This note addresses:
- the definition of Sukuk;
- the AAOIFI statement on Sukuk; and
- the implications of the AAOIFI statement.
Sukuk are defined by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) as:
‘certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity’.1
Often referred to as an ‘Islamic bond’, Sukuk are asset-backed trust certificates evidencing ownership of an asset or its usufruct (earnings or fruits). However, Sukuk securities comply with Islamic commercial jurisprudence and its investment principles which prohibit the charging or paying of interest.
The AAOIFI statement on Sukuk
AAOIFI is a not-for-profit organisation that was established to maintain and promote Shariah standards for Islamic financial institutions, participants and the overall Islamic finance industry. Since its establishment in Bahrain on 27 March 1991, it has been supported by institutional members (155 members from 40 countries, so far) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry worldwide.
The majority of the world’s leading Shariah scholars are members of the AAOIFI Shariah board. AAOIFI statements therefore represent the views of scholars who are on the Shariah supervisory boards of many of the institutions responsible for arranging and/or issuing Sukuk.
Sheikh Taqi Usmani (chairman of the AAOIFI Shariah board) published a paper2 which was circulated towards the end of 2007 in which he commented that most of the Sukuk in the market (those using a musharaka or mudaraba structure) are not in line with the principles of Shariah. As a result of the controversy caused by the statement made by Sheikh Taqi Usmani, the AAOIFI Shariah board convened a series of meetings in Bahrain on 13 and 14 of February 2008 after which a statement on Sukuk was produced (AAOIFI Statement) which seeks to provide some guidance in relation to Sukuk structures.
As mentioned above, the main structures affected by the AAOIFI Statement are the mudaraba and musharaka Sukuk structures. Mudaraba sukuk are investment Sukuk which represent the ownership of units of equal value in the equity of the mudaraba. The Sukukholders provide the capital for the Shariah compliant investment activity that is undertaken by the investment agent. The investment agent is paid an agreed fee out of any profits derived from the business activity.
Musharaka Sukuk are investment Sukuk that represent ownership of musharaka equity. The musharaka agreement is a form of joint venture agreement between the issuer and (usually) the originator to engage in a Shariah compliant investment activity in accordance with a business plan that is appended to the musharaka agreement. Any profits received from the musharaka arrangements are distributed between the issuer and the originator as agreed.
Mudaraba and musharaka Sukuk gained popularity over the last couple of years because they allowed Sukuk to be issued without being wholly reliant on the existence of underlying tangible assets (as in the case of Ijara-based Sukuk) in order to generate a return for the Sukukholders.
Sheikh Taqi Usmani stated that the mudaraba and the musharaka sukuk were in breach of the principles of Shariah because they provide the issuer with a purchase undertaking to buy back the underlying assets from the issuer at face value on the expiry date of the Sukuk or in the event of a default. In other words, the credit on the Sukuk was based on the credit worthiness of the provider of the purchase undertaking and not the assets underlying the Sukuk.
The guidance in the AAOIFI Statement stipulates that the purchase undertaking should not be based on an exercise price which is calculated by reference to the face value of the Sukuk at the maturity date or upon the earlier dissolution of a Sukuk. Instead, any such undertaking may be based on the net asset value, market value, cash equivalent value or any price agreed upon at the time of purchase. The Sukuk manager can only guarantee to repay the capital to Sukukholders at face value in cases of negligence or violation. Sukukholders in a mudaraba or musharaka-based structure need to understand that the Sukukholder must have some risk in these structures. Shariah principles encourage the sharing of risk and profit.
Generally, under most mudaraba and musharaka sukuk, the provider of the purchase undertaking is also the investment agent. The role of the investment agent under a mudaraba sukuk is ultimately to use his or her best efforts to make a profit for the Sukukholders, for which the investment agent is entitled to be paid an agreed proportion of the profit. It is not the role of the investment agent to guarantee the capital repayment of the Sukuk in the form of a purchase undertaking or otherwise.
Similarly, the nature of a musharaka partnership is that the partners agree to maintain the assets of the joint venture on a trust basis. Except therefore in the case of wilful default, negligence or breach of contract, it is not permissible to stipulate that a partner under a musharaka agreement will guarantee the capital of another partner in the same contract.
According to the AAOIFI standards and our discussions with scholars, purchase undertakings under which the exercise price is calculated by reference to the face value of the underlying assets are permissible under Ijarah sukuk. This is because under an Ijarah contract (lease) the originator usually sells the asset to the SPV and then leases it back from the SPV for the Sukuk term. The lease payments from the originator to the SPV are used to pay the Sukukholders their periodic distributions. It is permissible for the originator to undertake to purchase the tangible asset at face value on the maturity date. The Sukukholders still bear the risk of total loss of the asset. If the asset is destroyed in some way the originator (in accordance with Shariah) will not be under an obligation to buy the asset.
Although Sheikh Taqi Usmani famously said “85 per cent” of existing Sukuk issues would fall foul of basic Shariah principles, it is not believed that the scholars will look retrospectively at those Sukuk that have already been issued. Sanctity of contracts is a very important concept in Islamic jurisprudence. The purpose of the guidance is to ensure that future Sukuk are structured more closely with the guidelines set out in the AAOIFI statement and the AAOIFI standards themselves. However, anecdotal evidence from clients suggests that Sukuk using musharaka or mudaraba structures may be suffering from reduced liquidity in the secondary market.
The tension that exists in the market is between, on the one hand, those arrangers, originators and issuers who seek the certainty of fixed income returns and, on the other hand, the Shariah principles that require mudaraba and musharaka-based financing to operate in accordance with profit and loss principles. The pricing of these risks obviously differ and the “fixed income” nature of the instrument is thrown into doubt.
The Implications of the AAOIFI Statement
The AAOIFI Statement stipulates that an investment agent should not undertake to buy the assets from the Sukukholders or their representatives at face value at the maturity or early dissolution date. This means that Sukukholders will be taking a risk (with regards to the potential depreciation of trust assets) if they rely on a purchase undertaking from the originator to purchase the assets at market value. The risk on the assets is in addition to the credit performance and risk on the originator which investors have traditionally taken.
There is currently an increasing amount of lateral thinking in this area within the Islamic finance industry in order to address this issue. There is likely to be a move towards calculating the periodic distributions on the basis of principal and profit repayments during the term of the Sukuk. This will avoid the need for the originator to repurchase the assets at market value on the maturity date of the Sukuk. We can see an example of this approach under the terms and conditions of the Villamar Sukuk (issued in May 2008)3 in which the cashflows generated from the trust assets (using a musharaka structure) are used for the purposes of gradually redeeming the Sukuk on periodic distribution dates. A similar approach is taken in the Sorouh securitisation (issued in August 2008)4, in which the certificates amortise using a mudaraba structure.
We may also see a move towards:
- creating security in favour of the Sukukholders in more Sukuk transactions; and
- establishing reserve accounts in favour of the Sukukholders, in order to protect the capital investment of the Sukukholders in the event of a default.
It is anticipated that there will be a number of innovative structures that emerge as a result of the AAOIFI Statement guidance which will encourage practitioners in the industry to think creatively.
However, there may be limits on that creativity and if the attempt is merely to devise another fixed income instrument (devoid of profit and loss sharing characteristics) it is unlikely to succeed. In many respects, it will not just be the legal character that has to adapt but also the risk and reward expectations of the participants in the market.