Sukuk under development

Author: | Published: 1 Sep 2009
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The evolution of the Islamic finance market from simple, low-return instruments to more sophisticated structures has generated increased attention in recent years. One of the more important recent evolutions in Islamic finance has been the development of the sukuk market.

Even though by global standards the size of the sukuk market remains relatively small, it has experienced much growth. Factors contributing to this growth are numerous and include: (i) increasing investment activities in the Middle East and Asia, and related increase in the need for funding; (ii) surplus savings and reserves in the Middle East and Asia; (iii) investors' desire for higher returns and greater diversification of risk; (iv) the need for medium to long term investment returns, which was previously lacking in shariah compliant instruments but which is addressed by sukuk; (v) increasing desire for a secondary trading of Islamic instruments that has positioned sukuk instruments at the forefront; and (vi) increasing participation by non-Islamic issuers seeking to take advantage of the increased liquidity in the Islamic finance area. These developments confirm that sukuk has started to come into its own as a real and viable alternative to conventional investments.

From plain vanilla to innovation

Sukuk are commonly defined to be Islamic bonds but in fact they are not. A suk (the singular of sukuk) is a financial instrument or a certificate representing an ownership interest in shariah-compliant assets or business activities (as in case of mudarabah) with the right to the revenue and liquidation proceeds generated from such assets or business activities. Sukuk certificates can be tradable depending on the nature of the underlying assets, and carry an expected fixed profit rate or a floating profit rate that refers to an index such as Libor. These rates are usually referred to as profit coupons.

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."

Early sukuk were structured on the basis of murabaha contracts which entailed a cost-plus sale and were, therefore, un-tradable as they represented a share in debts and not assets. As the market has evolved, leases (ijara) and partnerships or joint ventures (musharaka) have become more popular sukuk assets due to strong demands for a secondary market for sukuk, and remain the most common form of sukuk at present.

Other possible underlying sukuk assets that are sometimes used and that qualify to be traded in a secondary market are mudarabah, which is based on profit and loss sharing arrangements equivalent to a trust, in which funds are deposited by sukuk holders (in this case, Rab Al Mal) with an investment manager (mudareb) that manages the funds in shariah-compliant investments in consideration for a fee.

Sukuk witnessed, recently, a further evolution of innovations and developments including the landmark issuance in 2006 of the exchangeable sukuk by Khazanah Nasional Berhad (Khazanah); the Malaysian sovereign wealth management entity. In this transaction, the sukuk can be exchanged for other shares held by Khazanah.

In the same year, a convertible sukuk, in which the sukuk can be converted into the issuer's own shares upon initial public offering, was issued by a Middle Eastern corporation, Ports Customs & Free Zone Corporation (PCFC) in Dubai, the U.A.E. This had a principal face value of $3.5 billion. It is considered as one of the world's largest sukuk issues to date. Following these landmark issuances, the development of the convertible and exchangeable sukuk continues to grow.

Convertible versus exchangeable sukuk

Convertible sukuk

Convertible sukuk have a standard feature of traditional sukuk in that the sukuk assets should be subject to one of the forms of shariah compliant transactions such as ijara, musharaka, or mudarabah and include profit return that is paid to the sukuk holders from the assets. Such profit is often computed as a percentage based on the face value of the sukuk, and should only be paid to the holders if the assets realize profits or capital gains.

But it is not uncommon to structure sukuk to secure the percentage of the expected profit distribution amounts and to secure the repayment of the sukuk redemption amount on maturity. In addition, convertible sukuk grants the holder the right to convert the sukuk certificates for shares or equity ownership in the issuer (or the obligor) following the conversion of the sukuk based on predetermined formulas.

The shares or the equity to be delivered against the redemption of the convertible sukuk do not need to exist at the time of issue. Often, such shares (or equity portion) are issued in the future by the issuer (or the obligor) upon exercise of the conversion option by the holders.

The holders can convert the sukuk into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. Convertible sukuk are, therefore, considered a hybrid sukuk with both beneficial ownership of the assets and equity features. Although convertible sukuk typically have a low profit rate, they carry additional value through the option to convert, and thereby participate in further growth in the issuing company's equity value.

From the issuer's perspective, the key benefit of raising money by selling convertible sukuk is a reduced cash-profit payment. However, in exchange for the benefit of reduced profit payments, the value of shareholders' equity is reduced due to the stock dilution expected when holders convert their sukuk into new shares.

As such, convertible sukuk are like any typical sukuk in that they have an issue size, issue date, maturity date, maturity value, face value and profit coupon. However, they also have the additional features that also exist in conventional convertible bonds:

Conversion price: This is the nominal price per share at which conversion would take place.

Conversion ratio: This represents the number of shares each convertible sukuk converts into. It may be expressed per number of sukuk or on a percentage basis.

Conversion value: This is the result of multiplying the conversion price by the conversion ratio.

Conversion premium: This represents the divergence of the market value of the sukuk compared to that of the conversion value.

Early redemption call feature

The ability of the issuer to call the sukuk early for redemption to encourage investors to exercise the conversion option early. Otherwise the issuer would repay the sukuk in cash at a lower amount.

Convertible sukuk are sometimes structured as pre-initial public offering convertibles so that the sukuk are converted into shares upon future-qualifying public offering of the issuer or of its affiliates. This was the case in respect to PCFC.

Exchangeable sukuk

Exchangeable sukuk are straight sukuk with an embedded option to exchange the sukuk for existing shares of a company other than the issuer (usually a subsidiary or company in which the issuer owns a stake) at some future date and under prescribed conditions.

Exchangeable sukuk are different from convertible sukuk in that convertible sukuk grant the holder the option to convert the sukuk into shares of the issuer (that are often new shares) while exchangeable sukuk grant the holder the option to exchange the sukuk with existing shares of another company that are owned by the issuer or the obligor. The pricing of exchangeable sukuk is similar to that of convertible sukuk, splitting it between straight ownership of sukuk assets in one part and an embedded option in another part and valuing the two separately.

Yield or profit distribution on an exchangeable sukuk is lower than the yield on a straight sukuk.

In case of the Khazanah exchangeable sukuk, the holders were granted the option to exchange the sukuk certificates for existing shares of entities held by Khazanah. Khazanah undertook to deliver the shares of one of its subsidiaries.

Possible structures of convertible and exchangeable sukuk

In convertible and exchangeable sukuk, the basic plain vanilla structure might vary to include a host of options. Such options are expected to be implemented in the future as the sukuk market develops. Such options may include the following:

Mandatory Convertibles/Exchangeable

These are mandatory convertibles that are exchangeable into a fixed number of common shares upon maturity. Conversion or exchange may be linked to a prescribed number of shares based on the market price of such shares at maturity to provide a minimum redemption value. It would be important to be extra diligent when reviewing related offering documentation as confusion can arise between the terms redemption and conversion.

Contingent-convertible (Co-co) sukuk

Co-co sukuk allows holders to convert into shares if the price of such shares is a certain percentage above the conversion price. For example, a contingent convertible with a market price of 10 per share at the time of issue, conversion premium of 20% and a contingent conversion trigger of 130%, can be converted at $12 only if the shares trade over a specified period above $15.60. This is the result of calculating the market price at issue (10) plus the conversion premium ($2) multiplied by the contingent conversion trigger (130%).

The Co-co feature would result in an immediate increase in diluted outstanding shares thereby reducing the earning per share for the issuer in accordance with the Generally Accepted Accounting Principles (GAAP).

Going-public sukuk (GPS)

These types of sukuk can be issued prior to listing of the issuer or the obligor and can be converted or exchanged into shares when the issuer or the obligor is listed on a stock exchange. Going-public sukuk have a short-term redemption feature in equity at the prevailing share price at the time of conversion or exchange or may be fixed at a discount to encourage conversion.

Convertible preferred-stock sukuk (CPSS)

CPSS can only be used in jurisdictions that allow issuers or obligors to issue preferred shares upon conversion exercise by the holders. GPSS would normally have a negative impact on the profit distribution rate.

Reverse convertible sukuk

These are sukuk that are linked to an index or underlying shariah-compliant shares, but which bear a high profit rate. The underlying index or underlying shariah compliant shares or basket of equities is defined as reference shares. At maturity, the investor will receive the full-par value of the sukuk in cash if the knock-in level is not breached at any time during the life of the sukuk. The knock-in level in conventional reverse convertibles is typically 70 to 80% of the initial reference price and is most commonly used in the US market. If the knock-in level is breached, the holders receive a predetermined number of the underlying shariah-compliant shares, in addition to the profit distributions.

The shariah perspective

Despite the emergence of convertible sukuk and exchangeable sukuk in the Islamic finance market worldwide, they have not, so far, been widely issued. This could be due to the difficulties with obtaining shariah approvals for these types of sukuk.

Under shariah, contracts that contain the elements of uncertainty (gharrar) are considered void. For convertible sukuk or exchangeable sukuk, the fact that conversion or exchange of the sukuk certificates is contingent and the characteristics of the company into whose shares the certificates convert or exchange may be unknown do not give rise to concern regarding uncertainty. This is because the characteristics of the company would be known even before the option was exercised.

In light of this, it is therefore imperative from a shariah-compliance perspective that the company be shariah compliant at the time of issuance of the sukuk, and remain so throughout the tenure of the sukuk. If there is a sustained breach of the shariah compliance tests and criteria, shariah scholars would have discretion to declare the company non-shariah compliant; which would in turn give the investors the right to have their respective sukuk redeemed by the issuer at an agreed price.

A convertible sukuk or exchangeable sukuk may be considered more in the spirit of shariah and hence approved by shariah scholars if the investor and project both have a reliable basis of calculation for the conversion formula. For instance, if the conversion or exchange formula were based on the audited net asset value (NAV) of the project, it would be more acceptable from the shariah point of view since actual and audited NAV provides more reliability on which to calculate the conversion or exchange amount.

Acceptance by both parties of the amount is another important factor in classifying the instrument as being shariah compliant. This is due to the principle in Islamic economics that both parties must come to an agreement. In conventional financial terms, this would be tantamount to an arm's-length transaction, it is also may be more acceptable to the shariah; (i) if the instrument is structured in a way that it would invest the sukuk proceeds into projects and real assets, due to the concepts of Islamic economics which encourage investment of funds into financial products; and (ii) if the instrument is designed so as to involve more risk taking and risk sharing between the issuers and the investors.

Despite the general principles on which convertible or exchangeable sukuk may be approved from the shariah perspective (at present whether the features of convertible or exchangeable sukuk are shariah-compliant), the matter of interpretation varies with different shariah boards. Having said this, the feedback from market participants is that the lack of issuances of convertible sukuk and exchangeable sukuk in the Islamic market is not because of difficulties with shariah compliance. Instead, it may be due to a lack of experience among the structuring advisers.

SPV structures

Many convertible and exchangeable sukuk are issued through special purpose vehicles (SPVs), typically a company based offshore in British Virgin Islands, the Cayman Islands or Jersey. The SPV liability under the sukuk is convertible or exchangeable into the equity of the obligor. Although the obligor may guarantee the SPV's liability under the sukuk on an unsubordinated basis, if the assets of such obligor are just shares of various subsidiaries, this would mean that the sukuk would effectively have a guarantee that is subordinated. This creates a fundamental weakness in the credit analysis of any convertible and non-convertible SPV debt.

Creating a supportive environment

Other than shariah consideration, the regulatory environment within which the convertible sukuk and exchangeable sukuk are issued must be supportive enough to encourage its growth. The regulatory framework must be proactive enough to pave the way for enhanced and innovative offerings such as convertible sukuk and exchangeable sukuk.

In this respect, proactive dialogue between regulators, practitioners and market participants is of utmost significance with a view to codifying shariah principles that are applicable to such complex transactions. Standardisation remains a key challenge that needs to be addressed. Shariah matters need to be regulated through a central body for Islamic banks and financial institutions.

In addition, to sustain the sukuk industry as a key component of the Islamic financial markets requires the introduction of laws that are specific for the sukuk market; in particular, addressing the complexities of convertible sukuk and exchangeable sukuk. The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, in actively introducing rules and regulations pertaining to the issuing and offering of sukuk, will assist in providing standardisation which in time should result in the maturation of the sukuk market.

As an illustration of the pressing need of a supportive regulatory framework in addressing the issues faced by issuers of convertible sukuk, reference is made to the obstacles encountered in the Aldar (a UAE entity) case. Amongst the problems faced by Aldar was that: (i) the existing shareholders of Aldar had a statutory right of pre-emption on any share issue, a right which had to be waived in an Extraordinary General Meeting (EGM); (ii) any EGM waiver is only valid under UAE law for a maximum of four years, raising issues if the sukuk have a maturity of more than four years; (iii) the notion of treasury shares does not exist for UAE companies, presenting complicated mechanics during the process of conversion; (iv) upon conversion, each issue of shares must be authorized by a resolution from the Federal Ministry of the Economy in the UAE; and (v) restrictions on the percentage of foreign ownership for certain UAE companies.

The experience of IIG in its sukuk issue also reflected the complexities of Kuwaiti share issues and the authorization process for investment companies.

Apart from the regulatory framework, the industry also depends on people that have the requisite expertise and knowledge regarding sukuk instruments. The development of human assets remains one of the key challenges faced by the sukuk market. Training and development of talented professionals is crucial in shaping the future of an innovative sukuk market. Assistance from academics in formulating the sukuk framework is also mandatory. Another important factor that needs to be addressed is the level of product understanding of these complex sukuk instruments by a wider range of investors to ensure that any innovations in sukuk issuance would be readily acceptable and comprehended by these investors. In short, contribution from all parties is needed to provide the foundation upon which the sukuk market is to remain supported and to enable it to continue to grow.

Becoming mainstream

It will take a few more years for shariah-compliant exchangeables and convertibles to become mainstream. This is because parties to sukuk issuances need to mature to enable them to extract the most value from such transactions. Having said that, with growing investor appetite and increasing financial sophistication, the future of convertible sukuk looks promising. There is no doubt that the Islamic market is increasingly able to develop products which meet the needs of issuers and investors with the same level of sophistication as that found in the conventional debt markets.

Author biographies

Hossam Abdullah

Al-Sarraf & Al-Ruwayeh

Hossam Abdullah is a partner with ASAR, Kuwait. He was born in 1971 and received his LLB (1992) and Diploma in International Trade Law and Investment (1993 – with honours at Cairo University, Egypt), Diploma in Private Law (1996 at IARS – ALESCO), and LLM, International Business Law (1998 at Manchester University, UK). He has been admitted to the Egyptian Bar Association since 1993.

Abdullah has over 16 years of extensive legal experience in corporate, banking and finance with an emphasis on structuring and handling Islamic finance transactions, debt and equity capital markets, investment funds, and M&A. He also has an in-depth knowledge of the shariah principles and has worked on leading Islamic and conventional transactions in Kuwait, the Gulf Cooperation Council region and the US.

Abdullah is fluent in English and Arabic.

Riza Ismail

Al-Sarraf & Al-Ruwayeh

Riza Ismail is an associate with ASAR, Kuwait. She received her Bachelor of Accounting (with merit) and LLB from the University of New South Wales, Australia. Ismail holds a Diploma in Shariah Laws and Practice from the International Islamic University, Malaysia. She is also presently pursuing Chartered Islamic Finance Professional. Ismail is admitted to the Malaysian Bar Association.

At ASAR, Ismail primarily focuses on banking and finance with particular emphasis on Islamic finance, securities laws and mergers and acquisitions related work. She has over eight years of legal experience; two years spent working in Kuwait.

Ismail is fluent in English and Malay.