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Home > Asset Management Best Practice > Sukuk Issuance and Issues in Purchase Undertakings

Asset Management Best Practice

Sukuk Issuance and Issues in Purchase Undertakings

by Barry Cosgrave

Executive Summary

  • Sukuk issuance utilizes a number of different shariah structures but all make use of the purchase undertaking.

  • The purchase undertaking is the key credit document in sukuk issuance. It provides for the return on an investment at maturity and under any early redemption right, whether arising as the result of a default event or otherwise.

  • Purchase undertakings have come under great scrutiny from shariah scholars, who feel that they have been developing into an instrument guaranteeing a return on certain types of sukuk that should be subject to the investment risk associated with an equity investment.

  • AAOIFI has sought to move sukuk away from classification as a pure debt instrument toward reclassification as an equity instrument, in order to better reflect the position of sukuk in the Islamic finance sphere.

  • An evolution in market perception will need to occur to move transaction risk disclosure, and therefore investor focus, away from focusing solely on the obligor under the purchase undertaking toward greater focus on the creditworthiness of the sukuk assets as well.

Introduction

As is the case with most Islamic finance instruments, the typical approach to sukuk is to take the equivalent instrument in conventional finance and to attempt to replicate it in a way that is shariah-compliant. In the case of sukuk, consideration is given to the important commercial features (such as rate of periodic return, return at maturity, and financial covenants), together with key legal considerations (such as transaction risk disclosure, events of default, and representations and warranties). The market has tended to place sukuk in the same asset class as a conventional bond and has thus identified sukuk as debt capital market instruments. However, this view is at odds with Islamic jurisprudence, which, though differing on certain issues of interpretation in relation to detail, has almost universally agreed that sukuk should be viewed as equity investments, thereby exposing the investor to ownership risk in relation to the assets they have purchased through their investment in sukuk. This issue came to a head in February 2008, with the announcement by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)1 that in its view the majority of sukuk in the market at that time were not in compliance with the precepts of shariah. The concerns of the scholars centered around the use and application of the purchase undertaking in sukuk transactions, and particularly the methodology used to determine the exercise price (or purchase price) for the sukuk assets upon an exercise by the issuer/trustee of its right to require the obligor to purchase those sukuk assets pursuant to the terms of the purchase undertaking.

What Structures are Used in Sukuk Issuances

In any issuance of a sakk (the singular form of sukuk) there are three main parties:

  • the sukuk-holders (or investors);

  • the issuer/trustee (normally a special purpose vehicle (SPV));

  • the obligor (the company that ultimately wishes to benefit from the proceeds of the sakk).

In a sakk, irrespective of the structure, the sukuk-holders will purchase the sukuk (or trust certificates) from the issuer/trustee at the issue price—for example, US$100 million. The issuer/trustee will then use the proceeds of the issue to purchase certain assets from the obligor. These assets will need to be shariah-compliant income-generating assets. In an ijarah sakk, the issue proceeds will be used to purchase certain “hard” assets (for example, machinery, automobiles, or aircraft). Those assets will then be leased to the obligor against payment of rental on a periodic basis to the issuer/trustee (acting in the capacity of lessor) under the terms of an ijarah (lease) agreement. The proceeds from that ijarah agreement will be used by the issuer/trustee to make payment of the profit amount due from it to the sukukholders under the terms of the sakk.

A slight variation on this structure is the istisna’a/ijarah structure, pursuant to which the issuer/trustee will use the issue proceeds in two ways: (i) a portion will be used to fund the purchase price payable in respect of certain hard or already existing assets; and (ii) a portion will be used to fund the construction of certain other assets. According to shariah principles, the assets purchased under (i) must be equal to at least 33% of the principal amount of the sakk and must not be allowed to drop below this ratio at any time during the life of the sakk. As each asset under (ii) is constructed, it will be delivered to the issuer/trustee and will become subject to the ijarah agreement. Further, shariah requires that by the maturity date of the sakk, the value of the hard assets subject to the ijarah agreement is equal to the outstanding face value of the sakk, i.e., that no assets remain to be constructed under the istisna’a agreement.

Musharakah, mudarabah, and wakalah structures differ from the structures described above in that they are sukuk that involve investment in certain assets. A musharakah is an equity participation arrangement between the issuer/trustee and the obligor under which each party contributes capital to a project and shares in its risks and rewards. While profits may be apportioned according to any previously agreed ratio, losses must be borne according to the ratio of capital contributed. A mudarabah involves the issuer/trustee (as investor) appointing the mudarib (investment manager) to invest its funds in certain shariah-compliant assets. Profits from those investments are shared according to a previously agreed formula, but losses in respect of the assets are borne wholly by the investor (the mudarib bears the loss of its time and effort). A wakalah structure involves the issuer/trustee as muwakkil (investor) appointing the obligor as wakeel (agent) to invest in certain pre-identified assets. Similar to a mudarabah, the muwakkil bears the loss in relation to the assets, while the wakeel bears the risk of loss of its time and effort.

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Further reading

Books:

  • Al-Omar, Fuad, and Mohammed Abdel-Haq. Islamic Banking: Theory, Practice and Challenges. London: Zed Books, 1996; ch. 10–11.
  • Al-Gamal, Mahmoud A. Islamic Finance: Law, Economics and Practice. Cambridge, UK: Cambridge University Press, 2006; ch. 6–7.
  • Iqbal, Zamir, and Abbas Mirakhor.An Introduction to Islamic Finance: Theory and Practice. Singapore: Wiley, 2007.

Report:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). “Shari’a standards.” Listed online at: tinyurl.com/c7hqjkl

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