Principles of Islamic banking and finance/PIBF203/Sukuk/Types of sukuks

Types of Sukuks

The market for Sukuk is now maturing and different Sukuk structures have been emerging over the years; they can be of many types depending upon the type of Islamic modes of financing and trades used in its structuring. The AAOIFI issued standard for different types of Sukuk, classifying some of these Sukuk as tradable and others as non-tradable based on the type and characteristics of the issued Sukuk. There are also other diversified and mixed asset Sukuk that emerged in the market such as hybrid Sukuk, where the underlying pool of assets can comprise of Murabahah, Ijarah as well as Istisna’a. In any sukuk transaction, the issuance of sukuk certificates will simply raise a cash amount required by an originator. The issuance itself will not entitle the investors to a return on their investment and, therefore, must be supplemented with another Islamic financing structure.

Sukuk Al Ijara

Ijara is the transfer of the usufruct of an asset to another person in exchange for a rent claimed from that person. Sukuk al-ijara is the most commonly used sukuk structure (based on volume of issuances) and is regarded by some commentators as the classical sukuk structure from which all other sukuk structures developed. Ijara is popular because it is simple and widely accepted and understood by both conventional and sukuk investors as well as by the international rating agencies. Sukuk al-ijara involves the transfer of ownership or benefit/usufruct of tangible assets such as real estate, aircraft or ships from an originator to an SPV, which then issues to investors sukuk certificates representing undivided ownership interests in such assets. The asset is then leased back to the originator by the SPV for a specified term, which is typically commensurate with the term of the certificates.

Each sukukholder is entitled to receive the rentals generated under the lease pro rata to its ownership interest in the underlying asset. The amount of these rentals is equal to, and used by the SPV to pay, the periodic distribution amount payable under the sukuk at that time. This amount therefore may be calculated by reference to a fixed rate or variable rate (e.g. LIBOR or EIBOR) depending on the type of sukuk issued. On the issuance date, the originator will enter into a purchase undertaking which gives the right to the SPV to oblige the originator to purchase the assets following a sukuk dissolution event or on scheduled maturity, at an exercise price equal to the principal amount plus any accrued but unpaid periodic distribution amounts. The money received by the SPV will be used to pay the dissolution amount due to investors under the sukuk.

Since the payments under the sukuk are dependent on payments to the SPV by the originator under the relevant ijara contract and purchase undertaking, in a similar manner to a corporate bond, the sukukholders are assuming the credit risk of the originator. Unless the sukuk is asset-backed, the documentation will typically provide that the only recourse available to the sukukholders in a default scenario is a contractual claim against the originator for non-payment of the purchase price for the assets in accordance with the purchase undertaking, which puts the sukukholders in a position similar to that of bondholders under a conventional unsecured bond.

Shari’ah requirements applicable to underlying ijara

The lease in an ijara must comply with all of the following general Shari’ah requirements applicable to leases:

− The lessor must have ownership of the asset or the usufruct right in that asset before entering into a lease contract.

− The benefit from an ijara must be lawful under Shari’ah, e.g. leasing property to a shopkeeper selling alcohol would be unlawful.

− The leased assets must continue to exist throughout the period of the lease and any assets which are consumed during that period cease to be leasable.

− The period of the lease and amount payable therefor must be specified in advance.

− The lessee must use the leased asset only for the purpose specified in the lease, or, absent a specified purpose, in conformity with common practice.

− The lessor must maintain and insure the leased assets during the lease period, provided that the lessor may, if it so wishes, delegate such obligation to an agent.

− The liabilities arising from the ownership of the asset, such as any harm or loss, are borne by the SPV, as lessor.

Sukuk Al Wakala

A wakala is an agreement between two parties whereby one party agrees to act on the other party’s behalf, in a manner akin to an agency arrangement. The principal (investor) appoints an agent (the wakeel) to invest funds in a pool of investments or assets that are purchased by the wakeel as agent and trustee of the sukukholders. The wakeel then uses its expertise to manage the investments for an agreed period of time in order to generate an agreed profit return. The principal (which is usually an SPV) will then use the profit return to fund the periodic distribution amounts payable to the investors by the issuer. Any profit in excess of the periodic distribution amounts is typically paid to the wakeel as an incentive fee. On the maturity date, the investment manager liquidates the sukuk portfolio and pays the proceeds of the liquidation to the principal to fund the dissolution amounts payable to the investors by the issuer. Shari’ah Requirements Applicable to Underlying Wakala The agency agreement in a wakala must comply with all of the following general

Shari’ah requirements applicable to wakala agreements:

− The principal may only require the wakeel to perform Shari’ah-compliant tasks.

− The principal can only receive the expected profit, any excess will be held by the wakeel for its benefit.

− The wakala agreement must be clear and unambiguous as to the duration of the wakala, the type of investments to be entered into by the wakeel and the conditions for termination of the wakala agreement.

− The wakala assets must comply with certain eligibility criteria. For example, at least 30 percent of the underlying assets must be tangible.

− A mechanism for replacing assets that cease to be Shari’ah-compliant must be in place.

Sukuk Al-Mudaraba

As you already know Mudaraba refers to a form of equity-based partnership in which one party (the rab al-maal) provides the other party (the mudarib) with capital and the mudarib uses its expertise and labour to invest the capital in return for a pre-agreed share of the profit generated.

In the context of sukuk, an SPV is usually established to issue the sukuk and contribute the proceeds raised from the investors as mudaraba capital (and therefore the SPV issuer becomes the rab al-maal). The originator of the sukuk contributes expertise, labour and possibly cash, serves as mudarib and manages the capital. Any profits generated by the mudaraba are divided between the rab al-maal and the mudarib in accordance with agreed profit-sharing ratios set out in the mudaraba agreement. The SPV uses the profits it receives from the mudaraba to make payments of the periodic distribution amounts due under the sukuk.

Prior to the AAOIFI Statement, sukuk al-mudaraba structures typically included a purchase undertaking in favor of the SPV, allowing for the purchase of the rab al-maal’s interest in the mudaraba for a pre-agreed exercise price. This exercise price was structured to ensure that the rab al-maal received the amount required to pay the dissolution distribution amount due to investors under the sukuk. Since the AAOIFI Statement, scholars have taken the view that an originator may not grant a purchase undertaking for any amount other than the market value of the rab al-maal’s interest in the mudaraba assets at the time of sale (on the basis that determining the value by reference to the value of the sukuk is akin to a guarantee of profit and principal which, unless given by an independent third party, is not permitted under Shari’ah).

While the inability to grant such a purchase undertaking has contributed to the decline of the mudaraba structure for sukuk, the structure recently has experienced a revival with the introduction of the sukuk as a method of increasing Tier 1 and Tier 2 regulatory capital for banks and financial institutions.

Shari’ah Requirements Applicable to the Underlying Mudaraba

The arrangement in a mudaraba structure must comply with the general Shari’ah requirements applicable to mudaraba agreements:

− A mudaraba contract may be unrestricted or restricted. Under an unrestricted mudaraba contract, the rab al-maal, the issuer SPV, permits the mudarib, the originator, to administer the mudaraba capital without any restrictions. The mudarib must exercise this freedom in accordance with the interests of the parties and the business contract, hence, with a view to making profit. Under a restricted contract, the rab al-maal imposes certain restrictions on the mudarib, however, not to the extent that the mudarib will be unduly constrained in his operations.

− In principle, the capital for the mudaraba must be provided in cash; however, it may be provided in the form of tangible assets with the value of such assets constituting the mudaraba capital. At least 33 percent of the capital should be invested in actual tangible assets in accordance with Shari’ah.

− The mudarib must have free access to the capital for the mudaraba to be considered valid.

− The profit-sharing ratio should be determined in advance and must be a percentage of the actual profit, not a percentage of the capital or a lump sum.

− However it is permissible to stipulate that if the profit is above a certain ceiling (up to which the profits are shared according to pre-agreed ratios) one party may take that additional profit.

− Any losses of the mudaraba enterprise will be borne by the rab al-maal but the rab al-maal is liable only to the extent of the proceeds invested. Sukuk investors will therefore be liable only for their invested proceeds.

Sukuk Al- Musharaka

As you already know. a musharaka arrangement entails the contribution of capital (either in cash or in kind) by two or more partners to the partnership. The musharaka partners share the profits in prearranged ratios. Any profits generated in excess of the level of profits required to enable the issuer to make the relevant payments to sukukholders are typically paid into a cash reserve for disbursement to sukukholders in the event that profits for a period are insufficient to cover the periodic distribution amount.

Shari’ah generally recognises two broad categories of partnerships; (i) sharikat al-’aqd (a contractual partnership) and (ii) sharikat al-melk (a property partnership). In the context of sukuk issuances, the sharikat al-’aqd entails an agreement between the originator and the trustee to combine their assets, labor or liabilities, while the sharikat almelk entails a transaction that results in the originator’s and the trustee’s joint ownership of an asset. When deciding between structuring a sukuk based on sharikat al-’aqd or sharikat al-melk, it is necessary to identify the nature of the originator’s business and whether any assets exist to support the issuance of a sukuk. If no tangible asset exists that could be contributed to the partnership in compliance with Shari’ah, the sharikat al- ’aqd structure may be the better choice.

While sukuk al-musharaka was previously one of the more commonly used structures, use of the musharaka has declined since the AAOIFI Statement, since Shari’ah scholars now take the view that it is not permissible for an originator to grant a purchase undertaking to the trustee to purchase the musharaka assets for any amount other than the market value of the trustee’s interest in the musharaka assets at the time of sale (on the basis that both partners should take the risk of both profit and loss). This inability to guarantee the return of the sukukholders’ initial investment through an undertaking to redeem the sukuk at face value has reduced the popularity of the structure.

Shari’ah Requirements Applicable to the Underlying Musharaka

The underlying musharaka in a sukuk al-musharaka structure must comply with the general Shari’ah requirements applicable to partnerships:

− The profit-sharing ratios of each partner must be determined in advance.

− The profit-sharing ratios may be in proportion to the percentages of each partner’s capital contribution but partners may also agree to share profits in a manner that is not proportionate to their capital contributions, provided that an additional percentage of profit beyond the percentage of the contribution is not in favour of a sleeping partner.

− Stipulations to the effect that any partner’s profit will constitute a lump sum or a percentage of the capital of the partnership are void.

– It is permissible to set aside surplus profit in a reserve account to fund any shortfalls in future periodic distribution amounts or in the exercise price.

− Any losses of the partners must be proportionate to their respective capital contributions. − The musharaka assets must comprise between 33 percent and 50 percent tangible assets, depending on the consulting Shari’ah scholars’ views.

− Any partner may terminate the musharaka by giving notice to the other partner.

− Upon termination, any tangible assets that form part of the musharaka will be liquidated and distributed together with the intangible assets to the originator and the trustee in proportion to their respective capital contributions, or units held in the musharak

Sukuk Aal-Istithmar

The term Istithmar is understood to mean broadly “investment” and the sukuk al-istithmar is therefore sometimes referred to as an investment agency sukuk. Under a sukuk al-istithmar structure, rights under Islamic contracts (including rights under ijara contracts and murabaha or istisna’a receivables) can be packaged together and sold to form the underlying assets for a sukuk issuance. The income generated from such an investment package can then be utilised to make the relevant payments to the investors under the sukuk. On the issuance date, the originator enters into purchase undertaking which gives the right to the entity acting as sukukholders’ agent to oblige the originator to purchase the investment package following a sukuk dissolution event or on scheduled maturity at an exercise price that is equal to the principal amount plus any accrued but unpaid periodic distribution amounts. The money received by the SPV will be used to pay the dissolution amount due to investors under the sukuk.

Shari’ah Requirements Applicable to the Underlying Al-Istithmar

The Al-Istithmar structure must comply with the following general Shari’ah requirements:

− To ensure that the sukuk are not debt instruments and therefore tradable, the net asset value of ijara contracts, shares and asset-based sukuk comprised in the sukuk assets as at any given date may not be less than 30 percent of the net asset value of the sukuk assets taken as a whole as at the closing date.

− A custodian may need to be involved to ensure sufficient separation of the originator’s assets from the sukuk assets. − Principal amounts from the underlying assets must not be used to service coupon payments under the sukuk

Sukuk Al-Manafa’a

In the manafa’a structure, the underlying asset is the capacity or rights of commercial activities, allowing for the use of intangibles. The grant of these rights can take a number of forms depending on the nature of the asset involved. In circumstances in which the issuer does not hold unencumbered tangible assets or is commercially unable or unwilling to utilise them in a sukuk structure, the manafa’a structure may allow issuances based on available intangible assets. Mobile ‘airtime’ vouchers are one of a number of intangible asset classes used as underlying assets for Islamic financing transactions which have been introduced into the market over the last few years. Other such asset classes include intellectual property rights, tariffs due on electricity meters and receivables due on petrochemical marketing contracts. The ‘airtime’ structure was first used in 2007 by the Saudi Arabian telecommunications company, Etithad Etisalat Company (Mobily), for the purpose of a syndicated financing. At that time, the airtime structure represented a novel Islamic finance instrument specifically designed for telecommunications operators, which often have limited physical assets, but significant value in their telecommunications license. Then, in 2010, Emirates Telecommunications Corporation (Etisalat), Mobily’s principal shareholder, adopted the airtime structure for its sukuk programme, although no issuance has yet taken place under Etisalat’s programme. In December 2013, Ooredoo, the Qatari telecommunications company, issued a five-year US$1.25 billion ‘airtime’ sukuk under its US$2 billion trust certificate issuance programme, the first time a sukuk utilising the airtime structure had been issued in the Middle East. In addition, during the course of 2013, UAE-based air carrier, Emirates Airlines, utilised passenger revenues as the underlying asset for its US$1 billion, 10-year amortising sukuk, while the Saudi Arabian General Authority of Civil Aviation issued an SAR15 billion (US$4 billion) sukuk which was partly based on a sale of its rights to charge and collect fees from airlines. The use of the manafa’a structure indicates growing innovation in structuring sukuk and the increasing flexibility of Shari’ah advisers in recognising the legitimate use of those assets.

Sukuk Al-Istisna

The word istisna’a is derived from the Arabic term sina’a, meaning to manufacture a specific commodity, and is a financing method used for the production of specific goods. The structure has thus developed to be particularly useful for raising funds for the construction phase of a project, with the proceeds from the sukuk issuance being used to pay the contractor, who will deliver the project in the future. Upon issuance of the sukuk, the originator enters into an istisna’a contract with the trustee, pursuant to which the originator agrees to manufacture or construct certain assets and undertakes to deliver those assets at a future date in return for which the trustee makes a payment of the sukuk proceeds. The trustee undertakes to lease the assets to the originator under a forward lease (known as an ijara mawsufah fi al-dimmah) for an overall term that reflects the maturity of the sukuk. The trustee uses the rental received from this advance rental (or actual rental following the delivery of the asset) to pay the periodic distribution amounts to investors under the sukuk. On the issuance date, the originator enters into a purchase undertaking which gives the right to the trustee to oblige the originator to purchase the assets following a sukuk dissolution event or on scheduled maturity at an exercise price that is equal to the principal amount plus any accrued but unpaid periodic distribution amounts. In the event that the sukuk dissolution event happens prior to the delivery of the assets to the issuer, a refund and compensation amount will be paid in order to leave the trustee with an amount sufficient to cover the face values of the certificates plus any accrued but unpaid periodic distribution amounts. The money received by the trustee will be used to pay the dissolution amount due to investors under the sukuk.

Shari’ah Requirements Applicable to the Underlying Istisna’a

The underlying istisna’a structure in a Sukuk al-istisna’a must comply with the following general Shari’ah requirements:

− The subject matter of the istisna’a contract must be items that can be transformed by manufacture or construction. Items such as products of nature, such as animals, fruits and vegetables are not included. − The price and features of the item to be manufactured need to be specified in advance.

− The purchaser may split the purchase price into staged payments that correspond to certain milestones in the building process, as long as these are agreed upon with the contractor in advance.

− The purchaser may fix a maximum time for delivery, even though specifying the delivery time is not necessary under the istisna’a agreement. Specifying the time in the contract allows the purchaser to decline accepting the goods and paying the purchase price.

− Liquidated damages provisions are also permissible and can help to ensure that the contractor delivers on time.

− A majority of Shari’ah scholars hold that forward leasing, ijara mawsufa al-dimma, is permissible. Under this view, advance rentals must be taken into account and refunded in full in case the asset is never actually delivered for leasing.

Despite these apparent advantages of the istisna structure, it is rarely used because market participants widely hold that istisna’a are not tradable during the construction phase. Additionally, Shari’ah scholars differ greatly in their opinions on advance rentals and istisna’a termination payments. Therefore, this structure is less attractive than other more flexible structures, such as the musharaka structure.

Sukuk A-Murabaha

A murabaha contract is an agreement between a buyer and seller for the delivery of an asset; the price includes the cost of the asset plus an agreed upon profit margin for the seller. The buyer can pay the price on the spot or establish deferred payment terms (paying either in instalments or in one future lump sum payment). Under a murabaha sukuk, the issuer of the sukuk will utilise the proceeds of the sukuk issuance to purchase commodities from a commodity supplier. The trustee will then on-sell the commodities to the originator of the sukuk at a deferred price, which reflects the purchase price plus profit for the trustee as compensation for its involvement in the transaction. The period for the deferred payments reflects the maturity of the sukuk. The instalments of the deferred price received from the originator are then used to make payment of the periodic distribution amount due to investors under the sukuk.

Although the sukuk al-murabaha is less commonly used as a stand-alone sukuk structure in comparison to some other sukuk structures, it has proved to be popular in the hybrid sukuk market, with an increasing number of sukuk being issued with mudaraba-murabaha structures. The al-murabaha is also commonly used as investments underlying a sukuk al-wakala structure

Shari’ah Requirements Applicable to the Underlying Murabaha

The underlying murabaha structure in a Sukuk al-murabaha must comply with the following general Shari’ah requirements:

− The rate and time period of the deferred price must be fixed in advance and agreed upon by both parties.

− The trustee’s profit must be clearly stated and agreed upon by both parties in advance. Mention of the total selling price is not sufficient.

− The trustee, as seller, must acquire title to the commodities before it may sell them on to the purchaser. A sale by a seller who has not acquired title will be void.

− Commodities must be in the physical or constructive possession of the seller. The seller is considered to have constructive possession when control, rights and liabilities have passed on to it from the supplier. For instance, such passing may arise when the seller appoints an agent to take the delivery of the goods.

− The seller must assume the risks of ownership before selling the commodities to the purchaser, including the transportation risks. The point when the risk of the commodities is passed on from the SPV to the purchaser must be clearly identified.

− The trustee may appoint the purchaser as its agent in the purchase of the commodities from the supplier. However, all documents and contracts relating to the sale of the commodities must be in the name of the trustee, not that of the purchaser.

− The commodities purchased must exist. Non-existent commodities make the murabaha contract void. In addition, the commodities must be Shari’ah-compliant, e.g. not an item, such as alcohol or pork, that could be used for an un-Islamic purpose.