Treasury has brought sukuk and similar instruments within the scope of UK financial regulation. In this article, Robert Finney and Matthew Sapte look at the changes.

Background

The UK Government wants to maintain the UK’s position as a Western leader in international Islamic finance and ensure that the market has access to competitively priced financial products. FSA already regulates Islamic banks and the provision of Islamic home finance products. But what the Government refers to as Alternative Finance Investment Bonds (AFIBs), in particular sukuk, have often not fallen cleanly within any existing category of regulated investment. This has created unfortunate uncertainty in the market, and the need for individual consideration of the regulatory treatment of each new sukuk issue.

Islamic financial instruments often appear to mirror the economic functions and effects of conventional financial products, but with different legal and risk characteristics. Many sukuk appear to be collective investment schemes (CIS) – a concept which is very broadly defined in FSMA. In contrast, conventional bonds benefit from a specific exemption from the CIS definition. Arguably, this disparity has discouraged the use of sukuk as a source of funding for UK issuers.

Treasury and FSA consulted in December 2008 on clarifying the regulatory categorisation of sukuk and similar instruments. They wanted to provide greater certainty to issuers, arrangers and investors, and to provide AFIBs with a regulatory treatment akin to that for conventional bonds where they are structured to have economic characteristics similar to conventional debt instruments. This would reduce the legal and compliance costs associated with an AFIB offering by UK issuers.

The choices

Treasury suggested four options. The most popular one, which Treasury later chose to implement, was to exempt AFIBs from the CIS definition, and create a new specified investment type for AFIBs under the Regulated Activities Order (RAO) – the statutory instrument which specifies definitions of investments and activities under FSMA. The overwhelming response (including responses prepared by Denton Wilde Sapte) was that AFIBs should be regulated in a manner equivalent to conventional debt securities, and this option was the best way to achieve it. Two other options also proposed e

xempting AFIBs from the CIS definition. They were to:

- define them by reference to existing tax definitions which have evolved over several years and now generally treat sukuk as corporate bonds if they satisfy certain conditions. We and many other respondents argued that a unique regulatory definition would be preferable as not all conditions of the tax definition were relevant in the regulatory context; or

- bring AFIBs within the existing RAO investment type of “debentures” in Article 77 (“an instrument creating or acknowledging indebtedness”), like conventional corporate bonds. Most respondents (like us) felt this may be inappropriate, given that AFIBs are by definition meant to be different from traditional instruments.

The final option, to do nothing, received no support.

Treasury’s decision

Last October, Treasury published a draft order amending the RAO and other relevant regulations. In January 2010, it laid the final Order before Parliament. Subject to the approval of each House of Parliament, the changes set out in the Order will be effective from 24 February. The RAO will have a new Article 77A, “Alternative Finance Investment Bonds”, bringing AFIBs within the scope of “specified investments”.

To fall within Article 77A, AFIBs must satisfy several conditions which, consistent with Treasury’s prior approach when legislating for Islamic financial instruments, make no reference to either the Shari’ah or the Islamic compliance of the instrument. These will be important factors to consider when structuring a UK sukuk. It will be interesting to see how some of these are actually implemented in practice, for example the requirements that:

  • the profit paid on a sukuk should not exceed (at the time the sukuk is issued) a reasonable commercial rate of return on a loan of the capital; and
  • the sukuk should be officially listed in the EEA or traded on an EEA “regulated market” or UK-recognised stock exchange.

The regulatory treatment of sukuk that are more akin to equity instruments or fail to satisfy the conditions is unchanged.

The Order also amends the CIS Exemption Order, so AFIBs benefit from the same exemption as conventional bonds, and also various other provisions of financial services regulation where it is appropriate to treat conventional bonds and AFIBs in the same way. FSA will also publish consequential changes to its rules: these may need to be more extensive than the limited changes consulted on last October.

As the sukuk market revives, these steps to change laws to cater for Islamic financial products may help to reduce the uncertainty surrounding the regulatory classification of sukuk that are issued, listed or traded in the UK.