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Home > Regulation Best Practice > Bankruptcy Resolution and Investor Protection in Sukuk Markets

Regulation Best Practice

Bankruptcy Resolution and Investor Protection in Sukuk Markets

by Kamal Abdelkarim Hassan and Muhamad Kholid

Executive Summary

This article examines the following:

  • Understanding the particular appeal sukuk has to investors.

  • Notable defaults and near-defaults of sukuk and the effects on the market.

  • Case study: Nakheel sukuk—a lesson to learn for Islamic finance.

  • Issues of enforceability in light of sukuk defaults.

  • Jurisdictional response to legal issues surrounding sukuk.

Introduction

According to the Kuala Lumpur-based Islamic Financial Services Board, a standards body for the Islamic finance industry, the Islamic finance industry is a roughly US$1 trillion asset that may almost triple to US$2.8 trillion by 2015. Arguably, sukuk is the catalyst that has put the Islamic finance industry on the global capital market map. Despite being the flagship product of the burgeoning Islamic finance industry, the sukuk market has not been immune to the economic downturn. Marketed often as a safer alternative than conventional bonds, the subsequent near and actual sukuk defaults have raised questions about sukuk-holders’ rights, how they will be treated, and what sukuk entails. A closer examination is required of the structural deficiencies of some sukuk structures that may result in nullifying the recourse of investors and the enforceability of sukuk contracts. Based on the above, we discuss bankruptcy resolution and investor protection in sukuk markets.

Sukuk by Any Other Name

Although a rose by any other name may well be a rose, a sukuk by any other name is not a sukuk. A commonly held description of sukuk, both within and outside the Islamic space, is one of an Islamic bond. Although many sukuk structures are designed to replicate the economic function of conventional bonds, their legal structures are different. “Any references to sukuk as being Islamic bonds are oxymoronic and misleading to investors who may believe they have certain bond-like remedies that, ultimately, may not be enforceable in some Islamic jurisdictions.”1 The Accounting and Auditing Organization for Islamic Financial Institutions’ (AAOIFI) shariah Standard no. 17 on investment sukuk carefully distinguishes sukuk from equity, notes, and bonds. It emphasizes that sukuk are not debts of the issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects, or investment activities. Sukuk may not be issued on a pool of receivables. Nevertheless, the importation of provisions and conventional contractual risk transfer covenants into the overall sukuk structure is the primary link between sukuk and bonds.

Given the standardized nature of conventional bond transaction in terms of (a) the relative rights and remedies of the parties, (b) the terms of many financial and commercial risk allocations, and (c) the legal documentation, one begins to understand the rationale for embedding the conventional provisions and covenant within sukuk structures. Shariah-compliant transactions of this type have not yet obtained an equivalent degree of standardization or concomitant certainty, consistency, predictability, or transparency, especially as to enforcement of the shariah, hence the importance of the work of the International Islamic Financial Market (IIFM) in its development of standardized Islamic financial transaction agreements. As long as the Islamic finance industry continues to play catch-up in term of contractual standardization, the sukuk investor may be left with cosmetically comforting structured Islamic notes that may lack the same legal safeguards and risk profile as the conventional bond to which they are often compared. Therefore, there is all the more reason to understand the sukuk structures, and in the event of default to know what, if any, recourse an investor would have under those structures.

Importance of Understanding the Fine Print in Sukuk Structures

Standard & Poor’s has grouped the various sukuk structures into three categories:

  1. Sukuk with full credit-enhancement mechanisms. These are sukuk that receive an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral. The guarantor provides shariah-compliant shortfall amounts in case the issuing vehicle (usually a special-purpose entity) cannot make payment.2

  2. Sukuk with no credit-enhancement mechanisms. This structure resembles an asset-backed security. The pool of underlying assets is the sole basis for the coupon and principal payment.3

  3. Sukuk with partial credit-enhancement mechanisms. This combines the first two categories, with a third-party guarantee absorbing a limited shortfall from an asset-backed transaction.

According to a report by Moody’s, many of the sukuk structures applied have been effectively reduced to a form that is identical to conventional unsecured bonds. Most asset-based sukuk may have the form of asset-backed sukuk, but not the substance.4 In other words, although most sukuk have assets in their structures, they were only considered as asset-backed or asset-secured if key securitization elements were present to ensure that holders enjoy beneficial title and realizable security over the assets and associated cash flows.

Although terminologically similar, asset-based and asset-backed have unique differences in credit risk with respect to a potential investor in a sukuk. This can be seen in the case of Tamweel PJSC, where two types of sukuk had been issued. In the Tamweel asset-backed sukuk, the freehold titles to the properties were transferred to the sukuk-holders along with the associated ijarah cash flows. The property or land titles are registered in the name of the investors. Any losses on those cash flows (that arise from the sale of distressed property) are passed on to sukuk-holders, who are exposed to the asset risk. Nevertheless, upon the insolvency of Tamweel, the assets continue to pay the sukuk investors. As for the unsecured or asset-based sukuk issued by Tamweel, the sukuk does not survive the insolvency of Tamweel. Investors in these two sets of sukuk are taking very different risks.

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Further reading

Books:

  • Adam, Nathif J., and Abdulkader Thomas. Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. London: Euromoney Books, 2005.
  • Mahmoud A. El-Gamal (trans). Financial Transactions in Islamic Law. Syria: Dar Al Fikr, 2003. (Translation of: al-Zahayli, Wahbah. Al-Fiqh Al-Islami wa ’Adillatuh. 4th ed. Volume 5. 1997).

Articles:

  • Fidler, Stephen. “Defaults pose latest snag in Islamic-bond market.” Wall Street Journal (June 16, 2009). Online at: online.wsj.com/article/SB124510859262816907.html
  • Howladar, Khalid. “The future of sukuk: Substance over form?” Moody’s Investors Service, May 6, 2009.

Report:

  • Accounting and Auditing Organization for Islamic Financial Institutions. “Investment sukuk.” Shari’a standard no. 17. 2004.

Websites:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI): www.aaoifi.com
  • Association of Islamic Banking Institutions Malaysia (AIBIM): www.aibim.com
  • International Islamic Financial Markets (IIFM): www.iifm.net
  • Islamic Financial Services Board (IFSB): www.ifsb.org
  • Islamic Research and Training Institute (IRTI; a member of the Islamic Development Bank): www.irti.org

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