International Structured Finance
Special Comment
Europe, Middle East, Africa
The Future of Sukuk: Substance over Form?
Understanding Islamic securitisation, Asset-Backed and AAOIFI principles
Author
Table of Contents
Khalid Howladar
Vice President – Senior Credit Officer
Asset-Backed & Sukuk Finance
+971 4 401 9542
[email protected]
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Introduction
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Moody’s, AAOIFI and the Role of Opinions
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Replication or innovation?
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Asset-‘Based’ vs. Asset-‘Backed’: Is There a Difference?
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Do Investors Have Any Rights to the Sukuk Assets?
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Where Is the Sukuk Profit Coming From?
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What Is the Role of Purchase Undertakings?
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Asset-Backed or Securitisation Sukuk
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The Future for Sukuk
Additional Contact
Anouar Hassoune
Vice President – Senior Credit Officer
Financial Institutions Group
+33 1 5330-3340
[email protected]
Business Development
EMEA
Faisal Hijazi
+971 4 401-9530
[email protected]
ASIA- PACIFIC
Dominique Gribot-Carroz
+852 2916-1120
[email protected]
Client Service Desk
London: +44 20 7772-5454
[email protected]
Websites
www.moodys.com
www.moodysmiddleeast.com
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INTRODUCTION
The current global crisis has allowed the Islamic Finance industry some time for
reflection, and as such, when considering the future of the sukuk market, we explore
in detail the issue of substance over form.
Sukuk structures are being tested for the first time by originator insolvency 1 and
proposed restructurings 2 . In these more difficult periods it is important that all
investors understand that very few existing sukuk have asset ownership or security –
the majority are unsecured. Asset-backed sukuk or Islamic securitisations generally
perform very differently from asset–based under stress 3 . Most Islamic market
participants are aware that sukuk, sometimes known as Islamic bonds, should grant
the investor a share of an asset or business venture along with the cash flows and
risk commensurate with such ownership. However, while this is indeed the Shari’ah
‘ideal’, most current structures have more in common with conventional fixed income
or ‘debt’ instruments from a risk/return perspective. The recent highly successful
Indonesian sovereign sukuk (US$650 million) shows there is still heavy demand for
these unsecured, asset ‘based’ structures, although the recent bonds of Qatar and
Abu Dhabi were not sukuk.
The assets in the structure are commonly for Shari’ah compliance only, and ultimately
have little or no bearing on the risk or performance of the sukuk. Investors should
note that, while all conventional asset-backed securities (ABS) are not sukuk, a true
asset-backed sukuk is accessible to the whole universe of global ABS investors, and
not just to the much smaller Shari’ah compliant investor base.
October 16th, 2008, East Cameron Partners L.P. (ECP), the originator of the ECP ‘asset-backed’ sukuk, entered Chapter 11 bankruptcy.
The originator also requested the court to re-characterise the ‘true sale’ of sukuk assets to the investors as a ‘secured loan’.
April 17th 2009, “Nakheel seeks to restructure $4bn debt” Middle East Economic Digest. Nakheel sukuk are ‘asset-based’ or unsecured
November 27, 2008, Tamweel PJSC asset-based sukuk (A3) placed under review with direction uncertain. Tamweel also has an assetbacked sukuk (senior notes Aa2 stable) where investors ‘own’ property and associated Ijarah leases.
6 May 2009
Moody’s recently published a Special Report 4 on the decline in global sukuk issuance in
2008 and referred to the possible impact from the statements made by AAOIFI early last
year. Here we look at the issues raised and structural features from a purely analytical
and credit risk perspective. Parties involved in such activities may find the sukuk analysis
undertaken by Moody’s helpful in bringing transparency and understanding to these often
complex structures.
MOODY’S, AAOIFI, AND THE ROLE OF OPINIONS
Most sukuk issuance is not
consistent with AAOIFI
recommendations
The disparity between the ‘ideal’ and the ‘reality’ of sukuk was highlighted by AAOIFI 5 in
February 2008, when it published six principles regarding sukuk structures and initially
noted that around 85% of existing sukuk were not in compliance with these principles.
Subsequently, many sources attributed the market decline to these statements. In
reality, that the decline in sukuk market volume in 2008 was probably due more to
prevailing global credit market conditions (it was a very difficult time to raise funds,
whether conventional or Islamic) rather than to any direct reaction to the AAOIFI
statements (as recently highlighted in our review).
Moody’s focus is on the substance
of the risk – not the form
Moody’s ‘pure’ focus on credit risk, along with our extensive coverage of regional
structured finance and long experience of looking at hundreds of structured transactions,
may well qualify Moody’s to comment meaningfully on these structures and in a way that
enhances understanding of their Islamic characteristics, as we strive to strip away the
sometimes excessive structural and legal complexity and confusion surrounding sukuk
products, getting to the real ‘substance’ of the sukuk without being distracted by the
‘form’. This focus on the substance of the risk and return is helpful when trying to
assess a product’s compliance with a given set of Shari’ah principles or views.
Even within a particular sukuk
‘type’, the risk/return
characteristics can vary
significantly
While terms such as mudarabah, musharakah and ijarah are widely applied, the actual
legal structure behind the ‘name’ and sukuk risk characteristics can vary significantly –
even within a single ‘type’. Thus, until there is some broad consensual standardisation
on terminology or form, investors will need to look at each structure individually to
understand the cash flow, risk and return profile, irrespective of the name/type of sukuk
structure used.
Moody’s provides opinions only on the credit risk associated with such instruments.
Moody’s does not opine on Shari’ah unless it somehow affects credit risk.
Terminology can be confusing
The common theme of ‘form over substance’ throughout modern Islamic finance has, in
our experience, created confusion for some market participants. ‘Asset-backed’ and
‘asset-based’ are semantically similar descriptions but mask significant differences in
credit risk. ‘Shari’ah-based’ and ‘Shari’ah-compliant’ are two more recent terms that
seem to add some confusion.
AAOIFI statements were a positive
effort to bring more transparency
to sukuk structures
While there was some debate regarding the method of its release, the AAOIFI’s
comments constituted a positive effort towards improving transparency and bringing the
‘substance’ of sukuk products closer to the basic tangible and risk-sharing principles on
which there is an almost universal consensus – it is in the implementation of these
principles that matters become complex for investors. Whether or not the market agrees
with the comments, at the very least it raises the right questions for those to whom such
adherence is important.
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Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis, But Some Impact from Shari'ah Compliance Issues (January 2009)
The author has based his comments on the English translation made available on the AAOIFI website: http://www.aaoifi.com
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 2
TO REPLICATE OR INNOVATE?
What is the goal of the Islamic
finance movement?
To replicate or innovate?
A key question for participants is whether the goal of the Islamic finance movement is to
essentially replicate in its entirety the conventional financial system. How wary should
practitioners be of creating instruments and investments that are identical in substance
to conventional ones by combining a redundant succession of trades and labelled with
‘new’ Arabic names? Or how much emphasis should be placed on innovation that
encourages and favours particular types of investment (such as more tangible risksharing ones) and funding that is closer to Shari’ah principles, regardless of terminology
and origin? For example, private equity investments in the technology companies of
Silicon Valley in the US are in substance and inherently compliant with the Shari’ah
investment principles, despite the absence of any Islamic terminology.
Islamic finance is part of the
globalised financial system – it is
not immune from the credit crisis
In addition, an Islamic financial market will always need to interact and engage with the
conventional one – it does not exist in some ‘isolated’ bubble thus some level of
‘contamination’ may be difficult to avoid. The credit crisis has proved the globalised
nature of the world we live in: imagining that a sub-prime crisis could never happen in
Islamic finance would be to encourage complacency. As the Gulf countries now
contemplate the effects of property and stock market declines coupled with low
economic growth prospects in the short term, Islamic and conventional institutions alike
are feeling the pain of reduced liquidity and credit losses.
The ideals of Islamic finance are
receiving more attention in the
current crisis
There has been much discussion in the media about looking at alternative financial
systems as various parties seek to avoid such crises in the future. While the ideals of
Islamic finance offer some compelling ideas, the reality is that much of Islamic finance
today is focussed on replicating the conventional system. This makes it competitive with
the conventional and gives customers (financial depositors and consumers) the products
they want. However, an inevitable consequence is that any problems/flaws are also likely
to be replicated. The benefits of a truly alternative investment approach are more likely
felt, and the industry more sustainable, when those aspects that are different about
Islamic finance are emphasised and practiced.
Asset intermediated financing may
contain excessive leverage/debt
For example, requiring assets in return for funding makes institutional debt/leverage
more difficult. But where financing (vs. arbitrage) is the driver and moral hazard is
mitigated, selling assets for cash may encourage some funding discipline. It is also
crucial that the whole concept is religious and spiritually motivated, which brings in
powerful non-regulatory drivers for ethical financing and social responsibility. To be clear,
these are ideals and, at this relatively early stage in the industry there is heavy debate
as to how to apply these ideals in actual practices.
Ethical and moral drivers are a key
part of the ‘ideal’
Acknowledging the different
motives and moral hazards that
exist in the industry is important
The different motives of the parties involved in the industry also need to be considered –
it is not always religious or moral ethics that drive the market forward. The pursuit of
profit is a powerful and perhaps legitimate driver that is in keeping with human nature,
but introduces moral hazards and possible conflicts of interest that need to be dealt
with, or at least acknowledged. Key roles need to be institutionalised for the longer-term
transparency health, future and sustainability of the industry.
Ultimately much is subject to
interpretation, and is difficult to
judge on Shari’ah compliance
Ultimately, much is subject to interpretation and opinion. Although there is no real
provision for individuals (who within the faith are generally considered equal under Allah)
to ‘judge’ on Islamic ‘compliance’– as opposed to offering advice, guidance, opinions
and education - the market in the Gulf, tends to follow the various opinions of a relatively
small and overstretched circle of prominent scholars.
Ultimately the sukuk investors will
decide the future of the market
AAOIFI has its views, but market participants can, and will, make their own decisions
based on the precedence given to Shari’ah compliance in their own agendas and
economic objectives – where the need for financing may be the key driver. Conventional
finance has had many hundreds, if not thousands, of years to reach its current form and
is still evolving. ‘Modern’ Islamic finance is relatively young and following its own path
before it reaches a point of stability/consensus. From a Shari’ah perspective, it may be
the sincere niyyah or intention of the parties that is probably the most important.
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 3
Asset-‘Based’ vs. Asset-‘Backed’: Is There a Difference?
AAOIFI Principle 1:
Sukuk holders should have asset
ownership
Asset transfer should be legally
certified
The first point highlighted by AAOIFI relates to assets. It proposes that sukuk investors
should have rights over the sukuk assets, that they should be sold ‘legally’ and that the
originating company should ‘transfer’ the assets. This is not the case in the majority of
sukuk issued to date – although we have seen a couple of notable Islamic
securitisations where the assets were ‘truly’ sold: Tamweel and Sorouh PJSC, both UAE
transactions. They still account for the minority of overall issuance at less than a few
billion of an approximate total of US$85 billion issued to date.
Shari’ah encourages financing
against assets
This point derives from the fact that Shari’ah promotes the concept that financing should
be raised only for trading in, or construction of, specific and identifiable assets. Trading
in general ‘indebtedness’ is prohibited, and therefore the issuance and trading of
conventional bonds is not seen to be compliant. Conventional bonds usually represent
non-asset-backed interest-based funding for general corporate purposes.
Sukuk risk and return should be
linked to the sukuk assets
Thus, it is encouraged that all sukuk returns and cash flows be linked to assets
purchased, or (in the case of project finance) those generated from an asset once
constructed and not simply be income that is interest-based. This requirement for
‘tangibility’ has significant – and problematic – effects in other areas, such as hedging
and derivatives. For borrowers to raise ‘compliant financing’, they will need to utilise
assets in the structure. These ‘companies or banks’ that provide the assets are
commonly referred to as ‘originators’.
Moody’s ratings address the
expected loss on an investment
relative to the promise
In essence, the key substance of a sukuk is the return/profits, payment/cash flows of
the instrument as well as risk (of loss) - how much income/profit can the investor expect
to receive when comparing it to how much was due/expected? How likely is it that they
will lose on the investment or that the sukuk will default? In our assignment of ratings to
such instruments, it is exactly these aspects that we analyse quantitatively, qualitatively
and legally to assign our credit ratings.
Asset-based sukuk have the ‘form’
of asset-backed but not the
‘substance’
It is an effort to adhere to the above principle that has given rise to the term ‘assetbased’ sukuk, which in most cases actually addresses this principle in form but not in
substance. Understanding the substance should be the first and most important step in
any analysis, be it Shari’ah compliance or credit risk. In the majority of the sukuk rated
by Moody’s, as per our usual credit analysis, we have gone in great detail through the
sukuk documentation (sometimes hundreds of pages) to understand the actual source of
risk and source of the profit and principal/capital payments.
Most sukuk are thus identical in
credit risk to a conventional
unsecured bond
While there are many sukuk structures (14 described by AAOIFI), the majority of those
applied (be they ijarah, musharakah or mudarabah) effectively ‘reduce’ to a form that is
an Islamic equivalent of a conventional unsecured bond. Much complexity is generated
by asset-based aspects of the structure, but the ultimate objective is to replicate the risk
and return characteristics of a fixed income bond.
The assets are not usually legally
transferred
So what of the assets in these structures? Usually there is some plot of land, a building
or something tangible at the heart of the sukuk. The critical question is (as per the
AAOIFI statement): is there any ‘legally’ recognised asset ownership or interest for sukuk
investors?
Do Investors Have Any Rights Over the Sukuk Assets?
If the intention is asset-backed,
Moody’s seeks legal comfort that
the asset ‘value’ belongs to the
investor
If our analysis validates some form of asset ownership or security, then the sukuk
risk/profit is driven more by the value and cash flows of the asset. Even if the originator
were to default and go bankrupt, then sukuk investors should be in a good position to
recover much of their investment, obviously depending on asset quality, i.e. if the
building or land was truly sold to the sukuk, then it is the building or land value that
affects how much Sukuk investors will recover. However, if the security is property and
the originator is a real estate developer, there is a significant chance that both may be
impaired at the same time. In most existing sukuk cases, the originator would actually
aim to legally retain the asset in question, hence the sukuk and is structured to effect
this.
4 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?
Evidence of binding sale,
enforceable rights, transfer,
beneficial interest or equivalent is
required
When is something ‘truly’ sold? Simplistically, there must be an agreement that is
evidence of a binding sale transaction from the originator to the sukuk investors.
However, it does not end there. While there is a freedom of contract principle in the UAE
(the most active international sukuk market), such contract needs to be shown to be
legal, valid, binding and ultimately enforceable on all parties under the laws of the
country where the assets and company are based in order for Moody’s to give any value
to the asset security. Most often, effective registration of the property in the name of the
new owner(s) is conclusive evidence of legal transfer and binding in any court process.
Legal opinions from international
and local law firms are key to
asset-backed ratings
Moody’s relies heavily on legal opinions from law firms expert in local and international
law as to how the law would be expected to operate in such circumstances. If we believe
that such contracts are not binding or that they are voided in a bankruptcy court
situation, then we give limited value to the assets in the structure, and the risk and
rating analysis is usually focussed on the issuing corporate or bank.
While a sukuk may apply the
‘name’ of a particular structure, it
may not follow the principle of the
structure in substance
It is important to note that, under disclosure and securities laws and regulations of the
exchanges, it is very unlikely that the ‘asset’ risk/return of a sukuk will be
misrepresented directly to investors. However, Moody’s has met market participants
who, without access to (or interest in) the legal detail, sincerely believe there is asset
security and that the investment/financing provided is collateralised. We therefore
believe that the term ‘asset-based’ is confusing; currently, we see in substance only two
types of sukuk from an asset perspective – simply secured and unsecured.
East Cameron Asset-Backed Sukuk: Who owns the assets?
ECP Sukuk issued July 2006
ECP filed for bankruptcy October
2008
Sukuk enforcement event
triggered in sept 2008
ECP is challenging the ‘true sale’
of assets to the sukuk investors
Asset-backed’ investors should
have first claim to the sukuk
assets
Legal issues affect conventional
and Islamic markets equally
The East Cameron Partners L.P. (ECP) sukuk was relatively small one at USD
165.67mm and was issued in July 2006. It was the first issued by a US company and
was a genuine effort at an asset-backed Musharaka. It was secured by an interest in
the oil and gas royalty rights on two gas fields in the Gulf of Mexico. On 16 October
2008, East Cameron Partners (the originating company), filed for Chapter 11 /
bankruptcy in the US courts.
An sukuk enforcement event was then triggered on the 3rd September 2008 the due to
a shortfall in the stressed [oil and gas] reserves. As an asset-backed structure sukuk
investors already have legal rights over the oil and gas assets but ECP has requested a
ruling that the transaction was not a ‘true sale’ but a ‘secured loan’. In the former
sukuk investors have sole rights to the assets in the latter they would lose their rights
and share the assets with the other creditors should ECP enter Chapter 7 (liquidation).
Ultimately providing asset security for investors is a legal issue that impacts
conventional and sukuk structures equally. The concept is well tested in the US so
investors rights should be preserved if structured correctly. In the Middle East, legal
systems are less tested and secured sukuk are the minority. Investors in asset-based
sukuk have no senior claim or lien over the sukuk assets – but this is deliberate and
clear to most parties.
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 5
More transparency and awareness
is required
Many of the current sukuk types adhere to AAOIFI in form, but not in substance. In
Moody’s efforts to provide the clear credit analysis that can help support a healthy and
long-term sukuk market, we aim to encourage as much transparency as possible so that
investors are fully aware of the true nature of such securities. This helps prevent investor
disputes at a later stage should the company or assets become distressed.
In a default, sukuk investors have
no assets in an asset-based sukuk
– they are unsecured
From a risk perspective, it is critical for investors to note that, currently, upon the
insolvency of a sukuk originator, the assets ‘involved’ would be clawed back into the
bankruptcy estate. The sukuk investors would have no first-lien or prior ranking or
security above any other unsecured creditor. It is this aspect that drives the rating of
corporate and bank sukuk. If the likelihood of a loss on the sukuk is based not on the
assets but on the performance of the originating company – then the rating will be the
same as the company’s unsecured rating. However, compared to conventional bonds,
the immaturity of the market means that most of the special sukuk mechanisms are
untested in a distressed environment.
Current asset-based structures are
driven by issuer and investor
demand
To recap, without evidence of a legal ‘true sale’, a local court-recognised beneficial
interest or equivalent, we give little or no benefit to the assets in an ‘asset-based’
sukuk. The ‘form’ of the risk and return may appear to be that of assets but the
‘substance’ may be purely that of corporate or bank risk – not asset risk. Importantly,
in most cases, this is exactly what the borrowers and investors want. Many, with full
knowledge and understanding, are content to transact on this basis.
Where Is the Sukuk Profit Coming From?
The ‘self-generation’ of money
from money and usury is prohibited
As Shari’ah considers money to be a measuring tool for value and not an ‘asset’ in itself,
it requires that one should not be able to receive income from money alone. This ‘selfgeneration’ of money from money is riba, and is typically forbidden. However, some note
that it is the ‘usury’ interpretation that is the more relevant, i.e. when interest is applied
in an exploitative (usurious) manner that can force individuals into debt traps and a cycle
of poverty. This is not unique to Shari’ah - many non-Islamic countries have usury laws.
Trading and selling debts other
than at par value is prohibited
The implications for Islamic financial institutions and securitisations are that the
trading/selling of debts or receivables (without the underlying asset) for anything other
than par is not permissible. However, it should be noted that for some of the existing
sukuk, some Shari’ah boards appear to accept that as long as such receivables are a
‘small’ portion of the overall income flows, their presence is acceptable (although there
is some variation in the definition of ‘small’).
AAOIFI Principle 2: To be tradable,
sukuk should not be backed purely
by receivables
The second point raised by AAOIFI prohibits the selling of receivables or debts. As such,
in both of the sukuk securitisations seen to date, the physical assets (land and
properties that are generating the cash flows) have also been sold to the investors as
well as the payments/receivables due on those assets. If Tamweel or Sorouh PJSC were
to become insolvent, the legal ownership of the properties and land would reside with the
investors.
AAOIFI and IFSB play key roles in
achieving harmony and consensus
Institutions such as AAOIFI and the Islamic Financial Services Board have a crucial part
to play in bringing together the various parties in an organised fashion to debate the
issues and reach a consensus that will ultimately lead to sufficient standardisation to
meet the ‘common’ long-term goals of Islamic finance.
AAOIFI Principle 3: Sukuk profit
should not be supported by the
mudarib (usually the borrower)
In the rated Gulf sukuk structures, there is typically a rent, lease management income
derived from the ‘asset’. Under the (ijarah) lease type agreements, the company usually
agrees to pay sukuk holders income for use of the asset and these form the periodic
fixed income stream that replicates the coupon in a conventional bond.
Currently most sukuk cash flows
are not dependent on the assets
In other structures (mudarabah, musharakah), there may be some cash,flows from the
assets that are passed to the sukuk holders to pay the profit. However, if there is an
excess income, it is taken as an incentive fee; if there is a shortfall, the originator has
(ultimately) an obligation to pay the difference. The third AAOIFI principle appears to
relate to this practice, and discourages payments or loans if there is a shortfall in the
expected earnings. Thus, similar to the purchase undertaking discussed below, the
investors again rely on the corporate or bank to pay their profit – not the underlying
assets.
6 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?
Malaysia: Domestic harmony with some recent controversy 6,7
More unified regulatory and
Shari’ah views due to domestic
focus
Centralised Shari’ah Advisory
Council
Shari’ah is part of the regulatory
system
Different views on receivables in
Malaysia
The domestic nature of the Malaysian sukuk market is actually a key factor
underpinning its ongoing growth, as all parties (regulators, courts, scholars, lawmakers,
bankers) work together more easily without concern for more nationalistic interests.
There are two Shari’ah Advisory Councils (under the Securities Commission and Central
Bank) that advise the regulators on Islamic capital markets, banking and Takaful. Under
the guidelines, the relevant parties generally adhere to the policies through the
compliance officer, managers, trustee, etc.
The individual Shari’ah boards at local financial institutions are responsible for
ensuring adherence to the Shari’ah supervisory board – but may differ with good cause.
It is a clear part of the regulatory framework and greatly helps liquidity, and brings
some cohesion to the various viewpoints and transparency when comparing Islamic
institutions and sukuk products.
It is worth noting that Malaysia, which has a comprehensive domestic Islamic capital
market, does not place receivables in the same category as their Gulf counterparts and
hence allows sukuk to be 100% backed by receivables without any associated tangible
asset. This is a major difference between the two largest markets (Far East and the
Gulf) and affects the overall liquidity potential of a global ‘Islamic capital market’.
Shari’ah related legal dispute – Islamic home finance contract
Application of Islamic asset
finance contract to housing
rejected
In multiple recent court cases the application of an Islamic asset financing method to
home finance was found to be in conflict with the Islamic Banking Act (1983). Care
must be taken as in some instances defaulters can possibly try use Shari’ah
inconsistencies just to avoid payment – so it is important that objective legal clarity is
achieved for a healthy industry.
Bai al-Inah and Bai-Bithaman Ajil
contract
The contract in question was the Bai al-Inah and Bai-Bithaman Ajil (BBA) contract and is
analogous to a deferred payment sale. This contract is particularly prevalent in home
finance contracts and is defined by the Malaysian Securities Commission as “A
contract that refers to the sale and purchase transaction for the financing of an asset
on a deferred and on an instalment basis with a pre-agreed payment period. The sale
price will include a profit margin”.
The civil court judge in question ruled there had been no bona-fide sale hence the profit
element due was questionable. The profit due is calculated to take into account the full
term of the financing but another key issue was that a default prior the maturity did not
require the financier to forego the ‘future’ profit due despite the earlier recovery (and
likely sale) of the property. There was much emphasis on the actual substance of the
transaction -- clauses 27 & 29 of the ruling respectfully stated that:
“Transactional schemes that purport to be Islamic must be viewed as a whole rather
than, by closing one eye in succession, to view the agreements in the transaction as
separate components, so that the transactions are seen for what they are, before
forming an opinion on permissibility.”
“…it is not sufficient that the distinction between a sale and a loan is maintained in
form, but it must also be maintained in substance. It is the reality and not the form and
labels that matter.”
No legitimate asset sale hence
profit due is questionable
Judge focussed on substance
over form
6
7
The Islamic client can also be
placed in a poorer position vs.
the conventional one
Given that the goal of Islamic Finance was to encourage an ethical alternative to
usurious forms of finance, the fact that (dependent on timing of default) the client
could be in a significantly poorer financial position that those of a conventional
mortgage was also an issue.
Appeal court has upheld original
contract
Ultimately an appeal court ruling on 31 March 2009 upheld the contract, and reiterated
that a BBA contract is a sale transaction and therefore should not be compared to a
loan transaction. This provides some comfort, but the market has started to move away
from such contracts and is closely scrutinising itself.
The author would like to thank Dr Akram Laldin and the team at the International Shari’ah Research Academy (ISRA) for their assistance.
The author would also like to thank Professor Barry Rider for his input at the IFSB/QFIS event in Doha this May.
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 7
Legal considerations are key in sukuk / Islamic finance
Legal transparency, regulation
and Shari’ah principles are very
important
A key point from these events are that the legal details of contracts are important, and
that the genuine and subjective views on Islamic ethics may be an important
consideration in court enforcement situations. Such issues may be applicable to
Sukuk transactions although the institutional nature of the parties involved perhaps
makes social and ethical considerations a smaller part of the any judicial process.
However ongoing transparency, understanding and a focus on substance are very
important for long-term sustainability.
What Is the Role of Purchase Undertakings?
AAOIFI Principles 4 & 5: Asset
purchase undertakings for par
value are discouraged unless the
entity is unaffiliated to the original
asset owner
The purchase undertaking contracts are key in almost all asset-based structures to date.
This mechanism is used to repay principal to the sukuk investors and is generally a
contract that (often with a corresponding sale undertaking) ‘obligates’ the originator to
‘buy’ back the assets at par value (i.e. independent of the ‘actual’ realisable asset
value). This ‘par’ element of the purchase is discouraged in the fourth and fifth of
AAOIFI’s points. Repurchasing the assets at some measure of actual value – e.g. the
present value of future lease income – is acceptable, as is having an unaffiliated third
party (i.e. not the originator/mudarib) agree to purchase for a nominal fixed value.
Asset purchase undertakings at
market value are acceptable
Given that the assets are unlikely to have been the subject of a legal sale initially, the
main purpose of this contract is to create a payment obligation on the originator. In the
event of the corporate going bankrupt, this claim can be ‘accelerated’ and hence
investors should have a claim for this amount (i.e. the principal due). Again, given its key
place within the sukuk structure, Moody’s requires a legal opinion that supports the
enforceability of the claim generated by the undertaking. Assuming the opinion is
satisfactory, sukuk investors have an unsecured claim (although Moody’s has seen
examples where an indemnity against the ‘originator’ for failure to repurchase is the
ultimate and enforceable source of the claim). Crucially, from an investor perspective,
such claim should rank at the same level as other unsecured creditors, both
conventional and Islamic. Sukuk investors here have no priority over the sukuk assets.
Usually, however, the asset was
not ‘legally sold’ in the first
instance
AAOIFI Principle 6: Encourages
more detailed oversight from
scholars to ensure compliance
Shortage of Shari’ah human capital
makes comprehensive oversight
difficult
The sixth and final AAOIFI point is more operational and regards the assignment of
fatwas and approvals rather than any structural comments, noting that approving boards
should be more hands-on in the documentation and execution. While good in theory,
there are some practicalities that make this difficult. First and foremost, the shortage of
qualified scholars means that (in the past) relatively little time can be devoted to each
and every sukuk, especially when the complete legal documentation governing the
structure can span hundreds of pages. Secondly, the complexity of English legal
documentation can prove problematic even to native speakers without a legal
background – most scholars are fluent first in Arabic and, in addition, have little
familiarity with the civil codes or common laws involved that dictate asset rights and
enforcement in the local courts. In most commercial instances, Shari’ah laws only are
relevant where explicitly incorporated into the laws of the country. Only in Saudi Arabia
can Shari’ah judges potentially preside over institutional and investor disputes that could
arise.
ASSET-BACKED / SECURITISATION SUKUK
Islamic securitisation is closer to
the Shari’ah and AAOIFI principles
It is into this market that we have seen securitisation sukuk or Islamic securitisations.
These innovative and legally complex structures are the closest that sukuk currently get
to the financing ideals of asset ownership and risk sharing, although the structures raise
another controversial topic: the tranching of different classes of Sukuk holders (i.e. each
have a different rank in the allocation of profits and losses), but that will be the topic of a
future report.
They require a ‘true sale’ of the
assets to investors
The critical difference is that these structures (notable are the Tamweel and Sorouh PJSC
sukuk) have a registered ‘true sale’ of the underlying assets to the investors. In Sorouh,
the underlying title to the plots of land are transferred to the investors with the
associated cashflows (payments for land purchase).
8 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?
A tale of two sukuk - Tamweel PJSC asset-‘backed’ vs. asset-‘based’
Tamweel PJSC has issued both
types of sukuk
Asset-backed / secured sukuk
Senior notes rated Aa2 and
Stable, should survive bankruptcy
Asset-based / unsecured sukuk
Notes rated A3 on review,
direction uncertain – would not
survive bankruptcy
The secured investors should still
be paid, even upon company
insolvency
In the Tamweel asset-backed sukuk, the freehold titles to approximately 1,000
properties are transferred to the sukuk investors along with the associated ijarah cash
flows; these are the sukuk assets. The property/land titles are registered in the name
of the investors at the relevant land department. Any losses on those cash flows (that
ultimately arise from the sale of distressed property) are passed on to sukuk holders,
who are exposed to the asset risk. Even upon the insolvency of Tamweel, the assets
will continue to pay the sukuk investors. The sukuk should survive. The asset-backed
bankruptcy remote nature of this sukuk means the senior notes obtain an Aa2 rating –
the maximum possible in the UAE.
Tamweel also has issued an unsecured or asset-based sukuk. The rating of this sukuk
is currently A3 (on review, direction uncertain). This is four notches below the secured
one due to it’s asset-based nature. This sukuk would not survive the bankruptcy of
Tamweel. The two sets of sukuk investors are taking very different risks
In both asset-backed cases there is no recourse back to the originators; these sukuk
should survive their bankruptcy. Some key features are:
−
The risk of principal/capital repayment depends on asset performance, not a
purchase undertaking from the corporate at nominal (or market) value.
−
The risk of profit payments depends on the performance of the assets, not that of
the mudarib/originator. If the assets perform badly, investors may lose profit as well
as principal. If they do well, they are paid the expected profit. Even if the corporate
defaults, the sukuk holders retain the assets and the cash flows should continue.
Expected profit and risk varies by
class
−
Profit and loss allocation varies according to the sukuk class. The senior-most
classes have fixed profit rate spreads due to their less risky and more senior
position in the investment. The junior-most class or equity is the most risky by far
but retains all the excess variable profit that may be generated. This sharing of
losses is usually done in a ratio that tries to fairly reflect the allocation of profit. In
the Sorouh sukuk, it did not issue an equity note, but returned all the excess profit
beyond the due amounts to repay the capital invested in order of seniority.
Substance is asset ownership and
risk transfer
The substance of securitisation sukuk is one of asset ownership and risk sharing (of the
assets and associated cashflows) and satisfies many of the AAOIFI principles. Again, it
should be highlighted that the structural ‘substance’ of many existing unsecured sukuk is
a deliberate construction; many companies do not want to ‘sell’ their quality assets to
investors, many investors do not actually want asset risk, but want the equivalent of
conventional bonds. Widespread structuring approaches mean they get the desired debt
funding in sukuk form and investors are happy with this for the most part.
AAOIFI recommendations could
lead to more asset-backed sukuk
issuance once markets normalise
It should also be emphasised that while certain sectors of securitisation have recently
fallen into disrepute, the financing technology applied is still a critical part of the global
landscape and even part of Central Banks’ current solution to the liquidity crisis. As in
many other (less complex) markets, losses in the sector are usually the result of very
high leverage and an unexpectedly rapid decline in the quality of underlying assets.
Leverage and credit quality are not new concepts, but the form was unfamiliar to many
investors. A total loss of confidence is another key driver. Securitisations are relatively
new in the Middle East, but Shari’ah could become a key positive driver of such
transactions if sukuk compliant with the AAOIFI guidelines become favoured by
investors 8 .
Cash flows are 100% due from the
assets; if assets perform badly,
investors lose
8
Please see report “Securitisation in the Middle East: Exploring The Untapped Potential of the Region” (SF147632isf) published October 2008
for more information.
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 9
THE FUTURE FOR SUKUK STRUCTURES
Continued diversity of opinion but
market slowdown triggered by
global crisis not AAOIFI
That some sukuk have been successfully issued since the publication of AAOIFI’s
comments without adopting their recommendations shows that there is still a diversity of
opinion and, with a topic so subjective, no single agency, institution or individual can
really hope to unilaterally ‘legislate’ Shari’ah law. Indeed, the success of Indonesia’s
recent sovereign sukuk shows that there is strong demand (although it is not clear how
much was sold to Islamic investors for whom compliance would actually be a
consideration). The Islamic view is that only through ijtihad (mental
effort/struggle/evolution/reasoning) will the market reach consensus. However, the
healthy debate triggered by AAOIFI and this paper is hopefully a good starting point for
the next evolution of sukuk.
Global crisis is having a significant
effect, but long-term prospects
still positive
Rapidly changing market conditions and unprecedented events are all playing a key part
in reshaping the sukuk markets. At the moment, the infant bond, sukuk and debt market
growth has stalled awaiting some stability in pricing and a return of investor confidence.
But, given the long-term local need and sizeable Muslim populations in Europe, the
Middle East, Africa and Asia, it is just a matter of time before growth resumes, although
the recent conventional bond issuances from Qatar and Abu Dhabi is an ambiguous sign
for GCC sukuk markets.
AAOIFI encourages ‘true’ assetbacked structures
As they stand, the first five AAOIFI recommendations encourage movement away from the
bulk of current unsecured structures towards secured, asset-backed ones. This
complements the broader trend towards more secured lending that is evident currently
across the region but perhaps not the broader demand for debt finance that is needed in
any developing capital market.
While securitisation sukuk are closer to the Shari’ah ideals, they are still not perfect, and
if interest and evolution continues, we will likely see more hybrid equity type structures
where the some element of the profit on all (asset-backed) sukuk classes may potentially
vary from the the expected return.
The comments and market
conditions allow time for
consolidation and reflection
In the midst of this global turmoil and the market pause, the AAOIFI comments have
provided for some self-reflection in the industry, in particular among the scholars whose
role in the market is currently crucial. Although it would probably be more beneficial in
the long term if such fatwas were provided by institutions, it will likely be these highly
respected and learned individuals who will, in some form, drive the shape of the market
for some time.
Long-term market health and
sustainability requires more
education
For the long-term health and sustainability of the market, Moody’s believes all parties
need to be very clear about the ‘substance’ of the underlying sukuk risk in question to
avoid the situation where some parties will be confused/distracted/misled by complex
Islamic terminology or legal jargon.
Only by supporting those aspects
that make Islamic finance different
will it likely contribute something
of value
If the key features of cash flows, risk and return of certain sukuk are, in substance, the
same as those of an interest-bearing conventional bond, then it may perhaps be best to
make this clear to sukuk scholars and investors at inception. One result of such
transparency may be that the sukuk market does not grow as fast as before, another
that the asset-backed market may take a greater share of future volume. Regardless,
rather than replication, it is probably only by supporting and encouraging those features
that make Islamic finance different will it likely add any sustainable and long term value
to the global financial system.
10 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?
APPENDIX 1 – RATED ASSET-BACKED SUKUK EXAMPLES
Table 1:
ABS/CMBS: Sun Finance Limited 9 / Sorouh Real Estate PJSC
Class
Rating
Investor
A
B
C
Sub'n
Aa3
A3
Baa3
NR
Public
Public
Public
Originator
Balance AED %-age
2761
251
1004
1004
55.0%
5.0%
20.0%
20.0%
Currency
Spread
Maturity
WAL
AED
AED
AED
AED
E+200
E+250
E+350
0
Jan 2015
Jan 2015
Jan 2015
0.95
2.03
2.55
No Class “D” note issued, but receivable balance remains in deal as over-collateralisation, Basis is EIBOR, WACC E+240
Abu Dhabi’s first securitisation of
land and associated payments
The recent Sorouh transaction (Sun Finance Limited) is an innovative example of an
asset-backed sukuk financing. It is a hybrid of asset-backed securitisation and project
finance. Sorouh required funding to help deliver a portion of the Abu Dhabi’s Reem
island development (Shams), which is one of their major projects and part of the
government’s urban master plan for the city.
Investors are taking risk on
Sham’s project success, which is
largely delinked from Sorouh’s
financial health
Sorouh raised AED4.106 billion by selling land and the associated AED5.7 billion of
payments due for the land under the purchase contracts of 109 sub-developers working
on the estate. A sizable portion (approximately AED1.7 billion) was put into escrow to
fund the construction costs and help delink somewhat the sukuk performance from that
of Sorouh. Ultimately, investors are expected to be repaid from the payments from the
real estate developers under the land purchase contracts assuming the land and
infrastructure get developed according to the schedule. They have no recourse back to
Sorouh. Losses will occur if the buyers default and the land value has significantly
fallen
Table 2
RMBS: Tamweel Residential ABS 1 10 /Tamweel PJSC
Class
Rating
Investor
A
B
C
D
Aa2
Baa1
Ba3
NR
Public
Public
Public
Originator
Balance USD
177.45
15.33
9.87
7.35
%-age
Currency
Spread
Maturity
84.5%
7.3%
4.7%
3.5%
USD
USD
USD
USD
L+35
L+120
L+395
NA
Aug 2037
Aug 2037
Aug 2037
Aug 2037
LIBOR Basis, WACC L+57
Tamweel was the first
internationally placed RMBS in the
region
The pioneering Tamweel Residential ABS transaction was the first international and
publicly rated Islamic securitisation of ijarah (lease-to-buy) receivables of residential
properties located in Dubai. The deal to date has performed very well with zero defaults
in the pool.
Originator raised non recourse
funds secured by property assets
and associated leases
From an Islamic perspective, the deal was important as it was the first true-sale,
globally rated, asset-backed sukuk in the region and ‘complies’ with the recent Shari’ah
recommendations issued by AAOIFI.
This transaction is a good example of a company raising secured funds on high-quality
assets and while it was initially unrated (it subsequently obtained a public issuer rating
of A3), this weakness was mitigated by strong back-up servicing mechanisms. The
transaction achieved Aa2 ratings on the senior notes – the highest rating currently
possible in the UAE.
Such asset backed funding is a
key part of liquidity provision in
Europe
9
10
Such deals are a key part of global liquidty mechanisms to direct liquidity into home
finance providers and ultimately to homebuyers. Although no such program exists in the
UAE, the situation with Amlak and Tamweel is still in flux and may yet involve such
asset backed funding.
Please see Moody’s Pre-Sale Report; Sun Finance Limited (SF136098isf) published July 2008 for more details.
Please see Moody’s Pre Sale Report: Tamweel Residential ABS CI (1) Ltd, (SF101479isf) published June 2007 for more detail
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 11
APPENDIX 2 – MOODY’S SUKUK RATINGS
Table 3
Country
Issuer
SECURED SUKUK (Asset-Backed)
Originator Name
Amount (US$ mm)
Issue Rating
UAE
UAE
UAE
UAE
Tamweel Sukuk Ltd. Class A
Tamweel Sukuk Ltd. Class B
Tamweel Sukuk Ltd. Class C
Tamweel Sukuk Ltd. Class D
Tamweel PJSC
Tamweel PJSC
Tamweel PJSC
Tamweel PJSC
185.90
16.10
10.30
7.70
Aa2
Baa1
Ba3
NR
UAE
UAE
UAE
Sun Finance Ltd. Class A
Sun Finance Ltd. Class B
Sun Finance Ltd. Class C
Sorouh Real Estate PJSC
Sorouh Real Estate PJSC
Sorouh Real Estate PJSC
750.68
68.24
272.97
Aa3
A3
Baa3
650
650
5,000
750
1,500
1,250
1,000
2,043
272
5,000
1,021
872
600
300
350
475
300
Baa1
Ba3
A2
A1
A1
A1
A1
A1
A3
A3
A3
A1
A3
A3
Baa1
Ba3
A2
UNSECURED SUKUK (Asset-Based)
Saudi Arabia
Indonesia
UAE
UAE
UAE
UAE
UAE
UAE
UAE
UAE
UAE
UAE
Malaysia
Malaysia
Malaysia
Kuwait
Qatar
Golden Belt 1 B.S.C.
Indonesia Global Sukuk
ADIB Sukuk Co. Ltd.
DIB Sukuk Co. Ltd.
DP World Sukuk Ltd.
Dubai Sukuk Center Ltd.
EIB Sukuk Co. Ltd. Programme
JAFZ Sukuk Ltd*.
Tamweel Sukuk Ltd
DB Sukuk Ltd
Sukuk Funding (No. 2) Limited*
DEWA Funding Ltd*
Malaysia Global Sukuk Inc.
MBB Sukuk Inc. (Subordinated)
Sarawak Corporate Sukuk Inc.
NIG Sukuk Ltd.
Qatar Alaqaria Sukuk Co.
Total amount of issuance rated by Moody's:
Saad Trading Contracting & Financial Services Co
Republic of Indonesia
Abu Dhabi Islamic Bank
Dubai Islamic Bank PJSC
DP World
DIFC Investments LLC
Emirates Islamic Bank PJSC
Jebel Ali Free Zone FZE
Tamweel PJSC
Dubai Bank PJSC
Aldar Properties PJSC
Dubai Electricity & Water Authority
Government of Malaysia
Maybank
State of Sarawak
National Industries Group Holding S.A.K.
Qatar Real Estate Investment Co
22,033
* Actual Issuance in AED, USD Equivalent listed
12 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?
The Future of Sukuk: Substance over Form?
Moody’s Investors Service • 13
SF154199isf
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14 • Moody’s Investors Service
The Future of Sukuk: Substance over Form?