Sukuk
Majid Dawood
Yasaar Limited (Dubai)
CEO
Sukuks are an extraordinary development in the arena of Islamic finance enabling the raising of finance in the international capital markets and have been utilized by sovereigns, corporate entities and financial institutions both Muslim and non-Muslim, by means of Shariah compliant structures that are akin to securitization. The sukuk era was first launched by Malaysia in 2002 and now total more than US$60 billion and the growth rate since inception has been incredible. The market is maturing but has had some recent setbacks based on issues raised by some Islamic economists and Shariah Scholars. What are Sukuks? Sukuks are generally referred to as the equivalent of bonds in the conventional finance sense, though they are structured to be compliant with the principles of Shariah. Sukuks represent the ownership or usufruct of an asset as opposed to the conventional bond which is primarily an interest based debt security. As trading in debt is not permissible under Shariah, where the sukuk certificate represents a debt to the holder there can be no secondary market in these and may only be exchanged at par value. The benefits of a sukuk are that the tradable ones provide for medium to long term fixed or variable rates of return and in many instances are rated by international rating agencies to enable investors to determine the risk: reward parameters of particular issues. They also provide income streams during the term of investment with ease of settlement and possible appreciation. Types of Sukuks Principally there are three kinds of sukuks being utilized currently, but there are many variations and permutations that can be created from these. There are also four other categories of sukuks that are employed but not as broadly as the three main ones. The three main forms of sukuk structures used are: Sukuk al Mudaraba, Sukuk al Musharika and Sukuk al Ijara. The first two are mainly debt based and the third one is based on leased assets revenue streams, then there are Sukuk al Murabaha, Sukuk as Salam and Sukuk al Istisna and Hybrids combing the features of some of the others. The Sukuk structures used in any particular instance are primarily based on the purpose envisaged, so it depends on whether the purpose is project related, asset related or balance sheet related. What is meant by this is that in the case of Project basis the financing is raised for a specific project whereby, for example land acquired and a specific project developed on it and then can be restructured as a sale and lease back to provide the certificate holders a revenue stream from the usufruct. In the case of Asset basis the financing is used to acquire assets whose beneficial rights are passed to the Certificate holders via a SPV (Special Purpose Vehicle) for a fixed term and the returns can be either fixed or floating and benchmarked to Libor or some other such acceptable benchmark. Although the benchmarking is to a conventional benchmark, there is no interest earned on the Sukuk and the benchmark is strictly for benchmarking purposes. As the Islamic finance industry is young and a fraction of the international global finance market, there is not in existence a critical mass to result in an Islamic benchmark to relate to. When the industry reaches a substantial level then it is expected that further development will take place on multiple fronts. Sukuk al Mudaraba provides an ownership in equal value units in the Mudaraba equity and registered pro rata in the names of the holders for the returns emanated from those equity holdings. Mainly these are used for public participation in major investment projects. The procedure applied is as follows; the Mudarib agrees contractually with the owner of the assets to construct/commission a project; a SPV is created to issue a sukuk to raise funds for the project; the Mudarib as manager/agent collects the regular or periodic profit proceeds and final capital from the operations of the project for further distribution to the investors. On completion the Mudarib hands the finished project to the owner. 
Sukuk al Musharika is similar in many ways to the Sukuk al Mudaraba except for the incorporation of the set up of the relationship between the issuer and the sukuk holder, where the sukuk issuer forms an advisory committee comprised of some of the members from among the sukuk holders to be a party to the investment decisions. These are used for either new projects, development or financing a business on a partnership basis and can be traded. Here the procedure followed is the establishment of a Musharika agreement between the business (corporate) and the SPV for a fixed period and on an agreed profit sharing ratio; the corporate manages the business as an agent for the SPV for a fee. The corporate provides an underlying physical asset and the Sukuk holders (investors) provide the cash through the SPV. There is a periodic purchased transfer of the Musharika shares in the SPV by the corporate from the investors till there are no Musharika shares left in the SPV at the end of the fixed period. 
Sukuk al Ijara is structured to represent the ownership of equal shares in real estate, or other tangible assets or their usufruct. Here the sukuk holders have the right to own the real estate or assets, receive rental income on them and these are tradable. The sukuk holders as owners bear all the maintenance charges and any damage to the real estate or assets. Among the procedures to be met, it is essential that the assets being leased and the rental streams on them are clearly identified and in the knowledge of the parties to the contract. The maintenance charges herein are to the account of the Lessee and those relating to the assets are to the account of the owner. A SPV is characteristically utilised to hold the assets. This sukuk too is tradable. The procedure for the structure is to have the Obligor sell certain assets to an SPV at a mutually agreed purchase price; the SPV raises funding by a Sukuk issue to meet the cost of the purchase price which is passed to the obligor; following on is a lease back agreement between the SPV and obligor and the rental revenues are passed to the sukuk holders. At maturity the SPV would sell the assets back to the obligor at an agreed value. 
Sukuk al Murabaha are structured to purchase commodity and the return is based on maturity (sale) of the commodity contract, but due to its debt based nature these sukuk are not tradable. Sukuk al Salam reflect the ability to advance funds for delivery at a future date and is based on the Salam principle. One main consideration in this contract requires that the purchased goods are not re-sold before actual possession at maturity and therefore being debt based cannot be traded. Sukuk al Istisna These certificates carry equal value and are issued to facilitate mobilising funds to produce items to be owned by the certificate holders. The issuer is usually the manufacturer/supplier/seller. The investors are the buyers of the items being produced. The sukuk holders own the produced items and are entitled to the sale price of the certificates or the proceeds of the sale of the product sold on the basis of a parallel Istisna. Sukuk al Istisna are primarily used for financing large infrastructure projects. The advantage of Istisna for financial intermediation is based on the ability for the contractor in Istisna to enter into a parallel Istisna contract with a subcontractor. This enables a financial institution to undertake the construction/production for a deferred price, and sub contract the fabrication to a specialist firm. As the sale of these debt certificates to a third party at any price other than their face value is not permitted under Shariah these cannot be traded in the secondary market. 
Hybrid Sukuk Since issuing Sukuk and trading them are important means of investment and investors demands hybrid sukuks or mixed asset Sukuks developed in the market. Here the underlying pool of assets can comprise some of the attributes of sukuks structured as Istisna, Murabaha, Ijara and others. Portfolios of assets comprising of different classes permits diversification of funds and thereby the risk profile. Due to the fact that Murabaha and Istisna contracts are not tradable on secondary markets as securitised products a minimum of 51 percent of the pool in a hybrid Sukuk must comprise of tradable sukuks. As the receivables from Murabaha and Istisna sukuks form part of the asset pool, the return on these can only be at a pre-determined fixed rate of return. 
Recent Issues There was a major issue that arose when a senior and well respected Shariah Scholar stated that in his view a large number of Sukuk available in the market were not entirely Shariah compliant. The debate raged and concerns were heard globally. However, the matter was discussed at many forums and also at the regulatory levels. The concerns raised were the purchase undertakings and the sale at maturity at face value. After numerous meetings of the AAOIFI Shariah committee an agreement was reached to establish more stringent standards for way forward. Below in essence, is the statement released by AAOIFI on the matter.
Introduction In view of the expanding application of Sukuk worldwide, the pubic interest in them, and the observations and questions raised about them, the Shariah Committee of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) studied the subject of Sukuk issuance in three sessions; firstly, at Madinah on 12 Jumada al-Akhirah 1428 AH (27 June, 2007), secondly, at Makkah on 26 Shaban 1428 AH (8 September, 2007), and thirdly in the Kingdom of Bahrain on 7 and 8 Safar 1429AH (13 and 14 February, 2008). Following the meeting of the working group it appointed on 6 Muharram 1429AH (15 January, 2007) at Bahrain which was attended by a significant number of representatives from various Islamic banks and financial institutions, the working group presented its report to the Shariah Committee. Following its consideration of what took place at these meetings, and of the papers and studies presented there, the Shariah Committee, while emphasizing all that has been stated concerning Sukuk in the Shariah Standards, advises Islamic financial institutions and Shariah supervisory boards to adhere to what follows when issuing Sukuk. First: Tradable Sukuk must represent ownership for Sukuk holders, with all of the rights and obligations that accompany ownership, in real assets, whether tangible or usufructs or services, that may be possessed and disposed of legally and in accordance with the Shariah. All of this should be in accordance with Shariah Standard (17) on the subject of Investment Sukuk, articles (2) and (2/1/5). The manager of a Sukuk issuance must establish the transfer of ownership of such assets in its books, and must not retain them as its own assets.
Second: It is not permissible for tradable Sukuk to represent either revenue streams or debt except in the case of a trading or financial entity that is selling all of its assets, or a portfolio which includes a standing financial obligation such that debt was incurred indirectly, incidental to a physical asset or a usufruct in accordance with the guidelines mentioned in Shariah Standard (21) on the subject of Financial Paper.
Third: It is not permissible for the manager of Sukuk, regardless of whether the manager acts as a mudarib (investment manager), or a sharik (partner), or a wakil (an investment agent), to undertake to offer loans to Sukuk holders when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve for the purpose of covering such shortfalls to the extent possible, on condition that the same be mentioned in the prospectus. There is no impediment to the distribution of expected earnings on account, in accordance with Shariah Standard (13) on the subject of Mudaraba, article (8/8), or to obtaining project financing on the account of the Sukuk holders.
Fourth: It is not permissible for the mudarib (investment manager), sharik (partner), or wakil (investment agent) to agree to purchase assets from Sukuk holders or from whoever represents them for a nominal value of those assets at the time the Sukuk are extinguished at the end of their tenors. It is permissible, however, to agree to purchase the assets for their net value, or market value, or fair market value, or for a price agreed to at the time of their purchase, in accordance with Shariah Standard (12) on the subject of Partnership and modern partnerships, Article (2/6/1/3) and with Shariah Standard (5) on the subject of Guarantees, Articles (1/2/2) and (2/2/2). It should be understood that the Sukuk manager acts as guarantor of [investor] capital at its nominal value in cases of negligence or mala fides or non-compliance with stated conditions, regardless of whether the manager is a sharik (partner), wakil (agent), or mudarib (investment manager). If, however, the assets of a Sukuk al-Musharaka, or Mudarabah, or Wakalah, are of lesser value than assets leased by means of a lease ending in possession (ijarah muntahiya bi't-tamlik), then it will be permissible for the Sukuk manager to agree to purchase those assets at the time the Sukuk are extinguished for the remaining lease payments on the assets, by considering these payments to be the net value of those assets.
Fifth: It is permissible for the lessee in a Sukuk al-Ijarah to agree to purchase the leased assets when the Sukuk are extinguished for their nominal value, as long as the lessee is not also an investment partner mudarib, or agent.
Sixth: Shariah supervisory boards must not consider their responsibility to be over when they issue a fatwa on the structure of Sukuk. Rather, they must review all contracts and documentation related to the actual transaction, and then oversee the ways that these are implemented in order to be certain that the operation complies at every stage with Shariah guidelines and requirements as specified in the Shariah Standards, and that the investment of Sukuk proceeds and what those proceeds are converted to takes place in accordance with one [or another] of the approved Shariah methods of investment as stated in Shariah Standard (17) on the subject of Investment Sukuk, Article (5/1/8/5). In addition to all this, the Shariah Committee advises Islamic Financial Institutions to decrease their exposure to debt-related operations and to increase their operations based on true partnerships and the sharing of risk and reward and thereby achieve the higher purposes of the Shariah. Conclusion
The sukuk market is maturing and there is growing development due to considerable interest from issuers and investors from all parts of the Muslim and non-Muslim world. Sukuk have established themselves as an alternative means for raising funding for medium term tenor transactions from the medium and long-term savings and investments pools comprising a wide and large investor base. Many different sukuk structures have emerged over the short period of their existence though the majority sukuk issuance so far has been Sukuk al Ijara, as their basis is on the undivided pro-rata ownership of the underlying leased asset, is tradable at par, premium or discount. It is the aspect of tradability of the sukuk in the secondary market that has made them more acceptable and popular. However, that is not to say that other types of sukuk are not popular, it is just that they can be used for specific purposes and in the cases of non tradability the attraction is less. For a while due to concerns of issues mentioned above there was a lull in Sukuk issuance to ascertain the direction that would be taken by the Shariah Scholars. The statement from AAOIFI has cleared the path and those that have been issued in the past will progress to maturity but new issuances will have to be based on the new standards. We can expect a huge surge in new issuances as well as innovative structures.
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