Thursday, December 10, 2009

A brief summary of the GE Capital sukuk

Before the Dubai debt crisis hit the region and focused all of the attention towards that aspect of the Islamic finance industry, there was a very significant new issue from GE Capital (prospectus available from NASDAQ Dubai) that in other situations would have received much more attention than it did. The sukuk for $500 million, which yields 3.875%, was a first for GE Capital, although not the last according to the company: “’We intend to be regular issuers in the sukuk market and are heartened by the support we have seen in this first transaction,’ GE's senior vice president and treasurer, Kathy Cassidy, said.”

The structure of the sukuk is somewhat unique from many other ijara sukuk and has a number of interesting components that differ from what has been the norm for an aircraft-based ijara sukuk. The proceeds of the sukuk are not used to directly finance a new aircraft purchase. Instead, the funds are used to purchase a portfolio of existing leases from two subsidiaries of a wholly-owned subsidiary of GE Capital. The direct subsidiary, Delaware-domiciled Sukuk Aircraft Leasing Inc. (SAL), owns the two subsidiaries, SAL Investments 1 LLC and SAL Investment 2 LLC, which have portfolios of leases for aircrafts.

The transaction involves the two SAL Investment companies selling the leases to the SPV, GE Capital Sukuk Ltd. (Bermuda-domiciled), that pays for the purchase using the proceeds of a sukuk issued to investors with a return of 3.875%, payable semi-annually in May and November for five years (due in 2014). The SPV then enters into an Agency Services Agreement with the parent company of the two SAL Investment companies to service the leases. Not all of the proceeds of the sukuk are used to purchase the leases; $50 million is set aside in reserve account for the use by SAL due on maturity or early termination of the sukuk to cover any expenses, is called the Funded Reserve Account. There are other reserve accounts established for airplane replacement and substitution.

The unique aspect of the Agency Services Agreement is that it takes leases which are not Shari’ah-compliant and strips out the non-compliant aspects of it so that none of the returns to the investors come from interest, penalties. The sukuk prospectus describes that SAL must “ensure that any Lease Revenues received by it which comprise Non-Qualifying Revenues are segregated and paid to buildOn, Inc. or any other Sharia compliant charity as determined by SAL”. Any Non-Qualifying Revenues are donated to buildOn, Inc., a charity in the US which describes it’s activities as:
”a non-profit organization that empowers primarily urban U.S. high school students through in-class and intensive after-school programs. In addition to tremendous contributions of community service in their own cities and neighborhoods, buildOn youth actually build schools and bring literacy to children and adults in developing countries around the world. buildOn programs are designed to build confidence and real-world capabilities in American youth while also empowering communities world-wide to overcome the crippling cycle of illiteracy, poverty and low expectations by opening the door to education.”
During the term of the sukuk, the leases generate revenue, the non-Shari’ah-complaint parts are stripped out and donated to charity, and the lease payments are passed to the SPV, which then makes the periodic payments to the sukuk certificateholders. In this way, the returns provided by the sukuk are equivalent to an unsecured debt.

The unsecured status (both of the payments and any guarantee from GE Capital should the lease payments not be sufficient to cover payments), which is made explicit:
“The payment obligations of SAL under the Purchase Undertaking will be direct, unconditional, unsecured and general obligations of SAL and shall rank at least pari passu with all other unsecured, unsubordinated and general obligations of SAL, other than those mandatorily preferred by law.”

“The Guarantee is unsecured and ranks equally with all other unsecured and unsubordinated obligations of the Guarantor.”
At maturity, the SAL Investment companies will repurchase the aircraft (and the future stream of lease payments) from the SPV to provide funds to redeem the sukuk.

In addition to the basic structure described above of converting non-Sharia’h-compliant leases into Shari’ah-compliant ijara cashflows, there are a couple additional features that provide sukuk certificateholders with additional security: 1) an insurance undertaking; and 2) a reverse commodity murabaha using the funds in the reserve accounts. I will start describing the latter.

The reserve accounts (Funded, Unfunded, and Replacement Airplane Accounts) use the funds between each periodic payment date or aircraft substitution date to fund commodity murabaha transactions with the Servicing Agent, SAL, at the same rate as the underlying sukuk, 3.875%. This ensures that there is sufficient funds to pay the 3.875% rate on the entire principal amount, not just the amount used to purchase the airplane leases ($450 million). However, it also may not provide the same return as if it were credited on the remaining $50 million because of the expenses the Funded Reserve Account pays to the Servicing Agent to service the leases.

The prospectus describes:
“The Master Murabaha Agreement will be entered into on the Closing Date between the Trustee and SAL, acting in a personal capacity and on a voluntary basis, and will be governed by English Law. The terms and conditions on which each Murabaha Contract will be entered into will be set out in the Master Murabaha Agreement, including provision for (i) each Murabaha Contract to be entered into on the Closing Date and, thereafter, on each Periodic Distribution Date, in the case of amounts credited to the Funded Reserve Account and on each Aircraft Substitution Date and Aircraft Loss Settlement Date, in the case of amounts credited to the Replacement Aircraft Account, (ii) the date of the deferred payment of the purchase price for the relevant commodities to be the next succeeding Periodic Distribution Date, as the case may be (iii) the profit payment in respect of such deferred payment to be determined by reference to a rate of 3.875 per cent per annum and (iv) the Deferred Payment Price to become immediately due and payable on the occurrence of a Termination Event or a Total Loss Settlement Date and to be paid without the need for any notice or demand on the relevant Termination Date or the Total Loss Settlement Date, as the case may be.”

The other feature is a form of insurance against loss of the aircraft being leased. In the absence of a way to refigure the insurance on the airplanes being leased to conform with Shari’ah requirements, the sukuk structure provides a way for the sukuk certificateholders to be compensated from the insurance payouts without entering in any non-Shari’ah-compliant transactions. The prospectus describes:
”Pursuant to the Insurance Undertaking SAL shall undertake that: (i) following the occurrence of an Aircraft Loss Event, it shall, on the relevant Aircraft Loss Settlement Date, pay any Aircraft Loss Shortfall into the Replacement Aircraft Account; and (ii) if, following the occurrence of a Total Loss Event, the sum of the insurance proceeds paid into the Transaction Account by the Servicing Agent on or before the Total Loss Settlement Date in accordance with the Servicing Agency Agreement as described above and any other amounts standing to the credit of the Transaction Account on the Total Loss Settlement Date is less than the Total Loss Amount (the difference between the amounts standing to the credit of the Transaction Account on the Total Loss Settlement Date and the Total Loss Amount being the Total Loss Shortfall, it shall pay the Total Loss Shortfall into the Transaction Account on the Total Loss Settlement Date.”

The GE Capital sukuk is an interesting adaptation of a typical ijara structure to incorporate non-Shari’ah-compliant leases without violating the Shari’ah restrictions around the payments on cash balances in reserve accounts, non-Shari’ah-compliant payments from a lease agreement and the applicability of non-compliant insurance for sukuk certificateholders. It incorporates these features into an unsecured sukuk, guaranteed by GE Capital. This demonstrates the flexibility of Islamic finance, but the innovative features of the sukuk—as well as its unsecured nature and guaranteed status—are reminders that there remain questions about whether innovation is always beneficial. For example, is the use of non-Shari’ah-compliant lease contracts that have their non-compliant cashflows stripped out and donated to charity simply a new frontier of transforming conventional financial instruments into Shari’ah-complaint instruments by wrapping (or unwrapping in this case) a conventional financial product?

If anything comes out of the attention paid to the Nakheel sukuk and the questions about its ability to meet the obligations to sukuk certificateholders, it should be a close examination of how new Islamic financial products are structured and what the ‘innovations’ mean for the industry’s future as a whole.

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