Modes of Issuing Sukuk

By: Camille Paldi

CEO of FAAIF

Securitization and Sukuk

• Sukuk are issued under several forms based on securitization.

• Securitization plays an important role in structuring of sukuk and drivers are liquidity, risk transfer, and capital needs.

• Securitization allows banks and also non-financial institutions to obtain liquidity from assets, which cannot be sold in financial liquid markets.

• It is a process of pooling financial assets for making a new asset-backed security, which is then divided into units.

Securitization and Sukuk

• Risk assessment is done by a reputed rated agency and then is sold to investors as sukuk.

• It is also termed as structured finance in the investment banking community.

• The returns from sukuk can be fixed or variable, which depends on the securitization process and underlying structure.

• It has to be ensured that Islamic securitization comply with the Shari’ah and be free from Riba (interest), Gharar (uncertainty), and Maysir (gambling).

Securitization and Sukuk

• Islamic securitization must involve the tangible underlying asset with the risk-reward sharing spirit and it places paramount importance on the real economy through undertaking real project activities.

Securitization and Sukuk

• Securitization is widely practiced by financial institutions, as it enables them to efficiently remove assets from their balance sheet based on the concept of asset monetization.

• The funds generated, corresponding increase in their equity capital.

• This is also practiced widely to raise cheaper capital for business expansion.

• This process also attracts tax savings in some jurisdictions.

• An ideal technique for Shari’ah compliant securitization.

Asset-Based Sukuk

• That evidences indebtedness that originates from contract of exchanges of murabahah, bai bithamin ajil or istisna’a, arising from back to back sale of the issuer’s assets. Such sukuk gives the holders the rights to the obligations attached to the indebtedness;

• Arising from ijarah contracts through sale and leaseback or lease of third-party held acquired assets with purchase option obligations (financial lease);

Asset-backed Sukuk

• Asset-backed sukuk refers to sukuk backed by income generating assets sold/transferred by an originator.

• The originator sells the assets to a special-purpose vehicle (SPV) that holds them and issues the sukuk.

• The repayment to sukuk holders is from the revenue generanted through underlying sukuk assets.

• Investment sukuk refers to sukuk where the SPV is not required for issuing the sukuk.

• Investment sukuk is issued directly by the originator of the venture ot the investors.

Securitization in Special Purpose Vehicle (SPV)

• An SPV is a legal entity created by the sukuk sponsor or originator, to fulfill a temporary objective of the sponsoring firm.

• SPVs have no purpose other than the transaction(s) for which they were created, and they can make no substantive decisions;

• The rules governing them are set down in advance and carefully circumscribe their activities.

• SPVs are used in structured finance transactions such as securitization.

• SPVs can be created through entities such as trusts, corporations, limited partnerships, and limited liability corporations.

Securitization in SPV

• SPV is an independent entity with no direct connection with the originator, and such an entity is known as orphan SPV rather than a subsidiary of the originator.

• The SPV will normally have a very minimum share capital and staff as it is a mere tool to facilitate the transfer and issuance of the sukuk. It is not supposed to conduct any real business activities.

• Their administrative functions are performed by a trustee who follows pre-specified rules with regard to the receipt and distribution of cash; there are no other decisions.

Securitization in SPV

• Assets held by the SPV are serviced via a servicing arrangement;

• They are structured so that, as a practiced matter, they cannot become bankrupt.

Securitization in SPV

• The originator sells the assets to the SPV and receives cash and removes the assets from its balance sheet.

• The SPV then issues sukuk to finance the purchase of the assets;

• These bonds can be traded in the marketplace and are referred to as securitized products.

• The underlying assets purchased by the SPV are then grouped into tranches and sold to meet the credit risk preferences of a wide range of investors.

Securitization in SPV

• Tranches are number of related sukuk offered as part of the same transaction.

• The SPV holds the assets on trust for the benefit of the holders of the sukuk, using the income from the assets to make periodic payments to the sukuk holders.

• Offshore SPVs are often used for purchasing assets for certain tax advantage, foreign exchange preference, and for speed factor in issuing sukuk.

• Offshore = Less tax.

Securitization and SPV

• Labuan, Cayman Islands, Bermuda, BVI, Luxembourg, Jersey, Singapore, and Hong Kong.

• The Labuan Financial Exchange had 11 sukuk listings totaling $8.6 Billion in 2013 including Nomura and SGI-Mitabu Sukuk.

Asset-Based Securitization: Debt Securitization

• The structuring of financial obligations into capital market securities adds value in terms of credibility and liquidity to the indebtedness (portfolio of Islamic financing receivables).

• Traditionally, securitization has been used as a mode of financing by converting the illiquid pool of assets into more liquid marketable securities, but contemporary structuring is also motivated by higher returns, diversification, hedging objectives apart from plain vanilla funding.

Asset-Based Securitization: Debt Securitization

• Asset-based sukuk under this structure represents cash flows that include profits on the basis of either being fixed or variable for maturities that can be fixed, revolving, either long term or short term.

• As a credit enhancer, the underlying asset in the initial contract of exchange transaction is taken as collateral for the securities.

Asset Basis Sukuk: Financial Ijarah

• Another instance of asset-based sukuk is under the sale and leaseback or lease of third party asset, with a purchase option obligation given to the lessee.

• The underlying asset in this transaction is the leased asset and in view of the structure being a finance lease, the ultimate ownership of the asset will be passed to the lessee through pre-agreed settlement consideration, upon the maturity of the lease.

Malaysian Global Sukuk

Under this transaction, the investors pool their capital by way of subscribing to the sukuk issued by the SPV.

The proceeds will be utilized to purchase the land parcels, under a true-sale transaction, from the Federal Land Commissioner.

The relationship between investors will be under a collective investment arrangement.

Malaysian Global Sukuk

• The SPV, upon having the beneficial title to the land parcels transferred to it, then enters into an ijarah contract with the Government of Malaysia.

• The SPV is the lessor and the Government is the lessee.

Malaysian Global Sukuk

• The SPV, having the beneficial title to the land parcels transferred to it, then enters into an ijarah contract with the Government of Malaysia. The SPV is the lessor and the Government is the lessee.

• Upon expiry of the ijarah contract, the SPV – as the lessor – will transfer ownership of the SPV and beneficial title to the land parcels to the Lessee. The pre-agreed Dissolution Amount will be equivalent to the face value of the sukuk.

Asset-Backed Sukuk

• Asset-backed sukuk is a securities formation process, in the form of capital market instruments i.e. sukuk, of equal value that represents an undivided interest in the ownership of an underlying Shari’ah compliant cash flow generating asset.

• A SPV held and managed by trustees, legally will be under the control of the holders of the securities or sukuk will acquire the asset under a true-sale arrangement.

• The function of the SPV is to hold the assets on behalf of the investors or Sukuk-holders, by way of a trust deed created over the assets.

Asset-Backed Sukuk

• The relationship between the sukuk investors is in the form of a collective investment contract of musharakah or mudharabah.

• The originator, i.e. the entity seeking to transfer or dispose of its asset to the SPV must not hold any equity stake directly or indirectly in the SPV i.e. bankruptcy-remote.

• This structure differentiates the concept from asset-based securitization due to the true-sale of the asset by the originator to the SPV and the insulation of the investors from insolvency risks arising from the originator.

Asset-Backed Sukuk

• The true sale and the restriction of the originator from being an owner or shareholder of the SPV results in the asset transfer being a bankruptcy remote transfer.

• What it means is that the transfer of the assets by the originator to the SPV is such that even if the originator were to go bankrupt, or get into other financial difficulties, the rights of the investors on the assets held by the SPV is not affected.

• In other words, the investors would continue to have a paramount interest in the assets irrespective of the difficulties, distress or bankruptcy of the originator.

Asset-Backed Sukuk

• This concept of securitization may be applied to any asset that has a reasonably ascertainable value, or that generates a reasonably predictable future stream of revenue.

• It can therefore be applicable as well to receivables or debt for as long as the transfer is a genuine transfer, and not as a mere paper transaction.

• In other words, the transfer of receivables has to be a true sale of the receivables, and not merely a financing against the security of the receivables.

Asset-Backed Sukuk

• Asset-backed securitization thus is an asset-based transaction in which the funding for the acquisition of the asset is derived from investments evidenced by the sukuk issued by the SPV.

• The asset is purchased from the originator under a true sale arrangement.

• The true sale isolates the asset completely from the originator and at the same time all rights and obligations in the said asset are transferred to the SPV.

Asset-Backed Sukuk

• However, all obligations on the sukuk i.e. the income stream attached to it shall rest upon the originator who now plays the role as servicer i.e. the entity that is undertaking to administer the assets or perform such other services on behalf of the SPV as may be required in the said securitization transaction.

Asset-Based v Asset-Backed Sukuk

Asset-Based Asset-Backed

Feature Shari’ah compliant assets or business venture to facilitate issuance of sukuk.

Shariah compliant assets or business venture form primary sources of income or return to investors.

Accounting Treatment On-balance sheet (for originator/obligator).

Off-balance sheet (for originator/obligator- true sale criterion).

Funding Cost Market driven – mainly depending on originator/issuer credit rating.

Mainly based on the strength of the asset cash flow.

Rating Corporate rating of issuer/obligator.

Strength of the asset cash flow.

Investment Sukuk

• Unlike an asset-backed securitization where the sukuk is issued by the SPV, Investment sukuk is issued directly by the originator of the venture to the investors.

• In the case of mudharabah, the originator will be the managing partner of the venture without contributing any capital, but only his skills and expertise.

• In the case of musharakah, the originator can be an equity partner to the venture that will be formed by contributing capital in the form of cash or kind, to it.

Investment Sukuk

• In Malaysia, the issuance of Investment Sukuk is guided by the Guidelines on the Offering of Islamic securities.

• The sukuk issued by the originator, to the investors – normally in the form of musharakah sukuk or mudharabah sukuk – represents evidence of their capital contributions to the investment activity, and their rights to the cash flow from this activity.

• The sukuk structure normally involves the provision of additional protection to investors against late payment of obligations, potential risks on loss under events of default or occurrence of termination events by the sukuk issuer, in the form of credit and/or liquidity-enhancement schemes, such as stand-by liquidity facilities or purchase undertakings under the principle of wa’ad (promise).

Investment Sukuk Structures

• Musharakah or Mudharabah between investors.

• Musharakah between investors and the originator or issuer for undertaking special projects.

• Musharakah between investors and the issuer for participation in the issuer’s business operations.

Musharakah or Mudharabah Between Investors

• Under the concept of musharakah or mudharabah, financiers form a collective investment agreement among themselves for purposes of investing in a venture.

• This is normally termed as Isthimar bil-wakalah or Investment through an agent under the AAOIFI standard.

• An example is the Nucleus Avenue (M) Berhad’s (“Nucleus”) Sukuk Musharakah.

Nucleus Sukuk

• Nucleus’s sukuk programme involves a combination of a RM600 million commercial papers/medium-term notes programme and a RM5.6 billion medium-term notes programme (also collectively known as the senior sukuk) and a RM1.7 billion cumulative non-convertible Islamic sukuk (junior sukuk).

• Both the senior and junior sukuk had also been issued under the musharakah principle.

Nucleus Sukuk

• The investors in this case form a musharakah among themselves, to invest in the sukuk issued by Nucleus, a musharakah venture company, i.e. a vehicle created to own certain income-generating trust assets.

Nucleus Sukuk

• Nucleus’s issuance of the musharakah sukuk and investments by the investors are simultaneously conducted.

• The latter are classified as Senior and Junior investors, and are entitled to Senior Sukuk and Junior Sukuk, respectively.

• The sukuk in this case are trust certificates that represent the sukuk holders proportionate undivided ownership in the trust assets.

• Nucleus will issue unilateral wa’ad as purchase undertaking for relevant portions of the trust assets, upon maturity of the sukuk or upon occurrence of dissolution events, at pre-agreed redemption amounts.

Nucleus Sukuk

• Under the terms of the investments, the income generated by the trust assets must be distributed to the sukuk holders, based on pre-agreed ratios.

• Under the above sukuk issuance, the issue of the Senior and Junior Sukuk will be simultaneously conducted by Nucleus.

Musharakah between investors and originator or issuer to undertake special project

• Assar Chemicals Sdn Bhd’s (Assar) RM 150 million Serial Sukuk Musharakah (Assar Sukuk), issued in 2005.

• Under the Assar sukuk transaction, the investors and the originator established a musharakah venture under style of Assar Senari Sdn Bhd (ASSB), with respective equity contributions of 87% and 13%.

• The business objectives of ASSB is to develop an independent oil terminal (IOT) for the storage and delivery of petroleum products within the Kuching area in Sarawak, Malaysia.

Assar Sukuk

• Upon completion of said terminal, the musharakah will lease the facility to Assar for a period of up to 9 years.

• The terminal will then be used to cater to the storage and delivery requirements of 2 major petroleum companies operating out of Kuching.

Assar Sukuk

• Assar issues musharakah sukuk, capital injections into ASSB;

• Trustee appointed to manage the IOT project;

• Ijarah agreement executed between Assar and the Trustee, acting on behalf of ASSB; to commence upon commissioning of the IOT;

• Completed IOT handed over to ASSB, as the owner.

Assar Sukuk

• In a musharakah between investors and issuers, capital contributions from investors will be in the form of cash; that from the issuer will be either cash or kind.

Musharakah Between Investors and Issuer to Participate in the Issuer’s Business

• This enables investors to participate in the business of the issuer, but way of a preferential participation process.

• A close comparison to such musharakah is the issuance of preference shares by companies.

• An example of musharakah between investors and issuer for participation in the issuer’s business is AmIslamic Bank Berhad’s (“Am Islamic”) sukuk.

• Subordinated sukuk musharakah for an issuance of up to RM400.0 million.

Musharakah Between Investors and Issuer to Participate in the Issuer’s Business

• The issuer issues subordinated musharakah sukuk to investors in consideration of their capital contributions to the musharakah venture.

• The musharakah venture involves the participation of investors or sukuk holders in the general Shari’ah compliant financial services business of the issuer.

• AmIslamic, the issuer, is the musharakah manager for this musharakah venture.

AmIslamic Sukuk

• The creation of the trust in favor of the sukuk holders will, inter aliea, evince the following:

• Creation of the trust relationship between the issuer and the sukuk holders, under which the trust will hold the trust asset (i.e. the sukuk account and permitted investments from funds in the said account) for the benefit of the sukuk holders.

• The issuer’s obligations under the musharakah venture.

• Sukuk holders share the income from the musharakah venture, based on their respective proportions of the face amount of the sukuk; losses will be based on and limited to each musharakah partner’s respective capital contribution to the musharakah capital (equivalent to the amount of issued sukuk).

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