FATWA IN ISLAMIC FINANCE

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SUKUK: AN INTRODUCTORY REMARKMarjan Muhammad* and Beebee Salma Sairally** – Sukuk, also known as Islamic securities or Islamic bonds, represent one of the most significant instruments of the Islamic capital markets. Sukuk have been extensively used for raising government funds via sovereign sukuk issuances as well as obtaining funds for companies through corporate sukuk offerings. Sukuk were initially introduced as an alternative instrument which serves the same purpose of providing long-term financing as conventional bonds, however, without compromising the requirements of Shariah (Islamic law). The features of the early sukuk issuances thus mimicked those of fixed-income instruments. Nonetheless, over time the features of sukuk have evolved to include their own distinctiveness while at the same time maintaining some characteristics similar to bonds.

WHAT IS SUKUK?The Arabic term sukuk literally means certificates. Technically, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines investment sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services, assets of particular projects or special investment activity.” The definition of Securities Commission (SC) of Malaysia, however, is broader referring to sukuk as “certificates of equal value which evidence undivided ownership or investment in the assets using Shariah principles and concepts.” It is noted that these two definitions would have an impact on the type of assets that qualify as the underlier for a tradable sukuk: while the SC recognizes financial assets such as receivables as the underlying asset, the AAOIFI does not allow such assets.

HOW IS SUKUK DIFFERENT FROM BONDS?Bonds represent a contractual debt obligation where the investors provide a loan to the issuer. The repayment of bonds consists of the principal (capital) at the time of maturity and interest in the form of periodic coupon payments. Even in the case of zero-coupon bonds, the investors will receive accumulated interest at the end of the maturity period in the form of the difference in the discounted price of the bond at the time of issuance and the face value received by the bond holder. Since bonds have violated the principle of interest-free loan as per the Shariah requirement, scholars have introduced sukuk as an alternative instrument for raising financing. As such sukuk, unlike bonds, do not establish a lending relationship between the issuer and the investors. Rather, sukuk utilise Shariah contracts such as sale, lease and partnership as the underlying relationship between the issuer and the investors to enable the latter to enjoy returns on their investment. Figure 1 below explains the relationship established between the bond/sukuk issuer and holder graphically.

* Marjan Muhammad, PhD, is Head of Research Affairs at the International Shariah Research Academy for Islamic Finance(ISRA), Kuala Lumpur, Malaysia.** Beebee Salma Sairally, PhD, is Research Consultant at the International Shariah Research Academy for Islamic Finance (ISRA).

BOND ISSUER (BORROWER)

SUKUK ISSUER (PURCHASER/ LESSOR/PARTNER)

BOND HOLDER (LENDER)

SUKUK HOLDER (INVESTOR)

BOND: LENDING RELATIONSHIP

SUKUK: RELATIONSHIP BASED ON SHARIAH CONTRACTS UTILISED

CA

SH

CA

SH

BO

ND

C

ER

TIF

ICA

TE

SU

KU

K

CE

RTI

FIC

ATE

Figure 1: Relationship established between Bond/Sukuk Issuer and Holder Source: Authors’ Own

FATWA IN ISLAMIC FINANCE

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Moreover, bonds are only in the form of debt, whereas sukuk may include debt (created from sale-based transactions) as the underlying assets (in Malaysia only) and non-debt assets such as tangible assets, usufructs and rights, assets of particular projects or investment activities.

The differences between bonds and sukuk are summarized in Table 1 below.

BONDS SUKUK

Primary Level Relationship

Loan Various Shariah contracts

Return Interest on loan

Profit gained from sale, lease or partnership contracts

Tradability in Secondary Market

Sale of debt Shariah standards at the global level (e.g., AAOIFI) only allow the sale of tangible assets, some intangible assets and interest in ventures, whereas Malaysia allows the sale of debt (for sale-based sukuk) at discount.

Table 1: Comparison between Bonds and Sukuk Source: Adapted from ISRA, 2011, p. 398

STRUCTURES OF SUKUKSukuk are commonly structured based on the underlying Shariah contracts such as murabahah, bay’ bi thaman ajil (BBA), salam, istisna’, ijarah, musharakah, mudarabah and wakalah. The classification of sukuk based on the Shariah contracts is depicted in Figure 2 below.

In addition to the above, some of the sukuk structures have become more complex where a combination of at least two underlying Shariah contracts has been utilized. For instance, the Sukuk al Istithmar issued by the Islamic Development Bank’s (IDB) Solidarity Trust Services Ltd in 2003 comprised ijarah, murabahah and istisna’ contracts; Projek Lintasan Shah Alam Bhd in 2008 utilised ijarah, mudarabah and ijarah mawsufa fi thimmah contracts for undertaking the toll-road project; and the Government of Malaysia’s USD 2 billion dual-tranche Wakala Sukuk in 2011 combined the wakalah structure with ijarah assets, receivables from murabahah contracts and Shariah- compliant shares.

From the Shariah perspective, there is no preference of one contract over the other. However, the issuer normally chooses the type of Shariah contract based on some factors such as economic objectives, the availability of underlying assets, the level of debt of the company, the credit rating of the issuer, the legal framework in the jurisdiction and the tax implication of a structure (ISRA, 2011).

Figure 2: Sukuk Structures based on the Underlying Shariah Contracts Source: Adapted from the Securities Commission Malaysia (2009)

SUKUK BASED ON SHARIAH CONTRACT

SALE BASED

BBA IJARAH MUSHARAKAH WAKALAH

MURABAHAH IJARAH MUNTAHIYA BI TAMLIK

MUDARABAH

ISTISNA’

SALAM IJARAH MAWSUFAH FI DHIMMAH

LEASE BASED

EQUITY BASED

AGENCY BASED

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Sukuk have also been classified based on the following technical and commercial features: (i) type of issuer such as sovereign and corporate (ii) underlying asset such as asset-based, asset-backed and asset-light; (iii) convertibility such as convertible and exchangeable sukuk; and (iv) others such as subordinated and stapled sukuk.

GROWTH AND DEVELOPMENT OF THE SUKUK MARKETThe sukuk market has grown considerably since the pioneering issue by Shell MDS Malaysia in 1990, which was of a modest size of RM 125 million (USD 30 million) using the bay’ bi thaman ajil (BBA) concept. Post-1990, the sukuk market developed modestly after 2000 with a total of 3 sukuk issuances at the corporate level worth USD 336 million. After a slump in 2008, a positive market trend is notable thereafter. In fact, the market appears to have reached its peak in 2012 with over USD 81 billion of new sukuk issuances—representing an increase of over 66 percent compared to 2011. The market for 2013 looks poised to remain equally healthy with new sukuk issuances already exceeding USD 48 billion in the first-half of 2013. Going forward, market opportunity remains bright as global demand for sukuk continues to grow, well exceeding its supply. According to estimates by Ernst & Young’s Global Islamic Banking Center of Excellence, it is forecasted that global sukuk demand will rise to USD 900 billion by 2017 from the estimated USD 300 billion in 2013. Figure 3 shows the growth in the new sukuk issuances during the period 1995 to mid-2013.

In terms of issuances by country, Malaysia remains the world’s largest sukuk market, garnering 61% of the total market space between the period 1995-2013

and representing, in size, over USD 48 billion of new sukuk issuances in 2012 and over USD 29 billion in the first-half of 2013. Saudi Arabia and United Arab Emirates follow thereafter, representing 9% of the global sukuk market each. The country-wise distribution of sukuk issuances is depicted in Figure 4.

With regard to the Shariah contracts used in the structuring of sukuk, according to Figure 5 on the next page, it is noted that at the global level the ijarah and musharakah structures have been among the most popular, followed by the murabahah contract. In the beginning years of the sukuk market development, there were a number of sukuk al-ijarah issuances—since its preponderance to mimick conventional bonds with fixed periodic rental payments. However, from 2004-2008 sukuk al-musharakah issuances increased until negative criticisms were raised against equity-based sukuk by Sheikh Taqi Usmani in 2007. Sukuk al-musharakah issuances thereafter slumped considerably and were taken over by sukuk al-ijarah between the period 2009 to mid- 2013. Issuances using the musharakah contract appear to have again recovered in 2012, reaching a peak of USD 16.9 billion compared to sukuk al-ijarah, which stood at above USD 19 billion

.

Figure 3: Total Annual Growth in Sukuk IssuancesSource: Bloomberg

ISSUANCE: TOTAL ANNUAL GROWTH

Figure 4: Sukuk issuances by countrySource: Bloomberg

SUKUK ISSUANCE (1995-2013)

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llo

ns

(US

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CRITICISMS RAISED AGAINST SUKUKAt AAOIFI’s annual event in Bahrain in November 2007, Sheikh Taqi Usmani, Chairman of the Shariah Board of AAOIFI raised three main criticisms against sukuk relating to the following issues: (i) sukuk holders not having real ownership interest in the underlying assets; (ii) the regular distributions to sukuk holders not being based on actual performance of the underlying assets; and (iii) guarantee of the return on capital via the use of purchase undertakings.

The first criticism pertained to asset-based sukuk where there is no legal sale of the underlying assets and as such no real transfer of ownership of the assets to sukuk holders from the originating company. Legal documentation in asset-based sukuk indicates that the sukuk holders do not have an interest in the underlying asset, which conflicts with Shariah principles that require sukuk investors to have rights over the sukuk assets.

The other two criticisms focused mainly on the structural features of the sukuk al musharakah, sukuk al murabahah and sukuk al wakalah structures—the so-called equity- based sukuk. The criticisms highlighted the use of Shariah- compliant funding to make up for any shortfalls in actual profit below the stipulated percentage to sukuk holders; the payment of any excess profit realized beyond the expected profit percentage as incentive fees to the manager; and the use of purchase undertakings to guarantee the sukuk holders’ principal such that it is expected that the issuer will buy back the underlying asset at the expiration date of the sukuk or in the event of default at face value regardless of their true value on that day. Such practices convert the equity-based sukuk to debt-based structures whereby the sukuk are redeemed at par value at the maturity date and sukuk holders are paid a guaranteed periodic return on capital throughout the duration of the sukuk.

Figure 5: Sukuk issuances based on Shariah contractsSource: Bloomberg

Figure 6: Sheikh Taqi Usmani’s Criticisms against SukukSource: Authors’ Own

II. REGULAR DISTRIBUTIONS TO SUKUK HOLDERS NOT BASED ON ACTUAL PERFORMANCE OF UNDERLYING ASSETS

III. “GUARANTEE” THE RETURN OF CAPITAL VIA PURCHASE UNDERTAKING

I. SUKUK HOLDERS’ OWNERSHIP OF ENTERPRISE ASSETS

SHEIKH TAQI USMANI’S MAIN CONCERNS

CONTRACT PERFORMANCE

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SHARIAH RESOLUTIONS TO ADDRESS SHARIAH CONCERNSAs a response to the various Shariah concerns, the AAOIFI issued additional guidelines on sukuk structures in February 2008, stating that the following are prohibited in equity- based sukuk: (i) the use of Shariah-compliant financing to smooth out periodic income distribution amounts to sukuk holders; and (ii) the use of purchase undertakings in order to guarantee the return of the principal amount to sukuk holders at its par value. The AAOIFI Resolution, on the other hand, does not prohibit the use of purchase undertakings in sukuk al ijarah, if the lessee is not an investment partner, mudharib or agent. Moreover, the AAOIFI Resolution stated that the use of a reserve account to cover shortfalls is permitted and so is distribution on account, so long as the latter is subject to reconciliation prior to a final distribution.

The recent resolution of the International Islamic Fiqh Academy (IFA), a branch of the Organization of Islamic Cooperation (OIC), in its 20th session (2012) also iterated, similar to the resolution of the AAOIFI (2008), the non- permissibility of purchasing equity-based sukuk at their nominal value or at a predetermined price, which leads to the capital of sukuk holders being ensured; and of providing loans to sukuk holders when actual sukuk revenue is less than expected, although it allows for recourse to reserve accounts to redress potential shortfalls.

Regarding sukuk al ijarah, the IFA prohibited the current structure of asset-based sukuk al ijarah as it is a form of inah (sell and buy-back arrangement). The IFA pronounced the impermissibility of selling an asset on a cash basis on the condition that the seller leases the asset via a lease ending in ownership, whereby the total rental payments and repurchase price [paid by the sukuk issuer] would be more than the cash price [paid by the sukuk holders]. Such stipulation is impermissible, regardless of whether it is mentioned explicitly or implicitly, because this would be a form of the prohibited inah, and therefore, sukuk cannot be issued using this structure.

The IFA also placed emphasis on the fact that sukuk should establish genuine ownership of the underlying assets, in line with both the Shariah and conventional law, along with enabling its attendant legal effects, such as the power of disposal of the assets and bearing the liability associated with ownership.

CONCLUSIONWhile the development of sukuk originated from the idea of finding an alternative to interest-bearing bonds, today with the rising Shariah concerns about the sukuk structures, emphasis is being placed by fiqh councils to ensure that sukuk structuring aligns closely with the principles of the Shariah. The aim is to demarcate clearly the differences between sukuk and conventional bonds in terms of the structure, design, utilisation of proceeds and overall objective of supporting genuine activities and economic development. This certainly adds confidence to the sukuk market and will contribute to the further growth of the overall Islamic finance industry.

For more information, please mail nimap@bloomberg.net.

Disclaimer: The views and analysis expressed herein result from an independent review by researchers at the International Shariah Research Academy for Islamic Finance (“ISRA”), based on information provided by Bloomberg Finance L.P. and its affiliates (“Bloomberg”). Bloomberg believes the information used herein came from reliable sources, but do not guarantee its accuracy. No information or opinion expressed herein constitutes a solicitation of the purchase or sale of securities or commodities. While every care is taken in the preparation of this publication, no responsibility can be accepted by ISRA or Bloomberg for any errors.