Principles of Islamic banking and finance/PIBF203/Sukuk/Sukuks: Basic features

Sukuk: Basic features
Sukuk represent the proportional ownership of an existing asset or a pool of diversified assets, and a pledge against existing or future cash flows generated from these assets for a specified period of time. The risk and return associated with underlying assets and these cash flows are passed to sukuk holders. These assets may be tangible or intangible, existing or described with deferred delivery, usufruct or services. Under Sukuk structure the investors, sukuk holders each hold an undivided beneficial ownership in the underlying assets. Afshar, Tahmoures A. (2013) “Compare and Contrast Sukuk (Islamic Bonds) with Conventional Bonds, Are they Compatible?”, Journal of Global Business Management, Vol. 9, No. 1, pp. 44-52.

Shari'ah principles underlying Sukuk
As mentioned above, even though Sukuk as a modern instrument of Islamic finance is new, the principles underlying Sukuk are not. These principles are discussed below. a.	Riba is prohibited (haram)

The prohibition of riba is one of the most important prohibitions and it would not be an exaggeration to state that it is the central prohibition pertaining to Islamic finance. Thus, it is the traditional view that Islam does not allow making money out of money or simply from lending or borrowing. That is all qard (loan) in Islam is regarded at qard hasan (a charitable or gratuitous loan), where the lender is prohibited from getting anything extra or above the original principle sum.

Drawing from the same principle, the shariah scholars determine that Islamic financial institutions should not involve in transactions or securitizations where debts or receivables are traded differently than at par. As Mahmoud El Gamal articulated: “ … in finance – the forbidden riba is essentially ‘trading in credit’” and the forbidden gharar is ‘trading in risk,’ as unbundled commodities.”

b.	Gharar (excessive uncertainty) is prohibited

While it is not clear as to how to make the notion of uncertainty or risk operational or quantifiable, this principle of prohibition of gharar is aimed that removing uncertainty from a transaction as much as possible by making the contracts as specific and detail, so that no relevant, let alone basic, information is left clearly specified. This is accomplished primarily focusing on the contractual terms or any kind of uncertainty or lack of sufficient specificity in regard to the existence of an underlying asset.

c.	Islamic financial contracts must be asset-backed

Islamic finance requires that all the transactions must be asset backed, and any trading must relate to specific and identifiable assets. As mentioned above, trading in debt, as in conventional bonds, is equated with Riba, which is not permissible in Islam. Conventional bonds are interest-based investment vehicles that can general obligation bonds, without necessarily related to any specific asset. Drawing on this principle, returns and cash flows related to a sukuk must be linked to assets purchased, or an asset upon construction, if it is related to project finance. Thus, the assets to underlie a sukuk must be tangible, with the ramification that application of such principle would essentially preclude the derivative products or transactions.

Based on the abovementioned principles, the salient features of sukuk can be summarized as following. Though on the surface there might be some similarity, the underlying structure and provision are quite different for Sukuk. A special purpose vehicle (SPV) – an entity that is created solely for a particular financial transaction or series of transactions – is generally used to issue sukuk. Unlike conventional bonds, where returns are calculated based on market interest rate, and similar to stocks, Sukuk return is to be calculated based on expected profit the asset or the project-finance asset.

Like in a trust certificate, sukuk-holders get an undivided proportion of ownership in the underlying asset or the project-financed asset, and based on this ownership he is entitled to the cash flows from that underlying asset. To avoid gharar, all obligations and rights must be clearly specified/deﬁned. The income or cash flow from a Sukuk must be tied to the underlying asset or the project asset. And, of course, like all transactions in Islamic finance, Sukuk must be backed by assets, often insisted as ‘tangible’ assets.

Furthermore, since any guaranteed, fixed or predetermined return is considered riba, Sukuk holders cannot be given any guarantee regarding regular payment as in an annuity. Sukuk holders cannot receive the guarantee of redeeming Sukuk at its face value. Unlike conventional bonds, where interest payment is not tied to the income generated by the company, let alone from any specific asset, in case of Sukuk the stream of cash flow.

Despite all these well known and well established principles, there is a big gap between the realm of theory/ideal and that of practice. As per the standard of conventional bond market, bonds must have a guaranteed flow of income and redemption must be possible at full face value. Collateralization, guarantee of performance, and other type of risk-minimizing or risk-shifting provisions are quite common on the basis of which conventional bonds are rated by various rating agencies. It seems that to receive ratings from these leading bond rating agencies, such as Standard & Poor’s or Moody’s, those risk-minimizing or risk-shifting provisions have also found their way into most Sukuks.

Thus, it is not surprising that some prominent Shariah scholars have taken issue with the current practice of Sukuk contracts. AAOIFI is the leading Shariah standard setting institution for Islamic financial institutions, which had issued Shariah standards for Sukuk and the chairman of AAOIFI’s Shariah board is Mufti Muhammad Taqi Usmani. During the past several years, when Sukuk became so popular that it was experiencing explosive growth, in 2008 Mufti Usmani issued a public statement asserting or accusing that 80 percent of the sukuk in the market are unislamic.

Asset based and asset backed sukuks
There are two types of Sukuk, asset based and asset backed. Under the asset based Sukuk, the Sukuk holders have beneficial ownership in the asset. The Sukuk holders have recourse to the originator if there is a shortfall in payments. The beneficial ownership is a legal term where specific property rights, such as its use and title belongs to a person even though legal title of the property belongs to another person. A common example of beneficial owner is the owner of funds held by a nominee bank or for stocks held in the name of brokerage firm. Under asset backed Sukuk, the Sukuk holders owned the asset and as a result do not have recourse to the asset but to the originator if there is a shortfall in payment.

Asset backed sukuks
These sukuks involve granting the investor (sukuk holder) a share of a tangible asset or business venture along with a corresponding share of the total risk (that is, a share commensurate with this ownership). In this structure, there is a true sale transaction, where the originator sells the underlying assets to a special purpose vehicle (SPV) that holds these assets and issues the sukuk backed by them. The buyers of sukuk don't have recourse to the originator if payments are less than usual. A true sale implies that the assets of the issuer will not be added to the assets of the originator in the event of default and liquidation. The sukuk holders must assume any losses in case of impairment of sukuk assets. Asset-backed sukuk are, thus, closer to equity than debt, and for that reason are not so popular in the market of sukuk offerings.

Asset-based sukuks
Assets based sukuk involve the issuer purchasing the underlying assets and then investing, trading or leasing them on behalf the investors (sukuk holders), using the funds raised through the issued certificates (sukuk). This structure, most often, takes the guise of a sale-lease to the originator and is embedded with a binding promise from the originator to repurchase the underlying assets at maturity. In this structure, the sukuk holders can only require the originator to purchase the underlying assets. As such, the sukuk holders have an unsecured debt claim against the originator embodied in the payment of the purchase price following an execution of the binding purchase promise. This implies that sukuk holders don't have full recourse to the underlying assets and the underlying assets are not used as collateral. Asset-based sukuk grant only beneficial ownership to the sukuk holders, so that in case of default, the investor would be left without any claim on these assets. In this structure, the originator typically transfers to the investors only the beneficial ownership of the SPV issuer. But shari'a stipulates a transfer of assets to sukuk holders. However, since investors have no recourse to the assets, the structure does not pay any attention to the asset risk, but rather concentrates on the creditworthiness of the sponsors of the sukuk.