Shari’ah Issues in the Sukuk Structure

Shari’ah Issues in the Sukuk Structure

By: Camille Paldi

CEO of FAAIF

The Rulings of AAOIFI Resolution on Sukuk (February 2008)

• Sukuk, in order to be tradable, must be owned by the sukuk holders with all rights and obligations of ownership in the underlying, tangible assets; The AAOIFI ruled that the manager issuing sukuk must certify the transfer of ownership of such assets in its books and must not keep them as his own assets, stressing that there must be a real transfer of assets.

• Sukuk, in order to be tradable, must not represent receivables or debts at all. Exceptions are made for cases where (a portfolio of) the assets of a financial entity that are sold includes unintentionally some debts that are incidental to the tangible assets present therein. Thus, in all other cases the pool of assets cannot represent debts or receivables, not even when the debts represent a minority of the pool of assets of 49% or even less.

• It is not permissible to offer interest-free loans to the sukuk holders in case of shortfalls. However, it is permissible to establish a reserve account for the purpose of covering such shortfalls. The AAOIFI also permitted payments on account, so long as these payments are subject to final settlement at maturity date.


• Second, the fourth ruling of the AAOIFI Resolution clarified that purchase undertakings according to which interests in the partnerships, that is in the mudarabah, musharakah, or wakalah, are brought back at nominal value are not permissible.

• It is, however, permissible to offer a purchase undertaking according to which the originator can buy back the interests at their market value or at a price to be agreed upon at the moment of the sale.


• The AAOIFI Resolution clearly rules out several structural mechanisms that were developed in practice.

• Although an idealist approach towards the Shari’ah framework is adopted in the Resolution, practical considerations are also taken into account, and therefore several mechanisms are provided as alternatives such as the reserve account and payments on account in the equity-based structures.


• As a result, the idealist approach in the AAOIFI Resolution did not merely criticize contemporary practice by reference to the ideal structures from a Shari’ah perspective, but it also provided some real alternatives showing the way forward to the market.

Shariáh Issues in the Primary Issuance of Sale-Based Sukuk

• In Bai al inah, which means sale of cash, the structure requires the client to have an asset that can be sold and bought back.

• If the client (issuer) does not have the asset, they will try to source it on a temporary basis from either subsidiaries or parent companies.

• Most commonly, the parent/subsidiaries of the issuer will provide the asset to the issuer using a hibah contract (gift).


• The issuer will sell and buy back the asset.

• Thereafter, the issuer will return the asset to the original owner through another hibah transaction.

• Only the Shafií and Zahiri schools validated this instrument while the Hanbali, Hanafi, and Maliki schools prohibited it on the basis that it is a trick to allow borrowing money and paying riba.


• However, the global Islamic capital market utilizes tawarruq rather than bai al inah.

• Tawarruq involves two separate sale contracts, one spot and one deferred.

• However, unlike bai al inah that involves two parties, tawarruq involves three parties.

• When tawarruq is used in a commodity murabahah arrangement, it will be coupled with a murabahah transaction.


• The transaction will start with the investors buying the commodity on a spot basis and selling it to the client on a deferred basis with a mark up.

• The issuer then sells this commodity on a spot basis to a third party, usually a commodity broker.

• The transaction will start with the investors buying the commodity on a spot basis and selling it to the client on a deferred basis with a mark up.

• The issuer then sells this commodity on a spot basis to a third party, usually a commodity broker.

Shariáh Issues in the Secondary Market of Sale-Based Sukuk

• Under both bai al inah and tawarruq structures, sukuk holders own the underlying asset only at the onset of the issuance date.

• Upon the sale of the asset, the sukuk holders no longer own the asset.

• Instead, they own the debts due from the issuer. As both sukuk are debt in nature, they are categorized as sale of debt, bai al dayn.

• They cannot be traded in the secondary market in some jurisdictions in the Middle East etc.

• Only the Maliki and Shafií classical scholars have allowed the sale of debt to third parties, provided that it meets certain conditions.


• Due to the prohibition of riba, sale of debt to third parties at a discount is not permissible.

• Selling this in exchange for payment of money would require it to be on spot basis and for an equal amount.

• If discounting occurs, the buyer of the debt will obtain more money in the future compared to what he paid for the debt.

• On the contrary, the Shariáh Advisory Council of SC has approved the sale of debt even with discounting as long as it is a cash transaction.


• The SAC considers debt to be as good as an asset and, therefore, it can be freely traded.

• Therefore, in Malaysia, sukuk murabahah holders can trade this sukuk in the secondary market and it can be sold at any price.

• If the investors in sukuk murabahah were to sell it to other investors, it can only be done at par to avoid invoking Shariáh issues pertaining to bai al dayn.

Shari’ah Issues in Equity Based Sukuk

• The most fundamental Shariáh challenge that equity-based sukuk face is to structure them in a way that provides certainty of return and certainty of capital.

• As for certainty of capital, an unconditional purchase undertaking at par is used to achieve this effect.

• Unconditional means that, regardless of the performance of the venture, the obligor will have to buy back the assets or interest in the venture if the investors exercise the purchase undertaking.


• In addition, the triggers for these unconditional purchase undertakings always include default.

• In asset-backed sukuk, either there will be no purchase undertaking used or the purchase undertaking will be conditional.

• A conditional purchase undertaking means that it can be exercised only if the venture is performing.


• In 2007, Mufti Taqi Usmani raised concerns over both practices above (liquidity facility and purchase undertaking at par) in equity-based sukuk. Following this, in 2008, AAOIFI produced a formal pronouncement on sukuk reiterating its standards.

• Besides highlighting that a tradable sukuk must represent tangible assets or tangible assets with receivables appended to it, the pronouncement clearly highlighted the parameters that must be observed in applying the liquidity facility and purchase undertaking in equity-based sukuk (EBS comprising of musharakah, mudarabah, and wakalah).


• According to AAOIFI, the usage of liquidity facility and the purchase undertaking at par contradicts the nature of EBS.

• The liquidity facility is viewed as providing assurance to the return. AAOIFI does not allow the obligor to provide a liquidity facility.

• However, it allows the utilization of reserves from actual operation to manage fluctuations in income.


• As far as purchase undertaking is concerned, AAOIFI views this as providing assurance of capital.

• This is because the undertaking by the obligor (at the beginning) to repurchase the assets from sukuk holders for its nominal value would assure the principal/capital invested by the sukuk holders remains intact.

• For equity-based sukuk, AAOIFI only allows the purchase undertaking to be priced at the net value of assets, its market value, fair value, or price to be agreed in future.


• The pronouncement clearly states that for equity-based sukuk that use an ijarah portfolio as the underlying asset, it is allowed to have the purchase undertaking at remaining rental value.

• In addition, for sukuk ijarah, AAOIFI allows the purchase undertaking to be at nominal value.


• Unlike sale-based and lease-based instruments, equity-based instruments do not require the existence of assets.

• In other words, the investors do not have to buy assets from the obligor.

• The investors can just provide monetary capital.

• The purchase undertaking at par and the liquidity facility then makes equity-based sukuk very bond like.


• This is the rationale behind the AAOIFI pronouncement.

• That is why for equity-based sukuk that have an ijarah portfolio as the underlying asset or for sukuk ijarah (that requires assets to be existent) the parameter for the purchase undertaking is more lenient.


• There are jurisdictions and scholars that still allow the application of purchase undertaking at par in equity-based sukuk because they view the purchase undertaking as a mere promise and not a binding contract.

• Therefore, it is not construed generally as a provision of guarantee.


• After the AAOIFI pronouncement, the application of equity-based sukuk in the global space reduced substantially.

• They dropped from 73% in 2007 to 38% in 2008.

• The investors and arrangers in the global sukuk market prefer to use sukuk ijarah as they are less controversial, even with the use purchase undertaking at par and liquidity facility.


• The application of liquidity facility is much easier to manage even with the AAOIFI pronouncement.

• However, the issue of purchase undertaking at par has posed interesting challenges for the market players that wish to comply with AAOIFI.

THE END

Shari’ah Issues in the Sukuk Structure

Economy & Finance

Transcript of Shari’ah Issues in the Sukuk Structure