Development and Regulation
of the Sukuk Market
by
Wan Abdul Rahim Kamil
ICM Consultant
1
Contents
Introduction
Booming international sukuk market
Growing importance in domestic funds raising
activities
Key contributing factors
Malaysian initiatives
Sukuk
Definition
Crucial distinction
Salient features
Types of sukuk
Trading profile
Transaction structures
Ijarah sukuk
Musharakah sukuk
Talking Points
What is being rated?
Accounting and regulatory issues
Trend and Challenges
Continue importance
Shari'ah and accounting convergence
Critical mass
Regulation and legal frameworks
Q&A
Issuance Processes
Parties involved
Process flow
Distribution methods
Documentation
2
1
Abbreviation
AAOIFI = Accounting and Auditing Organization for Islamic Financial
Institutions
SFA
= Statement of Financial Accounting
GCC
= Gulf Cooperation Council
IFSB
= Islamic Financial Services Board
SC
= Securities Commission, Malaysia
SCA
= Securities Commission Act, 1993
MARC = Malaysian Rating Corporation Berhad
RAM
= Rating Agency Malaysia
3
Introduction
Booming international sukuk market
Phenomenal growth last few years
Average growth of 40% p.a. vis-à-vis the 20% p.a. registered by the overall Islamic
finance sector
Gross market size for sukuk, as at December 2006
USD52.5 bil. (2006) vis-à-vis USD1.8 bil. (2002)
aggregate of Malaysian & GCC standards issuance
USD32.1 bil. (2006) vis-à-vis USD1.5 bil. (2002)
Malaysian standard issuance
Islamic assets under management worth approximately USD500 bil.
Source: American Journal of Islamic Finance & Fitch Ratings, March 2007
Growing importance in domestic funds raising activities
Emergence as the preferred choice in the private debt securities market since 2004
55% (2006) & 71% (2005) of total bonds approved by the SC, in value terms, vis-à-vis
49% in 2004
Source: Securities Commission 2006 Annual Report
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2
Introduction (cont'd)
Key contributing factors
General factors
Oil-driven financial liquidity in the Gulf region
Emergence of the required critical mass
Entrance of new market participants, both Muslim and Non-Muslim alike e.g. western
financial institutions/underwriters and investors
Availability of new Shariah compliant products i.e. through some feverish innovation
by the new market participants
Concerted regulatory efforts/government initiatives
Comprehensive and facilitative regulatory policies cum infrastructure e.g. rules,
regulation, market place and favorable tax incentives
The availability and adoption of acceptable standards issued by AAOIFI and the
integration of Islamic financing with global corporate and risk management standards
through IFSB
5
Introduction (cont'd)
Malaysian's initiatives
Establishing benchmarks and innovative products
The first global sovereign sukuk, raising USD600 mil, in 2002 by Malaysian Government
an international benchmark for the issuance of global and sovereign sukuk as it was
listed on several stock exchange e.g. the Luxembourg Stock Exchange, Labuan
Stock Exchange and the Bahrain Stock Exchange
The first exchangeable sukuk, raising USD750 mil, in 2006 by a government linked
company
Incorporating full convertibility features common to equity-linked transactions
USD850 mil issuance in June 2007 (oversubscribed by 13 times & 50% by Middle
East investors)
Host country of the IFSB since 2002
Enactment of Islamic Financial Services Board Act 2002, which grants the immunities
and privileges that are usually granted to international organizations and diplomatic
missions
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3
Introduction (cont'd)
Malaysian initiatives (cont'd)
Adding depth to the market/ “market making” roles through the accommodation of inbound
investment from the GCC countries and vice versa
Notable shift from debt-based bonds premised on cost-plus-sale agreements or cost-plus
production agreements, to lease-based or profit-sharing sukuk
Key efforts
Encourage the distribution of sukuk outside the established home market
Encourage and facilitate the inclusion of both national and international prominent
scholars on local banks’ Shariah boards (for the banks to operate across the different
schools of thoughts)
Introduction of additional favorable tax incentives involving Islamic securities e.g.
MudharabahMudharabah and Musharakah contracts
Signing of bilateral agreements with international peers e.g. Dubai Financial Services
Authority, Central Bank of Bahrain etc.
7
Introduction (cont'd)
Malaysian initiatives (cont'd)
Launching of the Malaysian International Islamic Financial Centre in 2006
Objectives
Accelerating the process of bridging and strengthening the relationship between the
international Islamic financial markets and thereby expand the investment and trade
relations between the Middle Eastern, West Asia and North Africa regions with East
Asia
Key roles
To act as a centre for origination , issuance and trading of Islamic capital market and
treasury instruments
To act as an investment gateway to the region specializing in Islamic fund and wealth
management, and as a takaful and retakaful centre.
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4
Sukuk
Definition
“Certificates of equal value representing, after closing subscription, receipt of the value of the
certificates and putting it to use as planned, common title to shares and rights in tangible
assets, usufructs and services, or equity of a given project or equity of a special investment
activity".
Source: AAOIFI
AAOIFI issued a Shariah standard on "Investment Sukuk" in May 2003, which became
effective from 1st January 2004
Sukuk represents a common share in the ownership of the assets made available for
investment, whether these are non-monetary assets, usufructs, services or a mixture of
all these plus intangible rights, debts and monetary assets
The wide application parameters enable the Sukuk to be issued both on existing as well
as specific assets that may become available at a future date.
9
Sukuk (cont'd)
Crucial distinction
The aim of Islamic finance is not simply to engineer financial products that mimic conventional
financial instruments as understood in the West, but rather to develop innovative types of
assets that are Shariah compliant
Sukuk should not simply be regarded as a substitute for conventional interest-based
securities (which are contractual debt obligations)
The claim embodied in sukuk is not simply a claim to cash flow but an ownership claim and it
confers a beneficial interest to the holder in terms of holding a proportional ownership of the
underlying asset as well as the income that it generates
The sukuk holder also assumes all rights and obligations for the maintenance of the asset
10
5
Sukuk (cont'd)
Salient features
Complete transparency with regard to all information relating to offering and to the underlying
assets
It represents actual and legal ownership stakes in specified tangible assets and services
Is issued and traded on the basis of Shariah nominated investment contracts and in
accordance with the specific Shariah rules that may govern such contracts
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Types of sukuk
The AAOIFI has issued standards for 14 different types of Sukuk, where some of
these Sukuk are classified as tradable and others are classified as non-tradable
based on the type and characteristics of the issued Sukuk:
Ijarah
Musharakah
Musharakah Mutanaqisah
Mudharabah
Istisna'
Wakala
Salam
Murabahah
Bai Bithaman Ajil
The common principles on which sukuk (and the accompanying features) is
issued is briefly highlighted in the next few slides
12
6
Sukuk (cont'd)
Ijarah - definition
“Ijarah means leasing of asset pursuant to a contract under which a specified permissible benefit
in the form of a usufruct is obtained for a specified period in return for a specified permissible
consideration”
Ijarah Sukuk features
Represents title deeds of equal shares in a leasing project, usually equipment or real
estate and entitle the holders the right to own shares, receive rental fees and/or dispose
of their sukuk in a manner that does not affect the right of the lessee
Sukuk holders bear all the cost of maintenance of and damage to the assets and to
maintain it in such a manner that the lessee may derive as much usufruct from it as
possible
Normally the maintenance is assigned back to the issuer through an agency
agreement
The duration of the rental and the fee are agreed in advance and ownership of the asset
remains with the lessor
Subject to risks related to the ability and desirability of the lessee to pay the rental
installments and risks arising from potential changes in asset-pricing and in maintenance
and insurance costs.
13
IJARAH SUKUK
2. SPV issues sukuk to investors that
represent beneficial ownership of the assets
1. Sells assets to SPV at
purchase price on cash basis
Ijarah Sukuk
Client
3. Proceeds from
issuance of sukuk
Special Purpose
Vehicle (SPV)
4. Lease the asset to client
3. Proceeds from
issuance of sukuk
Investors
6. Distribution of rental payment
(profit to sukuk holders – investors)
5. Rental payment
7. At maturity, SPV sells the asset back to
the client
8. Proceeds from the sale of the asset will be used to repay the
investors, in term of the principal amount of the sukuk
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7
Sukuk (cont'd)
Musharakah - definition
“Musharakah means partnership and refers to the commingling of capital provided by
the partners for the purpose of sharing in profit/loss”
Musharakah Sukuk features
Represents ownership of the project or the assets of the activity as per their respective
shares in the Musharakah venture i.e. profit and loss sharing business venture
All providers of capital are entitled to participate in management, but not necessarily
required to do so
Normally the issuer is appointed as the Musharakah partners’ agent in managing the
business
The profit is distributed among the partners in pre-agreed ratios, while the loss is borne
by every partner strictly in proportion to respective capital contributions
Musharakah sukuk is treated as negotiable instruments and can be bought and sold in
the secondary market
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MUSYARAKAH SUKUK
6. Upon maturity of the sukuk, issuer repurchases asset musyarakah (purchase undertaking)
5. Profit payment to investors
4. Issuer issues purchase undertaking to buy back the asset upon maturity of the sukuk
3. Issuer issues sukuk musyarakah to evidence the participations in the musyarakah venture
Musyarik 1
(Issuer)
Capital X
Musyarik 2
(Investors)
Musyarakah
sukuk
1. Issuer provides capital
1% of capital
2. Investors provides
99% of capital
Capital Y
Musyarkah agreement
Issuer and investors agreed on
profit and loss distributions
Musyarakah venture
4. Return from musyarakah
venture channeled to issuer
7. Proceeds from the sale of the asset will be used to repay the investors, in term of the principal
amount of the sukuk
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8
Sukuk (cont'd)
Mudharabah - definition
“A form of partnership in profit whereby one party provides capital (Rab Al-Mal) and the other
party acts as an entrepreneur (Mudharib) who solely works the capital”
Sukuk Mudharabah - features
Sukuk holders are considered to be owners of common shares in the Mudharabah capital
and all benefits and returns are related to the investor’s percentage of ownership in the
capital
The issuer of these certificates is the Mudharib, the subscribers are the capital providers,
and the realized funds are the Mudharabah capital
A Mudharabah Sukuk gives its owner the right to receive his capital at the time the sukuk
are surrendered, and an annual proportion of the realized profits as agreed
On the expiry of the specified time period of the subscription, the Sukuk holders are
given the right to transfer the ownership by sale or trade in the securities market at
their discretion
Mudharabah Sukuk neither yield interest nor entitle owners to make claims for any
definite annual interest
17
MUDHARABAH SUKUK
6. Upon maturity of the sukuk, issuer repurchases asset mudharabah (purchase undertaking)
5. Profit payment to investors
4. Issuer issues purchase undertaking to buy back the asset upon maturity of the sukuk
3. Issuer issues sukuk mudharabah to evidence the participations
of rabb al-mal in the mudharabah venture
Entrepreneurship
Rabb al-mal (Investors)
Mudharabah
sukuk
Mudharib (Issuer)
2. Issuer provides
entrepreneurship
1. Investors provide
capital
Capital Y
Mudharabah agreement
Issuer and investors agreed on
profit and loss distributions
Mudharabah venture
4. Return from mudharabah
venture channeled to issuer
7. Proceeds from the sale of the asset will be used to repay the investors, in term of the principal
amount of the sukuk
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9
Sukuk (cont'd)
Istisna' - definition
“A purchase contract of an asset whereby a buyer will place an order to purchase the asset which
will be delivered in the future. ”
Sukuk Istisna' features
Represents ownership of the item/asset or the selling price of the manufactured
item/asset to be constructed or manufactured under the Istisna' contract.
Proceeds from the sukuk will be utilized to fund the manufacturer or the contractor during
the construction of the asset
Investors are not obliged to pay all the investment in advance, but to pay gradually
before the beginning of each stage of the manufacturing process of the commodity
Sukuk holders shall acquire title to that asset upon completion or immediately passes title
to the developer on agreed deferred payment terms
Alternatively, the sukuk holders can also leases the asset to the developer under an
Ijarah sukuk
If the sukuk are listed during the Istisna’ period, the sukuk should be traded only at par as
the underlying assets do not yet exist
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ISTISNA’ SUKUK
5. Financier delivers ordered project to client
1. Client requests financiers to deliver with full completion certain project value at
RM (X +Y) million i.e. Istisna’ sale price in installment basis (over deferred period)
2. Client issues sukuk istisna’ to evidence obligations
to pay sale price in several instalments
Client
Istisna’ Sukuk
Financier
3. Financier requests contractor to develop project as requested
under (1) at RM X million i.e Istisna’ purchase price. Payment term :
Pre-agreed terms or on spot basis
Contractor
4. Upon full completion, project handed over by contractor to
financier
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10
Sukuk (cont'd)
Trading profile - AAOIFI Investment Sukuk Standard
Principles
AAOIFI Features
Tradability
Universally
Malaysia
Ijara
Sakk must lay title claim to
asset, directly or beneficially.
Universally tradable.
Musharaka & Sakk must lay title claim to Tradable depending Freely tradable.
Mudaraba
asset, but this may include on the asset type.
no debt form
participation in business
ownership or operations.
assets e.g.
Frequently, an undertaking is
Murabaha
added to make a Musharaka
receivables
more debt like.
21
Sukuk (cont'd)
Trading profile - AAOIFI Investment Sukuk Standard (cont'd)
Principles
AAOIFI Features
Istisna’
Sakk must lay title claim to
asset.
Tradability
Universally
Malaysia
Restricted trading.
Freely tradable.
Hybrid between
an uncompleted
asset and a
debt (obligation
to deliver the
uncompleted
asset).
Murabahah & Sakk represents assets
Non-tradable.
Bai Bithaman purchased and intended for
Ajil
sale. Once the sale is made,
the sakk represents a debt.
Freely tradable.
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11
Issuance Process
Parties involved - Malaysia
Parties
Principal Adviser/
Lead Arranger
Features - Snapshot
To advise on all aspect of an
issue to ensure compliance with
regulatory requirements and
market conditions/requirements
Qualified advisers:
investment/merchant banks
Islamic banks
commercial banks
(instruments without equity
conversion features only)
international investment
houses/banks (for
international issuance)
May assume role of Lead
Manager, which manages the
issuance process into the market
place e.g. book-building
processes
Shariah Adviser
To advise on all aspect of an
issue to ensure compliance with
Shariah principles:
structuring
documentation
investments
administrative & operational
matters
Qualified advisers:
independent Shariah adviser
registered by the SC
Islamic Bank licensed
institution approved by Bank
Negara Malaysia to carry
out Skim Perbankan Islam
an international Shariah
adviser (foreign currency
denominated issuance)
23
Issuance Process
Parties involved - Malaysia
Parties
Legal Adviser
Features - Snapshot
To advise on all legal aspect of
an issuance to ensure
compliance with subsisting laws
To conduct legal due diligence
for the purposes of satisfying
Section 32B of the SCA:
Normal scope of works:
advising on legal implications
& drafting of issuance
documents (legal) as legal
adviser
acting as secretary to the
due diligence working group
and preparing the due
diligence planning
memorandum & verification
notes
Reporting Accountant
To conduct financial due
diligence on the issuance
Normal scope of works:
to verify the consistency of
the assumptions applied and
the mathematical accuracy
of the cash flow projections
& to express an opinion on
the same
to provide advice and an
express opinion on tax
related matters (where
applicable)
to conduct financial due
diligence on financial
matters specified by the due
diligence working group
24
12
Issuance Process (cont'd)
Parties involved - Malaysia (cont'd)
Features - Snapshot
Parties
Regulatory Authorities
Rating Agencies
Primary responsibilities:
approval of issuance vis-àvis the SCA and guidelines
facilitating issuance
infrastructure e.g. FAST &
RENTAS
facilitating listing processes
on stock exchanges
To analyze, evaluate and advise
a specific credit rating to a sukuk
issue and continuously monitor
the rating thereafter
Includes:
Securities Commission
Bank Negara Malaysia
Ministry of Finance (onshore
foreign currency
denominated issuance &
applicable to multilateral
financial institutions and
development banks only)
Bursa Malaysia Berhad (for
listing of sukuk only)
Acceptable agencies:
Malaysian Rating
Corporation Berhad
Rating Agency Malaysia
Berhad
international rating houses
such as Standard & Poor's,
FitchRatings (for onshore
foreign currency
denominated issuance &
international issuance)
Credit rating indicates timeliness
of repayment/redemption:
from AAA to D range
25
Issuance Process (cont'd)
Parties involved - Malaysia (cont'd)
Features - Snapshot
Parties
Issuers
Both public and private limited
companies, with funding
requirements:
Schedule 2 and 3 of the SCA
Section 4 (6) of the
Companies Act, 1965
Foreign entities (for foreign
currency denominated
issuance):
foreign government
multilateral development
banks/financial institutions
multinational corporations
Investors
Both foreign and local based
investors are allowed to
subscribed to the sukuk:
Schedule 2 and 3 of the
SCA
Malaysian Government
Gazette
Recent
guidelines
by
the
Securities
Commission
on
“sophisticated investors” for
foreign currency denominated
issuance:
total net personal assets
exceed RM3 mil or RM10
mil for corporations
aggregate consideration for
any acquisition is not less
than RM250,000
26
13
Issuance Process (cont'd)
Parties involved - Malaysia (cont'd)
Parties
Trustee
Features - Snapshot
Statutory requirements under the
SCA to appoint a trustee and the
issuance of a trust deed
To safeguard the interest and
act for the benefit of the sukuk
holders based on the terms of
the trust deed
A trustee shall be:
company registered as a
trust company under the
Trust Companies Act 1949
a corporation that is a public
company under the
Companies Act 1965 or
under the laws of any other
country which has been
allowed by SC to act as
trustee
Independent Bond
Pricing Agency
To complement the
government’s objective of
building a more efficient,
sophisticated and liquid bond
market
Bondweb Malaysia Sdn. Bhd:
April 18, 2006 - first Bond
Pricing Agency in Malaysia
shareholders consisting of
key institutions from the buyside, sell-side and market
intermediaries
to provide daily independent
and objective fair value for all
Ringgit denominated bonds,
and to facilitate daily mark-tomarket valuation of bond
portfolios
27
Issuance Process (cont'd)
Process flow
Stages
Main
Tasks
Preliminary Stage
Consultation with friendly banker(s):
on funding objectives and requirements
on mode of financing, the possible
transaction structures and all other
requirements for issuing sukuk e.g.
required information, SC guidelines &
Shariah requirements
Appointments:
Principal Adviser/Lead Arranger (“PA”)
Shariah Adviser (“SA”)
Legal adviser (“LA”)
Reporting Accountant (“RA”)
Rating Agency (“RAy”)
Concept papers (initial and revised copies)
Engagement letters detailing by PA, SA,
LA, RA and RAy:
scope of works
the deliverables
fees
Request for proposals or letter of offer(s)
Deliverables
Stage 1
Collation of information on the issuer incl.
industry information and other information
required for an issuance
Letter of offer detailing by PA:
the indicative/final salient terms and
conditions incl. the mode of issue e.g.
book building/bought deal
Funding Objectives and Requirements vis-à-vis Shariah Requirements
28
14
Issuance Process (cont'd)
Process flow (cont)
Stage 2
Stage 3
Formation of due diligence working
group & conduct due diligence:
PA, LA, RA & senior management
team of issuer
guidelines issued by SC is available
Completion of due diligence exercise
Stages
Main
Tasks
Rating process begins
Fine tuning:
terms and conditions for issuance
cash flow projection
Completion of rating exercise
Finalization:
terms and conditions for issuance
SC submission papers
Shariah pronouncement obtained
Preparation of SC submission papers
Deliverables
Due diligence planning memorandum and
minutes of due diligence meetings
Verification notes, RA letters together with
finalized cash flow projections
Provision of information and clarification to
rating agency/due diligence working group
Credit rating & Shariah pronouncement
Draft SC submission papers
SC submission papers incl. any other prior
regulatory approvals to be in place
Funding Objectives and Requirements vis-à-vis Shariah Requirements
29
Issuance Process (cont'd)
Process flow (cont)
Stages
Main
Tasks
Stage 4
Submission to SC:
14 working days from the date of
receipt of all declarations, complete
information and documentation
deemed approval for qualified issuers,
upon fulfillment of certain conditions
(foreign currency issuance only)
Stage 5
SC's Approval
Finalization and execution (where
applicable):
OC
legal and issuance documents
Issuance of OC to potential investors
Drafting:
offering circulars (“OC”)
legal and issuance documents
Issuance of preliminary OC to potential
primary subscribers (bought deal basis)
Clarifications and additional information
pursuant to queries from SC
Deliverables
Formal written approval from the SC
Final OC
Draft OC (incl. preliminary OC where
applicable), legal and issuance documents
Executed legal and issuance documents
Funding Objectives and Requirements vis-à-vis Shariah Requirements
30
15
Issuance Process (cont'd)
Process flow (cont)
Stage 6
Stages
Main
Tasks
Stage 7
Preparation for issuance:
furnishing issuance information to Bank
Negara Malaysia e.g. FAST and
RENTAS
internal approvals for issuance incl.
preparing the necessary funding by
banks (where applicable)
Confirmation from potential Primary
Subscriber (where applicable):
bought deal mode & sell down clause
Issuance into the market place
Secondary trading
Continuous obligations (post
issuance):
compliance with SC’s approving
conditions
compliance with the terms and
conditions of issuance
maintenance of credit rating
Road shows (where applicable)
book building mode
Deliverables
Standard forms by Bank Negara Malaysia
Proceeds from sukuk issuance
Informing SC on new Primary Subscribers’
participation (where applicable)
Fees for the advisers
Funding Objectives and Requirements vis-à-vis Shariah Requirements
31
Issuance Process (cont'd)
Distribution methods
Modes
Book Building
Features - Snapshot
Potential cost savings due
to competitive book building
Investors encouraged to bid
aggressively
One price will be offered to
all successful investors
Bought Deal
Private negotiation between
issuer and the Investment
Bank
Eliminate under-subscription
risks
Full transparency of order
book to issuer
Certainty in cost for issuers
that do not wish to take on
interest rate uncertainty from
date of mandate till issuance
Road show may be
undertaken to promote and
create awareness of issuer
Primary subscriber charges a
margin due to market risks
incurred
Usually for high credit
standing issuers
Tender
A competitive bidding system
allows issuer to take
advantage of the market
demand for the notes issued
Various prices offered to
successful investors
Full transparency of
competitive bidders to issuer
Issuer has no control on
pricing and allocation under
the tender process
Expedient and simple
method of issuance i.e. no
marketing and road show
involved
32
16
Issuance Process (cont'd)
Documentation
Shariah advisers’ participation is crucial
To ensure compliance with Shariah
Should be involved from the onset i.e. structuring the transaction structure and drafting of
the initial salient terms and conditions
Type of documents
Issuance/transaction documents
Facility agreement (based on applicable Shariah principles)
Subscription agreement
Purchase undertaking agreement (as in a sukuk Musharakah issuance)
Security documents
Trust deed
Deed of assignment (where applicable)
Memorandum of charge (where applicable)
33
Structuring Essentials in Sukuk
Transaction and Execution
In structuring a sukuk transaction, the primary funding objectives and
requirements of the issuer is paramount and together with the Shariah
tenets, should form the basis for all decisions vis-à-vis the fund raising
exercise.
The following are some of the essential elements in structuring a sukuk
transaction:
(a) Availability of Assets, Usufruct, Services or Business Venture and Shariah
Contracts
Under `uqud mu`awadhat, such as bai` bithaman ajil, murabahah, istisna` and ijarah, an
asset must be made available for sukuk to be issued. This asset can either be in the form
of tangible or intangible asset.
(I)
Nature of Underlying Asset
(i) Any asset used as an underlying asset in structuring sukuk must be Shariahcompliant. Therefore, any asset used for Shariah non-permissible activities, such as
a building for conventional banking activities or businesses, cannot be used as
underlying asset.
17
(ii)
(iii)
An encumbered asset, such as an asset charged to a financial institution
or an asset that is co-owned with another party, can only be used as
underlying asset provided the issuer has obtained consent from the
chargee or co-owner.
Receivables can be used as the underlying asset for the issuance of
sukuk. The receivables must be transacted on cash basis (on spot) in
order to avoid bai` kali' bi kali' (sale of debt for debt).
The availability of Shariah compliant assets, usufruct, services or an intended
business venture thus is a crucial element when it comes to structuring sukuk as it
would determine which Shariah contracts to be adopted. For example, in the
instance where there is in existence a physical and income generating assets
such as a power plant (with an accompanying power purchase agreement), an
Ijarah based sukuk could be issued.
In circumstances where there are no such assets but an intended business venture is
to be pursued, other Shariah contracts such as those under the Musharakah and
Mudharabah would need to be considered. Additionally, the capacity of the issuer to
contribute capital would also determine the type of contracts to be employed, hence
the type of sukuk to be issued.
In the case of sukuk musharakah, the minimum number of sukuk investors upon
issuance (i.e. at primary market level) is at least two. Nevertheless, there is no
minimum requirement of sukuk investors in the secondary market. At this stage, the
transaction is no longer that of the creation of the collective contract for capital-raising
but has moved to transactions on the issued securities.
18
(b) Risk Elements and Credit
Underlying the sukuk issuance is the risks involved and in most
circumstances, the risk elements and credit issues will determine the
transaction structure, the rating and pricing as well as the potential investor
take-up rates.
The various risks and credit issues are normally structured or minimised
under the transaction structures by way of ring-fencing cash flow streams
arising from assets by way of legal instruments or achieving true sale of the
ownership of the subject assets to special purpose companies that are
bankruptcy remote, amongst others.
(c ) Tax and Legal Issues
When structuring sukuk issuance, one must also take into considerations the other
crucial component involving the tax and legal provisions. Some example includes:
The dividend streaming provisions, especially in circumstances whereby the investment
sukuk is in assets where the only source of income to be derived is by way of dividend flow
to holding company. In such circumstances, the availability of tax credit under Section 108
of the Income Tax Act, for the franking of dividend, needs to be ascertained.
The tax relationships within the various tax jurisdictions, especially to ensure tax efficiency
purposes;
True sale requirements for asset-backed securitisation needs;
Financial assistance provisions, especially in a non parent-subsidiary situation. Under the
Companies Act, the provisions of guarantee or on-lending situations are only permitted
within a parent-subsidiary relationship.
19
Transaction Structures
Ijarah sukuk
Purchase Undertaking
Payment for investments
Sells sukuk assets
Pays for sukuk assets
Originator
Lease sukuk assets
Investors
SPV Issuer
Pays rental for sukuk assets
Sukuk
Servicing/management agreement
Declaration of trust over sukuk assets
Issues
the size of issuance is restricted by the value of the sukuk assets
tax implications on the transfer of “ownership”
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Transaction Structures (cont'd)
Musharakah sukuk
Purchase Undertaking
Payment for investments
Beneficiary/
Originator
SPV Issuer
Investors
Sukuk
Contribution in kind
Cash contribution
Musharakah
Declaration of trust over the sukuk assets
Musharakah
Business
More adoption of this structure with the most notable being the the USD3.5 bil. sukuk
by Ports, Customs & Free Zone (DP World)
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Issuance Process (cont'd)
Documentation
Shariah advisers’ participation is crucial
To ensure compliance with Shariah
Should be involved from the onset i.e. structuring the transaction structure and drafting of
the initial salient terms and conditions
Type of documents
Issuance/transaction documents
Facility agreement (based on applicable Shariah principles)
Subscription agreement
Purchase undertaking agreement (as in a sukuk Musharakah issuance)
Security documents
Trust deed
Deed of assignment (where applicable)
Memorandum of charge (where applicable)
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Talking Points
What is being rated: Shariah compliance or issuer default risk?
Parties
FitchRatings
View Point
Does not require a sukuk to be
Shariah compliant to assign a
credit rating
The issue of Shariah compliance
would not necessarily affect the
rating assigned to a sukuk:
exception when
documentation specifically
incorporates Shariah noncompliance as an event of
default
MARC
Where a Musharakah principle
has been used as the underlying
structure for a fixed income
instrument:
rating considerations are
inextricably linked to the
rating considerations applied
to issues under conventional
principles i.e. credit default
risk/timeliness of payments
Does not verify nor confirm
Shariah compliance:
responsibility lies with the
appointed Shariah
board/committee
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Talking Points (cont'd)
What is being rated: Shariah compliance or issuer default risk? (cont'd)
Parties
FitchRatings
(Ijarah sukuk)
Areas of relevance
Priority ranking of obligations
vis-à-vis conventional debt
obligations:
conditionality and revocability
of lease payment obligations
importance of the assets to
the lessee
# of liens on the assets
Credit enhancement:
level of credit enhancement
Repurchase commitment:
willingness and ability to
honor commitment
enforceability of contractual
terms and jurisdiction
Role of recovery:
likelihood of recovery
MARC
(Musharakah sukuk)
Strength of returns and cash
flows:
strength of the counterparty
making the payments i.e.
counter party risks
whether the certainty of
returns hinges on certain
contractual obligations & the
complexity of such contracts
i.e. performance risks
Assessment of possible events
that could result in the
dissolution of the partnership
Enforceability of the security
under the Musharakah
instrument
beneficial ownership in
place?
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Talking Points (cont'd)
Accounting and regulatory issues
Purpose
Islamic accounting objectives, concepts and principles has to be developed
based on Shariah requirements
However, it also needs to adapt to the modern accounting regulatory
environment to make it relevant to be practiced in our time
The need for a codified Islamic accounting standard will provide a sound
accounting regulation as part of a comprehensive regulation of Islamic
financial institutions
Investments in sukuk give rise to a number of accounting and reporting issues
related to recognition, measurement and disclosure
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Talking Points (cont'd)
Accounting and regulatory issues (cont'd)
Features - Snapshot
Issues
Recognition
AAOIFI FAS 17:
investment in sukuk and
shares shall be recognized
on the acquisition date and
shall be measured at cost
investment in sukuk and
shares held for trading
purposes and available for
sale shall be measured at
their fair value
unrealized gains or losses
as a result of remeasurement need to be
recognized in the income
statement
additional requirement is the
share of portion of income
related to owners’ equity and
portion related to unrestricted
equity investment account
holders must be taken into
consideration:
crucial as no proper
treatment and disclosure of
this transaction of profit
sharing and distribution may
lead to confusion as to the
method, ratio and process
to disburse profit that have
been taken place.
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Talking Points (cont'd)
Accounting and regulatory issues (cont'd)
Features - Snapshot
Issues
Measurement
AAOIFI FAS 17:
sukuk held to maturity
needs to be measured
based on historical cost
except that if there is
impairment in value where
it should be measured at
fair value
the difference in value will
be recognized in the
income statement and the
information related to the
fair value is then need to
be disclosed in the notes to
the financial statements
sukuk held for trading and
available for sale, the
measurement is to be
based on fair value
sukuk held to maturity is to
be measured by the
historical cost rather than
fair value
issue arises when quoted
market prices may not be
available
conventionally the estimate
is based on the net present
value or other valuation
techniques, which may
have its deficiencies e.g.
significantly affected by the
assumptions used e.g.
discount rates, future cash
flows etc.
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Talking Points (cont'd)
Accounting and regulatory issues (cont'd)
Disclosure
Features - Snapshot
Issues
AAOIFI FAS 17:
classification of sukuk
according to their
maturities need to be
disclosed for investment in
sukuk
issuer needs to disclose, if
material, the face value of
the sukuk, the percentage
of sukuk acquired from
each party issuing the
sukuk and each type of
sukuk
the party guaranteeing the
sukuk and the nature of the
guarantee
the contractual relationship
between the issuer and/or
manager of sukuk and the
holders of such sukuk
disclosure requirements
indicates the need for the
Islamic institutions to be more
transparent in disclosing
financial information pertaining
investment in securities
especially
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Trend and Challenges
Continuing importance
Sukuk market to remain a prominent avenue for funds raising exercise globally going forward
USD70 bil. issuance in first quarter of 2007
USD160 bil. mark by the end of the decade
Source: Standard & Poor’s Estimates
Key growth driver
Projected financing needs arising from economic developments in the Middle East
(USD500 bil.) and Asia (USD1 tril) over the next 5 years
Progressive development of regulatory frameworks and collaborations among Islamic
financial centers and authorities
The involvement of more participants from the GCC
Source:
The Challenge for a Global Islamic Capital Market: Strategic Developments in
Malaysia, June 2007
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Trend and Challenges (cont'd)
Challenges
“need to mobilize excess Islamic funds to cash deficits economic units in a Shariah compliant
manner”
The lack of standardization and homogeneity i.e. Shariah & accounting convergence
No single interpretation of Islamic law, each financial institution has a board of religious
scholars who determine which products are Islamic, and what one bank considers
Shariah compliant may be unacceptable to another
Adoption of accounting standards set by AAOIFI as mandatory is not widespread i.e. only
8 member countries of the Islamic Development Bank whereas in other markets, the
banks tend to follow the standards set by local regulators instead
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Trend and Challenges (cont'd)
Challenges (cont'd)
Critical mass
Need for greater diversity in the type and maturity in sukuk
Creation of more secondary trading platform/market
Regulation and legal frameworks
huge number of Islamic financial institutions in market place but many Muslim countries
still do not have enabling legislation in place covering the issuance of sukuk,
establishment of trusts and Special Purpose Vehicle
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Question & Answer Session
Questions & Answer Session
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Thank You
by
Wan Abdul Rahim Kamil
ICM Consultant
[email protected]
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