In April, delegates from as far away as Tanzania and Malaysia gathered in London to attend the IIBI sukuk workshop, looking at the factors facing these instruments and examining the detail of some actual structures used by recent issues.

The spectacular growth of the sukuk market from 2004 through to 2007 may have slowed recently. The announcement by AAOIFI in 2008 regarding the perceived compliance of some sukuk arrangements coincided with the credit crunch. While the slowdown may initially have been a reaction to the global financial turmoil, internal pressures within the industry itself have not helped to ease investors’ minds. The workshop examined the underlying structure of these instruments, their strengths and the sources of their future appeal.

Sukuk are sometimes compared to conventional bonds – which they are not, although they do share some similar financial characteristics. Bonds are debt instruments, so could never comply with Shari’ah. The workshop looked at those aspects that make sukuk different from bonds and the essential factors that make sukuk Shari’ah-compliant – the actual ownership of the underlying asset(s) by the sukuk holders; the underlying Shari’ah-compliant contract types, whether ijara, musharakah, mudarabah, murabaha or indeed any of the fourteen types recognised by AAOIFI; the returns to the sukuk holders being linked not to an interest rate but to the actual profit of a project (which includes the risk of loss) – all coming together to make sukuk closer to conventional bank securitisation than to conventional bonds.

Muhammad Ismail, financial controller of Sony Europe, explained that securitisation is a financial process where cash flow-producing assets are pooled and repackaged into securities that are sold to investors. In Islamic finance, this process is achieved through ‘taskeek’ – the process of issuing sukuk, which are certificates that represent ownership of the asset pool. In this way, the owner of income-producing assets, for example residential or business properties that produce rental income, can package and sell them to a special company set-up purely for this purpose (called a Special Purpose Vehicle, or SPV) which, in turn, re-sells packets of those assets to investors. The certificates representing this ownership are called sukuk. Periodically, income from the assets is distributed to the investors – the sukuk holders. At the end of the term, the assets are re-sold and the investors re-coup an amount of their original investment. It was this ‘buy back’ arrangement used in some types of sukuk (mostly mudarabah and musharakah-based contracts) that was questioned in 2008.

Despite the current downturn, sukuk have several factors that may favour them when the expected upturn in the markets occurs. The sukuk issues to date have proven to be stable and prudent investments and have created a knowledge and experience base in the market for issuers and support services alike. The maturity of the market, even at this early stage, is setting the scene for more standardisation which may reduce legal costs and improve confidence by sukuk participants.

The workshop heard that the size and coverage of the issues to date means that there is potential for growth outside of the traditional Muslim markets, with interest being shown by the monetary authorities of Singapore and Hong Kong, as well as the governments of UK and France. Although most sukuk issues have been done by governments or government-backed entities, there is more potential for large corporates of international standing to enter the market and benefit from raising long term funding through sukuk issues, rather than the conventional debt markets. An increase in the size and depth of the sukuk market could benefit the Islamic finance community in general by providing a ready secondary market that will provide Shari’ah-compliant liquidity. This is not a significant source at the moment because most sukuk are held by investors until maturity, partly because of a lack of viable alternative Shari’ah-compliant investment types.

The degree of Shari’ah compliance and the nature of the AAOIFI announcement may have been misreported in some quarters. Mufti Muhammad Nurullah Shikder, EVP and head of Shari’ah advisory and compliance at Gatehouse Bank, felt that the comments related to purchase undertakings at the end of the sukuk term, and particularly those regarding sukuk issues whose underlying contract-type was a mudarabah or musharakah. The trend of issues at that time was moving towards these types of contract because of what was seen as the guaranteed buyback, and the announcement reversed that trend. The comments did not relate to ijara-based contracts which make up the majority (around 80 per cent) of the market. The basic problem was whether or not the purchase undertaking actually amounted to a guarantee to buy back the assets at their face value (not market value), thereby guaranteeing the capital, and eliminating the possibility of profit or loss – an essential element of Islamic investment products.

The workshop looked at other issues relating to sukuk that are of interest to Shari’ah scholars and authorities, some of which relate to profit distribution. It is not disputed that incentives can be in place to reward the manager for good performance. However, sometimes the nature and size of these incentives may be in question. In a mudarabah-based structure, for example, the manager (mudarib) is often rewarded for good performance, which generally means that the performance has exceeded an agreed benchmark. When this occurs, the mudarib is paid from the investors’ (rab-almaal) share of the profit according to a pre-agreed ratio. Depending on the ownership of the mudarib, this could raise the potential for a conflict of interest.

Of particular relevance to the workshop’s participants were the case studies and observations presented by Richard T de Belder and Matthew Sapte, partners at an international law firm, Denton Wilde Sapte. These experienced market participants examined some of the actual structures used in recent issues and some of the practical problems that needed to be overcome. For example, the workshop heard that one of the common problems with ijara-based contracts – avoiding gharar while still enabling variable rental amounts – can be accommodated by splitting the lease term into individual lease periods and giving appropriate notice for each individual term at a known rental. For other structures, profit distribution can raise the problem of having different classes of investors – each with different risk/return profiles.

De Belder and Sapte demonstrated the structures used, and the specific issues involved, in the convertible mudarabah sukuk used for the Aldar Properties issue, an Abu Dhabi property developer; the Tamweel $210 million sukuk, which is sometimes referred to as a ‘true’ sukuk involving Islamic securitisation of properties and leases, but which involved special operational issues relating to the dual SPV structure and issues relating to UAE law. They also discussed an Abu Dhabi-based issue, the Sun Finance (Sorouh) sukuk, where the property sale formed the basis of the mudarabah assets but legal and Shari’ah-compliance issues existed, relating to how the three different investor classes could be accommodated, how the mudarabah approach could be used and, particularly, how the purchase undertaking was structured in light of the AAOIFI statement.

Phil Heath, director, Pricewaterhouse-Coopers, tackled the topic of taxation on sukuk, particularly from a UK perspective in light of the changes made by the government. These changes have been progressively incorporated into UK tax legislation since 2003 with particular changes relating to sukuk in the 2007 Finance Act but still more changes being expected in 2009 tax legislation. These changes will bring sukuk legislation in line with conventional corporate bonds and securitisations and address capital gains and capital allowances issues.At some point in the future, investor confidence will return to the market, and sukuk offer a proven and ethical alternative to the conventional debt markets. With international interest rates at historic lows, financial intermediaries may look to sukuk, whose returns are dependent on actual profits from the project and not interest rates, to begin the financial re-building process.