Monday, January 11, 2010

Are ijara sukuk debt or equity?

Dr. Hussain Hamed Hassan, a prominent Shari’ah scholar provided some interesting comments in an interview with Emirates Business 24/7 about the relationship between the Islamic finance industry and the financial crisis. There are several interesting comments and some of them are open to some debate and I disagree with one of them in particular. Before I discuss them, however, I want to add a caveat to my analysis.

Dr. Hassan is a well regarded Shari’ah scholar with far more qualifications than I or many other people in Islamic finance and in particular the application of Shari’ah standards in modern financial products. My comments are largely limited to how the Islamic finance industry works in practice compared to his description. Every so often an article is published with the criticism of Shari’ah scholars (usually accompanied by charges of ‘fatwa shopping’ by banks offering Islamic financial products). I am not going to go down this route because I—and I believe most people in the Islamic finance industry—believe that the differences of opinion between Shari’ah scholars is one based on legitimate disagreements and does not indicate any opportunism on their part.

Dr. Hassan describes that “the Islamic financial system does not allow trading in debt, which has been the root cause for the present crisis. […] Sukuk clearly represent equity ownership and has no linkage to debt. The issuer of the sukuk is selling an asset to the holder of the sukuk. The sukuk holders [in an ijara sukuk] are owners […] and they are entitled to the rentals generated by the asset.”

This may be the case in theory for Islamic financial instruments (insofar as how the legal reality is constructed), but it is often not the case in practice. The ijara sukuk with a repurchase agreement at par creates a stream of rental income from the underlying asset, which is in line with what Dr. Hassan describes. However, the insertion of the repurchase clause where the issuer repurchases the asset at par or in cases of default makes the instrument a debt. The sukuk holders have no recourse to take possession of the asset; their claims are transformed into unsecured debt obligations against the issuer.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Shari’ah board (of which Dr. Hassan is a member) removed the possibility of repurchase at par for mudaraba and musharaka sukuk. In terms of ensuring that sukuk retain some features of equity (repayments are not guaranteed and depend on the performance of the underlying assets or business), this was an entirely appropriate move. However, the exemption provided under some circumstances to ijara sukuk leaves that as one of the forms of tradable debt open to issuers. The sukuk certificateholders retain ownership of the asset and therefore are selling a claim to that asset when they trade ijara sukuk in the secondary markets, but the claim on the assets when a repurchase agreement (at par) is present remains unsecured debt.

Were the Islamic finance industry to move away from this type of ijara sukuk (which in my opinion would be disruptive, but not cataclysmic) and include the requirement that repurchase agreements of ijara sukuk were done at market value or even at a value agreed upon between issuers and investors at the time of redemption or default, it would leave the ownership intact until the sukuk certificates are redeemed. The price of this redemption would be determined on the redemption date, it would remove some of the debt-like qualities of the sukuk. In addition, this would provide sukuk certificate holders with actual ownership of the assets upon default and they could either negotiate a sale to the issuer or, if that is not possible, be able to lease the assets to the company or a third party, or alternatively, sell the assets at the current market price.

This idea is a relatively simplistic assessment on my part of the issues facing the Islamic finance industry over the tradability of sukuk and the role of repurchase agreements. However, when describing the Islamic financial industry, I believe there remain disagreements about whether the products like ijara sukuk do or do not constitute a debt. In the strict legal sense they don’t. The sukuk is a stream of rental payments with two sale transactions as bookends. However, in the actual outcome—fund the purchase with the sukuk proceeds, make rental payments and redeem the certificates at par through a purchase undertaking—they are debt. The asset (and more importantly the change in its market value) is removed from the final transaction in order to mimic a bond with par redemption.

Despite my criticism presented above, I believe that it is incredibly useful when Shari’ah scholars provide more clarity about their thinking about the industry and the products used by the industry. I would recommend reading Dr. Hassan’s interview in full from the link above.


Anonymous said...

Hi Blake

We need to bear in mind the following additional issues:

1. From an English law legal perspective, the sukuk certificates should represent debt i.e. if the issuing SPV defaults on its payments to sukukholders, sukukholders should have a debt claim against the SPV for the outstanding principal + profit. (I use the word 'should' as none of this has been tested in an English court to date, although I understand that US courts have formed a similar view on the recently defaulted East Cameron sukuk).

2. Obviously the sukukholders' claim against the SPV is only as good as the assets the SPV holds. One of those assets should be a back-to-back debt claim against the obligor (ie the real credit for the sukuk) pursuant to the purchase undertaking. However, a large number of US and UK lawyers take the view that the Purchase Undertaking only creates a damages, and not a debt, claim. Why? Because it is a sale contract, and the normal recourse for a seller under a sale contract where the buyer breaches its obligation to pay the purchase price is damages. Any other solution would be inequitable, as the seller (ie SPV in a sukuk) would own the asset AND have a debt claim against the buyer, thereby creating a windfall. (A good parallel is the legal outcome when a purchaser of an ISDA-based share option does not pay the strike price on the exercise date.) This is a major problem for investors, as a damages claim is much weaker than a debt claim for a variety of reasons which I won't go into now. However, I have not seen a lot of writing on what is for me a fundamental issue.

3. In addition to the SPV's damages claim against the obligor, if a 'true sale' of the sukuk assets took place at closing, then the investors will also have recourse to the sukuk assets. Unfortunately, most (I have seen estimates at around 90%) of GCC sukuk do not involve a 'true sale' of assets.

4. One huge point of confusion regards whether the sukukholders 'own' the sukuk assets. The sukukholders can only own the sukuk assets, under English law, if (i) there has been a 'true sale' of LEGAL title to the sukuk assets to the SPV and (ii) the SPV has validly given each sukukholder a valid proprietary interest (namely, BENEFICIAL title) pursuant to a valid Declaration of Trust. In order for the Declaration of Trust to be legally valid and enforceable, title to the assets in respect of which the trust is declared needs to be capable of being split as between LEGAL and BENEFICIAL title. Whilst this 'split' is recognised in common law jurisdictions, it is not recognised in any GCC jurisdiction. Where proprietary rights in the sukuk assets are governed by the law of a GCC country (e.g. UAE law in respect of real estate sukuks in the UAE, like Nakheel, as immovable real estate has to be governed by the laws in the jurisdiction in which such real estate is located), the overwhelmingly view is that the Declaration of Trust will not work and will therefore not create a proprietary interest in the sukuk assets. This is often spelt out in the risk factors of sukuk OCs, but again lack of precedent means there is still much confusion on this.

There is a lot more to be written on all this, but hopefully this is of interest.

Blake Goud said...

Thanks for your detailed comment. I think you present a number of important points that I had not considered about how many sukuk interact with the legal understandings in the jurisdictions in which they operate.

With regards to the purchase undertaking only creating damages versus creating a debt, I share your concern if the structure puts sukuk investors at a disadvantage in a bankruptcy compared to conventional bond investors. Most of the sukuk prospectuses classify the claims as unsecured obligations of the issuer in a default where a purchase undertaking is triggered. The possibility that those unsecured obligations would be treated as damages rather than debts are probably a risk factor many investors do not consider.

On the point about 'true sale' versus beneficial ownership, I think your point is right on the mark. The permissibility of purchase undertaking at par value in ijara (now that it is not permissible in mudaraba and musharaka) has led to that being the foremost structure used in new issuance. This leads to a greater likelihood that the debt versus damages question will be decided in courts in the future.

I think that to the extent possible, sukuk should avoid the use of par purchase undertakings because it creates uncertainty about the use of the underlying asset and the legal rights investors have over that asset. This happens even though the prospectuses clearly describe that the only recourse for investors is through the purchase undertaking and they are not (in most cases) given any right to enforce their claim by taking possession of the asset.

If the asset-based structure of sukuk were scrapped in favor of an asset-backed structure (at least for ijara), it could clear up this issue, although it might diminish the appetite of investors if they are not promised redemption at par even when the asset depreciates in value significantly. On the other hand, it could increase the awareness of investors about what their risks.

However, as you point out, the use of an asset increases the legal risks when that asset is located in a jurisdiction where enforceability is not well understood or defined.

Thanks again for the thought-provoking comment.


Anonymous said...

Blake - one other overriding point in all this is to remember that sukuks are priced on the basis of creating debt (and not equity) claims. If we remove the purchase undertaking at par, so that investors are effectively taking equity risk in the underying assets / credit, then pricing will increase commensurately with that risk. This would remove the ability of sukuks to compete with conventional bonds and definitely hamper the industry. An equity deal will always price higher than a debt deal because (i) equity ranks behind debt in an insolvency, hence added risk and (ii) there is no guaranteed return (i.e. dividends or their equivalent are dependent on the obligor making a profit and directors choosing to declare dividends.

Blake Goud said...

You are correct about the impact of removing the purchase undertaking on the pricing of the sukuk and I don't think it is necessarily practical to remove it. It would indeed hamper the industry's growth significantly.

However, I think that there should be a move away from unsecured sukuk. If there is a default, the investors are left with nothing more than an unsecured claim against the issuer to recoup their investment, despite the use of an asset to structure the sukuk which is sold to the investors. As you noted, the investors' claims from the purchase undertaking against the issuer in a default is essentially subordinated to the conventional bond holders.

I think the compromise between removing purchase undertakings and the status quo could be either the use of a true sale rather than the transfer of beneficial ownership to the SPV. That would provide investors with some collateral in a default, which could also be accomplished by a grant of a fully perfected mortgage over the asset, which was used in the Nakheel sukuk (although that was never tested in a court).

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