SHARIAH PRINCIPLES IN ISLAMIC SECURITIES : BBA, MURABAHAH, ISTISNA & SALAM

CONTENTSBond : an overviewFeature of Bond Islamic Securities (IS) Additional featuresStructuring Islamic SecuritiesIS Based on Bay Bi Thaman AjilIS Based on MurabahahShariah Observations on BAIDS/MUNIFSIS based on IstisnaIS Based on Salam

LEGAL FRAMEWORK FOR ICM &IS IN MALAYSIAThe main regulator for ICM & IS is the SC, similar with the conventional capital & securities marketThe legislation governing ICM & IS is generally similar with the overall market (ICM & IS part and parcel of overall capital market)However, there are some special provisions for the Islamic instruments to ensure their Shariah compliance*JJ FUU UKM

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LAW AND REGULATIONSKEY LEGISLATIONSCapital Market and Services Act 2007Securities Commission Act 1993 (SCA)Securities Industry (Central Depository) Act 1991 (SICDA)Companies Act 1965 (CA)OTHER RULES AND GUIDELINESRegulations;Ministerial OrdersOrders and directives given by the Securities Commission;Guidelines*JJ FUU UKM

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EXAMPLES OF SOME OF THE GUIDELINESGuidelines on the Offering of Private Debt Securities (PDA Guidelines) 200 (including IPDS until 2004)Guidelines on the Offering of Asset-Backed Debt Securities (including IABS)Guidelines on the Minimum Contents Requirements for Trust DeedsGuidelines on Contents of Prospectus for DebenturesGuidelines on the Offering of Islamic Securities 2004 (the guidelines take way IS from the PDS Guidelines after 2004)*JJ FUU UKM

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IMPLEMENTATION OF SHARIAH REGULATIONThrough the supervision of the SCs Shariah Advisory Council (SAC)The SAC basically:Advice on operation and developmentAdvice on compliance criteria and guidelineReview proposals and inquiries and give legal opinionsPromote harmonisation and convergence of Shariah principlesProvide general guidance on matters related to Islamic investment and transactionsThrough independent Shariah advisory for Islamic securities & unit trusts*JJ FUU UKM

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REGULATION OF IS CENTRES ON THE SHARIAH ADVISER & PRINCIPLES USEDMust appoint an independent Shariah advisorShariah adviser or Shariah consultant must be approved and registered by SCEnsure IS is structured along any SAC approved Shariah principlesAny new principles not listed in the Guidelines must consult SCs SACEnsure harmonisation of Shariah principles and practicesJJ FUU UKM *

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WHAT IS SUKUK ?JJ FUU UKM *

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SUKUKSukuk (plural of Sakk) certificate/securitiesAAOIFI Shariah Standard on Sukuk: Certificates of equal value representing, after closing of subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a special investment activityGuidelines on IS 2004 Sukuk:A document or certificate which represents the value of an asset

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LEGAL FORM Legal form of a traditional sukuk requires:An instrument or security which represents rights in the underlying assets (and its cash flow) primary levelCan be traded secondary levelJJ FUU UKM *

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SHARIAH COMPLIANCETo be Islamic, the structuring of the securities and sukuk must ensure thatContract creating the indebtedness / financial obligation at the primary level is Shariah compliantMode of trading of the bond/ securities / sukuk at the secondary level is Shariah complianceRedemption of sukuk upon maturity is Shariah compliantJJ FUU UKM *

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ISLAMIC SECURITIES (SUKUK) ADDITIONAL FEATURESIndebtedness or financial obligation must be Islamic in origin i.e., contracts that lead to obligation must be Shariah compliant, e.g.Bay Bi Thaman AjilMurabahahBay al-InahBay al-SalamIjarahIjarah Thumma al-Bay

IstisnaQard al-HasanMudarabah/MusharakahMuqaradah

Contd...Supplementary principles include :Bay DaynBay Muzayadah ( sale by tendering)Daman/Kafalah (security)Hak Tamalluk (required ownership)Hibah (gift)Hiwalah (tranfer of debt/obligation from one party to other)Ibra (to waive total/parcel (rebate))Ittifaq Dhimni (implied understanding)Sanadat (certificate of paper securities+ equities)SukukUjrah/Ajr (Fee)Wakalah (agency)

Contd...The process of securitization and trading of the securities at the secondary market must be lawful bay al-dayn (sale of debt)The purpose of issuance must be lawful

TYPES OF ISLAMIC SECURITIESISLAMIC DEBT SECURITIESBBA papers/debt securitiesMurabahah papers/debt securitiesIstisna papers/debt securitiesNON-DEBT (EQUITY-BASED) SECURITIESSukuk al-IjarahSukuk al-MusharakahSukuk al-MudarabahJJ FUU UKM *

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BOND : AN OVERVIEWIt is an evidence of debt issued by the issuer/borrower to investors/lendersIt is defined as an IOU with promise to pay a financial obligation at the end of a specific periodIt comes under the definition of debenture as per Securities Commission (Amendment) Act 2000Debenture in this context includesDebenture stock i.e., loan stocks BondsNotesAny other evidence of borrowed money (does not include instruments creating indebtedness for borrowed moneys to defray the considerations incurred in the ordinary course of business and checks, bankers draft or any other bill of exchange

Conclusion : Bond is a debt instrument with fixed income i.e., the obligation to pay the debt is being evidenced in securities or certificates issued by the borrower/issuer

FEATURES OF BONDIndebtedness arising out of loan or any other financingSecuritization a process of transforming an illiquid asset into a tradable security that gives the illiquid asset the liquidity feature by the deployment or creation of some market mechanism which allows:The borrowers/issuers to have direct access to the capital market; and lenders/investors are able to liquidate their positions or to opt for better investment opportunities. Creation of secondary market selling and buying

BONDS VIS A-VIS SUKUKBond evidence indebtedness onlySukuk evidence any financial obligation either debt or otherwiseThus, sukuk are wider than bonds

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CONVENTIONAL BONDS VIS-A-VIS SUKUKConventional Bonds :Primary level loan contract to create indebtednessReturn to Investors is the extra amount charged on the loan amount interest chargesThe loan indebtedness is securitised with coupon / zero couponSecondary level trading of the bonds amount to trading of debts, normally with discountingIslamic Sukuk :Primary level very rarely use loan contract because no value-added return from debt leveraging due to prohibition of riba in loan transactionsPrimary level use a variety of contract to create financial obligations between Issuer & Investors, e.g, : sale, lease, equity partnership, joint venture partnershipReturn to Investors comes from the in-built profit elements in the sale, lease or partnership contractsThe financial rights under the contracts are securitizableSecondary level tradability of the sukuk depends on the nature of the financial rights underlying the Islamic securities

STRUCTURING ISLAMIC SECURITIESIslamic Securities Based on Bay Bi Thaman Ajil (BAIDS)Islamic Securities Based on Murabahah (MUNIF)

STRUCTURING ISLAMIC SECURITIESIslamic indebtedness/obligation must be created first between the issuer and the investorsIslamic indebtedness must originate from one of the above mentioned contracts (as listed in SC Guidelines on IS)The names or type of Islamic securities are currently determined by the contract into which both the issuer and investor entered at the first placeCurrently, there are many different structures/types of IS e.g., Qard Hasan, Bay Bi Thamanan Ajil, Murabahah, Istisna and Ijarah

ISLAMIC SECURITIES (SALE-BASED)

BAIDSMINIFs SUKUK SALAM ISTISNASUKUKBay al-InahBay al-InahIstisna Mudarabah& & & &Bay al-DaynBay al-Dayn Bay al-Dayn Bay al-Salam

ISLAMIC SECURITIES BASED ON BAY BI THAMAN AJIL (BAIDS)Arranger and Issuer shall indentify certain asset for the purpose of buying and selling under the principle of Bay Bi Thaman Ajil (BBA)The Primary Subscriber on a bought deal basis, purchase the asset from the Issuer at the Purchase Price by cash saleThe same asset will then be resold to the Issuer by the Primary Subscriber at the Selling Price (the Purchase Price plus Margin of Profit) by deferred payment sale (BBA)By now, the Issuer owes the Subscriber worth of the Selling Price

Contd...The debt/financial obligation arising out of the above deferred payment sale (BBA) is securitized by the issuance of IS in the form of Primary and Secondary Certificates (BAIDS)The total face value of the Certificates shall be equivalent to the total Selling PriceNormally the Primary Certificates represent the Purchase PriceThe Secondary Certificates which represent the margin of profit are normally structured to mature periodically (semi-annually or annually as the case may be)

Contd...These BAIDS will be traded on the secondary market based on the concept of bay al-dayn (sale of debt)Examples of BAIDS are KLIA Bond, Midciti Resources, Hualon, Penang Bridge, TNB, KFC, SPLASH, etc.Popular before 2005

BASIC STRUCTURE FOR BAIDS (MALAYSIAN PRACTICE)

Resale of the Assets at the Selling Price (deferred payment)

2.

1.

IssuerIssuersAssetsPrimary SubscriberIssuerIdentified AssetsPurchase of Assets by the Primary Subscriber at Purchase PriceBBACreation of the Debt

BASIC STRUCTURE FOR BAIDS (MALAYSIAN PRACTICE)

Primary Subscriber pays the Purchase Price

1.Trading

2. The issuer issues the IDS/Bond evidencing the debt (sale price) arising from the second leg of the sale of assets (which is a BBA)IssuerPrimarySubscriberSecondaryMarketThe Securitization processBAIDS

ISLAMIC SECURITIES BASED ON MURABAHAHEssentially, from the Shariah perspective, there is no major difference between IS based on BBA or Murabahah except that the underlying contract between the issuer and investor shall be Murabahah instead of BBAHowever, the industry (and regulators) have viewed IDS based on Murabahah differently from BAIDS, from structuring point of view BAIDs are normally for long term financing needs, and Murabahah for short/medium term financing needsThe issuance of Murabahah bonds is better known as Murabahah Notes Issuance Facility (MUNIF) for both underwritten and non-underwritten notes

Contd...The mechanism of MUNIF The investors/financiers will start tendering to purchase the asset of the issuer The successful tenders/financiers will purchase the identified asset by cash saleThe financiers will subsequently resell the same asset to the issuer by deferred payment sale, with mark up, known as Murabahah

The debt arising out of this marked-up (Murabahah) deferred payment sale will be securitized by the issuance of promissory notes in the form of MUNIFThese MUNIFS will be traded on the secondary market under the principle of Bay al-Dayn. Examples of MUNIF Islamic Commercial Papers are MISC, PKNS, Puncak Niaga, MOCCIS, STRATAVEST, MIDVALLEY, etc

MURABAHAH NOTES ISSUANCE FACILITY

4. Debt arising from the sale transaction is securitised by issuance of Murabahah Notes

Disbursement of Purchase Price

1. Identify 3. Subsequently, Issuer assets purchase back the asset atSelling Price

Sell assets on tendered basis

2. Issuer &ArrangerPrimary SubscribeTPMs/UnderwritersAsset

MURABAHAH COMMERCIAL PAPERS

2. Tender Panel Members pays Asset Purchase Price in cash proceeds to ISSUER

3. Tender Panel members sells back Assets to Issuer at Asset Sales Price (with mark-up)

1. Tender Panel Members Purchase Assets of up to RM xxxMillion from ISSUER ISSUER5. Facility AgentTender Panel Members/Investor4. ISSUER issues MCPs of 14 days to 12 month tenure, evidencing obligations to pay6. Trustee

STEPSSteps 1 and 2 : The underlying Asset is purchased by the successful Tender Panel Members at the Purchase Price and cash payment shall be made to ISSUER for the Asset Purchase PriceStep 3 and 4 : Immediately thereafter, the underlying Asset is resold to ISSUER at the Asset Sale value of the MCPs to be issued. ISSUER makes payment towards the Asset Sale Price over a deferred period as evidenced by issue of the MCPs with maturity ranging from 14 days to 12 months (short-term in nature)Step 5 : The tender process and the issuance of the MCPs will be through BNMs FAST and facilitated by the Facility AgentStep 6: Trustee shall act in trust for the benefit of the MCP holders under the terms of the Trust Deed and of the MCPs

SHARIAH OBSERVATIONS ON BAID/MUNIFSAre they really based on Bay Bi Thaman Ajil or Murabahah?Prima facie, they are based on Bay al-Inah (sell and buy back)Difference between BAIDS/MUNIFS is technical and industry-driven, rather than of Shariah requirement

SUKUK MURABAHAH: MURABAHAH WITH INVESTMENT CERTIFICATES

Fixed Rate InstrumentUSD 200 million1.A special Purpose Company (as 4. SPC issues investmentInvestment Agent) buys, on a spot Certificates to the PrimaryBasis, USD 200 million worth of LME Subscribers for USD 200m Metal warrants (commodity) from Broker A 2. SPC sells the commodity to the corporate at USD 200m plus profit margin payable basis (6 monthly Trading ? payments of profit and bullet payment USD 200 million of USD 200 million at maturity)

USD 200 million

3. Corporate sells on a spot basis the Commodity to Broker B for USD 200 million

Investment CertificateThe Certificates can be rated and listed PrimarySubscribersSecondary MarketSPC(Investment Agent)CORPORATELME BrokerALME BrokerB

STRUCTURING ISLAMIC SECURITIESIslamic Securities Based on IstisnaIslamic Securities Based on Salam

ISLAMIC SECURITIES BASED ON ISTISNAThe Istisna bond is structured to finance projects which will be completed/constructed in the future e.g power plant, highways, etcThere have been a few experience of Istisna bonds in Malaysia, e.g:- Prai Power (2002)- SKS/ Tanjung Bin Power (2003)- Sarawak International Medical Centre by SSHMC (2004)Each of the completed Istisna bonds issue has its own unique structure

ISTISNA BOND : 1st MODEL

2. Issuer sells asset to the SPV

3. Issuer purchases the same 1. Istisna asset from financiers at the Contract marked-up price

Issues IstisnaNotes/bondsProceeds from the IS issueIssuerProject CompanySPVContractor

OBSERVATIONSPersonal observation : This structure is more inclined towards BBA or Murabahah or Inah bonds instead of Istisna because the obligation or indebtedness of the issuer did not arise from manufacturing contract but from deferred payment sale.Issue on asset used in the sale & purchase transaction right under concluded contract?

ISTISNA BOND : 2ND MODELIstisna bonds based on parallel istisnaThe issuer, being awarded the project by awarding party, will enter into istisna contract with the Financiers i.e. The Financiers are to deliver the completed project to issuer and the issuer is supposed to pay the Istisna Price to the Financiers (inclusive of profit margin), to be paid deferred at an agreed maturity dateThe issuer, being indebted to Financiers, will issue Istisna bond to the Financiers

ISTISNA BOND : 2ND MODEL1st Istisna contract (Construction Cost + Profit Margin)

Issues Istisna bonds

Create2nd Istisna SPV contract(Construction Cost)

IssuerFinancierProject Company(SPV)

Contd...The issuer will create an SPV for Project management purposesThe Financiers will then enter into (second) istisna contract with the SPV where the payment of the purchase price (equivalent to construction cost) is paid by the Financiers based on contractually agreed terms, e.g., by progressive payment, one lump sum, etc.

ISTISNA SUKUK 3RD MODEL

4.3.1.2.

. The RM 5.6b SKS Power Istisna MTN was structured based on this structure

STEP 1: Issuer and Financier will execute an Istisna Purchase Agreement, under which Issuer will agree to construct and deliver & sell to the Financier a specific asset (The Asset)STEP 2: The Istisna Purchase Price will be RMXXX Million and will be disbursed in one lump sumSTEP 3: The Financier and Issuer will execute an Istisna Sale Agreement, under which the Financier will agree to construct and deliver to Issuer the asset. Delivery to Issuer will take place upon the Financier taking delivery of the Asset under the Istisna Purchase Agreement . STEP 4: The Istisna Sale Price will be equivalent to the aggregate of the Istisna Purchase Price and Profit thereto. The Sale Price will be payable according to an agreed payment scheduleSTEP 5: The Issuer issues the Istisna Bond to evidence the future payment of the Istisna Sale PriceFINANCIER(On Behalf of Investors)ISSUER

SHARIAH ISSUESIn both the 2nd & 3rd models of Istisna, the istisna bonds (sukuk) represent the sale price under the istisna sale agreement (securitisation of the obligation to pay the istisna sale (price)The trading of the Istisna bond (sukuk) is the trading of istisna debt/sale price (bay al-dayn), which under classical Islamic law is not yet established (ghayr mustaqir) until the istisna asset is completed and delivered to the satisfaction of the buyerThe rule of sale of debt requires the debt to be established (mustaqir) for the purpose of secondary trading to avoid gharar

Is the istisna debt an established debt?SC indicated that contractual guarantee of payment of istisna sale price by the issuer is sufficient to establish the debt against the issuer in favour of the financier/subscribers of the istisna bonds/sukuk, despite the nature of istisna contract that originally depends on successful construction of the istisna asset in order to conform the istisna sale price.

BAY AL-SALAM SUKUK(3-9 MONTHS)

BMA the Mudarib - The Mudarib will collect - 100% cash payment sport the subscription money - Future delivery of crude oil

- Proceeds of the sale price - The Mudarib will get a will be collectedbank guarantee or security for the promise to purchaseIncorporate a Special Purpose MudarabahTo issue and offer Participation Sukuk to the MarketThe Mudarabah will purchase crude oil on Bay al-Salam basisAt maturity after selling the crude oil and receiving the proceeds, the Mudarabah will be liquidated (redeemed) or renewedAt delivery of the crude oil the Mudarib will sell the purchase crude oil @ the agreed price to the refineryThe Mudarib will get from Bahrain refinery a promise to purchase the delivered crude oil in the future @ an agreed price

THANK YOU/SYUKRAN