view, the SPV’s statement should be consolidated
with the statement of the Corporate. This is based on the IFRS 10, which
“requires an entity (the parent) that controls one or more other entities
(subsidiaries) to present consolidated financial statements”. The IFRS 10 defines
“control” as follows (IN 8):
“An investor controls an investee when it is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect
those returns through its power over the investee. Thus, the principle of control
sets out the following three elements of control:
a. power over the investee;
b. exposure, or rights, to variable returns from involvement with the
investee; and
c. the ability to use power over the investee to affect the amount of the
investor’s returns”.
From the above proposed structure, the Corporate meets these criteria: It has
power over the SPV, it affects its variable returns (i.e. profits), and has certain
rights over such returns of the SPV.
Accordingly, the IFRS 10 requires consolidating the statements of the SPV with
the Corporate. When this is done, the assets that have been transferred to the
SPV will return back to the statement of the Corporate (and the Sukuk
certificates held by the Corporate will be eliminated to avoid double counting).
The funds contributed by external investors will show up on the assets side of
the Corporate’s statement.
On the liability side, a “Non-Controlling Interest” (NCI) item will show up on
the Corporate’s statement. This item reflects the Sukuk held by external
investors.
From an accounting point of view, therefore, the transfer of some or all of the
assets of the Corporate to the SPV has no material impact on the status of the
Corporate, nor on its balance sheet. Further, it has no impact on its operations,
since the Corporate will remain to be the manager of the SPV.
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From a legal point of view, however, the assets on the balance sheet of the
Corporate are shared between equity holders of the Corporate and external
Sukuk holders. More important, the external investors (the “Non-Controlling
Interest”—NCI) have the same seniority against the assets of the Corporate as
its creditors.
The following example should clarify these points.
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Example
To make things concrete, suppose, suppose Company XYZ (the Corporate) has
three assets: Receivables, Office equipment, and a Factory. Total value of the
assets is $100 million. Further, the Company has debt obligations of $60 million.
Thus, total equity of the company is $40 million.
Company XYZ
Assets ($millions)
Liabilities ($millions)
Receivables
25
Equipment
15
Factory
60
Total Assets
100
Debt
60
Equity
40
Total Liabilities & Equity
100
The Company needs to expand its productive capacity by building a new
factory, and needs say additional $100 million to do so. For this purpose, the
Company will issue MLP Sukuk.
From the previous discussion, the Company will establish an SPV, and move its
assets to it. In return, the Company will have Sukuk certificates of the same
value on its books. Thus the books of the SPV will be as follows:
SPV
Assets ($millions)
Liabilities ($millions)
Receivables
25
Equipment
15
Factory
60
Total Assets
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100
Debt
0
Sukuk
100
Total Liabilities & Equity
100
And the balance sheet for the Company will be as follows:
Company XYZ (after transferring the assets to the SPV)
Assets ($millions)
Liabilities ($millions)
Sukuk
100
Total Assets
100
Debt
60
Equity
40
Total Liabilities & Equity
100
Issuing Sukuk to Investors
Next, the SPV issues additional Sukuk certificates to investors. Suppose the SPV
issues $100 million. The balance sheet then becomes:
SPV
Assets ($millions)
Liabilities ($millions)
Cash
100
Receivables
25
Equipment
15
Factory
60
Total Assets
200
Debt
0
Sukuk
200
Total Liabilities & Equity
200
Investors now are partners with the Company in the SPV; they share the assets
of the SPV as per their contributions. Seniority however is achieved by having
the Sukuk held by investors protected from the creditors of the Company in
case the latter defaults. So, in principle, creditors of the Company and investors
should be at the same level of seniority with respect to the assets of the SPV.
Although investors are protected from the bankruptcy of the Company, they
are still taking the risk of the assets, since assets may for any reason fail to
perform as expected. This risk however is common to both investors (Sukuk
holders) and creditors of the Company.
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Management
The Company shall be the manager of the SPV. However, if the performance of
the appointed management team becomes of concern, Sukuk holders have the
right, by a certain proportion of votes, to request the Company to replace the
management team and/or review its managerial policies. However, the
Company as such shall remain the manager of the assets.
The right to intervene in management gives investors an additional layer of
protection. Unlike creditors, investors supervise and monitor the performance
of the Company so that, in principle, they can act before signs of underperformance become apparent.
Consolidation
Based on previous discussion, the SPV’s statement should be consolidated with
the Company’s statement. Hence, the consolidated statement becomes:
Company XYZ, Consolidated Statement
Assets ($millions)
Liabilities ($millions)
Cash
100
Receivables
25
Equipment
15
Factory
60
Total assets
200
Debt
60
NCI (Sukuk)
100
Equity
40
Total Liabilities & Equity
200
In this manner, the MLP Sukuk show up on the Company’s statement as a
different class of investors who share the assets of the Company, but do not
share its debts. Accordingly, Sukuk holders have the same level of seniority
against the assets as creditors of the Company.
By consolidation, there should no concern about the transfer of the assets to
the SPV. This transfer is only a step to provide Sukuk holders the protection
from bankruptcy, i.e. the seniority over assets. The transfer of assets therefore
takes place “in the background” to achieve the desired outcome.
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Cushion Capital
The basic idea of Cushion Capital is to offer investors a cushion against losses
up to a certain limit. The concept is close to that of “over-collateralization” in
conventional finance. However, over-collateralization usually applies to debtbased instruments, while capital cushion applies to equity and musharakahbased instruments, rather than debt-based instruments.
Cushion capital effectively plays the economic role of a “guarantee.” From an
economic point of view, a guarantee simply means that the guarantor is
pledging additional assets to the creditor/beneficiary. Equity, in contrast, offers
no additional assets. For Sukuk, an issuer may offer investors additional
certificates, which will give investors protection comparable to that of a
guarantee.
But there are important differences between the two instruments:
1. Cushion capital does not lead to default or bankruptcy of the issuer in
case of loss beyond the additional protection. In case of debt, in
contrast, the debtor must cease operations, leading to economic and
social losses. Thus, cushion capital serves essentially the same objective
of a guarantee, but without the negative costs associated with default
and bankruptcy. To some extent, it combines the best of both: debt and
equity.
2. A cushion capital is specified and assigned upfront to Sukuk holders. A
guarantee, in contrast, does not assign any specific portion of assets to
investors. Since the company may borrow and/or issue guarantees to
several different parties, the ultimate portion of assets backing each of
these obligations will not be specified to investors upfront.
To apply cushion capital in MLP Sukuk, investors are offered the option to own
additional Sukuk certificates, at no upfront cost. (Obviously, the return they get
will be reduced accordingly.) The value of these additional Sukuk is determined
as agreed. For example, if the cushion is to be 10% of investors’ capital of $100
million, then investors are offered the option to own additional Sukuk the value
of which is $10 million. The option to own the additional Sukuk is to be
exercised at maturity.
In case the Company fails to redeem the principal Sukuk certificates, investors
have the right to liquidate their Sukuk in the market. In this case, they can use
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the additional Sukuk to recover any possible losses. However, if the Company
redeems the Sukuk at par, then investors give up the right to own the
additional Sukuk. That is, investors have the right to own the additional Sukuk
only in case the Company does not redeem their certificates at par.
Also, if the total market value of the principal and additional Sukuk exceeds the
nominal value of Sukuk held by investors, investors agree to give up the
additional profits. Investors therefore own additional Sukuk only to the extent
needed to recover losses in their capital.
Example
Following the previous example, suppose the SPV issues $100 million of Sukuk,
and offers investors a cushion of 10% i.e. $10 million. The balance sheet of the
Company will be as follows:
Company XYZ (non-consolidated)
Assets ($millions)
Sukuk
Total Assets
Liabilities ($millions)
100
100
Debt
60
(Contingent cushion)*
10*
Equity
40
Total Liabilities & Equity
100
* Off-balance sheet item
The “contingent cushion” is an off-balance sheet item, and hence it does not
add to total liabilities. Shareholders of the Company have to account for the
cushion only when assets of the SPV fall in value. As pointed out earlier,
investors have the right to own the additional Sukuk certificates, but they agree
to give up any extra gain beyond their capital. Accordingly, the contingent
cushion will be to transfer to investors at maturity Sukuk certificates of value
up to $10 million.
For investors, the (aggregated) balance sheet is as follows (ignoring any debt
obligations):
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Investors
Assets ($millions)
Liabilities ($millions)
Sukuk
100
(Contingent cushion)*
10*
Total Assets
100
Debt
0
Equity
100
Total Liabilities & Equity
100
* Off-balance sheet item
Simulation
The graph below shows the value of MLP Sukuk under various possibilities of
loss in assets of the SPV. The graph shows the value for both cases: with and
without cushion.
In addition, the graph shows the value of additional equity in case the
Company decides to fund the new factory by issuing stocks rather than Sukuk.
Value of MLP Sukuk
100
95
90
85
80
75
Cushion = 10%
70
Cushion = 0
65
Extra equity
60
55
50
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
15.0%
17.5%
20.0%
90
Cushion = 10%
100
100
100
100
100
97.5
95
92.5
Cushion = 0
100
97.5
95
92.5
90
87.5
85
82.5
80
Extra equity
100
96.7
93.3
90.0
86.7
83.3
80.0
76.7
73.3
Loss in Assets, %
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The graph (and the table) above shows how the Sukuk with 10% cushion is able
to absorb losses up to 10% of assets. Naturally, investors would have taken
precautionary steps before reaching that stage. Still, the Sukuk with 10%
cushion is better able to withstand losses than Sukuk without cushion, which is
still better than equity. Investors are able to hedge or mitigate the risks to a
reasonable degree.
Note that a cushion of more than 10-15% is not a good practice in the financial
industry. Higher cushion will signal a low quality of the assets such that high
collateralization is needed to protect investors. Assets of good quality do not
need collateral of more than 10-15% to obtain high rating.
We have compared MLP Sukuk with equity. If we consider debt financing, then
it is clear that financing the new factory would not have been possible, since
the Company’s equity is only $40 million. In this case, borrowing additional
$100 million is not an (easy) option.
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Comparisons
It is helpful at this stage to compare the three kinds of financial instruments:
bonds, equity, and MLP Sukuk. The following table summarizes the
comparison.
Feature
Bonds
MLP Sukuk
Equity
Priority over assets
+
+
–
Intervention in management
–
+
+
Upside gain (potential)
–
+
+
Cushion against loss
+
+
–
Risk sharing
–
+
+
MLP Sukuk share with bonds the most two important features of debt
financing: priority over assets, and cushion against losses through overcollateralization. However, beyond the cushion, Sukuk holders share the risk
with the Company. Unlike debt, losses do not cause the SPV to default and
declare bankruptcy. Bankruptcy is a dead-weight loss to all parties, and it is in
the interest of all parties to avoid it in as much as possible.
For this reason, MLP Sukuk holders have the right to intervene in the
management of the SPV to correct for any mismanagement or malpractice, in
order to save their investments and allow it a better opportunity to recover.
This feature is absent from bonds but is an important feature of equity.
MLP Sukuk also allows Sukuk holders, in principle, to share in upside returns; a
feature that is usually absent from bonds. Since MLP imposes no debt burden
upon the Company, it is a kind of risk sharing that the Company would prefer
over borrowing or debt financing.
Overall, MLP Sukuk combines features from both debt and equity such that it
offers a unique set of features to both issuers and investors.
MLP Sukuk vs. Prevailing Sukuk
It is also helpful to compare MLP Sukuk with the common forms of Sukuk.
Most Sukuk structures end up in a debt obligation on the Company, hence the
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common name: “Islamic bonds.” As already pointed out, MLP Sukuk creates no
debt obligation upon the Company, and are genuine partnership arrangement.
In addition, the MLP Sukuk is more efficient and transparent than the
prevalent Ijarah structures. The table below summarizes the main aspects of
the two.
Ijarah Sukuk
MLP Sukuk
Investors own specific tangible asset(s)
Investors share in the general pool
Represent a debt obligation
Represent a share in assets—no debt
Issuance is limited by availability of
tangible assets
Issuance is limited by productivity of
the Company
MLP Sukuk avoids the main Shari’ah issues in the common Ijarah Sukuk,
namely the undertaking to buy back. The buy-back undertaking is essentially a
debt obligation, and it is the basis for rating the Sukuk, if rating is provided.
The buy-back undertaking gives the traditional Sukuk transaction the same risk
profile as a bond. As discussed, the MLP Sukuk offer contingent redemption
based on the generated profits. Ultimately, it is the quality of the underlying
assets that gives investors the assurance of their investment. The rating of the
MLP Sukuk therefore is based primarily on the quality of the underlying assets.
Cushion capital offers an additional enhancement of the Sukuk.
From an economic point of view, MLP Sukuk involves no “redundant” assets
going back and forth for no reason except to obtain financing. Further, the SPV
in MLP Sukuk is permanent; it can be used for regular and sustainable issuance
of Sukuk. The prevailing Sukuk structure in contrast is designed as a one-time
only. Judging by the substantial costs of issuance, a one-time issue is highly
inefficient.
MLP Sukuk holders are partners in the SPV, and thus own both assets and
management rights over the SPV. Hence, the composition of the assets of the
SPV is not a constraint on issuance, as discussed earlier. In this manner, the
Company is able to share (“securitize”) any of its assets, tangibles and nontangibles. This gives corporates great flexibility in issuance.
In short, MLP Sukuk are more efficient, more flexible, and serves the objectives
and parameters of Shari’ah in a manner that is more credible than some of the
prevailing Sukuk structures.
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Third Party Protection
Sukuk investors vary in their abilities and propensities to take risk. Although
the MLP Sukuk so far provides several layers of protection, there is a room to
offer a general mechanism for mitigating Sukuk risks. There have been some
proposals for “Sukuk insurance” based on the concept of Takaful. However,
given the size of the Sukuk market, it might not be feasible to offer blanket
insurance to hundreds of billions of Sukuk. We can learn from the bonds
insurance industry. After the crisis, almost all of bond insurers went out of
business after guaranteeing billions of dollars’ worth of subprime debt that
soured during the financial crisis (Financial Times, Mar. 18, 2012).
A more resilient and transparent model is presented below. Alternative
mechanisms are also discussed.
Sukuk Protection Fund
An entity willing to provide protection to Sukuk holders (an insurance
company, an investment bank, or any other financial institution) establishes a
Sukuk Protection Fund. Investors who prefer to get additional protection on
their Sukuk exchange Sukuk certificates for units in Fund. The Fund shall
accept only Sukuk of a certain quality and with sufficient diversity. In this
manner, Sukuk holders are able to diversify their investments.
I suggest highlighting the fact that Sukuk issuers need to meet the quality
requirement of the Fund, which will reduce the adverse selection risk (that is
the fund choosing bad type of Sukuk).
In addition, the Third Party shall contribute from its own resource 5-10% say of
the Fund assets. The contribution of the Third Party is long term or permanent,
and thus cannot be liquidated ahead of other investors. Hence, the 5%
contribution plays the same role of cushion capital discussed earlier. It provides
a cushion to Sukuk investors against possible losses in the underlying Sukuk
issues.
Further, the Third party shall allocate a certain percentage of the returns on the
Fund as a reserve account to provide additional protection to investors.
Furthermore, the Third Party works as an agent for MLP Sukuk, representing
them in the management of the SPV. The Third Party naturally has an interest
that none of the Sukuk of the Fund fails or loses money. Hence, the Third Party
has a direct interest in monitoring the SPV and assuring that assets are
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managed as planned. As an institutional investor, the Third Party is better able
than small investors to play this role.
The role of the fund here will reduce the moral hazard risk.
In return for these services, the Third Party gets a percentage of the returns on
the underlying Sukuk of the Fund.
In summary, the Sukuk Protection Fund offers several layers of protection:
1. Diversification.
2. Reserves.
3. Cushion capital.
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(8)
Summary
To summarize, the steps to issue MLP Sukuk are as follows:
1. The Company establishes a SPV.
2. The Company transfers (some of) its assets to the SPV, in return for
Sukuk certificates representing the ownership of these assets.
3. The Company is appointed as the manager of the SPV.
4. The SPV issues new certificates to external investors; external investors
are partners with the Company in the SPV.
5. The Company promises to redeem Sukuk held by investors if the
Company’s share in aggregate profits is sufficient.
In this manner, the Sukuk held by investors allow them to have the following
layers of seniority and protection:
1. They have the same level of seniority against the assets of the SPV as the
creditors of the Company.
2. They have the right to intervene in the management of the SPV, giving
investors a comparable level of authority as the shareholders of the
Company.
3. They have an implicit priority over profits generated by the SPV over the
Company.
Additional protection can be obtained through:
1. Cushion Capital;
2. Third party protection.
With the above features, MLP Sukuk provide investors and issuers an
instrument that combines best of both bonds and equities.
‫واحلمد هلل رب العاملني‬
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