In July 2010, the United States Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Dodd-Frank Act mandated extensive changes to the financial regulatory system in the United States to redress perceived weaknesses in the system highlighted during the credit crisis. Section 941(b) of the Dodd-Frank Act authorised regulation of the asset-backed securitisation market and sets forth criteria intended to promote alignment between the interests of the parties originating the assets collateralising asset-backed securities ("ABS") with those of ABS investors.
On 24 December 2016, final rules implementing the risk retention regime in the United States became effective for all asset-backed securities (the "US Risk Retention Rules") other than residential mortgage-backed securitisations (to which the US Risk Retention Rules have applied since 24 December 2015).
Generally speaking, the US Risk Retention Rules apply to any security meeting the definition of an "asset-backed security" defined by the Dodd-Frank Act and the offer or sale of the asset-backed security into the United States (with exceptions if less than 10 per cent is sold into the United States). The US Risk Retention Rules require a sponsor of an ABS securitisation to keep "skin in the game" by retaining five per cent of the credit risk associated with any ABS that it transfers, sells or conveys to a third party. A crucial assumption underlying the required credit risk retention is that, by mandating a sponsor of ABS to hold an economic interest in its ABS transactions, the sponsor's interest will be more closely aligned with the interests of the ABS investors. If a sponsor acts in a manner that protects its economic interest in the transaction, by extension, it will provide investors with that same protection, while reducing investor losses attributable to poor financial asset-origination practices or undue risk-taking by the sponsor. In addition to ensuring that sponsors have the necessary economic interests to achieve the alignment objective by requiring them to retain credit risk exposure of five per cent of the value of the ABS, the US Risk Retention Rules also generally prohibit sponsors from hedging or otherwise transferring that risk.
Are Sukuk going to be affected under the US Risk Retention Rules?
As sukuk are not traditionally considered as asset-backed instruments, few market participants would guess that they could fall within the scope of the US Risk Retention Rules. Sukuk are a form of Shari'a-compliant fixed-income capital markets instruments that represent interests in an underlying funding arrangement structured according to Islamic finance norms. The holder is entitled to a proportionate share of the proceeds generated by such arrangement and, at the agreed future date, the repayment of the capital. In an asset-based sukuk structure, the overriding reliance of investors is on the credit strength of the obligor rather than the underlying assets, and only in an asset-backed sukuk, the profit return and return of capital would be ultimately based on the assets. The concept of securitisation of assets – limited in recourse solely by the performance of the assets underpinning them – has, to date, only enjoyed limited application in the Islamic finance space and the majority of sukuk in the international markets are asset-based, making them dependent on the creditworthiness of the sponsor. Therefore, banks or investors analyse the balance sheet of the sponsor and generally ignore asset performance reporting.
However, the definition of "asset-backed security" used in the US Risk Retention Rules is very broad and refers to the definition set forth in the Exchange Act: "a fixed-income or other security collateralised by any type of self-liquidating financial asset (including a loan, lease, mortgage, or other secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset." So broadly worded, this definition may appear to cover many asset-based sukuk that are not traditionally thought of as "asset-backed" or a securitisation. In a murabaha structure, for example, the covenant to pay the deferred consideration would neatly fit the concept of a self-liquidating financial asset.
Despite the asset-based (rather than asset-backed) nature of the majority of sukuk issued in the international markets, the US Risk Retention Rules need to be considered as to whether they are therefore applicable to such instruments upon a plain language application of the US Risk Retention Rules.
As most market participants are likely to be unaware of the breadth of the US Risk Retention Rules, we are advising our clients to proceed with due care and attention whilst structuring any Rule 144A or Reg S sukuk transaction and to consider the potential impact of the US Risk Retention Rules.