Structured finance has no particular definition. Generally, it involves the packaging together of various legal structures to produce a financial product or solution.
In an Islamic finance context, the starting point is to analyze the commercial objectives of the customer. Once those are known then it is a question of looking at the possible Shari’ah compliant financing techniques and undertaking the relevant due diligence, which can extend to matters such as legal research, tax analysis and a review of any underlying assets that are to be employed in the Islamic financing.
With complicated transactions (which is often the case with certain structured Islamic finance products) the challenge is to find a structure that will simultaneously satisfy the Shari’ah requirements, the secular legal parameters and commercial objectives of the customer.
From a transactional perspective, it is important to obtain the Shari’ah supervisory board’s initial approval of the structure as soon as possible. Once approved, it is usually prudent to have the Shari’ah supervisory board vet the initial drafts of the documents to ensure that there are no fundamental errors from a Shari’ah perspective.
It is not advisable to only ask the Shari’ah supervisory board to approve the documents once they have been fully negotiated. If the Shari’ah supervisory board reverts with material objections, the documents may have to be significantly amended and this is likely to have a knock-on impact on the projected closing date.
The scope of Islamic structured products is unlimited. Two examples are considered below to show some of the practical issues that need to be taken into consideration.
Derivative Style Products
A challenge for Islamic financial institutions has been to find products that can be the equivalent of the range of derivative and treasury products that are made available by conventional banks. The main issue that Islamic financial institutions face is that, under the Shari’ah, speculative transactions are not permitted. Many derivative transactions are considered to be either a form of gambling or generally speculative, and are banned.
Other Shari’ah issues, such as the need for there to be certainty about the subject matter of the contract and the general prohibition on currency being treated as a commodity, also have an impact on structuring derivative and treasury products that are Islamically acceptable.
Some forms of currency swaps have been accepted. However, there must be no element of interest and there must just be a simple exchange of one currency for another at agreed spot exchange rates.
The prohibition on interest means that conventional synthetic securities transactions will not be acceptable under Shari’ah principles.
Given that Islamic financing techniques involve assuming ownership (albeit briefly in the case of, for example, Murabahah financing), the Shari’ah position on ownership responsibilities needs careful consideration as the key precept of Islamic financing is that the Islamic financier will at some stage be the owner of the asset and keep certain owner related risks.
Murabahah (Tawarruq) and SALAM contracts have been used in various structured products with WA’AD (undertakings or promises) to mimic conventional products such as interest rate swaps and products whose returns are by reference to indices.
Whether, because of the current credit crisis, there will be a continued appetite by Islamic financial institutions to produce the equivalent of conventional derivatives is a matter for some conjecture.
Islamic financial institutions cannot purchase conventional bonds because they merely represent a debt obligation. The Islamic equivalent of conventional bonds is Sukuk.
There are significant differences between Sukuk and conventional bonds. A Sukuk should be asset-based, with investors owning a pool of assets supporting the Sukuk issue and not just the right to a debt or a revenue stream divorced from ownership of the revenue producing assets.
Typical Sukuk Structure
A Sukuk structure typically involves an orphan special purpose company formed in a bank-neutral jurisdiction. This is done so that the Sukuk issuer is not a subsidiary of the originator in order to ensure independence from the originator and to assist in bankruptcy remoteness.
The funds generated on the sale of the Sukuk are paid by the Sukuk issuer to the originator in return for the purchase of the pool of assets. The Sukuk issuer would declare that it holds title to the assets on trust on behalf of the investors (and other persons who are entitled, for example, to be paid fees and other amounts in connection with the issue). Those trust arrangements will usually be under English law.
A true, asset-backed Sukuk should be similar to a conventional securitization with the investors’ only recourse being to the assets. However, in most Sukuk to date, the investors have primarily focused on a purchase undertaking from the originator to buy back the assets on either a scheduled or early redemption. The purchase price would be an amount that equals the initial investment (less any amounts already repaid) and any other amounts then outstanding.
This approach has meant that most Sukuk have been asset-based rather than asset- backed. Sukuk should arguably be structured so that they are in effect the same as a conventional securitization in that the investors (who own the assets under the Sukuk) should only be looking to those assets to obtain their financial returns and the recovery of their initial investments. However very few Sukuk have used this structure.
The AAOIFI February 2008 Statement
The AAOIFI is an organization based in Bahrain in which leading Shari’ah scholars participate in order to resolve issues and try to reach agreed settled positions. It is not a statutory industry wide body. AAOIFI’s statement on Sukuk was issued due to various concerns being expressed about some of the techniques that had been used in the structuring of Sukuk. These concerns related in particular to:
- the use of liquidity facilities in order to ensure that Sukuk certificate holders received timely payments, even if the assets were not generating sufficient income to pay them; and
- the use of purchase undertakings to buy back the interests of the investors using a pre-agreed formula such that investors would neither face any loss on their initial investment nor receive any gains on that investment.
It remains unclear how this statement will be interpreted by the Shari’ah scholars and the extent to which they feel bound to follow its provisions. Islamic financiers will need to carefully monitor its implementation.
Factors to Consider in Structuring Sukuk
The key factors that affect the structuring of a Sukuk include:
- Does the originator have any Shari’ah compliant assets that are available for a Sukuk?
- Is there to be a purchase undertaking or is the Sukuk to be structured as if it were a true securitization?
- Depending on the location of the assets, are there any local laws or regulatory requirements that could adversely impact the Sukuk structure from the perspective of both the investors and originator?
- Are there any tax, VAT, documentary or registration fee issues that need to be considered?
- Is it to be listed?
- Is it to be rated?
- What are the views of the originator’s Shari’ah supervisory board and of the Shari’ah compliant investors (who may sometimes have different views)?
Historically the Sukuk Ijarah was the only available Sukuk structure, however there are now other types, including Sukuk Mudarabah and Sukuk Musharakah. These structures are briefly analyzed below.
The originator sells various assets to the investors (acting through an SPV) for an amount which represents the value of the funds being made available by the investors. The investors then lease the assets to the originator (or a group company) under the common Ijarah financing structure.
The originator usually provides a purchase undertaking which allows the Sukuk investors to require the originator to buy back the assets on either a scheduled or early redemption. The price payable under the purchase undertaking will be the balance of the unpaid fixed rent and all other rental amounts that are then outstanding under the Ijarah.
The February 2008 AAOIFI statement has allowed purchase undertakings with Sukuk Ijarah to refer to a pre-agreed formula based on the balance of fixed rent as it considers the balance of fixed rent as being equal to the current value of the leased assets when the purchase undertaking is exercised.
This Sukuk structure can be based on a Shirkat ul-Aqd (partnership or joint venture) or a Shirkat ul-Milk (co-ownership). The Sukuk investors, acting through an SPV, would either invest their funds as part of the capital of a Shirkat ul-Aqd or acquire a co-ownership interest in Shari’ah compliant assets in a Shirkat ul-Milk.
The partnership or joint venture would invest in assets under an agreed business plan that would produce a return and the repayment of the investors’ initial investment. The co-owned assets in a Shirkat ul-Milk would also produce a similar return and be projected to repay the investors their initial investment.
However as a result of the February 2008 AAOIFI Statement, using a purchase undertaking with this structure is now problematic if the price does not reflect the asset value when the assets are purchased using the purchase undertaking.
The transfer of assets into and out of the partnership or joint venture (and back to the originator at the end of the Sukuk) can also lead to difficult tax and value added tax issues depending on the jurisdiction.
This is an alternative if the customer has no assets that it can lease through a Sukuk Ijarah or use in a Sukuk Musharakah. The investors (Raab al Maal) acting through an SPV will provide the funds to an investment manager (Mudarib).
The Mudarib who will usually be the originator or part of the originator’s group will invest these funds on their behalf pursuant to a pre-agreed business plan and feasibility study covering the customer’s business activity that it wants financed.
(first published in Islamic Finance news, April 2011)