Structuring of Sukuk

by Muhammad Hassaan Bhagat, Senior Consultant in Forensics & Compliance Department of Grant Thornton UAE

Islamic finance has caught the eye of Western countries with major financial centers around the world (e.g., London, Luxemburg, Singapore, and Hong Kong) opening up their markets to Islamic financing products including insurance (Takaful) and Sukuk Investments.

Foundation of Islamic financing is based on Shariah laws which prohibits the use of interest (riba), excessive uncertainty in products (gharar), gambling or bookmaking (maysir) and financing of prohibited activities which may harm the society in general.

For the past two decades, we have witnessed the rise of Islamic finance or ethical financing. Financial Assets of Islamic Financial Institutions stood at USD 2.1 trillion at the end of 2016 from USD 1.88 trillion at the end of 2015. Several reports by industry experts have indicated that Islamic Financial Institutions (IFI) outpaced their peers in terms of growth during the past decade.

Sukuk is one of most fastest growing products of Islamic Finance and offer a profitable avenue for deployment of funds on medium to long term basis. This instrument is defined as a certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) assets of particular projects or special investment activity by the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI).

Global Sukuk issuances in 2015 amounted to more than USD 63 billion and is expected to register double digit growth in forthcoming years.

Difference between conventional bonds & Sukuks

Sukuks are generally termed as Islamic model for conventional bond, however the two are radically different in characteristics given that Sukuks have to abide by Shariah principles. A conventional bond indicates a debt obligation towards the bond holder, whereas Sukuk enables the holders to claim beneficial ownership in underlying asset. Accordingly, sale of Sukuk infers selling of ownership in the assets backing them. Sukuks are priced based on the value of underlying assets, on the contrary, conventional bonds are priced based on the credit worthiness of the issuer.

In addition, funds raised from Sukuks can only be used against pre-determined purpose which must be Shariah compliant, whereas the funds raised from conventional bonds can be used to finance any asset, project and venture that complies with legal requirements.

Although it seems that economic impact created by Sukuks and conventional bonds is similar, the former is more complex in structure and is based on Shariah contracts / modes of Islamic finance.

Sukuk Structures

AAOIFI has specified fourteen (14) permissible Sukuk categories and number of Islamic finance techniques which can be employed to structure a Sukuk transaction. Critical factors which impact the type of structure for any Sukuk issuance includes economic objectives of the issuer, legal framework in the jurisdiction, tax and zakat implication, nature of assets and their usage and tradability of Sukuk in secondary market in accordance with Shariah principles. Most commonly used Sukuk structures include Ijarah (lease contract for use of assets), Murabaha (sale of goods at cost plus agreed mark-up) and Mudarba (a joint venture between two parties whereby one contributes cash and other party contributes efforts and skills).

In simplistic terms, regardless of the structure selected, the issuer of Sukuk creates a financial intermediary – Special Purpose Vehicle (SPV) and transfers the title of underlying asset to this SPV. SPV then issues the Sukuk and transfers the fund to the originator / issuer for utilization. This exercise is done to keep the underlying assets of Sukuk separate from other assets of the originator. Originator is able to use the underlying asset either via lease from SPV under ijarah agreement and/or manage the assets under musharakah or mudaraba agreement.

Following illustrative example of Sukuk Al Ijarah provides the overview of complexities involved in structuring of Sukuks.

  1. Sukuks are issued by SPV to create legal rights against the SPV for payment of Periodic Distribution Amount (i.e. profit) and the Dissolution Amount (i.e. principal) on redemption.
  2. Sukuks are purchased by Certificate holders and certificate holders pay proceeds to SPV (the “Principal Amount”). The SPV acquires the assets using the proceeds and as per agreement with the certificate holder declares itself as the trustee of the proceeds and assets acquired. (i.e. the land and contractual rights). Each Certificate is thereby intended to represent an undivided beneficial ownership interest in the relevant assets underpinning the trust.

3 & 4. The Trustee and the Company enters into a Sale and Purchase Agreement, pursuant to which the Company sells tangible assets to the Trustee in consideration for an amount equal to the Principal Amount.

5 & 6. The assets are leased back by the trustee to the Company, pursuant a lease agreement between the parties (Ijarah) in consideration for periodic payment of Rental by the Company (which shall be equal to the “Periodic Distribution Amount” payable by the Trustee to the Certificate holders).

  1. Certificate holders are paid Periodic Distribution Amounts by the Trustee using Rental.

8 & 9. Upon:

  • occurrence of an event of default or maturity, or
  • the exercise of any applicable put or call options (including a tax call)

The SPV as trustee will sell the land or other assets, pursuant to the exercise of a sale undertaking or purchase undertaking, to the Company. Consideration for such a sale/repurchase will be the payment of “exercise price”, which will be equal to the principal amount plus any unpaid periodic distribution amounts owed to certificate holders.

  1. The “dissolution amount” equal to exercise price is paid by SPV to the certificate holders.

The above structure also requires compliance with various Shariah requirements; for example, the lessor must have ownership of the asset or the usufruct right in that asset before entering into a lease contract. Secondly, lessee must use the leased asset only for the purpose specified in the lease, or, absent a specified purpose, in conformity with common practice, liabilities arising from the ownership of the asset, such as any harm or loss, are borne by the SPV, as lessor etc.

Challenges in Sukuk Structures=-

Lack of standardization amongst Islamic scholars, regarding various elements of Sukuk structures in the past, have led to revision in Sukuk structures. In 2007, Chairman of Shariah Council of AAOIFI, Mufti Taqi Usmani, highlighted various non-shariah compliant sukuk structures which included guaranteed return on capital of Sukuk holders and purchase undertaking by the originator/obligor to buy back underlying assets from the issuer at face value of Sukuk upon maturity or in case of default.

AAOIFI issued guidance on the points highlighted above and clarified that such structures were not permissible under Shariah and these undertakings should only require the asset originator/obligor to purchase underlying assets based on its market value, cash equivalent value or any price agreed upon at the time of purchase.

Cost, complexities and uncertainties involved in structuring Sukuks have encouraged several companies, which may otherwise have issued Sukuks, to raise funds through conventional bonds or seek financing through conventional banks.

Future Outlook

As Islamic finance has nurtured, Sukuk has now become promising source of Islamic finance for many sovereign states and companies in the Middle East and Southeast Asia. A staggering 61% of Sukuk issuances in 2015 were by sovereign states or quasi sovereign entities.

Despite boundaries, Sukuk market has grown and spurred interest from notable financial institutions in the European and US markets. Involvement of companies like Goldman Sachs and General Electric Capital in Sukuk transactions is a testament to financial viability of Sukuks and the diversification it offers to investor community.

Considering the potential of Sukuks, efforts are required to standardize Sukuk structures to reduce overall issuance cost of Sukuk. Financial markets of western countries have shown keen interest in Sukuk and this was evident from the fact that US based investors subscribed to 27% of 30 year tranche of Sukuk issued by Saudi Electricity Company in 2014. This indicates that open access to western markets for Sukuk issuers shall be advantageous for the Islamic finance industry and can result in more elevation in global Sukuk issuances.