Islamic Finance: Issues in Sukuk ed. by Mohammad Hashim Kamali and A. K. Abdullah by Kube Publishing

his collection of essays brings together leading scholars and practitioners to discuss contemporary issues in the rapidly-expanding sukuk market, and debates the challenges facing it since the 2008 financial crisis and a number of high profile sukuk defaults. It looks in particular at issues of Shari[ah compliance, the issue of replication in Islamic finance, the need to have a true sale in the asset securitization process, and the issue of sukuk defaults. It is highly recommended for practitioners, scholars and students of Islamic finance. The contributors are Abdul Karim Abdullah, Mohammed Imad Ali, Muhammad Al-Bashir Muhammad Al-Amineo, Rafe Haneef, Mohammad Hashim Kamali, Nermin Klopic, Raja Teh Maimunah, Faizal Ahmad Manjoo, Abbas Mirakhor, Sirajulhaq Hilal Yasini, and Sheila Ainon Yussof. Professor Mohammad Hashim Kamali is the founding chairman and CEO of the International Institute of Advanced Islamic Studies (IAIS) in Malaysia, and is a leading authority in Islamic jurisprudence, Islamic finance and human rights in Islamic law. A. K. Abdullah is Research Fellow at the IAIS. He previously lectured at several private institutions of higher learning both in Canada and in Malaysia, and also at the University Sains Islam Malaysia (USIM).

In a relatively short period of time the sukuk industry has become the most vibrant chapter of Islamic banking and finance. Rapid progress has, however, given rise to very many questions. This book provides insightful responses to topical questions that the students and scholars of Shari[ah would find refreshing and relevant. Sheikh Nizam Yaquby, Shari[ah scholar and advisor to numerous Islamic financial and institutions worldwide The papers in this volume contributed by scholars and practitioners demonstrate that Shari[ah compliance in sukuk structuring remains a challenge. They also remind us of the need to resolve the issue of overlapping jurisdictions that govern sukuk under the common law and the Shari[ah. This book will be of interest to members of the legal profession, especially in the corporate sector, and in Islamic banking and finance. Tun Abdul Hamid Mohamad, former Chief Justice of Malaysia

THE ISLAMIC FOUNDATION United Kingdom www.islamic-foundation.com

Islamic Finance Issues in Sukuk and Proposals for Reform

Tan Sri Zarinah Anwar, former Chairperson, Securities Commission Malaysia

Islamic Studies | Islamic Finance | Economics

Kamali and Abdullah

This is a valuable book that addresses current issues regarding the sukuk, both from the Shari[ah as well as the legal and regulatory perspectives and offers important insights and observations in response. The extensive analysis of the issues will help facilitate greater understanding of the challenges and contribute towards meaningful discussions on solutions.

Islamic Finance

Issues in Sukuk

and Proposals for Reform

isbn 978-0-86037-551-7 | US$24.95

Editors Mohammad Hashim Kamali and A.K. Abdullah www.iais.org.my

In the midst of continued turmoil in the financial markets, a search for credible alternatives is gaining pace. This book is engaged in a crucial discussion about the best Shari[ah-compliant ways of addressing the challenge of developing structures for sound investment, and, at the heart of this debate, is the assessment of ‘asset-based’ versus ‘assetbacked’ sukuks, which has come out well in this book. Dr. Mansoor Durrani, Senior Vice President, Head of Project Finance, National Commercial Bank, Jeddah, Saudi Arabia

Islamic Finance Issues in S uĚŁ kuâ&#x20AC;žk and Proposals for Reform

Editors Mohammad Hashim Kamali Abdul Karim Abdullah

International Institute of Advanced Islamic Studies, Kuala Lumpur, Malaysia

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Islamic Foundation, Markfield, United Kingdom

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Islamic Finance: Issues in Ṣukūk and Proposals for Reform Published in the United Kingdom By the International Institute of Advanced Islamic Studies and the Islamic Foundation International Institute of Advanced Islamic Studies Jalan Elmu, Off Jalan Universiti, 59100 Kuala Lumpur, MALAYSIA Tel: +60 3 7956 9188 Fax: +60 3 7956 2188 Email: email@iais.org.my Copyright © International Institute of Advanced Islamic Studies 2014/1435 AH, in Malaysia Distributed in Malaysia by International Institute of Advanced Islamic Studies The Islamic Foundation Markfield Conference Centre Ratby Lane, Markfield, Leicestershire LE67 9SY, UNITED KINGDOM Email: publications@islamic-foundation.com Website: www.islamic-foundation.com Qur’an House, PO Box 30611, Nairobi, KENYA PMB 3193, Kano, NIGERIA Distributed worldwide except for Malaysia by: KUBE PUBLISHING LTD. Tel: +44 (0)1530 249230 Fax: +44 (0)1530 249656 Email: info@kubepublishing.com Copyright © The Islamic Foundation 2014/1435 AH, all territories outside of Malaysia The right of the named contributors to be identified as the Authors of this work is hereby asserted in accordance with the Copyright, Design and Patents Act 1988. A CIP record is available from the British Library. ISBN: 978-0-86037-556-2 casebound ISBN: 978-0-86037-551-7 paperback ISBN: 978-0-86037-583-8 ebook Printed in Turkey by IMAK Ofset.

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CONTENTS Preface

Introduction

1. The ‘Ping-Pong’ of the Asset-Backed/Asset-Based Ṣukūk Debate and the Way Forward Faizal Ahmad Manjoo

2. Unresolved Sharīʿah Issues in Ṣukūk Structuring Muhammad Al-Bashir Muhammad Al-Amine

3. Ṣukūk: Perception, Innovation and Challenges Mohammed Imad Ali

4. Ṣukūk and Bonds: A Comparison Abdul Karim Abdullah

5. Measuring Sharīʿah Compliance in Ṣukūk Ratings: A Survey of Existing Methodologies Sheila Ainon Yussof

6. Concession Rights as Underlying Assets for Ṣukūk Sirajulhaq Hilal Yasini and Nermin Klopic

113

7. The Case for Receivables-Based Ṣukūk: A Convergence between Malaysian and Global Sharīʿah Standards on Bayʿ al-Dayn? Rafe Haneef

144

Interviews 1. Abbas Mirakhor – ‘Ṣukūk: Issues & Reforms’ by Sheila Ainon Yussof

162

2. Raja Teh Maimunah – ‘Issues in the Prevailing Financial Architecture with Special Reference to Ṣukūk’ by Zarina Nalla

167

Contributors’ Biographies

177

Transliteration Table

181

Glossary

182

Index

192

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Preface The collection of essays in this volume by scholars and practitioners of Islamic finance on the subject of ṣukūk could hardly have come at a more pertinent time. Since the global financial crisis started in 2008, Islamic finance has come under the spotlight. Questions are being asked regarding Islamic ṣukūk, in particular about some recent – and unprecedented – ṣukūk defaults. Questions are not confined merely to the causes of the defaults – concerns have surfaced about deeper issues of Sharīʿah compliance in ṣukūk structuring, including whether a lack of compliance at key stages of the securitisation process may have played a role in the defaults. It seems that the challenge of how to structure ṣukūk in ways that at once satisfy the requirements of Sharīʿah, the diverse expectations of the stakeholders, as well as the needs of the Muslim community, remains as relevant as ever. Sharīʿah compliance requires first and foremost the avoidance of interest (ribā), which has been categorically prohibited in the Qur’an, even as trade (bayʿ) has been permitted. Ensuring income is earned in the form of profit rather than interest, therefore, is of paramount importance. A good grasp of the difference between profit and interest (and by implication between trading and lending) is a sine qua non for issuing or investing in Sharīʿahcompliant securities. Whether income is earned in the form of profit rather than interest depends on whether the income-generating transaction is a loan or a sale. Profits are earned in the course of trading but interest is earned through lending. In order to ensure that income is earned in the form of profit rather than interest, income needs to be earned in the context of trading or investment, rather than as rental charge on money. In an interest-based loan, money is exchanged for (more) money. In a sale, by contrast, money is exchanged for an asset or service. Trading requires the counterparties to take risk and responsibility for the outcome of a trade or investment. Sellers face the risk of being unable to find buyers for their products or that the market price may be too low. Buyers face the risk that the products they buy may turn out to be of lower quality than expected or that their price may be too high. Investors in a business enterprise face the risk of incurring losses, and even of losing their entire investment. In interest-based lending, in particular collateralised lending, in contrast, contracts between creditors and debtors are structured in such a way that the risks of business enterprise are faced by one counter-party alone: the

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borrower. This means that risks are not shared by creditors. Ensuring that business risks remain with borrowers is achieved by requiring the latter to provide legally binding (interest) income and capital guarantees. In other words, lenders as a rule take no responsibility for the outcome of the business enterprises they help to finance. In some transactions, in particular in asset sales that fall short of being ‘true sales’, it becomes hard to tell the difference between sales and loans. This has been true in particular of the asset-based ṣukūk, where sale of underlying assets by originators to investors (ṣukūk holders) were not subject to a true sale. The ṣukūk contracts that resulted from these transactions, while formally appearing to have the character of sales, in substance came closer to loans. This was due not only to the lack of a true sale of the underlying assets to investors but also on account of the presence of income and capital guarantees in the ṣukūk structures, the hallmarks of conventional bonds. As a matter of fact, most ṣukūk have been structured as debt instruments, rather than as risk-sharing securities. However, when put to a test in trying times – as in the 2008-2009 financial crisis – ṣukūk structured to replicate conventional bonds failed to live up to expectations and instead brought unpleasant and costly surprises, as the ensuing defaults and near defaults have shown with abundant clarity. Apart from failing to reflect risk sharing – a sine qua non for earning income in the form of profit rather than interest – debt-like ṣukūk came with a risk that remains largely unfamiliar to investors in risk-sharing securities, namely, the risk of default. This type of risk is not found among the risks that face investors in profit-and-loss-sharing securities. The risk of default is a risk that specifically faces lenders. Default or the failure to repay a loan takes place within the context of lending, rather than investing. To make matters worse, debt-like ṣukūk raised the spectre of rising levels of debt, private as well as sovereign, with all its negative implications, in particular for taxpayers. In light of the current Eurozone debt crisis – which has been moving from the periphery to centre stage and has now engulfed the large economies of Italy and France, with the US debt crisis still looming large – this is not to be taken lightly, especially in cases of sovereign debt. The embedded debt-aversion traits of Islamic finance, together with its equally inherent risk-sharing principle, provide solid foundations for financial stability that merit the earnest attention of all concerned. If anything has become clear from the 2009 ṣukūk defaults and near defaults it is that, contrary to current practice, substance needs to be prioritised over form, not only to ensure Sharīʿah compliance but also to vi

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retain the credibility of Islamic finance and enhance investor protection. Ṣukūk – in particular participatory ṣukūk that proceed over the idea of risk sharing as a foundational principle – need to be structured so as to enable genuine profit-and-loss-sharing, rather than lending or quasi-lending presented as leasing. Structuring ṣukūk as risk-sharing instruments will ensure that the income generated by the underlying assets will take the form of profit. The fact is that risk sharing still remains in short supply in the Islamic finance industry. Islamic banking and finance institutions have yet to make risk sharing a significant feature of their activities. It is clear that financial innovation needs to go beyond replication of conventional structures. If Islamic finance continues merely to replicate conventional models, then Muslim societies will remain unable to realise the full benefits of financing on a risk-sharing basis, including the avoidance of debt, the need to service it, as well as a more even distribution of wealth. According to Muslim scholars, Sharīʿah allows exceptions on grounds of necessity (ḍarūrah) in order to overcome difficulties presented by special cases. One difficulty in Islamic securitisation was presented by the need to have a true sale – the only kind of sale recognised in Sharīʿah – of the underlying, profit or rent-generating assets to investors. In a true sale, all rights to an asset, including the right to sell the asset to a third party, are transferred by sellers to buyers. However, a true sale of the assets to investors would, in the case of sovereign issues, necessitate the sale of national assets to foreign interests. Politically, this might prove less than palatable. In addition, asset owners keen to generate liquidity on the basis of their assets have shown reluctance to sell them. This is why some Sharīʿah advisers have recognised a special type of sale: one that does not require sellers to transfer legal ownership of the assets to buyers. Such a sale falls short of a true sale. In a sale of this type, only some rights to an asset, such as the right to use an asset or obtain revenues from it, are transferred to buyers. Legal ownership of the asset remains with the sellers. As this type of sale is not recognised in Sharīʿah – or in most other legal systems for that matter – it had to be ‘imported’ from common law, or, more precisely, from trust law. In common law, such a sale proceeds over the idea of transferring ‘beneficial ownership’, hence falling short of the idea of a true sale. This ‘import’ of the common law notion of ownership into Sharīʿah, however, stretched the notion of ḍarūrah to its farthest reaches. It is clearly not a case of the classical notion of ḍarūrah but a convenient addition to the Sharīʿah notion of ownership. Sharīʿah scholars, clearly, have to look for better solutions. vii

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Another reason why asset owners, and the Islamic finance industry, have readily accepted the common law notion of beneficial ownership is that transfer of real ownership title involves detailed, often protracted legal proceedings that were deemed to be less than conducive to the fast-moving ṣukūk transactions. Additional incentives for arranging sales that fall short of true sales include the avoidance of sales taxes, capital gains taxes, and stamp duties, depending on the type of asset involved. These are avoided through opting for beneficial ownership. However, the application of a notion of sale imported from the common law of a type of sale not recognised in the Sharīʿah as a valid sale raised other issues. One of these is the question of how a departure from Sharīʿah in the process of structuring ṣukūk can reasonably be expected to produce a Sharīʿah-compliant security. How does one depart from Sharīʿah at key stages in the securitisation process and still produce ṣukūk that are Sharīʿah compliant? Can ṣukūk, whose essential characteristics have been altered by departing from key Sharīʿah principles (such as the notion of a true sale), remain Sharīʿah compliant? One of the consequences of borrowing from the common law has been a proliferation of a large number of ṣukūk – the so-called ‘asset-based’ ṣukūk – that bear a striking resemblance to conventional, unsecured bonds. It appears that, in at least some cases, investors in asset-based ṣukūk were under the impression that they were the legal and not just beneficial owners of the underlying securitised assets. One perceives a certain lack of transparency on the part of ṣukūk originators and the so-called ‘special purpose vehicle’ operators regarding the real status of the underlying assets, as well as other weaknesses, in the proposed ṣukūk structures. It is clear that at least some asset owners feared a collapse and even potential bankruptcy down the line as a result of the ṣukūk deals they entered into. Rating agencies for their part did not distinguish themselves with assiduous scrutiny, providing instead window dressing of sorts to their clients while ignoring deeper problems in their exuberance at the prospect of lucrative revenues. Apart from the issue of Sharīʿah compliance, beneficial ownership turned out to be also problematic for other reasons. Since it does not bestow legal ownership of underlying assets on investors, it does not allow them to recover their investments by selling the underlying assets at a time of distress, when originators may be facing bankruptcy and possibly default on their obligations. Investors are not in a position to sell the assets for the simple reason that they do not own them. From a legal perspective, they rank pari passu with unsecured creditors. This puts investors who are merely beneficial owners of the underlying assets in a vulnerable position. viii

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In hindsight, despite higher costs of issuance due to the need to pay taxes and stamp duties, it would have been better for all parties concerned to structure ṣukūk as asset-backed securities. Structuring ṣukūk as assetbacked could have been accomplished by ensuring that a true sale of the underlying assets by originators to investors took place. This would have solved several issues simultaneously. First, on account of a true sale of the underlying assets by originators to investors, the issue of whether the sale is compliant with Sharīʿah would not have arisen. Second, a true sale in the securitisation process would also have prevented the question as to whether beneficial ownership is acceptable under the Sharīʿah from arising. Third, a true sale would have provided stronger investor protection, as investors would have become legal owners of the assets. Finally, the principle of risk sharing would have been realised, as investors in asset-backed ṣukūk would have faced asset risk rather than originator risk. In light of the close resemblance of the vast majority of asset-based (bond-like) ṣukūk to unsecured bonds, one may wonder if the avowed ‘flexibility’ of Sharīʿah has not been taken a step too far. If common law can supplant Sharīʿah at one stage of the securitisation process, then why not at other stages further down the line? In light of the applications of the common law notions of sale and ownership in Islamic securitisation, one wonders whether the Islamic basis of ṣukūk has been eroded excessively to suit market convenience. Questions arise as to what can be done to restore the credibility of Islamic finance and avoid repetition of past failures. The chapters in this volume address these as well as other issues, and chart the way forward. It is to be hoped that Islamic finance will find its bearings and once again serve the purposes for which it was originally intended, namely genuine risk sharing, financial stability, and social justice. This may be accomplished by utilising risk-sharing partnership contracts, namely the muḍārabah and the mushārakah. In order to reflect genuine risk sharing, however, these contracts need to be structured without income and capital guarantees, as such guarantees effectively disable the principle of risk sharing in Islamic securitisation, and thereby transform bona fide ṣukūk into mere replicas of conventional bonds. Mohammad Hashim Kamali Abdul Karim Abdullah International Institute of Advanced Islamic Studies (IAIS) Malaysia December 2013

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Introduction Mohammad Hashim Kamali and Abdul Karim Abdullah This introduction consists of three parts: an overview of the ṣukūk industry; an introduction to the articles; and an introduction to the interviews.

Overview of the S ̣uku‾k Industry The ṣukūk industry is still in its early stages of development yet has already experienced turbulent times. The recent financial crisis brought in its wake the defaults of a number of ṣukūk for the first time. Other ṣukūk – including quasi-sovereign issues – nearly defaulted. No major issuing region has been spared. This new – and unexpected – development came as an unwelcome surprise to those who expected ṣukūk to perform better than conventional bonds, in particular the collateralised debt obligations (tranches of debt securities with varying risk/return profiles) that were at the heart of the crisis in conventional banking and finance. To make matters worse, the issuance of debt instruments also resulted in debts for issuers, in some cases of a substantial size. By all indications, this debt will take a long time to repay. Unlike risk sharing instruments, debtlike ṣukūk require originators to pay ‘fixed returns’ to ‘investors’ regardless of the profitability of the enterprises financed by the ṣukūk proceeds. This means that originators, unlike issuers of risk sharing securities, need to maintain payments of dividends to investors even when the underlying assets may be experiencing losses. The resemblance between the ṣukūk defaults and the defaults by issuers of conventional bonds has given the impression that Islamic ṣukūk may not – in substance – be much different from conventional bonds. As a result, the authenticity, if not also the credibility of Islamic finance, has been questioned. Has the development of the ṣukūk market taken a wrong turn at some point? If so, how did this come about? What can be done to set this important instrument of Islamic finance back on track? It is time to do a post mortem, ascertain what went wrong and propose how whatever ails Islamic finance can be remedied. This was the main reason why the International Institute of Advanced Islamic Studies (IAIS) Malaysia took the initiative to solicit the views of a number of leading figures in the industry, and which brought about the compilation of this volume of essays. 1

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The ṣukūk defaulted not only because the earnings of originators fell below expectations or turned into losses due to the contagion effect produced by the financial crisis. Other issuers were exposed to the fallout from the crisis, yet they did not default. A major reason why some ṣukūk defaulted – and others nearly defaulted – is that, for all intents and purposes, they were structured as debt instruments. Default, it cannot be overemphasised, is an event that takes place within the context of lending. Few informed observers doubt that even participatory ṣukūk, such as ṣukūk mushārakah, were structured as debt instruments. Lenders face the risk of default for the simple reason that – unlike funds raised on the basis of risk sharing – debt requires repayment. Default takes place when a debtor is unable to repay the principal amount of a loan, or to make a periodic payment on time. That the majority of ṣukūk have been structured as debt instruments is confirmed by the fact that ṣukūk are commonly referred to as ‘Islamic bonds’ or the ‘Islamic alternative to conventional bonds’. Even from the legal perspective, ṣukūk are treated as debt instruments. The ‘dividend’ yields on ṣukūk are routinely expressed as a percentage of the total amount ‘invested’ by ṣukūk holders – the same way as interest yields are indicated on bonds – rather than as a number of dollars per certificate out of the total profit earned by underlying assets. What is more, ṣukūk ‘dividends’ are routinely linked to interest rates such as LIBOR in a process known as benchmarking. The effect of this practice is that the earnings on benchmarked ṣukūk replicate interest earnings on conventional bonds. Benchmarking makes possible easy comparisons of dividend yields on ṣukūk with interest yields on conventional bonds, but raises the question as to in precisely what way do payments of such interest-like dividends differ from interest payments. Furthermore, in what way can a debt instrument be said to pay dividends, as normally dividends refer to payments of profits to holders of profit-and-loss-sharing securities such as ordinary shares. It appears that the process of structuring ṣukūk to replicate conventional bonds, while at least maintaining formal compliance with Sharīʿah, also replicated the major risks inherent in debt instruments. The greatest of these is the risk that the originator will fail to make a promised (legally obligatory) payment or payments, commonly known as the risk of default. Default is the inability of a borrower to pay back to a creditor a specified sum of money at a time agreed upon in advance, according to the terms of a given loan. It is a risk that faces all lenders. The ṣukūk defaults demonstrated that, while issuers of debt instruments may perform well under stable market conditions, a very different scenario could emerge at a time of crisis. Revenues may fall below levels necessary to service the fixed obligations that debt instruments invariably require 2

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their issuers to maintain regardless of prevailing economic conditions. Under such conditions, the possibility of default becomes real. As a result of a dramatic decline in revenues, due to adverse economic conditions, a number of issuers of debt-like ṣukūk were not able to maintain periodic payments or redeem the ṣukūk they issued. The point to be noted is that this would not, and could not, have happened had the ṣukūk been structured as profit-and-loss-sharing instruments, as such instruments do not require issuers to commit themselves to making legally-binding periodic dividend payments, or to refund to investors the principal sums invested on specified dates in future. In any case, the defaults made it abundantly clear that debt structures are risky not only for investors but also for originators. Profit-and-loss-sharing securities have significant advantages over debt instruments. Unlike debt structures, they do not come with income and capital guarantees. Profit-and-loss-sharing instruments require both issuers and investors to share the risks, rewards, as well as losses, if any. Profitand-loss-sharing instruments do not require originators to go into debt. The possibility of default, therefore, does not arise in the first place. Issuers of debt-like ṣukūk, however, are not in a position to capitalise on the advantages of profit-and-loss sharing, as all debt-like structures expose issuers to the risk of default. They do this primarily by incorporating income and capital guarantees into the ṣukūk structures, which effectively render the principle of profit-and-loss-sharing inoperative. In other words, structuring ṣukūk as debt instruments effectively transformed the ṣukūk, which are first and foremost profit-and-loss-sharing instruments, into replicas of conventional bonds. It should thus hardly come as a surprise that a number of debtlike ṣukūk shared the fate of their counterparts in conventional finance, conventional bonds, and either defaulted or nearly defaulted. A number of questions arise from the debacle. Is the conventionalisation of Islamic finance the right direction in which the development of ṣukūk should proceed? In what meaningful sense can replication of conventional bonds be viewed as financial innovation? Can the benefits of risk sharing be realised by replicating conventional instruments? Can debt structures be replicated without at the same time replicating the risks inherent in debt instruments, in particular the risk of default? Are income and capital guarantees, widely utilised in ṣukūk issuance, compliant with Sharīʿah? Is it in the interest of the originators to structure ṣukūk as instruments that burden them with debts and in addition expose them to the possibility of default? In the case of sovereign ṣukūk, is it in the public interest (maṣlaḥah) to incur debts that eventually have to be repaid using tax revenues? Is it fair to burden future generations with having to repay substantial portions of this debt? Is it wise, especially at a time when a number of sovereigns 3

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are teetering on the brink of default, to add to sovereign debt by additional borrowing? These are some of the questions that arise out of the ṣukūk defaults, and that the articles collected in this book, written by a number of well-informed scholars and industry practitioners, address and attempt to resolve. The articles identify and analyse issues and make practical proposals for reform. Problems appear to stem from the fact that ṣukūk origination, trading, and dispute settlement take place in different jurisdictions. Ṣukūk are commonly arranged and traded in places such as London. Yet securitised assets are normally located in Muslim lands. The problem of overlapping jurisdictions becomes acute in cases of disputes when the need for arbitration arises. If an obligor defaults, will the dispute be settled by reference to the common law or Sharīʿah? Significant differences exist between these two legal systems, rooted in different worldviews that, despite having much in common, are clearly not identical. The differences are real and no amount of financial engineering or innovation can paper over them. Some practices, for example the earning of interest, are permitted in one system but emphatically prohibited in another. It is difficult to see how convergence can take place on a key issue such as this without compromising in a fundamental way the basic identity of one system or the other. Another difference between the two systems is found in the notion of a sale. Common law recognises a sale that falls short of a ‘true sale’. In this type of sale the ‘buyer’ becomes entitled only to use the asset ‘purchased’, without, however, becoming its legal owner. Legal ownership remains with the seller. This means that the buyer cannot sell the asset he purchased. Yet a concept of a sale that falls short of being a true sale is conspicuously absent from Sharīʿah, where every sale has to be a true sale. Under Islamic law, buyers must be able to dispose of the purchased assets, including being able to sell the assets to third parties. Important implications for investor protection follow from the fact that the underlying assets are sold to investors by means of a sale that falls short of a true sale. Different types of sale result in different types of ownership. Where the sale of the asset falls short of a true sale, investors obtain merely ‘beneficial’ ownership of the underlying assets. This means that investors can use the asset, or obtain revenues generated by the asset, but they cannot sell the asset. They cannot sell the asset because they do not legally own it. Ṣukūk where investors have merely beneficial ownership of the underlying assets are known as asset-based. The great majority of ṣukūk issued are asset-based. Yet asset-based ṣukūk face numerous difficulties, as the chapters in this volume demonstrate. 4

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Where the sale of an asset is ‘true’, by contrast, investors become full legal owners of the asset. This means they can dispose of the asset in any way permitted by the law. Ṣukūk structured on the basis of true sales are known as asset-backed. After selling the assets by way of a true sale, originators no longer have any claims over the assets. This means that, in the case of a bankruptcy of the originator, the originator cannot claim any of the securitised assets from the investors for the purpose of selling them to third parties in order to pay off creditors. Different types of ownership provide different degrees of protection to investors. Full legal owners of the underlying assets (holders of assetbacked ṣukūk) are protected by the fact that, as legal owners of the assets, their profits come from the securitised assets rather than from the general revenues of the originator. This means that, in case the originator goes bankrupt, the dividend payments to investors continue uninterrupted, as the underlying assets are independent of the originator. In other words, investors in asset-backed ṣukūk face asset risk rather than originator risk. The securitised assets will have been sold by way of a true sale to a bankruptcy-remote special purpose vehicle (SPV) that acts as a trustee on behalf of the ṣukūk holders. The case is different with holders of asset-based ṣukūk. They enjoy little protection in case the originator defaults and is unable to maintain payments, because the dividends of the holders of asset-based ṣukūk come from the general revenues of the originators rather than from profits generated by securitised assets. Holders of asset-based ṣukūk thus face originator risk rather than asset risk. In case of bankruptcy of the originator, holders of asset-based ṣukūk have merely the status of unsecured creditors, with no prior claims to the securitised assets. Such investors are thus not in a position to recover their investments at a time of distress by selling the underlying assets because they do not legally own them. The protection such investors have, apart from insurance or guarantees provided by third parties where applicable, is the obligation by the originator to ‘repurchase’ the underlying assets in case he defaults on the payments. One problem with this ‘protection’, however, is that originators who have been unable to make a periodic payment (defaulted) are hardly in a position to have sufficient funds to make a much larger payment that would be required for repurchasing the underlying assets. Hence, protection in the form of the obligation to repurchase the underlying assets ‘upon default’ does not go very far. In the absence of a renegotiation of the agreement (restructuring), insurance or guarantees provided by third parties, investors in asset-based ṣukūk might thus face potentially catastrophic losses. 5

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Articles Faizal Ahmad Manjoo, in ‘The ‘Ping-pong’ of the Asset-backed/Assetbased Ṣukūk Debate and the Way Forward’, identifies two factors as the main causes of the problems besetting the ṣukūk industry: the absence of a true sale when underlying assets are sold to investors by originators; and the requirement to repurchase the securitised assets by originators from investors at par value when the ṣukūk mature. Sharīʿah, he points out, endorses neither practice. Problems arise in part from the fact that originators and investors have different goals. Originators want to raise money in the capital markets without, however, giving up (selling) any assets. Investors, on the other hand, wish to make profits without, however, putting their capital at risk. The objective of the originators was achieved by arranging a sale that fell short of a true sale. This enabled originators to retain legal ownership of the securitised assets even after ‘selling’ them to investors. The objective of the investors, on the other hand, was achieved by incorporating income and capital guarantees into the ṣukūk contracts. These enhancements produced what are known as asset-based ṣukūk. The problem with asset-based ṣukūk, however, is that income and capital guarantees run counter to the principle of profit-and-loss sharing. Moreover, due to the absence of a true sale, no transfer of legal ownership from originators to investors – as required by Sharīʿah – takes place when securitised assets are sold by originators to investors. Thus, if investors do not wish to be exposed to the credit risk of the originator – that is, if they do not wish to invest in ṣukūk that give them merely the status of unsecured creditors of the originator, it is better to take a risk on the assets rather than on originators. This can be achieved by investing in asset-backed rather than asset-based ṣukūk. In an assetbacked structure, the investor has, in case of a bankruptcy of the originator, recourse to the asset. Manjoo, accordingly, recommends asset-backed securitisation as the current asset-based structures fall short of meeting Sharīʿah requirements. Muhammad Al-Bashir Muhammad Al-Amine, in ‘Unresolved Sharīʿah Issues in Ṣukūk Structuring’, addresses the issues of sale, ownership and investor protection. These issues came under the spotlight after the defaults of some high-profile ṣukūk, which demonstrated the need to protect the rights of ṣukūk holders. Specifically, he argues, it is necessary to determine what rights investors have over the assets in the event of a default, and asks are these rights legally enforceable? At the heart of the problem is the question of whether or not there is a 6

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true sale of the securitised assets by originators to investors. This question is central to all other Sharīʿah issues. While recognised in common law, a sale that falls short of a true sale is not recognised as a valid sale in Sharīʿah. Under a Sharīʿah-compliant sale-and-purchase contract, the buyer has the right to keep the goods purchased or to resell them to a third party as and when he wishes. In other words, in order to maintain Sharīʿah compliance, there must be a transfer of legal ownership of the securitised assets from originators to investors (ṣukūk holders). Despite the urgency of these issues, the market appears slow in addressing them. As the asset-based structure normally results in debt creation, Al-Amine recommends asset-backed securitisation rather than maintaining the current practice of producing debt-based conventional bond-like structures. Mohammed Imad Ali, in ‘Ṣukūk: Perception, Innovation and Challenges’, observes that investors, rating agencies, and lead arrangers perceive ṣukūk as ‘Sharīʿah-compliant bonds’. Scholars, on the other hand, view ṣukūk in terms of whether they are asset-based or asset-backed. While some scholars are willing to endorse ṣukūk that are ‘akin to bonds’, others insist that ṣukūk need to enable genuine profit-and-loss sharing. Despite a diversity of views, many scholars agree that risks and rewards of the underlying ṣukūk assets need to be shared by the ṣukūk holders. The reason is that it is risk sharing that justifies the returns to investors on their investment. There has to be a clear ownership link between the ṣukūk holder and the underlying ṣukūk assets. Yet, instead of sharing the risks and rewards with the ṣukūk holders as required by the Sharīʿah, the current ṣukūk structures create a debt. The recent financial crisis showed, however, that no matter how innovative a debt structure is, it is still vulnerable to default because it is a debt structure. Accordingly, Ali recommends the utilisation of asset-backed structures. He concludes that merely structuring ṣukūk to replicate conventional bonds will not benefit the industry in the long run, either from a Sharīʿah or a commercial perspective. On the other hand, if the risks and rewards of the underlying ṣukūk assets are shared between the ṣukūk holders and the originators, then ṣukūk will have a bright future. Abdul Karim Abdullah, in ‘Ṣukūk and Bonds: A Comparison’, contrasts Islamic ṣukūk and conventional bonds. He notes that, apart from being free of ribā, ṣukūk structured as profit-and-loss-sharing instruments have other advantages over conventional bonds. Prominent among these is the fact that ṣukūk, as profit-and-loss-sharing instruments, do not require issuers to go into debt and therefore protect them from default, especially at times of stress. 7

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Sheila Ainon Yussof, in ‘Measuring Sharīʿah Compliance in Ṣukūk Ratings: A Survey of Existing Methodologies’, explores the possibility of a Sharīʿah-compliance rating methodology, where it is recommended that rating agencies factor in Sharīʿah credibility risks in their rating analysis frameworks. A survey of existing rating methodologies of ṣukūk by both international and domestic rating agencies indicates bias towards assessment of credit risks or creditworthiness of originator/issuer, and not Sharīʿah compliancy per se. This could be due to a lack of mandate or avoiding a conflict with Sharīʿah advisers whose role is to certify Sharīʿah compliance. It is recommended that the rating spectrum be multidimensional to include Sharīʿah determinants/parameters that measure the quality of underlying assets, integrity of scholars and their fatāwā and the robustness and effectiveness of Sharīʿah governance framework within rating agencies. This integrated approach will give full disclosures to investors on the quality of their investments and whether their rights are protected when a default occurs. The International Islamic Rating Agency (IIRA) has the potential to create an Islamic rating methodology for ṣukūk but more collaborations and acceptance are required from Islamic financial institutions to mandate this regional agency with the responsibility of developing an Islamic model. Sirajulhaq Hilal Yasini and Nermin Klopic, in their chapter on ‘Concession Rights as Underlying Assets for Ṣukūk’, explore the viability and permissibility of using intangible assets such as concession rights or concession contracts as underlying assets in the securitisation process. After surveying the relevant Sharīʿah literature, they conclude that the use of concession rights as underlying assets will be helpful to issuers who may otherwise lack sufficient tangible assets for the purpose of securitisation. They provide two case studies of successful securitisation using concession rights as underlying assets: the Saudi Electricity Company and the Saudi Basic Industries Corporation sukuk issues of 2007. Rafe Haneef, in ‘The Case for Receivables-based Sukūk: A Convergence between the Malaysian and Global SharīʿAh Standards on Bayʿ al-Dayn?’ attempts to bridge the current divide between Middle Eastern scholars and their Malaysian counterparts on the issue of the sale of ṣukūk in which some assets comprise receivables (debts). Currently, Middle Eastern scholars hold that, in order to qualify for secondary trading, at least 51% or 33% (as the case may be) of ṣukūk assets must be in the form of physical assets, in order to prevent ribā. On the basis of an analysis of relevant aḥādīth, he argues that wakālah ṣukūk consisting of mixed assets, physical as well as cash/receivables could, conceivably, be traded at less than the thresholds of 33% or 51% physical assets, as long as the price at which 8

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they are traded is equal to or greater than the value of the cash (and/or receivable) component of the portfolio of underlying assets. This would satisfy the requirement that debt could not be sold at less than par value. He suggests that it is preferable to rely on the principles of mudd al-ʿajwah of aḥādīth rather than on the maxim ‘ruling of the majority shall apply’.

Interviews This section features interviews with two prominent observers, Raja Teh Maimunah and Professor Abbas Mirakhor. The former interview is the more extensive of the two. In addition, there is a comment from Faiz Azmi. Raja Teh Maimunah, interviewed by Zarina Nalla, points out that Islamic finance differs from its conventional counterpart in that it funds the real economy. She disagrees that ṣukūk need to be asset-backed in order to comply with Sharīʿah and provide genuine protection to investors. Scholars, she feels, are unable to explain, from a practitioner’s point of view, how structuring ṣukūk as asset-backed would benefit the industry. She feels that a suitable legal framework can ensure investors’ protection. Once the issue of investor protection is settled, the difference between asset-backed ṣukūk and asset-based ṣukūk will become irrelevant. She feels that common law provides adequate protection to investors in asset-based ṣukūk, even if they do not legally own the underlying assets. Under trust law, she insists, investors have full rights over the assets. The originators are just the legal owners of the assets. Since the rights of the investors are not diluted at all, it is unnecessary for the investor to become a registered owner of the underlying assets. She insists that the recent ṣukūk defaults should not be regarded as a failure of the instrument but a myriad of things typical of any credit issue. She points out that structuring ṣukūk in the form of asset-backed securities would raise the costs of issuance. Issuers would have to pay sales taxes and stamp duties each time they were to sell the underlying assets – via a true sale – to investors. They would have to pay the same taxes and duties a second time when repurchasing the assets upon maturity. If the cost of issuance becomes too high for originators, they would be unlikely to opt for Islamic structures. Hence, insisting on a transfer of ownership of the assets from originators to investors acts as a deterrent to the growth of ṣukūk. Abbas Mirakhor, interviewed by Sheila Ainon Yussof, highlights the fact that, while ṣukūk need to be compliant with Sharīʿah, they are issued in places such as London, where they are governed by common law. While common law permits sales that fall short of true sales, Sharīʿah requires all 9

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sales, including the sales of underlying assets by originators to investors, to be true sales. In other words, investors need to become legal owners of the assets. The major lesson of the few ṣukūk defaults or near defaults has been the need to ensure the legal strength of the true sales in contracts. Muslim scholars have long criticised provisions of ṣukūk contracts that did not enable the complete transfer of property rights claims in cases of default. A legal transfer of ownership, as Dr Mirakhor emphasises, is a basic requirement of Sharīʿah-based finance. In economic terms it is understood as a transfer of all property rights claims resulting from the contract of albayʿ. This is the same as a true sale. Dr Mirakhor adds that, in so far as they provide guarantees to investors that their capital will be returned to them in full, repurchase undertakings are inconsistent with profit-and-loss sharing. Instead of debt-like instruments, he advises utilising profit-and-loss-sharing structures. He notes, however, that to encourage the growth of bona fide profit-and-loss-sharing ṣukūk, it will first be necessary to create a level playing field between debt and equity. Currently, bias in favour of the interest rate mechanism permeates the economy, macro-economic policies, commercial laws, administrative procedures, and even accounting rules. This has to change. On behalf of IAIS Malaysia, the editorial team records their profound appreciation and gratitude to each and every one of the contributors in both the articles and interviews. We believe that the insights, critique and reform proposals offered go a long way to address many of the yet unresolved hurdles facing ṣukūk, an undoubtedly burgeoning instrument of Islamic finance. The selected research input is richly endowed both in Sharīʿah analysis of issues as well as industry experience and expertise. That said, the IAIS editorial committee wishes to add that not all the views and suggestions held by the contributors represent IAIS’ own positions.

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THE ISLAMIC FOUNDATION United Kingdom www.islamic-foundation.com

Islamic Finance Issues in Sukuk and Proposals for Reform

Tan Sri Zarinah Anwar, former Chairperson, Securities Commission Malaysia

Islamic Studies | Islamic Finance | Economics

Kamali and Abdullah

Islamic Finance

Issues in Sukuk

and Proposals for Reform

isbn 978-0-86037-551-7 | US$24.95

Editors Mohammad Hashim Kamali and A.K. Abdullah www.iais.org.my