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The future of sukuk

Sukuk in general market parlance refers to negotiable financial instruments that do not have elements that are prohibited in Islam. Formal definitions can be found in international standards such as in the shariah standard of the Accounting and Auditing Organisation for Islamic Financial Instititutions (Aaoifi) as well as in local regulatory guidelines such as in the case of Malaysia issued by the Securities Commission of Malaysia. In the former, investment sukuk are described as certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity whilst in the latter sukuk are simply defined as a document or certificate which represents the value of an asset.

Although often referred to as Islamic bonds, sukuk do not evince borrowing. One of the fundamental differences between a sukuk and a conventional bond lie in the underlying contract that gives rise to the issuance of sukuk. Bonds are creatures of lending but sukuk is not premised on lending.

Arguably the most recent innovation in financial instruments sukuk, notwithstanding its religious roots, is not unlike any other financial instrument in that it is a product created by market demand. Hence it is no surprise that sukuk too have evolved into many variant structures and continues to do so as dictated by market forces.

These structures employ various Islamic contracts that are suitable for the financing required. Presently the choice of Islamic contracts is largely driven by the views on shariah on the acceptability of the structures employed and the ability of secondary trading of sukuk.

In Malaysia, the formal legal and regulatory framework for the issue of sukuk as well tax neutrality policies and incentives facilitate the issuance of sukuk. In addition, specific government policies relating to the promotion of Islamic finance, both domestic and internationally, provides impetus in Malaysia. The Malaysia International Islamic Financial Centre is testament to this.

Andri Aidham, Kadir Andri & Partners

Since the first sukuk was issued in Malaysia in 1990, the variants of sukuk structures that had been issued have seen a broad spectrum of innovative structures such as sukuk bai' bithaman ajil in 1990, sukuk mudharabah in 1994, sukukijarah in 2001, sovereign sukuk in 2002, sukuk musyarakah in 2005 and exchangeable sukuk in 2006. The sukuk structures themselves range from those that simply represent the payment obligations of deferred payment sales to more complicated trust certificates with exchangeable features. For example the exchangeable sukuk breaks new ground in using intangibles in its structure. These Malaysia-originated sukuk have been successfully marketed globally and listed on international exchanges such as Luxemburg and Dubai.

With the increasing global demand for sukuk, it is no surprise that market demands have pushed certain variants of sukuk to have modified features that mirror conventional bonds. This has highlighted the risk of contradicting views on shariah compliance for certain sukuk structures.

For example, attempts to create sukuk with debt obligation features in spite of being premised on profit and loss parity have led to structures that embed additional purchase undertakings by the issuer or lending obligations to the issuer by an obligor in a particular manner which for certain contracts under the shariah, such as musharakah and mudharabah, could render these contracts questionable for shariah. The concerns raised to the Shariah Board of Aaoifi on these types of practices led it to issue a statement in 2008 with more detailed guidance on the shariah standards it had issued on sukuk. That statement issued may appear awkward since almost all sukuk issued had already been endorsed by shariah advisers. The statement emphasises the need, in addition to the requirement of shariah advisers, for other advisers that are not only competent in their respective disciplines but also have a certain degree of understanding of the requirements of the shariah. In particular legal advisers play a key role to mitigate the inherent legal risks, including risks of shariah non-compliance in the structuring and documenting of sukuk, where a basic understanding of Islamic contracts may be insufficient to efficiently structure and document the sukuk as structures become more innovative.

Sukuk structures, being relatively new, hold great potential both in enhancing the efficiency of present structures as well as in the introduction of new ones. The new economic landscape makes sukuk even more relevant, with financial instruments that link relationships directly to real economic activities rather than just lending. With sukuk documentation just beginning to be tested in financial stresses, pushing innovation on sukuk provides the legal practitioner with new challenges in exciting times.

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