A new structure for mudaraba sukuk

One of the big unknowns for the sukuk market over the past two years is what would be done to incorporate the new rules laid out by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) relating to the structure of mudaraba sukuk. The ruling, which came in February 2008 (pdf), restricted the repurchase of mudaraba sukuk. Prior to that ruling, it was common for issuers (primarily Islamic banks) to issue mudaraba sukuk with repurchase agreements that stipulated a repurchase upon maturity of the entire par value. The AAOIFI rules were clarified with regards to loans to cover shortfalls:

"It is not permissible for the Manager of Sukuk, whether the manager acts as Mudarib (investment manager), or Sharik (partner), or Wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus."

And to the redemption amount:

"It is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase".

The example of a post-AAOIFI sukuk is the recently-issued SAR775 million ($193 million) Saudi Hollandi Bank subordinated, callable sukuk. The mudaraba sukuk, priced at 190 basis points over the Saudi Interbank Rate (SAIBOR) and is callable annually in and after 2014 until the year prior to its maturity in 2019. If the sukuk is not called in 2014, the expected profit payments are increased by a step-up margin for the final five years. The sukuk was issued to finance the expansion of the bank's Islamic finance business and is Tier II capital.

The important aspects of the Saudi Hollandi Bank sukuk from the perspective of the AAOIFI ruling is how the periodic payments and redemption value are determined. Under normal situations (i.e. outside of a default or winding up of the bank), the capital provided will be used in the Islamic banking business of Saudi Hollandi Bank and can be commingled with assets provided by the bank in this business. The net income is defined as the income minus direct costs of the Islamic finance business and any allocated costs and minus the current year provisions of Islamic finance business. This income is divided according to a profit-sharing ratio between the bank (10%) and sukukholders (90%).

If the net income exceeds the periodic distribution amount (the SAIBOR+190 basis points times the par value times the days in the period divided by 360 days), then the periodic payment amount is made and the excess is placed in a reserve account. If there is a shortfall, the difference is paid from the reserve account. If there is not sufficient funds in the reserve account, the shortfall is subtracted from the final redemption value (Condition 7(g): "If the monies (if any) standing to the credit of the Reserve are insufficient to cover such shortfall, the Issuer shall have the right to set off any such amounts due from the Sukukholders against the Redemption Amount to be paid to them by the Issuer pursuant to the Mudaraba Agreement."). At the redemption of the sukuk, if there is then a positive amount remaining in the reserve account, it is first used to cover any shortfalls in the redemption amount, with any remaining amounts paid to Saudi Hollandi Bank as an incentive payment.

This is a significant difference from how mudaraba sukuk worked before the AAOIFI clarification where the issuer would make an interest-free loan to cover any shortfalls in the periodic payments. There is also a difference in the redemption amount calculation. The redemption value at the maturity in 2019 will be "the aggregate face value of the Mudaraba Sukuk payable upon the redemption of the Mudaraba Sukuk by the Issuer upon the occurrence of the Expiry Date, the Optional Expiry Date, Regulatory Dissolution Date or the Event of Default Date, less any loss relating to the Mudaraba Assets not covered by the monies (if any) standing to the credit of the Reserve". There are some restrictions on redemption under the call provisions that protect the sukukholders relating to the value of the mudaraba assets. The bank can call the sukuk in the 5th, 6th, 7th, 8th and 9th years, but only if the redemption amount is not below the face value of the sukuk.

Things get difficult for investors, however, in the case of a default. Because the sukuk was issued as Tier II capital and is subordinated debt, the investors are not provided sole recourse against the assets of the mudaraba. The prospectus describes: "The obligations of the Issuer are not secured by any assets or security and are subordinated." The subordination is further described: "All payments by the Issuer to the Sukukholders of the Redemption Amount pursuant to the Mudaraba Agreement and all other amounts payable under each Transaction Document [...] will be subordinate in right of payment upon the occurrence of any Winding Up Proceeding of the Issuer to the prior payment in full of all deposit liabilities and all other liabilities of the Issuer, except in each case to those liabilities which by their terms rank equally in right of payment with or subordinate to the Subordinated Payment Obligations."

The Saudi Hollandi Bank sukuk is a new look for the mudaraba sukuk from what was common prior to the AAOIFI clarification and includes several changes that make it behave differently from conventional subordinated debt. There are changes that shift some of the risk that the mudaraba does not generate income sufficient to cover what are otherwise fixed payments and uses a reserve account to smooth payments over the term of the sukuk. One area of concern is that the sukuk creates greater risk for the investors without any corresponding potential return.

The aspect of the structure which confers greater risk without corresponding return is the structure of the reserve account. If the bank makes significant profits, the amount it must pay out to the sukukholders is limited to the specified return on the sukuk and further limited because in such a case, it may be advantageous for the bank to redeem the sukuk (assuming it is permitted by the Saudi Arabian Monetary Authority). Any excess return remaining in the reserve account is paid to the bank as an incentive payment. On the flip side, if there is a loss, the investors bear it in full.

This structure, while creating an incentive for the bank to maximize profits so as to generate earnings, it may also create an incentive to take on additional risks because the downside is borne by the sukukholders while the bank retains the upside. This incentive risk is somewhat minimized because equity shareholders should recognize that the regulatory requirements would force the bank to raise additional capital if it began making significant losses which could be dilutive to shareholders. However, this relies upon strong corporate governance, which may not be present (for example, see Lehman Brothers and Bear Stearns).

That caveat aside, the mudaraba structure used by Saudi Hollandi Bank is probably preferable from an 'authenticity' perspective to the 'old' mudaraba structure which used a repurchase agreement at par to redeem the sukuk regardless how the assets that supposedly were backing it performed. The development of sukuk and other Islamic financial products that substantively differ from conventional products (as opposed to mimicking them) will not happen overnight. It is likely to be a slow evolutionary process and the Saudi Hollandi Bank sukuk represents one step in that evolution.