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Sukuk: Pushing innovation

Sukuk in general market parlance refers to a financial certificate that does not have the elements that are prohibited in Islam. Formal definitions of Sukuk can be found in international standards such as in the Shari'ah Standard of the Accounting and Auditing Organisation for Islamic Financial Instititutions (Aaoifi) as well as in local regulatory guidelines. For example, in Malaysia, the Guidelines on the Offering of Islamic Securities issued by the Securities Commission of Malaysia. In the former, Investment Sukuk is 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. In the latter sukuk is simply defined as a document or certificate which represents the value of an asset.

They are also often referred to as Islamic bonds. But sukuk does not always evidence debt and is very much dependent upon the underlying contracts that is employed that gives rise to the sukuk issued. The richness in variety of the nature of sukuk can be seen in Article 5/1/2 of the Aaoifi Shari'ah Standard on Investment Sukuk. This states it is permissible to issue certificates for (to securitise) assets that are tangible assets, usufruct and services by dividing them into equal shares and issuing certificates for their value and in respect of debts owed as a liability. It is not permissible to securitise them for the purpose of trading. One of the fundamental differences between a sukuk and a conventional bond lie in the underlying contract that gives rise to the financial instrument. In a sukuk, it does not derive its existence premised on a lending transaction whereas conventional bonds almost always do.

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 that is created by market demand. Hence it is no surprise that sukuk too has evolved into the use of many variant structures and continues so as dictated by market forces.

These structures employ various Islamic contracts that are suitable for the financing required. The underlying Islamic contracts include deferred payment of a sale price (Bai' Bithaman Ajil) where the sukuk issued represents the debt of a sale price which is to be paid in fixed instalments. This structure requires a sale which is valid under the shari'ah and has specific restrictions with regard to the nature of the subject matter of the sale and a fixed price. This type of sukuk is similar to conventional bonds in evidencing debt obligations although the debt evinced by sukuk arises from a sale transaction as opposd to a lending transaction. The differences in the views of the permissibility in shari'ah of secondary trading of such sukuk have led to the issuance of such sukuk in markets where the Shari'ah views allows so as in Malaysia or is issued where no secondary market is contemplated such as for the purposes of recognised capital in computation of a bank's capital adequacy ratio.

A more popular structure employed has found a wider common ground in terms of the views on shari'ah on the acceptability of the structures and secondary trading of the Sukuk. A Musharakah is an Islamic contract to create parity of sharing of loss and profits in a common venture or common ownership of the undivided shares of assets. It is typically employed where there are assets which can be utilised to generate income for the purpose of the sukuk issuance. The returns to the holders of sukuk is by virtue of the ownership in the assets where returns on those assets are viewed as a consequence of ownership. Such sukuk does not grant the right to receivables on its own and hence the secondary trading of sukuk is not viewed from the shari'ah perspective as dealing in rights to income but in the subject matter property the sukuk represents.

In Malaysia, the existence of a formal legal and regulatory framework for the issue of sukuk as well tax neutrality policies and incentives facilitates the issuance of sukuk for local and foreign issuers. In addition, specific government policies relating to the promotion of Islamic finance as a whole and the government initiatives to develop Malaysia as an international Islamic finance centre provides the additional impetus for the growth of sukuk.

With the first sukuk issued in 1990 by Shell MDS, which is the first ever Ringgit sukuk issued, the variants of sukuk structures that had been issued out of Malaysia have seen a broad spectrum. They have charted many firsts such as first issue of sukuk Bai' Bithaman Ajil in 1990, sukuk Mudharabah in 1994, sukuk Ijarah in 2001, sovereign sukuk in 2002, sukuk Musyarakah in 2005 and exchangeable sukuk in 2006. The financing structures itself cover a vast range. For example, some simply represent the payment obligations of deferred payment sales (Bai' Bithaman Ajil) such as the sukuk of RM9.17 billion issued in the refinancing of conventional financing into Islamic financing by Plus. Others had more complicated trust certificates with exchangeable features such as in the several US dollar sukuk issued by Khazanah Nasional Berhad (Khazanah) and the Malaysian government held investment company through special purpose vehicles in 2006, 2007 and 2008 aggregating over $2.15 billion through global marketing and are listed in international exchanges of Labuan, Luxemburg and Dubai. The exchangeable sukuk issued by Khazanah demonstrates the robustness of sukuk structures. They can break away from the requirement of having to find a tangible underlying asset. This is typically required for the Islamic contracts used in the structures of sukuk previously issued by others. The exchangeable feature of Khazanah's sukuk allows investment holding companies to issue sukuk with features that manage the pricing of the Sukuk. This makes it a feasible financing alternative to conventional bonds and without the need to utilise physical assets for the purposes of the Islamic contracts employed.

With the increasing global demand for sukuk, it is no surprise that market demands may have pushed certain variants of sukuk to have features that mirror closely to those of conventional bonds. For example the certainty of an obligation to pay a determinable amount on a particular date notwithstanding the fact that the underlying Islamic contract employed on its own does not create such an obligation. Attempts to create sukuk that have debt obligation features have led to structures that embed additional purchase undertakings by the issuer or lending obligations to the issuer by an obligor. This is in a particular manner which for certain contracts under the shari'ah, such as those of Musharakah and Mudharabah, could render these contracts questionable from a shari'ah perspective. The concerns raised to the Shari'ah Board of Aaoifi on these types of practices have led Aaoifi to issue a statement last year to provide a more detailed guidance on the shari'ah Standards it had issued on Sukuk. That statement may appear awkward since almost all issuance of sukuk prior to the statement appear to have had the benefit of Shari'ah advisers endorsing the sukuk issued as being shari'ah compliant. What is clear is that the statement emphasises the need in structuring sukuk for advisers who not only are competent in their respective disciplines but also with particular understanding of the requirements of the shari'ah, in addition to the requirement of having shari'ah advisers. In particular legal advisers play a key role to mitigate the inherent legal risks including risks of shari'ah non-compliance in the structuring and documenting of sukuk where only a general understanding of Islamic contracts may be insufficient to efficiently structure and document the sukuk as structures get more innovative.

Sukuk structures being relatively new holds great potential to be developed further both in terms of enhancing the efficiency of present structures as well as the introduction of new ones. It is believed in the new economic landscape emerging from the current global economic situation, the potential of sukuk would make it more relevant in terms of having financial instruments that create relationship that link directly to investments as opposed to one of only lending.

Andri Aidham – Islamic Finance and Capital Markets

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