Turbulence in the financial markets during 2008 and the resulting collapse of the securitisation markets has made it increasingly difficult for companies to access these markets in order to raise additional finance. The Islamic securitisation market,
often referred to as the Sukuk market, has not been immune to this economic downturn, indeed it has also suffered from controversy over the very nature of some Sukuk structures and suggestions that some Sukuk in issue were not Shari’a-compliant.
However, even with a struggling global economy, organisations throughout the world still need to raise finance to fund their activities, and in some cases their expansion plans. With a continuing lack of bank credit and with no sign of a recovery for the IPO markets, corporate issuers seem to be returning to the financial and securitisation markets and several of these prospective issuers have indicated that they are either planning or actively considering raising funds thorough the Sukuk market.
This article will seek to show that Sukuk structures continue to be a useful way to raise finance for both Islamic and non-Islamic organisations. Furthermore, if, as is expected, the Sukuk-based securitisation market (particularly for asset-backed transactions), recovers more quickly than the conventional securitisation market, will those involved in structuring non-Islamic securitisation transactions learn any lessons regarding the principles of sharing risk and reward and reflect this in conventional structures?Sukuk
Many readers will be familiar with the general concept of Sukuk, but it is important to reflect on the basic principles in order to appreciate how the market for Sukuk may develop.
In Shari’a Standard No. (17) on Investment Sukuk, the Accounting and Auditing Organization for Islamic Financial Institutions, (AAOIFI) gives the following definition of Sukuk:
“Investment Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”.
The standard makes it clear that Sukuk must be backed by assets that are subject to a Shari’a-compliant contract, e.g. an Ijara contract, sets out 14 examples of Sukuk structures and distinguishes investment Sukuk from shares, notes and bonds.
Furthermore, the Standard makes it clear that the Sukuk documentation must demonstrate:
* That any income arising must derive from the underlying activities for which the funding has been used, and not simply comprise interest,
* The Sukuk must be backed by real underlying assets and these assets must be halal (allowable) in nature and be being utilised as part of a halal activity, and
* There must be full transparency as to rights and obligations of all parties.
Thus a large part of the conventional securitisation market – for example, mortgage-backed securities – would be prohibited because the income element (though not the principal) of the cash flow would be characterised as riba. Similarly, CDOs and other such instruments could not be allowed as an asset class as these represent “Debt” rather than an allowable commodity or activity. However, investment in tangible assets, used for productive purposes, and reaping the rewards arising from those assets is a core principle of Islamic finance and it is this principle on which Sukuk securitisation structures are founded.
Whilst AAOIFI standards are not compulsory from an international perspective, they are generally binding in six Middle Eastern countries, together with the Dubai International Financial Centre. Furthermore, it is difficult to imagine how an issuer would be able to obtain a fatwa from a recognised Shari’a Supervisory Board if the structure did not comply with Standard 17, thereby making adherence with the standard obligatory from a business perspective.AAOIFI resolution on Sukuk
In late 2007 Sheikh Muhammad Taqi Usmani, as Chairman of AAOIFI, issued a statement (that was subsequently heavily misquoted) in which it was claimed that many of the Sukuk structure in existence at that time would fall foul of basic Shari’a principles, in particular, many appeared to violate the principle of risk and profit-sharing by promising to pay back capital. Subsequently, in February 2008, AAOIFI issued a statement setting out six core principles for structuring and implementing Sukuk transactions, noting that it was these principles that were often being disregarded in the larger or volume-based Sukuk structures.
A key feature of the AAOIFI resolution is to be found in the final paragraph. This calls for Islamic financial institutions to:
“decrease their exposure to debt-related operations and to increase their operations based on true partnerships and the sharing of risk and reward”
Whilst there is still much debate as to whether Sukuk can be used to raise debt for an institution (i.e. where the underlying structure is asset-based), it is clear that the resolution endorses the use of Sukuk to finance the acquisition of actual assets on behalf of an Islamic entity and in particular where the financing is structured as a traditional asset-backed securitisation.The Markets
The growth of the Sukuk market in the 21st century, albeit from a very small base, seemed unstoppable, with an approximate cumulative doubling each year from 2002 through to 2007, see chart below.
The chart shows the dramatic decline in new issues during 2008, but it is impossible to determine how much of this decline was attributable to global economics and how much to restraint arising from concerns over the validity of Sukuk structures following the AAOIFI announcements. Similarly, many of the Sukuk issued previously would have had a 3 to 5 year tenure and therefore were repaid in 2008, with market conditions preventing these from being rolled over.
So what are the factors that will drive the resurgence of the Sukuk market. First and foremost is a need to finance the large number of construction and infrastructure projects throughout the GCC. Historically, the financing for many such projects benefited from direct or indirect governmental guarantees, but this was one of the concerns that led to the original AAOIFI statement as Sukuk holders are supposed to bear the risks of ownership and not be immune to affects of changes in the profitability of the venture; it remains to be seen as to how such support can be built into a structure whilst still giving an element of risk. Similarly, private companies throughout the region have been starved of finance and whilst these companies will need to demonstrate that they either have a strong track record or a good business case, together with a pool of appropriate assets to securitise, the entrepreneurial spirit of the region, coupled with pent-up demand for Shari’a-compliant investment products is likely to make such corporate Sukuk structures an attractive proposition for both regional and international investors.
International institutional demand for Sukuk cannot be understated, with both Islamic and non-Islamic or Western institutions participating in many of the large quasi-governmental Sukuk issues of 2006 and 2007. Similarly, several counties in the West have made various announcements as to their own plans to issue Sukuk, most notably the UK Treasury whose plans for a Sukuk have been on/off for the past three years.
The retail market for Sukuk is slowly opening up although demand seems to outstrip supply because of the lack of Sukuk available through the secondary market, which makes it difficult for retails investors to acquire Sukuk. Several institutions have established Sukuk funds to allow retail investors to participate in Sukuk issued by number of different institutions, but to date these too seem to be having difficulty in acquiring appropriate assets due to the lack of supply.Summary
The similarity between Sukuk and traditional asset-backed securitisation structures will be readily apparent. However, as demonstrated in the points raised above, there is much more to establishing a Shari’a-compliant securitisation transaction than a simple rewording of conventional transaction documentation.
The call for a “back to basics” approach contained within the AAOIFI resolution on Sukuk had a negative impact on the issuance of Sukuk in 2008. Whether this will affect the ability of institutions to create innovative Sukuk structures going forward is an unanswered question, but in the author’s experience, provided the basic tenets of Shari’a Law are adhered to, the Scholars will generally accept such innovation.
Global Arab Network
For further information on Islamic finance matters contact
, Volaw's Director of Islamic Finance and Funds Group.
Chart Source – Ernst & Young IFIR 2009