In recent times, particularly in Malaysia, large infrastructure constructions have been financed through the issuance of Sukuk. Although many different structures have been adopted, there are similarities in the fundamental features of most of the structures. The intention of this article is to provide a simple demonstration of how a structure can be adopted for the issuance of Sukuk using the basic components or fundamental features of an infrastructure project.
In a typical infrastructure financing, the common features in almost every deal will be the existence of a sponsor ("Sponsor") who has a project; the sourcing by the Sponsor of funding to construct the infrastructure project; and the existence of a construction contract between the Sponsor and a third party contractor.
The following transaction structure sets out a step by step illustration on how the existence of a construction contract between the Sponsor and a third party contractor can be used to create the underlying transaction for the issuance of Sukuk.
As a point of illustration, the Issuer in the diagram on the following page is a special purpose vehicle/company set up by the Sponsor to be the issuer of the Sukuk. Depending on local legislation requirements, the Issuer can be set up either as an "orphaned" company (i.e. shareholding in the Issuer be held on trust by trustees for the benefit of selected charitable organisation) or a subsidiary of the Sponsor, where its shares are held directly in the name of the Sponsor. Whichever is the most appropriate option will depend largely on the Sponsor's commercial requirements, accounting treatments and also tax treatments in the relevant jurisdictions concerned.
The diagram also demonstrates the existence of common features of infrastructure financing – the existence of a project owned by the Sponsor that requires funding which will enable the Sponsor to pay the third party contractor ("Contractor") under the construction contract.
Click here to view the structure.
This step involves the Issuer issuing Sukuk which may be subscribed by investors interested in participating in the infrastructure project. The Sukuk, once issued, represents the subscribing investors' ("Sukukholders") undivided interest in the infrastructure ("Asset") which the Issuer will commission the Sponsor to construct.
In consideration of the Issuer successfully issuing the Sukuk to the Sukukholders, the Sukukholders will remit/transfer the subscription proceeds for the subscription of the Sukuk to the Issuer.
In Step (1) above, it was mentioned that the Issuer will commission the Sponsor to construct the Asset. Based on the transactional structure illustrated above, this commissioning will be undertaken through the Issuer entering into an Istisna' contract with the Sponsor. An Istisna' contract is a construction and procurement contract for the commissioned manufacture of a specific asset.
Under the terms of the Istisna' contract, the Issuer will commission the Sponsor to construct and deliver the Asset to the Issuer by a specified date and at an agreed contract price which will be paid by the Issuer to the Sponsor in advance. The contract price to be agreed between the Issuer and the Sponsor for such commissioning will be such price equivalent to the proceeds received by the Issuer from the Sukukholders for the subscription of the Sukuk issued in Step (1) above.
Premised on the foregoing terms in the Istisna' contract, upon the Issuer's receipt of the proceeds for the subscription of the Sukuk issued, the Issuer will remit/transfer such proceeds to the Sponsor as fulfillment of its obligations under the Istisna' contract to pay the contract price in advance.
Upon the Sponsor's receipt of the Istisna' contract price, as illustrated in Step (2)(a), it is envisaged that the Sponsor will use such proceeds received to pay the Contractor in accordance with the terms of the construction contract.
With the illustration provided in Step (1), (2) and (2)(a) above, the first part of the infrastructure financing structure would have been achieved, that is, the Sponsor would have achieved its objective to secure funding for the construction of the Asset and all that is left would be to complete the construction and accept delivery of the Asset.
Let us now look at the second part of the structure which addresses the Sukukholders' objective i.e. the mechanisms put into place to address the Sukukholders' interest in the investment in the Sukuk/Asset.
Like any other investors investing in a project/asset, the Sukukholders' primary interest in subscribing to the Sukuk would be to receive a return for the investments made. Step (3) sets out the mechanics put in place to ensure the Sukukholders are able to meet such objectives.
In Step (3), the Issuer will enter into an Ijarah contract with the Sponsor relating to the leasing of the constructed Asset to the Sponsor. The leasing of the Asset by the Issuer to the Sponsor creates an obligation for the Sponsor to pay periodic rentals to the Issuer.
In most cases, although the construction of the Asset may not be completed, the obligation to pay lease rental will commence shortly after the execution of the Ijarah contract. To enable this to happen, the Ijarah contract between the Issuer and the Sponsor will have to adopt the concept of a forward lease contract.
It is essential for the Ijarah contract to be structured as a forward lease contract so that periodic distributions can also be made to the Sukukholders during the construction period of the Asset. This leads us to Steps (4) and (5) of the transaction structure.
In accordance with the terms of the Ijarah contract which will be structured on a forward lease basis, periodic lease rentals will be made by the Sponsor to the Issuer during the construction period of the Asset and over a period of pre-agreed timeframe after the construction of the Asset is completed.
Timing and regularity of such lease rental payment will need to coincide with the payment obligations of the Issuer to the Sukukholders under the terms of the Sukuk because the lease rental payments are the funding source of the periodic distributions agreed to be made by the Issuer to the Sukukholders.
Upon the Issuer's receipt of the periodic lease rental payments, the Issuer shall remit/distribute such proceeds as periodic distribution to the Sukukholders in accordance with the terms of the Sukuk.
Based on the descriptions set out above, although the principal objectives of the Sponsor procuring funding for the construction of the Asset and the Sukukholders getting their returns from the investments in the Asset have been addressed, one outstanding issue remains and that is the ownership of the Asset.
As it stands if the transaction structure completes at Step(4)/(4)(a) above, the ownership of the Asset will remain with the Issuer. This may not be ideal in the case where the Issuer is an "orphaned" company or where the Sponsor's intention of having the special purpose company as a subsidiary is to facilitate the issuance of the Sukuk.
This final leg of the transaction is necessary to ensure the Sponsor has the right to impose upon the Issuer to transfer the ownership of the Asset back to the Sponsor on the final maturity date of the Sukuk.
Premised on the above step by step description and sequence of events, it is understandable why in recent times, particularly in Malaysia, Sukuk issuances have become such a popular choice in facilitating infrastructure financing for large infrastructures, namely power plants, toll roads, social infrastructures like schools and hospitals and utilities infrastructures. In general terms, so long as there is a construction contract to facilitate the construction of the subject matter, it will be possible to consider using the Istisna'-Ijarah structure to facilitate the issuance of Sukuk.