Since the onset of the recent global ?nancial recession, headlines relating to sukuk defaults by Kuwaiti ?rm The Investment Dar Company, the ?nancial difficulties surrounding Saudi conglomerates the Saad and Algosaibi Groups, and previous uncertainty around the repayment of sukuk by Dubai property developer Nakheel have led to uncertainty among investors and analysts alike. Especially in relation to the nature of a sukuk investment and, in particular, whether it is a secured investment, therefore raising questions as to what the ultimate recourse of investors would be in a default scenario.
The Treatment of Sukuk in a Default Scenario
In accordance with the Shariah, money itself has no intrinsic value and is merely a means to facilitate the exchange of assets. Since money itself has no value, there should be no charge for its use. Interest (riba) is therefore prohibited (haram). At the heart of sukuk transactions are therefore investments in assets which will generate a return, which is permitted (halal).
The presence of these assets has often led investors to believe that an investment in sukuk is a more 'secure' investment than an investment in conventional bonds. The reason for this is that many investors have believed that they will have either direct recourse or some form of security over the assets in the event of a default.
In this article, the authors intend to explore the different types of sukuk transactions which have typically been structured and to explain that the nature of an investor's recourse in a sukuk transaction will be a function of the way in which that speci?c sukuk transaction has been structured and the commercial terms of such transaction.
Asset-Based Sukuk Structures
To date, the issuers of sukuk and the ?nancial experts who assist in selling such securities have tried to meet the requirements of Shariah-compliant investors seek a similar ?xed income risk pro?le to a conventional bond based on the ?nancial performance of a corporate entity with which they are familiar and in which they wish to invest.
In the majority of unsecured sukuk transactions, although the investment is prima facie, also an indirect investment in assets, ultimately, the investors have no direct recourse to the assets themselves or any recourse is contractually restricted to selling the asset back to the obligor.
Therefore, the repayment of the investment is ultimately dependent on the exercise of a purchase undertaking by the obligor of the assets at maturity or upon the occurrence of a default. Thus, as with a conventional bond, the investors take credit risk on the obligor who has granted the purchase undertaking and will effectively rank as an unsecured creditor of such obligor. While typically, there is a physical asset in the structure, it is present primarily to generate periodic pro?t payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets or security upon a default.
As a result, offering documents prepared for most sukuk transactions have very little disclosure (if any) in respect of the physical asset. Instead, disclosure focuses principally on the balance sheet, business and risks of the obligor.
Secured Asset-Based Sukuk Structures
As described above, the majority of asset-based sukuk structures will be ultimately dependent upon the credit of the underlying obligor. In order to provide greater assurance to investors, some underlying obligors have previously also provided security to investors in order to 'secure' the sukuk. The previous sukuk transactions by Nakheel are examples of such structures.
It is important to understand the way in which security has generally been granted by obligors in asset-based sukuk transactions. The obligor is typically not the issuer of the sukuk and therefore, no security is granted directly to investors in order to secure the obligations of the issuer under the certi?cates themselves.
The obligations of the obligor will be in favour of the issuer of the certi?cates, who will hold such obligations for the bene?t of the investors. The security is generally granted by the obligor in order to secure these obligations to the issuer under the transaction documents. To the extent that an obligor defaults under any of its payment obligations to the issuer, such as pursuant to the purchase undertaking, the security can generally be enforced against the obligor by or on behalf of the issuer to whom the obligation is owed. Any subsequent recoveries from the enforcement of the security will form part of the funds available to the issuer to repay the investors.
In addition, any security granted by an obligor under an asset-based sukuk transaction is not necessarily related to the assets underpinning the Shariah structure in the relevant transaction; in many instances, the assets which form the basis of the security may be different assets to those which form part of the sukuk assets. Following a default by the obligor of its obligations under the transaction documents, the security may therefore be enforceable, but the investors may still not have any recourse to the sukuk assets themselves.
Taking True Asset Risk – Asset-Backed Sukuk Structures
There are, however, Shariah-compliant structures in existence for an investor who wishes to have exposure to asset risk and to have direct recourse to those assets as opposed to exposure to the credit risk of the particular obligor.
One conventional product that has attracted a great deal of attention over the last few years for its potential compatibility with Shariah principles has been asset-backed securitisation. One of the cornerstones of the majority of conventional asset-backed securitisation transactions is a true-sale of assets. In order for the instruments ultimately evidencing an investment in an asset-backed transaction to achieve the appropriate credit rating, the transfer or sale of assets needs to be a sale which would survive the insolvency of the original owner (such as the assets are isolated from the bankrupt estate of the originator). This is only achievable to the extent that the transfer represents a true transfer of ownership which is legally perfected. Many market commentators describe this type of structure as the next stage of evolution for Islamic ?nancial institutions, allowing ?nancial institutions to move assets off their balance sheets as their asset books continue to grow relative to their capital base.
The Sun Finance securitisation, a securitisation of proceeds derived from the sale of plots of land by Sorouh Real Estate on the Shams and Saraya Master developments in Abu Dhabi, was one of the few Shariah-compliant sukuk to combine Shariah principles with asset-backed securitisation. In this transaction, the desired credit rating on the instruments was achieved by ensuring that the credit analysis was dependent upon the performance of the pool of assets and not the corporate credit of the originator.
In order to achieve the true transfer of ownership, the relevant plots of land which were the subject of the securitisation were sold by the originator to a newly established limited liability company in Abu Dhabi and the sale of such land was legally perfected by registering the land in the name of that company at the Abu Dhabi Lands department. By perfecting the sale and structuring the transaction, such that investors had exposure to the direct sale proceeds of the land, the rating of the sukuk was based on asset performance rather than the originator's credit-worthiness.
The result is that the investors in the sukuk certi?cates have sole recourse to the securitised assets for the repayment of their investment. To the extent that the assets do not perform and generate insuf?cient pro?t, the investors do not receive the expected pro?t on their sukuk certi?cates. In this way, the transaction represents a fully asset-backed, Shariah-compliant, non-recourse ?nancing.
Since the ultimate repayment of the certi?cates in an asset-backed sukuk transaction is dependent upon the performance of the assets and not any payment obligations of the underlying originator, it follows that no security will be granted by the underlying originator, but the investors will have full recourse to the assets.
We have discussed two different types of sukuk structures, one which is asset-based and where investors rely on the ultimate credit of the underlying obligor and one which is asset-backed and where investors have full recourse only to the underlying assets and their performance over time. We have also discussed the fact that some asset-based structures have been secured but that the security is granted by the obligor in order to secure its obligations under the transaction documents as opposed to security granted with respect to the payment obligations under the sukuk themselves.
Despite asset-backed transactions such as the Sun Finance transaction having paved the way for other similar structures which remove the credit risk of the underlying originator, especially in the recent climate of increasing corporate defaults, investors appear less willing to take true asset risk in such structures and appear to remain desirous of investing in the corporate credit of an underlying obligor with which they are familiar.
But equally, investors have also begun to demonstrate that they may be less willing to invest on the same unsecured basis or at least on the same commercial terms as they have previously done where they would be exposed purely to the credit risk of a particular underlying obligor. The answer for some investors may therefore be the sort of secured asset-based structures discussed.
However, one additional alternative for such investors may be a hybrid structure which lies somewhere between the current unsecured asset-based sukuk structures and true asset-backed transactions. Such structures would provide investors with recourse to both the corporate credit of the obligor which they desire as well as to the assets themselves to the extent that the obligor fails to ful?l its obligations, making for a much safer investment as a result of the dual recourse.
There is certainly precedent for similar transactions in the conventional 'covered bond' industry. In covered bond transactions, investors have initial recourse to the corporate credit of the issuer of the covered bonds. However, to the extent that the issuer fails to ful?l its obligations, the investor will also have recourse to an earmarked pool of assets.
What is also interesting is that in such structures, additional security from the obligor would also be unnecessary as, following a default by the obligor, investors would have recourse to the assets themselves which they would be able to realise in much the same way as any security to secure the obligations of such obligor would have been realised in a secured asset-based structure.
In conclusion, therefore, we have seen that whether or not sukuk represents a secured investment and the ultimate recourse of investors will be dependent upon the way in which a particular transaction has been structured. An unsecured asset-based sukuk represents an unsecured exposure to the corporate credit of the underlying obligor while an asset-backed sukuk transaction provides no recourse against the underlying originator but provides full recourse against the assets themselves. There are also secured asset-based sukuk structures where the sukuk themselves are not secured but rather, security is granted by the obligor in relation to its payment obligations under the transaction.
A further alternative structure may be the development of a dual recourse structure, whereby investors would have recourse to both the corporate credit of the obligor as well as to the relevant assets themselves to the extent that the obligor has defaulted.
The distinctions above have not always been evident to many investors who may have thought that they had made a more secure investment than they had in reality. Nevertheless, the increased focus on sukuk defaults in recent times has certainly meant that many investors have had to better understand the investments which they have previously made and to consider more earnestly any future investments which they may potentially make. If investors did not always take note of the old adage in the past, they will almost certainly do so going forward: "Caveat emptor!" ("Buyer beware!").
This article first appeared in Islamic Finance News (Pg 12, Vol 7, Issue 29, 21 July 2010). For more details, please visit www.IslamicFinanceNews.com