Saturday, January 23, 2010

Should Islamic finance move towards asset-backed securitization?

Two lawyers with experience in Islamic finance, Debashis Dey and Stuart Ure, wrote an article in The National about the future of sukuk and in particular, they highlight one of the important features of sukuk which is often misunderstood:
"In the majority of unsecured sukuk transactions the investors ultimately have no direct recourse to the assets themselves. The repayment of their investment is dependent on the exercise of a purchase undertaking by the seller of the assets at maturity or upon default. Thus, as with a conventional bond, the investors take credit risk on the seller who has granted the purchase undertaking.

Although typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default."
This is one of the aspects of sukuk which I have criticized because it isolates the actual asset from the transaction and thus creates an unsecured debt that appears to be based on an asset. While this is clear in the offering documents, the amount of different articles that talk about Islamic finance as being more stable because it is based on real assets suggest that they have not read offering circulars of sukuk.

The solution, if the industry wants to make the rhetoric match the reality, in the eyes of these two lawyers (which I agree with) is:
"While Sharia principles seem harmonious with the nature of asset-backed securitisation, for securitisation to become more mainstream in the GCC, three prerequisites will be required: firstly, investors will need to demonstrate a commercial desire to take the risk (and reward) associated with the true sale of assets in an asset-backed structure, including the management of those assets in a default scenario; secondly, those companies seeking finance will need to demonstrate a desire to sell their assets (which will have accounting and shareholder equity implications); and thirdly, a robust legal framework will need to evolve as bankruptcy and asset-selling laws in many jurisdictions in the GCC remain opaque and militate against securitisation structures."
These three points are important and have not been the focus of the future of sukuk as much as they should be.

The prime example for a sukuk which does use an asset-backed securitization structure that has run into trouble (and therefore is instructive when compared with recent defaults of unsecured asset-based sukuk) is the East Cameron sukuk. This sukuk was a musharaka between the issuer SPV and an oil-and-gas exploration & production company. The asset was an overriding royalty interest (ORRI) and the two parties split the production from the musharaka assets (natural gas), which was then sold to make periodic payments and redeem the sukuk.

The transfer of the ORRI to the musharaka SPV was a true sale and this has been upheld in the bankruptcy court overseeing the reorganization of East Cameron Partners. According to documents filed in the bankruptcy court, the sukuk investors have provided debtor-in-possession financing to the company and a reorganization plan is expected to be submitted sometime in January 2010. However, for the discussion of ABS structures for sukuk, the idea of using a true sale rather than a sale of beneficial interest that is common in unsecured sukuk has shown to protect sukuk investors by giving them rights to the underlying asset that is insulated from the claims of other creditors.

Of course, this case occurred in the U.S. where the legal system is more developed in terms of understanding and resolving claims regarding asset-backed securitizations than in other jurisdictions where sukuk are issued. The ability to take this example and generalize to sukuk issued elsewhere is, therefore, limited. However, lack of generality does not make it a useless exercise.

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