The Islamic finance industry continues to see rapid growth. So-called ‘sukuk’ or Islamic Participatory Certificates are a major factor of the continuing success of Islamic finance worldwide.
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines sukuk as “certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity”. In other words, sukuk are certificates that give the investor rights of ownership of underlying revenue-generating assets and rights and/or services (the ‘sukuk assets’) and of the income stream they produce. Sukuk are often governed by English law, owing to its versatile trust law provisions.
Sukuk are said to comply with Islamic law principles, which in the context of financial transactions may be summarised by the prohibitions of illicit gain, excessive risk taking, speculation, sale of assets one does not own and funding matters prohibited by Islamic law (the sale of pork products, for example), as well as the requirements that all risks and profits be shared and transactions be based on real assets.
In compliance with the prohibition of riba, commonly interpreted as a prohibition of interest, sukuk do not pay interest but are to provide a return in the form of the profit generated by the sukuk assets.
Shariah requires that the investor has an ownership interest in the underlying assets. Therefore, sukuk often involve, at their core, a form of asset monetisation, in that the underlying assets are isolated from the originator enterprise and transferred to a SPV, the issuer, who sells sukuk to investors in turn financing the asset transfer. Lease sukuk is a common structure in the industry. The originator sells the sukuk assets to the SPV, in order to lease them back in return for periodic lease payments, which are used to finance the ‘profit’ passed on to the investors. Generally, the ‘profits’ are so structured that they reflect coupon rates and payment cycles of conventional bonds.
Islamic finance categorises sukuk as asset-based or asset-backed instruments
Sukuk are commonly categorised as either asset-based or asset-backed. In the case of asset-based sukuk – i.e., the majority of sukuk issued worldwide – only beneficial, as opposed to legal, ownership of the underlying assets passes to the investors. The assets stay on the balance sheet of the originator and payments to investors primarily originates from the originator’s cashflows. Since no true sale occurred, there is no direct recourse to the underlying assets in case of bankruptcy.
The structure of asset-based sukuk generally dictates that at bankruptcy, investors may only compel the originator to purchase the issued sukuk, allowing sukuk owners to rank at best pari passu with unsecured creditors, however without direct asset recourse. Since no true sale occurred, the credit-worthiness of the sukuk depends on the rating of the originator. In theory, in the case of asset-backed sukuk, legal title to the sukuk assets passes to the investors with direct recourse to the sukuk assets. As a true sale transaction, the creditworthiness of the sukuk should accordingly only depend on the issuer, not the originator, payments to investors being made from revenue generated by the underlying assets. However, in practice, even asset-backed instruments rarely offer holders direct recourse to the assets.
Many experts consider asset-based sukuk to flout shariah. Notwithstanding the preference for asset-backed sukuk, the vast majority issued to date are de facto asset-based. Uncertainty as to their permissibility creates what can be described as a ‘shariah risk’. Sheikh Muhamed Taqi, a leading scholar, announced in 2008 that he considered 85 percent of sukuk issued worldwide to fall foul of shariah, perhaps contributing to the subsequent huge fall in sukuk volume.
The Holy Quran, as interpreted, decrees it a sin for a debtor to withhold his or her unpaid debt when able to pay, while simultaneously calling upon lenders to show leniency and accept late payment. Both sides are expected to compromise. In contrast to modern bankruptcy systems, Islamic law did not allow a judge to order debt forgiveness without the creditor’s consent. Western influence from the 19th century caused Islamic bankruptcy provisions to decline in use, with many states adopting Western principles. Given the lack of separate corporate personality under Islamic law, and the absence of efficient debt relief, this is unsurprising.
Likewise, the Islamic finance industry has failed to develop modern Islamic bankruptcy laws. Whereas the practice of Islamic finance has adopted an increasingly cosmopolitan and privatised character, bankruptcy systems continue to be embedded in national legal systems so that the task of clarifying the treatment of Islamic finance instruments and their professed shariah compliance falls largely to national courts.
Court cases relating to defaulted sukuk
A series of post-2008 defaults illustrates the difficulties surrounding sukuk when things go wrong. East Cameron Partners (ECP) filed for protection under Chapter 11 of the US bankruptcy code in 2008 in Louisiana. The originator tried to wrap the sukuk assets, which were royalty interests in oil and gas revenues held by an offshore SPV, into its estate, although the sukuk issuer had been advertised as bankruptcy remote, the assets having been transferred in a seemingly shariah-compliant true sale. The court accepted that the originator had sold the underlying assets in a true sale transaction.
The Investment Dar (TID) defaulted under a $100m sukuk in January 2009. The sukuk was governed by English law using an offshore SPV and the underlying assets were located in Kuwait. The sukuk was asset-based, providing investors with the option to sell the assets if TID defaulted in theory only. The prospectus specified that sukuk holders were to present a put option to TID, with the accompanying risk to rank pari passu with other unsecured creditors. In March 2010 TID obtained court protection under Kuwait’s new financial stability law, which halted all insolvency-related lawsuits against TID. TID thereafter agreed with Sukuk holders to restructure the debt over a six year period.
In summer 2009, Saad Group, a Saudi conglomerate, defaulted on a $650m sukuk issued in Bahrain due to a severe internal liquidity crisis after the Saudi Arabian Monetary Authority had frozen the group’s assets. It is reported that Saudi creditors were repaid after a settlement sanctioned by the Saudi authorities. However, foreign lenders argued that their entitlements had been entirely ignored and in 2013 a settlement had yet to be agreed.
In November 2009, Dubai World requested a restructuring of its $26bn debt. Investors feared that its $4bn Nakheel sukuk would also default. The sukuk was governed by English law and structured using English trust law concepts to bestow only beneficial ownership on the investors in the form of leasehold rights. Importantly, leasehold rights are not considered real rights under UAE law, where the assets indirectly owned by the government were located. Government assets may not be attached under UAE law. Ultimately, the default was prevented by Abu Dhabi.
Serious questions remain regarding sukuk’s treatment in bankruptcy. With some exceptions, including those referred to above, sukuks remain largely untested. When things go wrong, jurisdictional problems and the interaction between religious and secular laws make any means of redress more uncertain and less straightforward than what we are used to when dealing with conventional bonds or equity structures.
Steven Friel is a partner and Silke N. Kumpf is an associate at Brown Rudnick LLP. Mr Friel can be contacted on +44 (0)20 7851 6059 or by email: firstname.lastname@example.org. Ms Kumpf can be contacted on +44 (0)20 7851 6104 or by email: email@example.com.
© Financier Worldwide
Steven Friel and Silke N. Kumpf
Brown Rudnick LLP