Principles of Islamic banking and finance/PIBF203/Sukuk/Case studies

==EMIRATES AIRLINE - EXPORT CREDITS GUARANTEE SUKUK  ==

The Emirates Airline issued a USD913 million Ijarah based Sukuk in March 2015 in order to fund acquisition of aircraft for its fleet. The Sukuk was issued to fund purchase of four Airbus A380-800 to be delivered between April and July 2015, and is part of a larger plan to purchase USD107.5 billion worth of aircrafts from Boeing and Airbus over a period of time. Emirates Airline is an established player in the international Sukuk market with already two USD based Sukuk issues since 2005 worth a total of USD1.5 billion. This new issue has taken its share of the dollar based Sukuk market to almost USD2.5 billion. The Emirates Airline (Khadrawy Limited) Sukuk has a tenor of 10 years and provides a profit rate of 2.471% per annum. It has the benefit of a guarantee by Her Britannic Majesty’s Secretary of State acting by the Export Credits Guarantee Department of the UK Government (ECGD), currently being called the UK Export Finance or UKEF, although the prospectus of Emirates Sukuk uses the term ECGD Guarantee for the arrangement. The ECGD Guarantee makes this Sukuk issue the world’s first Sukuk financing supported by UKEF and also the largest ever capital markets offering in the aviation space with an export credit agency guarantee. Incidentally, the transaction has also been credited as the first Sukuk financing used to pre-fund aircraft acquisition, and the first Sukuk financing for this type of aircraft, that is, for the A380. The Sukuk certificates have been issued pursuant to Regulation S and Rule 144 A under the US Securities Act of 1933.

INSTITUTION BACKGROUND
Emirates Airline is the national airline for the Emirate of Dubai, with rights to operate domestic and commercial air services since 1985. The airline is a subsidiary of The Emirates Group, which is wholly owned by the government of Dubai’s Investment Corporation of Dubai. It is the largest airline in the Middle East, operating over 3,300 flights per week from its hub at Dubai International Airport, to more than 148 cities in 78 countries across six continents. Emirates is the world’s biggest international carrier, the seventh largest airline in the world in terms of revenue, and the largest airline in the Middle East in terms of revenue, fleet size, and passengers carried. The airline is also the fourth-largest airline in the world in terms of international passengers carried. The company operates four of the world’s longest non-stop commercial flights. Emirates Airlines operates a mixed fleet of Airbus and Boeing and is an industry bellwether for aircraft purchases, having purchased 200 aircraft in 2013 alone.

GUARANTOR BACKGROUND
The Export Credits Guarantee Department (currently operating as “UK Export Finance”) (“ECGD” or the “Guarantor”) is the United Kingdom’s export credit agency. ECGD is a British government department reporting to the Secretary of State for Business, Innovation and Skills. ECGD contracts on behalf of the Secretary of State and its liabilities are discharged by funds provided by Parliament or charged on the consolidated fund of the United Kingdom. An obligation of ECGD under a validly executed guarantee will therefore constitute an obligation of the United Kingdom. The UK has been keen to establish itself as the centre of global Islamic finance. “UKEF expects to incorporate the Sukuk guarantee into its standard product range so that it’s available for future transactions in other sectors.”

SUKUK STRUCTURE
The Emirates Airline Sukuk is based on Ijarah wa Istisna’a. Ijarah is buying and leasing of assets by the investor to the issuer. Istisnaa’ is a sale contract by way of order for certain product with certain specifications and certain mode of delivery and payment either in cash or deferred. In the Emirates Sukuk structure, the procurement of aircraft from the Manufacturer is executed by way of Istisnaa while the periodic cash flows are generated through an Ijarah model.

Parties to the Structure
The Emirates Sukuk structure is different from the previous Ijarah Sukuk structures we have seen so far. It can even be called complex, as it uses three special purpose vehicles (SPVs) in order to effectively execute both the Ijarah and Istisna’a legs of the structure. The following are parties to the structure:

• Khadrawy Limited, constituted as the Issuer/Trustee,

• Khadrawy Aircraft Limited, incorporated as the Owner Trustee (Owner SPV in the diagram), and

• Khadrawy Leasing Limited, incorporated as the Lessor (Lessor SPV in the diagram).

• Emirates Airline, which acts as Lessee under the Emirates Forward Lease Agreement and also as the Seller under the Purchase of Services Agreement.

• The UK Export Finance (UKEF), the Guarantor under the ECGD Guarantee. While in most Ijarah structures, the Issuer declaration of Trust is signed between the Trustee (who is also the sole SPV) and the originator, in this particular Sukuk issue, the Issuer declaration of Trust has been drawn up between the two SPVs, the Trustee and the Owner Trustee. There is a separate declaration of Trust between the Trustee and Emirates

Transaction Flow
• The Trustee issues Certificates to Certificateholders in consideration for the Issuance Proceeds and declares a trust in favour of the Certificateholders over the Issuer Trust Assets.

• Pursuant to the Purchase of Services Agreement, Emirates (as Seller) sells and transfers on the Closing Date to the Trustee (as Purchaser) all of the Rights to Travel in consideration for the ATKM Purchase Price. The “Rights to Travel” form the usufruct under this structure and have been measured as ATKM or Available Tonnes Kilometre – a measure of overall capacity multiplied by distance used commonly in the airline industry. The ATKM Purchase Price comprises both the initial ATKM amount paid by the Trustee to Emirates on the Closing date, as well as the ATKM on-Demand amounts payable as four installments later on at the time of the Delivery of each of the four specified aircrafts.

• Pursuant to the Owner Declaration of Trust, the Trustee contributes to the Owner SPV the Issuance Proceeds Balance and all of its interest, rights, benefits and entitlements, present and future, in and to the Rights to Travel and the Owner SPV uses such assets to: (a) credit the Secured Proceeds Account with the Issuance Proceeds Balance; (b) procure the acquisition of Specified Aircraft pursuant to the terms of the Procurement Agreement using funds from the Secured Proceeds Account and the Rights to Travel; (c) lease such Specified Aircraft to the Lessor SPV. In summary, the Issuance Proceeds Balance is held in the Secured Proceeds Account from the Closing Date, and the Rights to Travel (once transferred) are held on trust by the Owner SPV, pending application of both in accordance with the Transaction Documents in connection with the procurement of the four Specified Aircrafts.

• The Owner SPV will lease each Specified Aircraft to the Lessor SPV under the relevant Owner Forward Lease Agreement. The Lessor SPV will then sub-lease each Leased Aircraft to Emirates under the relevant EK Forward Lease Agreement. • The Issuance Proceeds Balance will be credited to the Secured Proceeds Account pending its application for the purchase of Specified Aircraft expected to be delivered during the Delivery Period in accordance with the Owner Trust Transaction Documents. The ‘Scheduled Delivery Dates’ of the specified aircrafts are set out in the Prospectus and fall between April 2015 and July 2015.

Periodic Distributions
• During the Delivery Period, the Periodic Profit Distribution Amounts are expected to be funded by advance rental payments under the Owner Forward Lease Agreements. Emirates is obliged under the EK Forward Lease Agreements to pay the same amount of advance rental to the Lessor SPV as the Lessor SPV is required to pay to the Owner SPV under the Owner Forward Lease Agreements. The obligation to pay initial advance rental payment amounts on the Closing Date, which in aggregate are equal to the first Periodic Distribution Amount, under the Owner Forward Lease Agreements will be satisfied by Emirates paying the corresponding initial advance rental payment amounts under the EK Forward Lease Agreements to the Secured Proceeds Account on the Closing Date. The obligation to pay further advance rental payment amounts and actual rental payment amounts under the Owner Forward Lease Agreements shall be satisfied by Emirates paying the amounts to the Transaction Account on the first Periodic Distribution Date and second Periodic Distribution Date, as applicable.

• To the extent that delivery of the Specified Aircraft follows the Scheduled Delivery, on Periodic Distribution Dates, an amount equal to the relevant portion of the first Periodic Profit Distribution Amount corresponding to the three Specified Aircraft which have delivered shall be paid as ‘Actual Rental’ while an amount equal to the relevant portion of the first Periodic Profit Distribution Amount corresponding to the fourth Specified Aircraft not yet delivered shall be payable by way of a further advance rental payment under the Owner Forward Lease Agreement.

• If a Specified Aircraft is not delivered prior to the first Periodic Distribution Date as expected, the relevant portion of the Periodic Profit Distribution Amount attributable to such Specified Aircraft not so delivered will be funded by a further advance rental payment in place of actual rental.

• Under the Owner Forward Lease Agreements, and in accordance with the Scheduled Delivery of Aircrafts, the Lessor SPV is also obliged to pay initial advance rental amounts on the relevant Delivery Date, an amount equal to the equity portion of the price payable to the Manufacturer for the Specified Aircraft. Emirates is obliged to pay the same to the Lessor SPV on the relevant Delivery Date under the relevant EK Forward Lease Agreements. The Lessor SPV’s obligation to pay to the Owner Trustee, and Emirates’ obligation to pay to the Lessor SPV in this case will be satisfied by Emirates paying such amount directly to the Manufacturer on the relevant Delivery Date. The Trustee will partially redeem the Certificates on each Periodic Distribution Date at the relevant Periodic Principal Distribution Amount in accordance with a Periodic Principal Distribution Schedule specified in the Prospectus. The outstanding principal amount of the Certificates shall be reduced by the relevant Periodic Principal Distribution Amount. The Certificates will be finally redeemed on the Scheduled Dissolution Date upon payment of the aggregate of the final Periodic Principal Distribution Amounts and the final Periodic Profit Distribution Amount.

• Following the Delivery Period End Date, by which time all four aircrafts should be delivered, actual rental amounts equal to the Periodic Distribution Amounts payable on the Certificates on each Periodic Distribution Date thereafter shall be payable by Emirates to the Lessor SPV under the EK Forward Lease Agreement, and by the Lessor SPV to the Owner Trustee under the Owner Forward Lease Agreements. There will be no need for any advance rental payments once all aircrafts have been duly delivered.

UK Export Finance Guarantee (ECGD Guarantee) and Associated Risk Factor
The UK Export Finance, represented by its old name ECGD, acts as the Guarantor of all the payments flowing from the Lessor SPV to the Owner Trustee SPV and from the Owner Trustee SPV to the transaction account, namely, the advance rentals, the actual rentals and the aircraft purchase prices. According to the Prospectus, the obligations of the Guarantor under the ECGD Guarantee constitute the obligations of the United Kingdom. The sum of the Guaranteed Amounts guaranteed by the Guarantor under the terms of the ECGD Guarantee will be equal to the amounts due under the Certificates. As a matter of current United Kingdom law, it is uncertain whether payments under the ECGD Guarantee would be subject to deduction of, or withholding, on account of United Kingdom income tax, which is currently 20 per cent. Under the terms of the ECGD Guarantee, if the Guarantor determines that United Kingdom tax should be withheld from a payment made by the Guarantor under the ECGD Guarantee, it is likely that the Trustee will not receive the full amount of the Guaranteed Amounts payable under the ECGD Guarantee. As a result, the Trustee will not be able to distribute to the Certificateholders the full amount of Guaranteed Amounts and Certificateholders will suffer a shortfall in expected payments.

PRINCIPAL TRANSACTION DOCUMENTS
The principal transaction documents are:

• the Purchase of Services Agreement between the Trustee as the Purchaser and Emirates as the Seller.

• the ATKM Purchase Undertaking by Emirates

• the declaration of trust between the Trustee, Khadrawy Aircraft Limited (the “Owner Trustee”) and Emirates

• the ECGD Guarantee;

• the Paying Agency Agreement;

• the Issuer Declaration of Trust

CONCLUSION
The Emirates Sukuk provides a refreshing change from the typical Ijarah or Wakalah based models which raise funds through Sukuk using an existing portfolio of assets set aside for the purpose. The Emirates Sukuk is in fact closer in spirit to some infrastructure Sukuk, as it results in creation of new assets – specifically, building and procurement of new aircraft for its fleet – the usufruct from which is securitized to generate periodic cash flows. For that reason alone, we feel that the structure deserves credit for innovation. The Sukuk also has the distinction for providing ‘testing ground’ to the UKEF in order to debut its new structure for providing guarantees to Sukuk. The UK sovereign guarantee provided the much needed boost to the otherwise unrated Sukuk. It was well received and attracted interest from a diverse group of Islamic and conventional investors from around the globe. The Sukuk attracted orders exceeding USD3.2 billion, recording an oversubscription of 3.6 times.