Sunday, May 24, 2009

Sukuk, SPVs and the 'true sale'

I want to begin this post with a caveat that this post is about a topic--legal and regulatory treatment of securitization--in which I do not claim an exceptional degree of expertise. However, I saw an article that deals with off-balance sheet, bankruptcy remote entities used for securitization of credit card receivables that I believe has relevance to the Islamic finance industry.

While I was writing an article for Islamic Business & Finance magazine about the bankruptcy of East Cameron Partners, which had issued the first U.S. corporate sukuk, I did some research into the SPV structure used in most sukuk transactions. In most sukuk transactions, assets are sold to an off-balance sheet SPV which pays for them using funds raised by issuing sukuk to investors. The use of these bankruptcy-remote SPVs provide investors with ownership of an asset that, at least in theory, will not be subject to claims made by other creditors of the company that sells them to the SPV to raise money if the company goes into bankruptcy.

They are also used in many sukuk to create asset-backed financing where investors do not have recourse to the company's other assets in case of default; a default usually triggers a dissolution of the SPV and, in effect, a redemption of the remaining principal through a repurchase by the company of the asset. Between November 2007 and February 2008, there was a good deal of attention paid to how the repurchase/redemption is structured from a Shari'ah-compliance perspective.

In the article, "Securitization: Advanta and the Fiction of True-Sale", the focus is on whether securitization--specifically the sale of assets to off-balance sheet entities--constitutes a 'true sale'. The 'true sale' concept provides the degree of separation that protects assets owned by the SPV from creditors of the company and the company from investors claims on its assets apart from the assets sold to the SPV. If the 'true sale' is not recognized, it would jeopardize the entire structure, which, in a bankruptcy proceeding, would be combined together, much to the chagrin of investors and the company. One law professor I spoke to writing the East Cameron article whose expertise is in securitization and bankruptcy law said that absent unusual circumstances, the 'true sale' would most likely be respected by bankruptcy courts.

Where I see the potential for problems for the Islamic finance industry is with the complex, multi-jurisdictional structure of many sukuk transactions that create asset backed sukuk. These also include some provisions for the company to repurchase the asset or be responsible for provide investors with some form of guarantee of the expected payments if there is a default. One of the main legal risks to the sukuk market is that there have been few cases where the structures used were tested in courts in many of the areas where sukuk are issued. If a 'true sale' was not recognized by a court it could shock the industry to an even greater degree than the AAOIFI ruling on repurchase agreements in sukuk or the OIC Fiqh Academy ruling on tawarruq. Apart from additional experience which may be coming if more sukuk issuers default, there's not much that can be predicted in advance, but this could be one of the most difficult 'growing pains' for the young industry.

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